Notional amount

Through the development of such techniques as injection moulding it is possible to make highly complex parts in one operation without the need for assembly work or the generation of more than a notional amount of scrap material. 

Until recently, the interest rate options market was dominated by OTC transactions—trades executed directly between professional counterparties like banks, insurers, investment institutions, and corporates. However, as Exhibit 17.14 shows, dramatic growth of the exchange-traded markets in recent years has seen them catch up with the OTC markets in terms of notional amounts outstanding, and the two are now neck-and-neck. 

Statistics on the relative size of the European market for exchange-traded interest rate options are relatively easy to come by, and the Bank for International Settlement (BIS) publishes a regular breakdown of geographic activity. This is summarised in Exhibit 17.15, which shows how notional amounts outstanding on European exchanges have quadrupled over the 3-year period from 1999 to 2002. 

Unfortunately, without a central clearing house to monitor and record all transactions, it is difficult to obtain reliable statistics for the OTC interest rate options market. However, the BIS conducts regular surveys of the markets and publishes a breakdown of notional amounts outstanding by currency (but not by country) of all interest rate derivatives (including swaps, ERAs, futures, as well as options) across all markets (OTC as well as exchange-traded). A summary of this is shown in Exhibit 17.16, from which it can be seen that the size of the euro-denominated market now virtually matches that of the US dollar, signalling the increasing importance of the European interest rate derivatives market. 

Exercise style Notional amount Strike rate Underlying swap ... 

Consider the hypothetical interest rate swap nsed earlier to illustrate a swap. Let s look at party X s position. Party X has agreed to pay 10% and receive 6-month EURIBOR. More specifically, assuming a 50 million notional amount, X has agreed to buy a commodity called 6-month EURIBOR for 2.5 million. This is effectively a 6-month forward contract where X agrees to pay 2.5 million in exchange for deliv-... 

In the previous section we described in general terms the payments by the fixed-rate payer and fixed-rate receiver but we did not give any details. That is, we explained that if the swap rate is 6% and the notional amount is 100 million, then the fixed-rate payment will be 6 million for the year and the payment is then adjusted based on the frequency of settlement. So, if settlement is semiannual, the payment is 3 million. If it is quarterly, it is 1.5 million. Similarly, the floating-rate payment would be found by multiplying the reference rate by the notional amount and then scaled based on the frequency of settlement. 

Note that each futures contract is for 1 million and hence 100 contracts have a notional amount of 100 million.) Similarly, the EURI-BOR futures contract can be used to lock in a floating-rate payment for each of the next 10 quarters. Once again, it is important to emphasize that the reference rate at the beginning of period t determines the floating rate that will be paid for the period. However, the floating-rate payment is not made until the end of period t. 

The same valuation principle applies to more complicated swaps. For example, there are swaps whose notional amount changes in a predetermined way over the life of the swap. These include amortizing swaps, accreting swaps, and roller coaster swaps. Once the payments are specified, the present value is calculated as described above by simply adjusting the payment amounts by the changing notional amounts— the methodology does not change. 

Credit default swaps involve the exchange of periodic payments (usually expressed as basis points multiplied by the notional amount of the swap)... 

Here each premium P is calculated on the notional amount and multiplied by its appropriate daycount fraction. The resulting cash flow is then discounted at the risk-free rate and finally multiplied by its survival probability, that is, the probability that the relevant preminm payment will actually take place, since in the event of a default all future premium payments will be cancelled. 

Perhaps the most important part of the default swap is the payment the buyer of protection will receive if a default occurs during the life of the swap. After all, this is precisely the protection the buyer is paying for. Upon a default, the buyer of protection will receive the notional amount of the swap after delivering to the seller-defaulted assets of the issuer. We define recovery value, or more briefly R, to be the value of these defaulted assets immediately following the credit event, so it can be more easily stated that upon a default the buyer of protection will receive 100% - R. 

However, the very flexibility of synthetics mean that there are a variety of other important decisions to be made regarding the allocation of cash flows. For example, in a traditional structure, the equity holder in our deal would undergo what is shown in Exhibit 22.9 upon the experience of a loss. The tranche size is reduced by the amount of the loss. The coupon will remain at the same spread, but the spread will be paid only on the reduced notional amount. 

In comparison with the traditional structure mentioned above, a residual structure would retain a significantly better coupon upon experiencing a loss. In the residual case, the notional amount upon which coupons would be paid would remain unchanged, but the coupon spread would be reduced by the spread of the defaulted credit. If the defaulted credit entered the portfolio contributing a spread of 1,000 bps (a very risky credit), its default would dramatically reduce the coupon paid, but the investor would still be better off than in the traditional case. The total impact on the coupon for a similar loss in the two scenarios would differ by approximately 400,000 per annum (rows 2 and... 

For our portfolio, the analysis of expected losses to the first loss equity tranche might look like that shown in Exhibit 22.13. Our binomial distribution indicates that there is a 29.7% chance of 1 default occuring. This default would generate a 70% loss (30% recovery) on Vm of the portfolio, or about 1.43% of the total notional amount. How-... 

Leveraged notes are notes that are issued by an SPV or an EMTN program and the notional amount of credit risk is larger than the capital commitment. These notes are typically issued as tranches of synthetic... 

Caps and floors are options on interest rates such as LIBOR, euribor, U.S. prime, and the commercial paper rate. A cap is a call option on interest rates, written by a market-making bank and sold to the borrower of a cash loan. In return for the premium, the bank agrees that if the reference rate rises above the cap level, it will pay the buyer the difference between the two. The cap thus places an upper limit on the rate the borrower must pay. The loan may precede the cap transaction and be with a third party. Alternatively, the cap may be transacted alongside the loan, or as part of it, as a form of interest rate risk management. In that case, the cap s notional amount will equal the loan amount. The cap term can be fairly long to match the loan term—commonly as much as ten years. 

The swap is diagrammed in FIGURE 10.6. The arbitrt eur receives the total return on the bank loan and pays the counterparty bank the bond return plus an additional 30 basis points, the price of the swap. These rates are applied to notional amounts of the loan and bond set at a ratio of 2 to 1, since the bond s price is more sensitive to changes in credit status than that of the loan. 

Swaps. Derivative contracts that exchange payments based on a specified notional amount, either as a percent rate (such as an interest rate swap) or other quoted cash flow... 

The notional amount of each tranche to transact is a function of the trade delta. This is the change in price of each tranche for a given change in credit spreads. The value of delta fluctuates, so the tranche notionals will need to be rebalanced periodically as the delta dictates. 

If a credit event occurs on one of the reference entities in the iTraxx, the contract is physically settled, for that name, for 0.8 percent of the notional value of the contract. This is similar to the way that a single-name CDS would be settled. Unlike a single-name CDS, the contract continues to maturity at a reduced notional amount. Note that European iTraxx indices trade under Modified-Modified restructuring (MMR) terms, which is prevalent in the European market. Under MMR, a debt restructuring is named as a credit event. ... 

---