0:04 This time around we'll be looking at how
0:10 do we manage interest rate risk exposure
0:13 using this new strategy and what is that strategy
0:14 strategy
0:16 this time around I'm talking about
0:19 options on interest rate futures
0:22 remember that interest rate futures is
0:25 one of the strategies that you can use
0:27 just the same we had FRA the for rate
0:30 agreement and later We looked at options
0:35 on FRA which is also referred to as IRG
0:37 interest guarantee. This time around I'm
0:40 looking at options on interest rate
0:44 futures. So it's similar concept with FR
0:48 but remember FRA and futures are totally
0:51 different things. Yeah. So in as much as
0:54 it's similar is similar in a way that
0:56 the options on interest rate futures is
0:59 the same as interest rate futures. The
1:01 only difference is that if you do
1:03 interest rate features, you have an
1:05 obligation you must perform. But when
1:08 you put an options on top of it, it
1:10 gives you flexibility
1:13 on that feature, which means you still
1:16 have the features. However, you will
1:20 decide whether you want to use it or not
1:23 and you have to pay premium.
1:25 So few things I'll just mention to you
1:27 is first of all you need to know that
1:30 you are always going to be buying always
1:31 buying the options. Remember what you
1:33 are looking for is flexibility. So you
1:35 need to buy the flexibility. So you are
1:39 always buying and what are you buying?
1:41 You might be buying put or you might be
1:44 buying call. How do you know whether you
1:46 should be buying put or you should be
1:48 buying call? I'm I'm going to explain
1:49 later because it's totally different
1:52 from the concept of FRA. This time
1:53 around you'll be using the concept of
1:55 features. The same concept of features
1:57 to decide whether it's going to be a put
1:59 or it's going to be a call that you
2:03 need. Very important to know that. Yeah.
2:09 So beyond that you need to also know
2:12 that the outcome is similar to the
2:14 future. So which means the three things
2:16 we always talk about will still be
2:19 relevant here. your initial if you
2:21 decide to exercise remember that is if
2:24 you decide to exercise so which means
2:26 you're going to have the initial futures
2:28 that you're buying you're going to close
2:32 the futures by doing the opposite yeah
2:37 this means you are exercising the option
2:38 that's when you decide exercise then you
2:47 so once you decide to exercise
2:49 definitely those three things will now
2:51 come into play. If you don't exercise
2:52 then you're only left with the rate
2:55 transaction then definitely you're going
2:57 to have premium that will be involved
2:59 because before you can say to yourself
3:00 that you have an option you must have
3:04 paid a premium. So let me use this
3:07 question to explain to you what the
3:10 options means when we're talking of
3:13 interest rate futures. Yeah, remember
3:15 you need to know whether you need a put
3:16 or a call. That's the first thing you
3:20 have to decide. Do we need a put or do
3:25 we need a call? So, put or call.
3:27 And I'm going to explain it the same way
3:29 I explain interest rate features to you.
3:30 This time around, all you need to be
3:33 asking yourself is what you are trying
3:36 to do. How do you say it? If you need to
3:39 say it in terms of bonds. So which means
3:43 if you want to borrow what does it mean?
3:46 If your exposure is borrowing
3:48 which means you are planning to borrow
3:51 in the future. Then in terms of bond it
3:59 So which means your future transaction
4:02 is to sell bond. So if you want to put
4:04 an option on top of that, what you are
4:14 to sell a bond. That is what it means in English.
4:19 So this is borrowing. That is what this
4:21 means. So which means if it is
4:23 borrowing, you are trying to hedge.
4:24 Remember if you're using features you
4:27 must always initiate your future
4:32 transaction in the same direction as the
4:35 uh the real transaction. So your future
4:37 transaction will be your real
4:39 transaction. So which means your future
4:42 transaction is to sell a bond which is
4:45 the same thing as your real transaction.
4:47 And if you want an option on it then buy
4:49 an option on it. And what is an option
4:51 to sell a bond? An option to sell a bond
4:55 is a put option.
4:58 So which means for borrowing, if you
5:04 what you must do is to buy. Remember,
5:06 you will always buy an option because
5:07 you are the one that want the
5:10 flexibility. So you buy a put. That's
5:12 what makes the difference. That makes it
5:17 boring. Buy a put on interest rate future.
5:20 future.
