F3 3.0 provides market correlation calibration for Libor and OIS rates.

Fincad, a Vancouver-based derivatives valuation and risk management software provider, has launched the latest version of its hybrid modeling and advanced curve building tool, F3.

Version 3.0 provides market correlation calibration for hybrid modeling and dual-curve stripping for the London Interbank Offered Rate (Libor) and overnight indexed swap (OIS) rates.

R E L A T E D A R T I C L E S Fincad Centralizes Data Management in New F3 Release, Adds

Negative Interest Rate Modeling Ability France's CNP Assurances Takes Numerix ESG Impending Disjunctures Spur New Tech Opportunities, C-Levels Say Fincad Enables Data, Model Sharing in F3 Analytics Platform

"The new F3 functionalities are beneficial to users looking to evaluate the impact of derivatives pricing with different discounting methodologies or for identifying optimal modeling choices," says Bob Park, Fincad president and CEO. "The cheapest-to-deliver curve functionality will construct a curve based on specific collateral agreements and numeraire currencies."

Bloomberg L.P. is a privately held financial software, data, and media company

headquartered in Midtown Manhattan, New York City. Bloomberg L.P. was

founded by Michael Bloomberg in 1981 with the help of Thomas

Secunda, Duncan MacMillan, Charles Zegar,[7] and a 30% ownership investment

by Merrill Lynch.[8] Bloomberg L.P. provides financial software tools such as an

analytics and equity trading platform, data services, and news to financial

companies and organizations through the Bloomberg Terminal (via its Bloomberg

Professional Service), its core revenue-generating product.[9] Bloomberg L.P. also

includes a wire service (Bloomberg News), a global television network

(Bloomberg Television), digital websites, a radio station (WBBR), subscription-

only newsletters, and three magazines: Bloomberg Businessweek, Bloomberg Markets, and Bloomberg Pursuit.[10] In 2014, Bloomberg L.P. launchedBloomberg

Politics, a multiplatform media property that will merge the company's political

news teams, and has recruited two veteran political journalists, Mark

Halperin and John Heilemann, to run it.[11]

In 1981, the former Wall Street investment bank Salomon Brothers was acquired,

and Michael Bloomberg, a general partner, was given a $10 million partnership

settlement.[12] Bloomberg, having designed in-house computerized financial

systems for Salomon, used his $10 million severance check to start Innovative

Market Systems (IMS).[13] Bloomberg developed and built his own computerized

system to provide real-time market data, financial calculations and other financial

analytics to Wall Street firms. In 1983, Merrill Lynch invested $30 million in IMS

to help finance the development of "the Bloomberg" terminal computer system

and by 1984 IMS was selling machines to all of Merrill Lynch's clients.[13]

In 1986, the company was renamed Bloomberg L.P., and 5,000 terminals had

been installed in subscribers' offices.[14] Within a few years, ancillary products

including Bloomberg Tradebook (a trading platform), the Bloomberg Messaging

Service, and the Bloomberg newswire were launched. Bloomberg launched its

news services division in 1990. Bloomberg.com was first established on

September 29, 1993 as a financial portal with information on markets, currency

conversion, news and events, and Bloomberg Terminal subscriptions.[15]

In late 1996, Bloomberg bought back one-third of Merrill Lynch's 30 percent stake

in the company for $200 million, increasing the company's market value to $2

billion. In 2008, facing losses during the financial crisis, Merrill Lynch agreed to

sell its remaining 20 percent stake in the company back to Bloomberg, Inc., the

trust that manages Michael Bloomberg's assets, for a reported $4.43 billion. After

the sale, Bloomberg L.P. was valued at approximately $22.5 billion.[16][17]

Bloomberg L.P. has remained a private company since its founding; the majority

of which is owned by Michael Bloomberg.[16] To run for the position of Mayor of

New York against Democrat Mark Green in 2001, Bloomberg gave up his

position of CEO and appointed Lex Fenwick as CEO in his stead.[18] Peter

Grauer is the chairman.[19] In 2008, Fenwick became the CEO of Bloomberg

Ventures, a new venture capitaldivision. Daniel Doctoroff, former deputy mayor in

the Bloomberg administration, now serves as president and CEO.[20] In

September 2014 it was announced that Michael Bloomberg would be taking the

reins of his eponymous market data company from Doctoroff, who was chief

executive of Bloomberg for the past six years after his term as deputy mayor.[21]

WHAT IT IS:

A swap is an agreement between two parties to exchange a series of future cash flows.

