Financial innovations have endowed companies with instruments both varied and flexible which can be taken advantage of to achieve their objectives. These are not the cause of Market volatility but rather a result. In fact, these contracts are mainly taken on as insurance against Market risk.

Derivative Products also allow one to manage movement risk in an underlying product (Futures, Interest Rates, Options, Shares, Deposits, etc.) without actually using the product itself. The reasons for using them are :

To reduce the cost of debt

To minimise Market risk

To optimise the asset yield

To ensure a balance between assets and liabilities

Even if the principle "players" remain the big banks, financial institutions and major corporates, nowadays these products concern all of us directly or indirectly. In fact, a life-insurance policy proposing a minimum yield, as well as a future "bonus" linked to movement in the Swiss Stock Market indicator (the SMI), incorporates Derivative Products. Indirectly, therefore, they touch everyone.

One must distinguish between 3 types:
  • Standard products used by the Stock Market; the 'Conf ' Future on Soffex for example
  • Mutual consent products (OTC [over the counter] bilateral contracts between two entities)
  • Products incorporated in Investment Bonds/Securities or insurance policies
Since 1960 these markets have shown an uninterrupted growth and have shown the greatest growth over the last 15 years. This was, in the main, induced by (and this is the greatest novelty of the 1990's) the development of OTC Derivative Instruments.

Thousands of bankers and financial experts have been quick to take advantage of the intertemporal dimension between Markets risks that inevitably lead all professionals to pay a price to have the flexibility of waiting, and of being covered whilst "waiting to see". The "option" concept is now omnipresent, as are "Swaps".

  • Rapidity/Access: Bound to OTC or organised Markets. Both being efficient
  • Cost: The ratio loaning/cost is 4 to 8 times more favourable (no stamp duty, commission,etc)
  • Flexibility: Exchanging a risk for one more managable (acceptable)
  • Liquidity: As a result of the first three, the liquidity in these products is decidedly superior than in the underlying products
Being active in OTC Interest Rate Markets since their creation (in FRA's, for example, TRADITION was actually a pioneer office; introducing the product into the interbank Market for the first time at the end of 1985), TRADITION has been able to acquire all the experience necessary to act equally well as both intermediary and consultant.

  • The possibility of creating a perfectly adapted cover because derivatives are standardised like Futures contracts
  • No "margin call" nor Cash guarantee, resulting in simplified administration
  • No exchange of capital, one deals exclusively on differentials and the use of negligable credit limits
  • No obligation to operate in the Cash Market with its disadvantage of an increase on the balance sheet
  • Ease of turning around positions simply by requesting a contract cancellation
  • No difficulty in obtaining quotes for large amounts


Advantages for Lender Advantages for Borrower
Flexibility maintained whilst dealing thanks to greater ease of obtaining credit lines and a greater choice of counterparties. Reduction in financial costs by taking advantage of Market inefficiencies

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Unlike spot markets, where currencies are exchanged on a fixed date, forward markets deal with delivery dates beyond the spot date. The basic concept of forward markets is simple: money carries a price, which is the interest rate. Each currency has its own rate of return. Forward markets are based on spot rates, plus the rate of return.

A forward (or more particularly an "Exchange Rate Swap") is a simultaneous buying and selling of one currency against another for equal nominal amounts over two different dates. To use the jargon of the market, the combination of selling the Spot and buying the Forward of foreign currency is called "lending", whilst the opposite of this is known as "borrowing". This terminology is justified as the person who buys some USD on a spot basis and resells them simultaneously over 3 months is disposing of this currency as if he had borrowed it for 3 months.

Swap points are the result of the two exchange rates (spot - forward). They represent the difference between the interest rates in the international Money Market (cash market) of the two currencies involved. Swap points could also be specified in % on an annual basis. This interest rate is called the swap costs or hedging costs in % per year.

