Interest Rate Derivatives interest, because, mistakes, correct, decrease

ba736

Hi all, I dont know how you all feel, but these interest rate derivatives can be pretty confusing and hard to keep straight. I have some questions and some outline which I will put down below. Please add or correct any mistakes you feel i have made.


Long FRA - allows you to "borrow" at rate of FRA. If rates go up, you win and can borrow at a lower rate than market rate. Used to protect from rising rates

Short FRA - allows you to "lend" at rate of FRA. If rates decrease, you win because you can lend at rates higher than market. Used to protect from decreasing rates.


(Instrument, Use for Long)
Payer Swaption, used for hedging floating rate liability

Receiver Swaption - used for hedging floating rate asset

Cap, used to protect floating liability from rising rates

Floor, used to protect floating asset from decreasing rates

Collar, used to protect floating liability from rising rates and funded partly by selling the floor

Reverse collar, used to protect floating asset from decreasing rates, funded partly by selling the cap

I have trouble with the use of these for a short side, so if anyone could fill me in i would appreciate it. For example, is a short side on a payer swaption trayinig to get exposure to floating rate? what is the purpose of selling this swaption? etc etc.

I will try to continue adding, but i thought id get it started and hopefully we can get a good list here.

smuggycfa

Ill take a shot at the short payer swaption:

This would also be a receiver swaption.

A payer swaption allows you to pay fix receive float, a receiver swaption allows you to pay float receive fixed.

A firm may do this if they are already receiving a floating rate through a lending program and would like to convert it to fixed; much in the same way that a firm who borrows float enters a plain vanilla in order to pay fixed.

sameeragarwal

good call...what an idiot *shakes head in shame*

So then a short payer swaption is obligating you to lend at a fixed rate and receive a floating rate should the counter party choose to exercise, which they would if rates went up.

A long receiver swaption on the other hand gives you the option to receive fixed and pay floating, which you would exercise if rates went down.

My mistake was that both are on the same side of the market, that is someone believing that rates will go down may take either position, but it was like saying a covered call is the same thing as buying a put.

bolligerallstar

So really, the short side of all of these is to make some income, and if rates move against you then you end up losing, while the long sides use it to speculate or to hedge assets and liabilitites...

ayodayo

nielsendc Wrote:
-------------------------------------------------------
> good call...what an idiot *shakes head in shame*
>
> So then a short payer swaption is obligating you
> to lend at a fixed rate and receive a floating
> rate should the counter party choose to exercise,
> which they would if rates went up.
>
> A long receiver swaption on the other hand gives
> you the option to receive fixed and pay floating,
> which you would exercise if rates went down.
>
> My mistake was that both are on the same side of
> the market, that is someone believing that rates
> will go down may take either position, but it was
> like saying a covered call is the same thing as
> buying a put.

*this should have read: "So then a short payer swaption is obligating you
> to lend at a fixed rate and PAY a floating rate"

Kapie

Nielsen - are you in Washington DC?

I think you are correct - a collar, where you buy the cap and sell the floor, is used to hedge a floating liability from rising rates (if it exceeds the cap strike, you can exercise. Although your floating liability has gone up, you get payment from exercising the cap which offsets the higher liability). A reverse collar, where you sell the cap and buy the floor protects a floating asset (if rates move down, you exercise the floor, receiving payments that offset the decrease of floating rate payments). Each of these is fully or partially funded by selling the other side short (sell a floor and use proceeds to buy a cap and vise versa)


The way i keep these straight is thinking about it from trading options. A collar is used to protect a stock that has gains (sell calls ont eh stock, use proceeds to buy a protective put). This is the same idea as a reverse collar on the interest rates (sell the cap and buy the floor).

Newhuman

Good stuff...that definitely makes sense.

No I'm in Sacramento, CA...possibly the worst city in the country to currently own a home lol