Brazilian Derivatives and Securities 1st edition by Marcos Carreira, Richard Brostowicz ISBN 1137477279 9781137477279

1  Financial Archeology

1.1  Interest rates and inflation

1.1.1  Record levels (the old days of overnight rates of 2% per day and the Real Plan); desperate times call for desperate measures

1.1.2  COPOM (the Brazilian FOMC): behavior, language, influence, targets and bands

1.1.3  The Brazilian Payment System (SPB): the end of the dual cash regime; CDI and Selic

1.1.4  A new era? What has changed under Tombini? Coordination and communication, or more subtle changes?

1.2  Foreign exchange

1.2.1  Testing the waters

1.2.2  Pegs and multiple currencies

1.2.3  Indexing of local instruments

1.2.4  Floating, ballast and hot air (on the different mechanisms to manage a floating currency)

1.2.5  Paganism (on how to avoid conversion, and the history of offshore x onshore spreads)

1.2.6  A bit of a fit (on the 2008 crisis)

2  We Mean Business

2.1  Calendars

2.1.1  Banking calendars and fixings

2.1.2  Trading and listed contracts

2.1.3  New York, Rio, São Paulo – the FX combined calendar

2.1.4  Notation used for moving forward or backward business days in a specified calendar

2.2  Interest rate fixings

2.2.1  Selic target

2.2.2  Selic

2.2.3  CDI

2.2.4  TJLP

2.2.5  TR

2.3  Inflation fixings

2.3.1  IPCA

2.3.2  IGP-M

2.4  Foreign exchange fixings

2.4.1  PTAX

2.4.2  EMTA

2.4.3  WMR

2.4.4  Observability for barriers

2.5  The 3 Ts in FX option pricing: a more precise version of the Black Formula

3  Interesting BRL Interest Rates

3.1 3  months in the life of an IR Swap

3.2 3  months in the life of a DI Future

3.3  Explaining it all

3.4  A simple swap

3.5  A promising future – The DI1 Future

3.6  My first numéraire – a more mathematical framework for DI Futures (DI1)

3.7  The still promising Future -> The Selic Futures (OC1)

3.8  Pricing BRL interest rate futures

3.8.1  DI Future (DI1) pricing

3.8.2  BRL onshore CDI curve construction

3.8.3  Selic Future (OC1) pricing

3.8.4  BRL onshore Selic spread curve construction

3.9  Giving 110%

3.10  The CDI+Spread is a multiplicative spread

3.11  How to price the 3 possible BRL Fixed X Float payoffs?

3.11.1  100% CDI case

3.11.2  CDI+Spread case

3.11.3  Percentage of CDI case

4  BRL Interest Rate Market and Credit Risk

4.1  Historical spreads

4.2  The term structure of volatility

4.2.1  Slope

4.2.2  Covariance

4.2.3  Principal components

4.3  Potential exposures

4.4  Zero curve: and the winner is …

4.4.1  Linear Interpolation (LI)

4.4.2  Flat Forward (FF)

4.4.3  Cubic Spline (CS)

4.4.4  Which is better?

4.5  Smooth operator

4.6  Sensitivities

4.6.1  Zero

4.6.2  Forward

4.7 A  framework for risk

4.7.1  Minimal description

4.7.2  The envelope and liquidity risk

4.7.3  The first, the last and the ugly

4.8  Trading forwards

4.9  Risk and P&L attribution

5  A Man with Two Clocks … Foreign Exchange in Brazil

5.1  FX Spot

5.1.1  Who can trade it

5.1.2  How, when and where to trade it

5.1.3  Observability

5.2  DOL

5.2.1  Contract details

5.2.2  Liquidity

5.2.3  DR1 and the roll

5.2.4  Payoff of DOL contract

5.2.5  Pricing a DOL contract based FRC, DI’s, nearest maturity FXFUT and CASADO quotes

5.2.6  Apples and oranges

5.2.7  Convexity corrections

5.3  Forward points strategies

5.3.1  FRP

5.3.2  “Casado”