Swap points are quoted in two ways with a bid and ask price. The concept of discounts and premiums arises from the relative advantage or disadvantage in terms of yield between two currencies being swapped, which has an effect on the forward exchange rates. There is a discount when the left quotation is greater than the right one and vice versa for the premium.

Swap $/CHF 6 months        -284/-282   = Discount

Swap JPY/CHF 6 months    78/80         = Premium

$ rates are at discount against CHF rates    = $ rates greater than CHF rates

Yen rates are at premium against CHF rate = Yen rates smaller than CHF rates

Spot Rate 1.4932 1.0200
Discount / Premium - 0.0282 + 0.0080
Forward Rate 1.4650 1.0280

A speculator who wants to buy USD/CHF would buy them in 2 months time in order not to have to swap the different cash flows every day. This deal is called an outright deal and is done at the forward rate.
The quoted periods are the same as on Deposits and the maturity dates must be included in the same way as Cash Deposit operations, knowing that "working day" means a working day in both countries involved in the transaction.


An importer wants to ensure in advance the maximum cost of his currency. So, on June 26, he bought USD 5 million for 3 months, value September 28. Three days before the maturity he learns that his merchandise has been withheld for a month. He therefore executes an Exchange Rate Swap as seen below:

Sell Spot + buy for one month USD 5 million, which gives him:

Value 28/09 Rate Value 28/10 Rate
Deal of 26/06 +5'000'000 1.48 -  
Deal of 25/09 -5'000'000 1.50 +5'000'000 1.49
Balance 0   +5'000'000 1.47

  • To place surplus liquidity in one currency and to finance it at the same time in another
  • To defer the maturity of a transaction


  • A single margin is applied between the price demanded and that which is offered for two simultaneous operations (i.e. giving one currency and borrowing another)
  • Unique way to place capital in internal Money Markets.

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Advantage can be taken of the relationship between swaps and Eurorates, either by arbitraging (taking advantage of any disequilibrium between markets but, due to the increased sophistication of the markets, they are becoming rarer) or by switching from one market to another. It is important to remember that if cash markets can create swaps, then swaps can create cash markets. In that case, Arbitrageurs could, for a specific currency, finance their needs cheaper or invest their surpluses at a better rate of return than using the cash market only. Being active in both markets and having access to the best prices, TRADITION is organising interest arbitrages for some of its customers by doing arbitrage loans or placements.

An arbitrage loan (called arbi loan) is an international interest arbitrage loan which consist of two deals :

A loan + an exchange rate swap

Borrowing for instance CHF and entering into an USD/CHF swap which means buying the dollars spot and selling them back outright would enable you to borrow USD.

Spot 3 months fwd
Currency 1 Currency 2 Currency 1 Currency 2
Loan in C2   +   -
FX swap + - - +
Balance + 0 - 0

Investing for instance CHF and entering into an USD/CHF swap which means selling the dollars spot and buying them back outright would enable you to invest in dollars arbitrage placement).

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An FRA is a forward contract in which two parties guarantee a rate applicable to a determined amount over a period where the "start date" is set in the future. Upon reaching this date, the operation begins, not with a borrowing nor loaning of capital, but with the payment of the difference between the agreed rate and that of the Market. The determination of the FRA rate is based upon the principle that the interest charge for the whole period should be equivalent to that of the "dormant" and "guaranteed" periods together (taking into account compound interest). The "dormant" period being from the time the contract is signed until the start date, and the "guaranteed" period from then to the maturity of the contract.

FRA's are the most popular financial instruments in Short Term Forwards.


On July 26, you lent CHF 20 million for 12 months at a fixed rate of 2.80 % that you financed for the first 6 months at 2.50 %. Today, August 26, you don't want to maintain the risk for the remaining period because you think that the rate is going up between now and the year's end. To do this, you can enter into a FRA for the remaining 6 months. The price TRADITION will quote you is thus a "5 months against 11 months FRA" at 2.72 to 2.75 %. In order to cover your exposure to Interest Rates, you "buy at 2.75 %" for a nominal amount of CHF 20 million. A transaction will then be closed with a counterparty that you find acceptable.