5:22 So which means remember when you
5:24 exercise your profit or gain will be
5:26 determined from how you open and close
5:30 the interest rate features then overall
5:32 impact will now be when you bring that
5:35 into your outcome of your rate
5:40 transaction. But if it's to be a deposit
5:42 or investment,
5:44 if you look at it in forms of bond, what
5:47 you are trying to do is to buy a bond.
5:49 Because when you buy a bond that you
5:51 invest, that is synonymous to buying a
5:53 bond. You are the one that is giving out
5:56 your money for returns and redemption in
5:59 the future. So buy a bond and if you
6:02 want to add an option to it then it
6:06 means you are buying
6:09 an option
6:13 to buy a bond
6:16 that's what it means
6:18 and in that case what you are trying to
6:22 buy the option to buy is a call. So
6:24 which means if it's a deposit you are
6:27 using a call. So that is how you will
6:30 know when to use call or to use put and
6:32 if you notice is directly opposite to
6:36 FRA because FRA when you are buying it's
6:38 a borrowing
6:39 because you are not looking at the
6:41 principle you are just looking at the
6:44 rate only so who is paying rate so
6:46 borrowing means you are paying interest
6:49 so paying means you're buying something
6:50 that's how it works in that so you need
6:52 to be able to understand how these
6:56 strategies differ and how you solve it
6:59 when you see them in question.
7:00 Yeah, still looking at this question.
7:02 Maybe I should bring this question a bit
7:05 down so we can start looking at it in
7:14 Yeah, let me put it here. So, we have
7:15 this question. Take few seconds and look
7:18 at it. Yeah. So, because this is talking
7:21 about borrowing. Yeah. So, should
7:23 calculate the result of that options
7:26 edge. The plan is to borrow 10 million
7:28 in a month's time for a tenor of 6
7:30 months. So is a borrowing. So number
7:33 one, we know that what we need is a put option.
7:35 option.
7:38 Now please pay attention to this. The
7:39 next thing you ask yourself is what's
7:48 and pay attention to this please. I
7:49 don't want to miss this. I'm going to
7:51 use this question to explain this. How
7:53 do you know the strike price that you
7:55 need? See, you have four different types
7:57 of strike prices available. What you
8:00 must always understand is if you are
8:03 selling, you want the highest
8:05 inflow for sure if you are going to
8:06 receive money. If you think you're going
8:09 to receive money, but remember
8:11 that the option we are talking about
8:14 here is a put option in this regard. And
8:16 a put option in this regard means that
8:19 we are selling a bond. But we are not
8:21 talking about the price of a bond here.
8:24 Yeah, pay attention like I said so you
8:27 don't get confused with the word sell.
8:30 We are selling a bond. Yes, but in the
8:32 risk that we are trying to manage is
8:37 interest rate. So at a rate
8:40 which is a paying rate this is an
8:42 expense to us.
8:46 So which means unlike when we just look
8:49 at put and say oh is inflow then want to
8:51 maximize it. It's different. A put here
8:54 is actually a problem for us. Is a is an
8:56 expense for us, a liability for us
8:59 because we need to pay in interest we
9:00 are talking about. In that case, we want
9:03 to go for the lowest interest rate. So
9:07 lowest net interest rate.
9:09 That's what we want to go for. And you
9:11 understand that for deposit it will be
9:14 the opposite. You want to go for the
9:17 highest net interest rate. Yeah. And how
9:20 do you go about this
9:21 exercise price? The first you need to do
9:24 is to take it to interest rate quickly
9:25 so that you know what it means. And this
9:36 This one will be five. And this one will
9:39 be 4.75.
9:41 So you already know what it means for
9:43 that rate. But beyond this rates for
9:46 this excise prices they give us premium
9:48 that are quoted in percentage. This
9:50 is.18% this one is not available so
9:52 we're not going to deal with it. So
9:54 which means
9:56 we are going to pay this for put pay
9:57 this for put pay this for put in
9:59 addition to all the strike price. So
10:02 which means the net interest rate for
10:04 strike price of 9475
10:06 is actually
10:21 You see if it was call it to be
10:26 different because for call all this
10:28 interest that we have labelled here will
10:30 be inflow and this will be expense. So
10:33 we'll just be deducting that will form
10:35 the net for call. So if we're talking
10:37 about core for instance
10:39 it will be 5.25
10:42 minus 1.02 and you have add something
10:47 like 4.23 here 4.35 4.54
10:49 4.54
10:53 and for so for call you want the highest
10:55 because buying bonds means you are
10:58 expecting to receive interest. So for
11:00 call you would have gone for the strike
11:03 price at this level but for put we want
11:05 the lowest and this is the lowest. So
11:07 which means the strike price I will be
11:15 So we already know that that will be the
11:19 strike price of our option. Once you
11:22 sort that one out then you ask the next
11:25 question. How many contracts? Because
11:28 remember before I always warn you before
11:30 you compute your premium on option you
11:32 need to know how many contract you need
11:36 and you must always compute your premium
11:38 on the number of contract because
11:41 sometimes you might have some amount
11:43 that you cannot edge because of the
11:46 restrictions coming from your
11:49 quantity or size of your contract. So
11:51 these questions already told us that the
11:53 total sum we need is 10 million and each
11:56 contract is 500,000.