HOW IT WORKS (EXAMPLE):

Swaps are financial agreements to exchange cash flows. Swaps can be based on interest rates, stockindices, foreign currency exchange rates and even commodities prices.

Let's walk through an example of a plain vanilla swap, which is simply an interest rate swap in which one party pays a fixed interest rate and the other pays a floating interest rate.

The party paying the floating rate "leg" of the swap believes that interest rates will go down. If they do, the party's interest payments will go down as well.  

The party paying the fixed rate "leg" of the swap doesn't want to take the chance that rates will increase, so they lock in their interest payments with a fixed rate. 

Company XYZ issues $10 million in 15-year corporate bonds with a variable interest rate of LIBOR + 150 basis points. LIBOR is currently 3%, so Company XYZ pays bondholders 4.5%. 

After selling the bonds, an analyst at Company XYZ decides there's reason to believe LIBOR will increase in the near term. Company XYZ doesn't want to be exposed to an increase in LIBOR, so it enters into a swap agreement with Investor ABC.

Company XYZ agrees to pay Investor ABC 4.58% on $10,000,000 each year for 15 years. Investor ABC agrees to pay Company XYZ LIBOR + 1.5% on $10,000,000 per year for 15 years.  Note that the floating rate payments that XYZ receives from ABC will always match the payments they need to make to their bondholders.

Investor ABC thinks that interest rates are going to go down. He is willing to accept fixed rates from Company XYZ

To do this, Company XYZ structures a swap of the future interest payments with an investor willing to buy the stream of interest payments at this variable rate and pay a fixed amount for each period. At the time of the swap, the amount to be paid over the life of the debt is the same. 

The investor is betting that the variable interest rate will go down, lowering his or her interest cost, but the interest payments from Company XYZ will be the same, allowing a gain (i.e. arbitrage) on the difference.  

WHY IT MATTERS:

Interest rate swaps have been one of the most successful derivatives ever introduced. They are widely used by corporations, financial institutions and governments.

According to the Bank for International Settlements (BIS), the notional principal of over-the-counter derivatives market was an astounding $615 trillion in the second half of 2009. Of that amount, swaps represented over $349 trillion of the total.

An interest rate swap is a contractual agreement between two counterparties to exchange cash flows on particular

dates in the future. There are two types of legs (or series of cash flows). A fixed rate payer makes a series of fixed

payments and at the outset of the swap, these cash flows are known. A floating rate payer makes a series of

payments that depend on the future level of interest rates (a quoted index like LIBOR for example) and at the outset

of the swap, most or all of these cash flows are not known. In general, a swap agreement stipulates all of the

conditions and definitions required to administer the swap including the notional principal amount, fixed coupon,

accrual methods, day count methods, effective date, terminating date, cash flow frequency, compounding frequency,

and basis for the floating index.

An interest rate swap can either be fixed for floating (the most common), or floating for floating (often referred to as a

basis swap). In brief, an interest rate swap is priced by first calculating the present value of each leg of the swap

(using the appropriate interest rate curve) and then aggregating the two results.

An FX swap is where one leg's cash flows are paid in one currency while the other leg's cash flows are paid in

another currency. An FX swap can be either fixed for floating, floating for floating, or fixed for fixed. In order to price

an FX swap, first each leg is present valued in its currency (using the appropriate curve for the currency).

HOW IT WORKS (EXAMPLE):

The most common type of interest rate swap is one in which Party A agrees to make payments to Party B based on a fixed interest rate, and Party B agrees to make payments to Party A based on a floating interest rate. The floating rate is tied to a reference rate (in almost all cases, the London Interbank Offered Rate, or LIBOR).

For example, assume that Charlie owns a $1,000,000 investment that pays him LIBOR + 1% every month. As LIBOR goes up and down, the payment Charlie receives changes.

Now assume that Sandy owns a $1,000,000 investment that pays her 1.5% every month. The payment she receives never changes.

Charlie decides that that he would rather lock in a constant payment and Sandy decides that she'd rather take a chance on receiving higher payments. So Charlie and Sandy agree to enter into an interest rateswap contract.

Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on a $1,000,000principal amount (called the "notional principal" or "notional amount"). Sandy agrees to pay Charlie 1.5% per month on the $1,000,000 notional amount.

Let's see what this deal looks like under different scenarios.