Signing of FRA contract

Execution date of FRA

Maturity of FRA


Dormant Period

>>>>>>>>/========= =======>>>>>>>>

Guaranteed Period


At the end of the first "financed" 6 month period, the FRA will be "fixed" taking the difference between your agreed rate and the Libor [fixed at 11:30 am (London time)] for the duration of your FRA, i.e. 6 months. In this example, if we assume a Libor of 2.97 %, you will receive the difference of CHF 10'113.14 (in two working days):


The interest is discounted because it is received or paid in advance (i.e. at the beginning of 6 month FRA in this case).


  • Managing exposure to Short Term Interest Rates. Covering Deposit positions
  • Transformation of Interest Rates
  • Arbitrage trading in order to "play the Interest Rate curve"
  • Buying the FRA to cover against a raising of rates
  • Selling the FRA to cover against a lowering of rates


  • "Lightening" of balance sheet (off-sheet dealing)
  • Strong reduction in interbank constraints (Company capital, liquidity, risk accumulation)
  • Reduction in credit risk (due to methods of compensation)
  • Close quotes given for personalised structures

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A Swap is an exchange of Interest Rates and/or currencies, based upon a determined amount and duration. It is considered an off-balance sheet operation.

An Interest Swap is a transaction whereby one party lends another an amount in a specified currency at a specified rate of interest (either fixed or floating). Simultaneously, he takes back, from the same counterparty, an identical amount in the same currency but at a different rate of interest (floating or fixed). Consequently, there is no exchange of capital neither at outset nor at maturity of the operation, and a simultaneous payment of both fixed and floating Interest Rates (although in actual fact the rates are calculated so only one net payment is made).


1962 The "Banque de France" proposes to the Central European banks to exchange, for renewable 3 month periods, Deposits and currencies to a value of USD 50 million, with a fixed Exchange Rate and Indexed Remuneration Rates in each currency on the base of the yields from Short Term State Bonds. This initiative stayed in place between Central banks until the middle of the 1970's; the private sector did not follow their example.

1977 First long structured Swap. "Morgan Guarantie" and "Banque Paribas" swapped the export contract for the Caracus Métro (drawn up in FRF) against USD.

August 1981 The deal that brought Swaps to the attention of the general public; transacted by "IBM" and the "World Bank".

February 1982 First Interest Rate Swap, between "Citibank" and "Continental Illinois".

End of 1992 Swap Market turnover exceeds USD 5'500 billion.


An investor thinks that the Long Term Rates are going to stabilise or even increase by 1 % (over 5 years) before dropping again. He, therefore, decides to undertake an Interest Rate Swap wherein he pays the fixed rate for 5 years, at the same time as receiving the floating rate every 6 months (Libor).


  • Management of exposure to Long Term Interest Rates.
  • Covering a balance sheet or investment position
  • Transformation of Interest Rate (fixed rate to floating for example)
  • Arbitrage (trading)
  • Long Term financing
  • Reduction in costs (taking advantage of Market inefficiencies)
  • Buyer of the Swap protected against an increase in the rates
  • Seller of the Swap protected against a lowering of the rates


  • "Lightening" of balance sheet (off-sheet dealing)
  • Strong reduction in the legal constraints of banking (Company capital, liquidity, risk accumulation)
  • Reduction in credit risk (due to methods of compensation)
  • Close quotes given for personalised structures

Accounting responsabilities:

Accounting is obligatory as with all financial operations. The notional amounts are net, dependent upon departments committments and must not be included in the balance sheet. It is, therefore, recommended that off-sheet accounts and a profit & loss account are opened for this type of operation.

A Currency Swap is an operation in which two counterparties agree to simultaneously borrow and lend in two different currencies but for an equal value in the notional amount. Currency Swaps involve an exchange of capital at the outset of the deal, an exchange of capital at the end as well as exchanges of interest.