11:58 But remember as I always told you during
12:00 the interest rate future that we looked
12:03 at interest rate is driven by period in
12:06 remember interest itself is equals to
12:08 the rate
12:11 time principle time.
12:14 time.
12:16 So when you are dealing with interest
12:19 rate risk you must not forget this tenor
12:20 and that is why to know the number of
12:22 contracts we are not just going to say
12:30 The popular mistake student makes just
12:33 the transaction size divided by the
12:36 contract size. No this will not be
12:39 correct. This one we need to aortion
12:40 with time. So we need to first of all
12:43 divide it by the total tenure of the
12:45 contract this time around which is three.
12:47 three.
12:50 Yeah it gave us. Then you multiply by the
12:52 the
12:54 tenor of the transaction which is six in
12:57 this regard. And in that case the
13:00 transaction size is 10 million contract
13:02 size is.5 million
13:06 and time 2 6 / 3 and that will give us
13:12 So we know the number of contract that
13:14 we need. Then our life is super easy
13:16 because now we can now go to step four
13:23 There is no option contract without
13:25 premium. So you must calculate premium.
13:27 Premium that is applicable in this
13:31 question is 0.18%.
13:35 So you need to do premium per contract.
13:37 always start like that so that you know
13:39 that once you have this is just to
13:41 multiply by the number of contract you
13:43 bought. So stay on the premium per
13:45 contract and your premium will always be
13:47 your rate. Remember just like it's
13:49 interest expense we are calculating
13:51 that's the premium rate times principal time
13:57 it's just simple you don't need to
14:00 memorize it your rate is 0.18% you know
14:03 rate is always annual yeah the principle
14:06 of the contract is 500 so every contract
14:09 has a principle of 500,000
14:12 so put that here
14:14 and this contract is for 3 months they
14:16 told us so we need to annualize ize that
14:21 in 3 months which makes it 3 / 12. And
14:24 if you look into that quickly on the
14:30 calculator, this will give us $2 to5.
14:32 But we know definitely that we have 40
14:35 contract. Yeah. So for if that's for one
14:41 contract, 40 contract will be 40 * 2 to5
14:44 which is equals to $9,000.
14:48 Simple, easy. That's the premium.
14:50 Now, once we So, once we pay this
14:53 premium, the next thing is for us to now
14:56 wait until the transaction date, which
14:58 will be in a month's time
15:00 because that's when we know whether
15:02 we're going to exercise or will not
15:05 exercise. So, we need to check whether
15:08 the market has moved against us or in
15:10 our favor. And if you look at what
15:14 they've said about the market, they said
15:16 the future interest rate see interest
15:20 rate has risen to 7.5. So if we have an
15:24 option at a strike price of 94.75
15:26 which is invariably 5.25%.
15:28 5.25%.
15:30 So we have an option to actually pay
15:34 interest at 5.25 and market has gone to
15:36 7.5 then that option definitely is in
15:46 and like I said once we decide to
15:49 exercise then the future transaction
15:52 come in all together. So initiation begins
15:54 begins
16:05 actually a sell because we bought an
16:07 option to sell.
16:10 We bought a put. So that's how we
16:14 initiated the bond. So initation
16:23 at 94.75.
16:33 Then we need to close it because we're
16:38 exercising the option. So which means
16:41 we need we must have bought this bond
16:44 that means we have exercised because
16:48 remember the option that we buy yeah is
16:52 that we always buy the option to
16:55 sell a bond if it's a borrowing and that
16:57 is what we bought here put that's why we
17:00 said a put option so if we are going to
17:03 exercise this put option we will buy the
17:06 bond future So we exercise means that we
17:09 bought we decided to sorry we we decide
17:12 to sell the bond futures because what we
17:14 is a put option an option to sell rather
17:17 sorry right so it means we going to sell
17:21 that future so that's why we exercise
17:24 this means we've exercised so that's
17:26 what it means and if we have sold bond
17:29 future at that strike price then we need
17:33 to close it and what do we need to do we
17:36 will We're going to close it by buying
17:43 and the question told us that
17:46 on that date future price has moved to 93.
