Example: Purchasing a cap while selling a Knock-in floor

Jumpstart using templates

Proceed as outlined previously for deals to be entered via a template, and choose Derivative templates. Here, use the template “Cap with Knock-in Floor…”.

Adjusting deal parameters

1. As previously described, enter a meaningful name and, optionally, record the name of the counterparty.
2. In Deal Details you should adjust e.g. start and trade date (in Europe, there is usually a 2-day lag between these dates) and maturity date.
   Furthermore, you can assign a derivative to either the asset or liability side by choosing the appropriate value in the drop down menu under Deal Details. This will make sure that underlying transaction and derivative are shown on the same side and correctly displayed in all reports.

   You might need to specify, but at any rate check, whether the instrument is to be bought or sold. Furthermore, sals.a supports a range of cap types. Further down in this description, we have outlined the special features of the structure described here.

   Payment frequency, as usual, shows the length of the interest period.

• Under Deal Details, you will also find important settings for this specific structure. Here is a short overview on this type of transaction.

Special features of a cap with sold knock-in floor

• A lightly structured instrument like a cap with knock-in floor comprises two components.
• Purchased interest rate cap and sold floor with knock-in component and identical strike price (here 4.8%)

The knock-in (or “KI”) component activates the floor after hitting of the agreed floor rate (here 3.75%). The sold floor component leads to better performance of the overall transaction (by reducing the premium to be paid for the cap or even creating a zero-cost structure through elimination of the premium on purchase of the cap).

Illustration of the risk profile:

Risk analysis in conjunction with an underlying transaction

The underlying transaction, here a floating rate 6M-Euribor loan, does involve significant risk based on a potential change in interest rates. In order to hedge against rising interest rates, the client has entered into a hedging transaction with a cap with knock-in floor at a hedge level of 4.80%. Should EURIBOR rates rise above 4.80%, the client will receive a compensation payment out of the cap in the amount of [6M EURIBOR – 4.80%]. Between 4.80% and 3.75% the derivative instrument will be neutral – no payments will be made to or received from the customer, respectively. In case 6M EURIBOR falls below 3.75%, the sold floor is activated and the client pays the difference of [4.80% - 6M EURIBOR] for the respective period.

Hence it can be summarized: If 6M EURIBOR is quoted below 3.75%, then total payments (derivative & underlying deal) equate to 4.80%. With EURIBOR between 3.75 and 4.80%, the client pays the actual EURIBOR rate (derivative neutral). With EURIBOR fixed above 4.80%, the client receives a compensation payment out of the cap, which will keep total interest cost at 4.80% no matter how much 6M EURIBOR rates rise.

Expert Settings

These can be adjusted by experienced users as needed.
At the end, press Calculate to instantly show results, if you like, and Save to make sure your changes are maintained if you finish here and don’t intend to change anything in the Deal Schedule as described below.

Amendments to the Deal Schedule

The Deal Schedule will provide you with the cash flow overview for the whole transaction, based on the data entered in sals.a and the current forward rates.

Example for the cap with knock-in floor (see screenshots in the description above):

• Left: BUY cap with strike price 4.80% [receiver of a potential compensation payment]
• Right: SELL KI-floor Strike 4.80% with KI-barrier at 3.75% [payer of a potential compensation payment]

1. Choose the columns to be displayed by pressing the button Choose Columns.
2. If needed, adjust values in the Deal Schedule. Underlined values can be changed. To revert to the original (automatic) value, simply delete your entry and press Calculate.
3. You may make changes anytime later after you have saved the transaction. Just click on the name of the desired deal in the report view and the deal entry mask will open up.
4. In addition, here you can see how the sals.a scenarios affect this particular transaction by choosing one in the “Scenario Selection” field at the bottom of the window.
5. Don’t forget to Save your changes in the deal schedule!

• Entering a Swap, using the example of an Interest Rate Swap
• Bermudan swaption pricing