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This type of operation does not involve the swapping of a fixed rate against a floating one, but of one floating rate against another. It could also, for example, involve an exchange of Libor on CHF against a domestic rate such as Pibor on FRF.


To finance itself, Canton Y will make a loan in 10 year EUR with Institution Z, benefitting from conditions more favourable than those received in CHF. In order to transform its EUR into CHF, Canton Y closes a 10 year EUR against CHF Basis Swap, including exchange of capital, with Bank X for CHF 100 million (Bank X will give CHF Libor and Canton Y gives EUR Libor).

The CHF/EUR Basis Swap was - 1/+ 1 (+ 1: to receive CHF and to pay EUR; the right hand side of the first column on the quote page). Therefore, the cost of the Swap to transform a borrowing of EUR into a borrowing of CHF is only one basis point.


A Basis Swap gives the advantage of being able to finance oneself in a different currency, where conditions are more favourable, than the one in which the need exists.

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This operation gives the buying party the right, but not the obligation, to enter into an Interest Rate Swap. To do this, it must pay a premium, just as with a standard Option, equal to the value of the instrument at the time of trading. The factors determining this premium are chiefly the strike price, the current Market price, the duration of the Swaption, the volatility and the cost of financing the Premium. There are two sorts of Swaptions :

  • A "receiver swaption": Whereby the buyer of the Swaption can receive the fixed rate and pay the floating rate (generally 6 months Libor).
  • A "payer swaption": Whereby the buyer of the Swaption can pay the fixed rate and receive the floating rate.

However, unlike an Interest Rate Swap with a forward start date, the buyer of the Swaption, who exercises his right, has the choice between entering into the Interest Rate Swap or being paid the difference between the strike price and the Market price at the maturity of the Option Period.


A pension fund manager, having noticed the lowering of rates over the last months, seeks to protect himself against an opposite movement at the end of the year. At the same time, he wants to maintain the possibility of profiting if rates continue to fall. He, therefore, buys a "Payer's" Swaption with the advantage of then knowing his "minimum" benefit for the year on his Long Term Interest Rate position.


  • Swaptions are frequently used to cover exposure due to obligations involving Options, i.e. "callable" and "puttable" Bonds
  • To cover Future Rate risk
  • To cover Long Term Rate risk at the same time as maintaining the possibility to profit from an advantageous movement in rates

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Interest rate Caps are a series of call options on interest rates in successive periods. From the perspective of the holder of a floating-rate loan caps provide insurance against the risk of upward movements in interest rates. If the rate of interest on the floating-rate loan rises above a certain level, called the Ńcap rate", the seller of the cap will have to pay the difference in interest to the holder of the loan.

Analogously to caps interest rate Floors can be thought of as a series of interest rate put options. A floor guarantees that the interest rate received on a deposit will be not less than a prespecified level. As well as the value of caps the worth of floors are determined by the sum of the prices of the options which comprise the caps / floors.

Caps and Floors have asymmetrical hedge character. The holder of such a financial instrument benefits from a favorable movement in interest rates but at the same time is protected against a rise (for the owner of a cap) or fall (for the holder of a floor) in interest rates.


The main features of caps can be illustrated by using an example: Take for example a loan with a principle of 28 million CHF where the rate is reset every 3 months equal to 3-month LIBOR. With a cap rate of 4 percent per annum and a quarter in which the 3-month LIBOR would be fixed at 6%, the holder of the loan and the cap will receive 140.000 CHF ( = 0,25 of 2% of 28 million CHF) at the end of this quarter. This 2% represents the difference between the cap rate of 4 percent and the actual 3-month LIBOR of 6%. Due to this effect, the interest rate/cost of the loan will not exceed 4%. If the 3-month LIBOR were below 4%, the holder would not execute an Option of his cap and would pay the available 3-month LIBOR.

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