17:48 93.
17:52 So that'll be at 93.
17:56 And if you try to get the difference
17:59 between that that
18:03 fact before I show you the difference,
18:06 let me just write it that is 1.75%.
18:10 For sure. But just to explain a bit more
18:13 for you. Remember selling bond future
18:15 means borrowing. It means you are paying
18:18 interest at So
18:33 However, when you buy a bond, buying a
18:35 bond is like an investment. So, which
18:45 at 7%. And you can see why this is
18:48 actually a gain.
19:24 will be equals to 1.75%. Remember this
19:27 is annual rate. Always remember please
19:30 very important not to get carried away
19:32 with this rate. It might mean a lot
19:34 between you passing and not passing. So
19:41 it's 1.75%
19:43 everything you must do it per contract
19:46 if not you might run into problem with
19:47 questions that you are not able to edge
19:50 fully I'll keep reminding you and the
19:52 tenor is always 3 months for the
19:54 contract so you analyze it and if you
19:56 press your calculator for this you see
19:59 that for each contract you have a gain
20:02 of $2,187.5 $5.
20:04 $5.
20:06 And if that is the case for 40
20:08 contracts, which means you're going to
20:10 multiply by 40,
20:12 that will give 87,500
20:15 87,500
20:20 total profit. So this is your total
20:24 profit on the contract.
20:26 So which means out of three things
20:29 you've initiated and you've closed
20:32 future two things done and we have this
20:34 figure from those two things then we
20:37 need to finalize it by doing the third
20:40 one which is the real transaction and
20:43 the real transaction will happen at the
20:45 spot market rate which they've already
20:51 told us is at um I think 7% 7.5%.
20:54 Yeah. So which means the 10 million will
20:59 actually be at 7.5% in reality.
21:02 So that's 7.5% as 10 million will
21:06 happen. But remember that
21:08 the rate transaction has a tenor of 6 months.
21:10 months.
21:14 Yeah. Convert it to years. Then this
21:18 will be 7.5% of 5 million which is
21:27 So which means normally this transaction
21:29 will require us to pay this but good
21:31 enough we've done some edging and we
21:33 have some savings from here. So which
21:37 means the net in real time will be we
21:39 need to reduce our interest by that 87,500
21:41 87,500
21:46 and eventually the net cost
21:48 will be the difference between the two
21:59 and that is how interest rate
22:01 features will work when you have options
22:04 on top of it. If there was no options on
22:06 top of it,
22:08 then you don't have the flexibility. But
22:10 it doesn't make any difference in your
22:12 calculation. The only difference is just
22:15 that there's now 9,000 with options.
22:18 That is additional cost to you. So which
22:21 means even for you to finish final final
22:24 you need to deduct your premium.
22:26 premium.
22:28 So which means you add it is an expense.
22:31 Plus is an expense. So they're both
22:36 expense and if you add that together
22:40 you have the total
22:44 liability expense for you is 0 0 this is
22:48 five and um
22:55 six trying to do it on top of my head 9
22:57 and three so
23:03 that's 396 6 no 296 sorry 296
23:11 that be 296 in total so you consider all
23:14 the options together yeah
23:16 add them together remember this negative
23:18 is showing that is an expense but to
23:21 avoid confusion let me just take all the
23:23 negative so that we know that we're
23:26 talking about them as cost so they are
23:28 both cost since they are both cost It's
23:31 easy. So
23:33 premium is a cost is a net cost and
23:36 that's that's a total 29659. So that's
23:38 the real situation
23:41 on the options. Yeah, I'm saying it
23:44 again. The options on interest rate
23:46 features is not different from interest
23:48 rate features. The only thing that just
23:51 slightly different is when you don't
23:54 plan to
23:56 exercise, there is no interest rate
23:58 features. But once you exercise is the
24:01 same thing just plus premium that you
24:03 have to add to it. But if you don't
24:06 exercise only premium and the rate
24:08 transaction is what you have left.
24:10 Please take notes and let me know if you