Scenario A: LIBOR = 0.25%

Charlie receives a monthly payment of $12,500 from his investment ($1,000,000 x (0.25% + 1%)). Sandy receives a monthly payment of $15,000 from her investment ($1,000,000 x 1.5%).

Now, under the terms of the swap agreement, Charlie owes Sandy $12,500 ($1,000,000 x LIBOR+1%) , and she owes him $15,000 ($1,000,000 x 1.5%). The two transactions partially offset each other and Sandy owes Charlie the difference: $2,500.

 

Scenario B: LIBOR = 1.0%

Now, with LIBOR at 1%, Charlie receives a monthly payment of $20,000 from his investment ($1,00,000 x (1% + 1%)). Sandy still

receives a monthly payment of $15,000 from her investment ($1,000,000 x 1.5%).

With LIBOR at 1%, Charlie is obligated under the terms of the swap to pay Sandy $20,000 ($1,000,000 x LIBOR+1%), and Sandy still has to pay Charlie $15,000. The two transactions partially offset each other and now Charlie owes Sandy the difference between swap interest payments: $5,000.

Note that the interest rate swap has allowed Charlie to guarantee himself a $15,000 payout; if LIBOR is low, Sandy will owe him under the swap, but if LIBOR is higher, he will owe Sandy money. Either way, he has locked in a 1.5% monthly return on his investment.

Sandy has exposed herself to variation in her monthly returns. Under Scenario A, she made 1.25% after paying Charlie $2,500, but under Scenario B she made 2% after Charlie paid her an additional $5,000.

Charlie was able to transfer the risk of interest rate fluctuations to Sandy, who agreed to assume that risk for the potential for higher returns.

One more thing to note is that in an interest rate swap, the parties never exchange the principal amounts. On the payment date, it is only the difference between the fixed and variable interest amounts that is paid; there is no exchange of the full interest amounts. 

WHY IT MATTERS:

Interest rate swaps provide a way for businesses to hedge their exposure to changes in interest rates. If a company believes long-term interest rates are likely to rise, it can hedge its exposure to interest rate changes by exchanging its floating rate payments for fixed rate payments.

SWAPTIONSA swaption is an option on a forward start swap which provides the purchaser the right to

either pay or receive a fixed rate. A buyer of a swaption who has the right to pay fixed and

receive floating is said to have purchased a 'payers swaption'. Alternatively, the right to

exercise into a swap whereby the buyer receives fixed and pays floating is known as a

'receivers swaption'.

Since the underlying swap can be thought of as two streams of cash flows, the right to

receive fixed is the same as the right to pay floating. In this sense, swaptions are analogous

to foreign exchange options where a call in one currency is identical to a put on the other

currency. However, the option terminology of calls and puts is somewhat confusing for

swaptions as it is not used consistently in the market. Some participants describe the right

to pay fixed as a call since it provides the right to buy the swap (i.e. pay fixed). Others look

at a swaption's relationship to the bond market and say that if you pay fixed you are short

the bond and therefore look at this swaption as a put. To eliminate any confusion, market

participants generally describe swaptions as 'payers' versus 'receivers' with respect to the

fixed rate.

Swaptions can be used as hedging vehicles for fixed debt, floating debt or swaps. The

primary purposes for entering into a swaption are:

to hedge call or put positions in bond issues

to change the tenor of an underlying swap

to assist in the engineering of structured notes

to change the payoff profile of the firm

Original interest arose from the issuance of bonds with embedded put features. Often, the

price of the bond did not fully reflect the fair value of the embedded option and the issuer

would sell a swaption to obtain a lower fixed cost of funds. This application of swaptions

continues today for both bonds with call or put features.

A significant percentage of these debt issues are swapped out to obtain cheaper LIBOR

funding. In these cases the issuer needs a facility to cancel the swap if the bonds are put or

called. To eliminate this exposure, the companies would enter into a swaption to offset the

underlying swap. This can be done two ways using either a cancelable or extendible swap.

A cancelable swap provides the right to cancel the swap at a given point in the future. An

example would be a swap with a tenor of 5 years that can be cancelled after year three.

This can be broken into two components. The first is a vanilla five year swap paying floating

and receiving fixed. The second component is a payers swaption exercisable into a two

year swap three years from today. The result is that when the original bond is called, the

swaption is exercised and the cash flows for the original swap and that from the swaption

offset one another. If the bond isn't called, the swaption is left to expire.

