An interest rate swap is a contractual agreement entered into between two counterparties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. Usually under an IRS one party pays fixed interest rate on the notional amount at pre-determined intervals while the other party pays floating interest rate e.g. 3 month KIBOR. IRS is undertaken to alter the interest rate risk profiles of the parties. It involves numerous variations of changing the profile from fixed-to-floating, floating-to-fixed or floating-to-floating etc.
It is an agreement to fix a future interest rate today for a single period. An FRA is the same as IRS but for a single period and is primarily used to hedge the interest rate risk against a possible rise in the rate for one period e.g. the customer can lock in the 6 month rate after 3 months ( 3 x 9 FRA in market terms). The customer may require to do a 3X9 FRA to hedge a 6month loan which they plan to obtain after three months.
In a CCS transaction one party makes periodic interest payments in one currency (fixed or floating rate) and the other party makes periodic interest payments in another currency(fixed or floating rate). A CCS has two principal amounts and two sets of periodic interest payments, one for each currency.
There are three steps in a CCS:
CCS can be used if the currency of borrowing is different than the home currency and the customer wishes to hedge the currency risk and / or interest rate risk. There may be numerous variations of CCS transactions e.g. from fixed-to-floating, floating-to-fixed or floating-to-floating etc.
An option is a contract offering the right, but not the obligation, to buy or sell an asset at a predetermined (strike) price. Following are option features.
Option buyer - Holding right
Option seller or writer - Granting right
To obtain the right, option buyer pays a premium which is also referred to as option price or premium. This money is paid at the start.
For FX option, underlying asset is foreign exchange
It is important to be specific in defining the contract i.e. Currency pair, Tenor (Expiry date), Strike price, Call/put, Exercise style
Call option - Right to buy
Put option - Right to sell
Call on one currency is always a put on the counter currency
Example: USD put/ JPY call or USD put is JPY call
a. European style- At expiry
b. American style- Any time till expiry date
Various structures with combinations of calls and puts can be formed to vary the pay offs according to the clients’ need.
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