Another way to obtain a similar result is to use an extendible swap. The components are a

three year pay floating / receive fixed swap and a receivers swaption whereby the holder

can exercise into a two year swap, three years from today. In this case, exercising the

swaption extends the swap to from three years to five years. This would be done if the bond

was not called. If the bond was called, the swaption would not be exercised. Extendible and

cancelable swaps are used in conjunction with related debt issues or when the user is

indifferent to swaps of different tenors. In the latter case, swaptions are sold to obtain the

premium which is then used to offset other financing charges.

Swaptions are also used in the engineering of structured notes in order to obtain the

contingent payoff profiles requested by the investors. These can be identified in some cases

where the cash flows change from fixed to floating or vice versa at some level of interest

rates. By reverse engineering a structured note into all of its components, one can calculate

its market price or amend the structure's payoff profile.

Finally, financial institutions or corporations may look at their balance sheet and identify

contingent interest rate risk that they have or would like to have. By using swaptions, the

asset / liability mix can often be altered to obtain the desired risk profile.

FINCAD Analytics value swaptions in many financial models including the Black Model and

SABR Model. To find out more information about FINCAD products and services, contact a

FINCAD Representative.

Related articles:

An option is a contract to buy or sell a specific financial product known as the option's underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange traded fund (ETF) or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted upon.Contracts also have an expiration date. When an option expires, it no longer has value and no longer exists.Options come in two varieties, calls and puts. You can buy or sell either type. You decide whether to buy or sell and choose a call or a put based on objectives as an options investor.Buying and SellingIf you buy a call, you have the right to buy the underlying instrument at the strike price on or before expiration. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, the option holder has the right to sell the option to another buyer during its term or to let it expire worthless.

The situation is different if you write or sell to open an option. Selling to open a short option position obligates the writer to fulfill their side of the contract if the option holder wishes toexercise.When you sell a call as an opening transaction, you're obligated to sell the underlying interest at the strike price, if assigned. When you sell a put as an opening transaction, you're obligated to buy the underlying interest, if assigned.

As a writer, you have no control over whether or not a contract is exercised, and you must recognize that exercise is possible at any time before expiration. However, just as the buyer can sell an option back into the market rather than exercising it, a writer can purchase an offsetting contract to end their obligation to meet the terms of a contract provided they have not been assigned. To offset a short option position, you would enter a buy to close transaction.

At a PremiumWhen you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn't fixed and changes constantly. The premium is likely to be higher or lower today than yesterday or tomorrow. Changing prices reflect the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point of agreement becomes the price for that transaction. The process then begins again.If you buy options, you begin with a net debit. That means you've spent money you might never recover if you don't sell your option at a profit or exercise it. If you do make money on a transaction, you must subtract the cost of the premium from any income to find net profit.As a seller, you begin with a net credit because you collect the premium. If the option is never exercised, you keep the money. If the option is exercised, you still keep the premium but are obligated to buy or sell the underlying stock if assigned.The Value of OptionsThe worth of a particular options contract to a buyer or seller is measured by its likelihood to meet their expectations. In the language of options, that's determined by whether or not the option is, or is likely to be,  in-the-money or out-of-the-money at expiration.A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option. The call option is out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price. A put option is out-of-the-money if its underlying price is above the exercise price. If an option is not in-the-money at expiration, the option is assumed worthless.

An option's premium can have two parts: an intrinsic value and a time value. Intrinsic value is the amount that the option is in-the-money. Time value is the difference between the intrinsic value and the premium. In general, the longer time that market conditions work to your benefit, the greater the time value.

Options PricesSeveral factors affect the price of an option. Supply and demand in the market where the option is traded is a large factor. This is also the case with an individual stock.

The status of overall markets and the economy at large are broad influences. Specific influences include the identity of the underlying instrument, the instrument’s traditional behavior and current behavior. The instrument’s volatility is also an important factor used to gauge the likelihood that an option will move in-the-money.

WHAT IT IS:

A call option gives the holder the right, but not the obligation, to purchase 100 shares of a particular underlying stock at a specified strike price on the option's expiration date.

HOW IT WORKS (EXAMPLE):

Options are derivative instruments, meaning that their prices are derived from the price of another security. More specifically, options prices are derived from the price of an underlying stock. For example, let's say you purchase a call option on shares of Intel (INTC) with a strike price of $40 and anexpiration date of April 16th. This option would give you the right to purchase 100 shares of Intel at a price of $40 on April 16th (the right to do this, of course, will only be valuable if Intel is trading above $40 per share at that point in time). Note that the expiration date always falls on the third Friday of the month in which the option is scheduled to expire. Every option represents a contract between a buyer and seller. The seller (writer) has the obligation to either buy or sell stock (depending on what type of option he or she sold; either a call option or a put option) to the buyer at a specified price by a specified date. Meanwhile, the buyer of an option contract has the right, but not the obligation, to complete the transaction by a specified date. When an option expires, if it is not in the buyer's best interest to exercise the option, then he or she is not obligated to do anything. The buyer has purchased the option to carry out a certain transaction in the future, hence the name.

 As a quick example of how call options make money, let's say IBM stock is currently trading at $100 per share. Now let's say an investor purchases one call option contract on IBM with a $100 strike and at a price of $2.00 per contract. Note: Because each options contract represents an interest in 100 underlying shares of stock, the actual cost of this option will be $200 (100 shares x $2.00 = $200).Here's what will happen to the value of this call option under a variety of different scenarios:

When the option expires, IBM is trading at $105.Remember: The call option gives the buyer the right to purchase shares of IBM at $100 per share. In this scenario, the buyer could use the option to purchase those shares at $100, then immediately sell those same shares in the open market for $105. This option is therefore called in the money. Because of this, the option will sell for $5.00 on the expiration date (because each option represents an interest in 100 underlying shares, this will amount to a total sale price of $500). Because the investor purchased this option for $200, the net profit to the buyer from this trade will be $300. When the option expires, IBM is trading at $101.Using the same analysis as shown above, the call option will now be worth $1 (or $100 total). Since the investor spent $200 to purchase the option in the first place, he or she will show a net loss on this trade of $1.00 (or $100 total). This option would be called at the money because the transaction is essentially a wash. When the option expires, IBM is trading at or below $100.If IBM ends up at or below $100 on the option's expiration date, then the contract will expire out of the money. It will now be worthless, so the option buyer will lose 100% of his or her money (in this case, the full $200 that he or she spent for the option).

WHY IT MATTERS:

Investors use options for two primary reasons: to speculate and to hedge risk. All of us are familiar with the speculation side of investing. Every time you buy a stock you are essentially speculating on the direction the stock will move. You might say that you are positive that IBM is heading higher as you buy the stock, and indeed more often than not you may even be right. However, if you were absolutely positive that IBM was going to head sharply higher, then you would invest everything you had in the stock. Rational investors realize there is no "sure thing," as every investment incurs at least some risk. This risk is what the investor is compensated for when he or she purchases an asset. When you purchase call options to speculate on future stock price movements, you are limiting your downside risk, yet your upside earnings potential is unlimited.

Hedging is like buying insurance. It is protection against unforeseen events, but you hope you never have to use it. Consider why almost everyone buys homeowner's insurance. Since the odds of having one's house destroyed are relatively small, this may seem like a foolish investment. But our homes are very valuable to us and we would be devastated by their loss. Using options to hedge your portfolio essentially does the same thing. Should a stock take an unforeseen turn, holding an option opposite of your position will help to limit your losses.

WHAT IT IS:

A put option is a financial contract between the buyer and seller of a securities option allowing the buyer to force the seller (or the writer of the option contract) to buy the security.

HOW IT WORKS (EXAMPLE):

In options trading, a buyer may purchase a short position (i.e. the expectation that the price will go down) on a security. This position gives the buyer the right to sell the underlying security at an agreed-upon price (i.e. the strike price) by a certain date. If the market price falls below the strike price, as expected, the buyer can decide to exercise his or her right to sell at that price and the writer of the option contract has the obligation to buy the security at the strike price. With the exercise of the put, the trader makes the difference between the cost of the security in the market (i.e. a lower price than the option strike price) and the sale of the option to the put writer (i.e. at the strike price). 

For example, if a trader purchases a put option contract for Company XYZ for $1 (i.e. $01/share for a 100 share contract) with a strike price of $10 per share, the trader can sell the shares at $10 before the end of the option period.  If Company XYZ's share price drops to $8 per share, the trader can buy the shares on the open market and sell the put option at $10 per share (the strike price on the put optioncontract). Taking into account the put option contract price of $.01/share, the trader will earn a profit of $1.99 per share.

WHY IT MATTERS:

Investors will often purchase a put option on shares they already own to act as a hedge against the decline in the share price. Puts and calls are the key types of options trading.