5.4  FX Future crosses

5.4.1  Payoff

5.4.2  Pricing and hedging

5.4.3  Convexity corrections

6  And the Even More Interesting USD Onshore Interest Rates …

6.1  3 months in the life of a FX Swap

6.2  3 months in the life of a DDI Future

6.3  Explaining it all

6.4  The DDI Futures (DDI) -> Why they were designed this way?

6.5  The mathematical derivation of a DDI contract price

6.5.1  DDI Future pricing

6.6  It takes two (DDI contracts) to (con)tango -> The FRA de CUPOM strategy (FRC)

6.6.1  FRC Future pricing

6.6.2  Handling a FRC trade before BVMF publication of the first DDI closing price

6.7  Calibration of the cupom curve

6.7.1  Calibration of the cupom curve on the short end

6.7.2  Calibration of the cupom curve on the long end

6.8  How to compute cupom interest rate risk?

6.9  Interpolation choices for the cupom curve

6.9.1  Log-linear interpolation of cupom curve forward discount factors curve in business days

6.9.2  Log-linear interpolation of cupom curve forward discount factors curve in calendar days

6.9.3  Log-linear interpolation of cupom curve in FX forward prices

6.10  The SCC contract

6.11  The mathematical derivation and pricing of a SCC contract price

6.12  The SCS contract – a modern, but exotic, cousin

6.13  The mathematical derivation of a SCS contract price

6.14  SCS Future pricing

6.15  Forward starting SCS contracts

6.16  A much simpler alternative to FRC contracts

6.17  A BRL Float or Fixed X USD onshore Fixed swap

6.17.1  Coupon payoff specification

6.17.2  Coupon pricing

7  Too Many Options?

7.1  IDI options

7.1.1  IDI options available indices and compounding methodology

7.1.2  IDI options payoff and other contractual information

7.1.3  IDI options common trading strategies

7.1.4  A simple Black pricing formula for an IDI option assuming the IDI index as its main underlying

7.1.5  How to fit a volatility smile for an IDI option assuming the IDI index as its main underlying

7.1.6  A simple Black pricing formula assuming the IDI index equivalent realized interest rate as the underlying

7.1.7  Is the IDI option smiling at you now?

7.1.8  Or is it smirking?

7.1.9  A discrete tree model that could fit the smirk volatility surface shape for IDI options

7.1.10  Delta hedging IDI options under the discrete tree model

7.1.11  Delta hedging IDI options under the SABR model

7.1.12  IDI options pricing under HJM model

7.1.13  IDI options historical volatility computation – how to price an IDI option if only the DI Futures market was liquid?

7.1.14  IDI digital options – limitations and applicability

7.1.15  OTC IDI options at Cetip

7.2  DI Future options

7.2.1  Basic trading information and definition of the contract codes

7.2.2  DI Future options payoff – smells like swaption?

7.2.3  DI Future options most common trading strategies

7.2.4  A simple Black pricing formula for DI Future options

7.2.5  Can DI Future options smile with the SABR model?

7.2.6  DI Future options pricing under HJM model – where’s the smile?

7.2.7  What about DI Future options under the BGM a.k.a Libor Market Model?

7.2.8  DI Future options historical volatility computation – how to price a DI Future option if only the DI Futures market was liquid

7.3  IR option strategies – VTF and VID

7.3.1  VTF

7.3.2  DI Future delta hedge computation by BVMF

7.3.3  VID

7.3.4  DI Future delta hedge computation by BVMF

7.4  Jabuticabas: risk management of options on interest rates

7.4.1  IDI options

7.5  BRL/USD Listed FX options

7.5.1  Contract details

7.5.2  BRL/USD Listed FX options payoff

7.5.3  A simple Black pricing formula for BRL/USD Listed FX options

7.5.4  Volatility surface based on SABR model

7.5.5  Volatility surface based on polynomial on FX delta

7.6  BRL/USD Listed FX options with daily margining

7.7  BRL/USD FX options: strategies

7.7.1  VTC

7.7.2  FX Future delta hedge computation by BVMF

7.7.3  Do you believe you are delta hedged?

7.8  OTC IR and FX options

8  The Mountain Goes to … Foreign Exchange Contracts Offshore

8.1  CME BRL/USD FX Futures

8.1.1  Contract details

8.1.2  Payoff

8.1.3  Pricing

8.2  OTC – NDFs

8.2.1  BRL/USD offshore NDFs – payoff and differences for the equivalent onshore NDF contract

8.2.2  A quick detour for pricing collateralized derivatives

8.2.3  Pricing a collateralized NDF contract offshore

8.2.4  How offshore NDFs are usually traded in the interbank market?

8.2.5  Revisiting the cupom curve construction based on NDF spread strategies

8.2.6  The mythical offshore BRL discounting curve

8.3  OTC – BRL/USD options

9  Start from Where? Constructing Markets for FX Forwards, Futures, Onshore USD Interest Rates and Offshore Instruments

9.1  Observability of contracts

9.1.1  Spot x DOL

9.1.2  FRC x Forward x DOL

9.1.3  NDFs and forward points

9.2  Structures

9.2.1  Dates

9.2.2  Events (breaks, fixings, market points)

9.2.3  “The Triangle”

9.3  Curve construction

9.3.1  Cupom Cambial

9.3.2  Forwards

9.4  The offshore x onshore spread

9.4.1  Changing standards

9.4.2  Convertibility, demand and taxes

9.5  The mythical offshore BRL discounting curve

10  Offshore IR Products Based on CDI Fixings

10.1  Offshore BRL Fixed-Float swaps

10.1.1  Offshore BRL Fixed-Float swaps payoff

10.1.2  Foreign market participants appetite for offshore BRL Fixed-Float swaps

10.1.3  Which discounting curve to use for offshore BRL Fixed-Float swaps pricing?

10.1.4  Is this a quanto swap? Let’s analyze it from a hedging perspective

10.1.5  Now let’s analyze it from a mathematical perspective

10.1.6  BRL Fixed-Float offshore breakeven historical swap rate

10.1.7  Calibrating an offshore BRL Fixed-Float swap basis curve

10.2  Offshore BRL Fixed-Float swaptions

10.2.1  BRL Fixed-Float offshore swaption payoff and specification

11  The Dual Case – US Libor Onshore Swaps

11.1  Payoff of US Libor onshore swaps

11.2  Pricing of US Libor onshore swaps

12  FX Trading (Interest Rate and Fixing) Market and Credit Risk

12.1  Fixing

12.2  The term structure of the Cupom Cambial

12.2.1  Slope

12.2.2  Casado

12.3  Potential exposures

12.4  Interpolation and sensitivities

12.5  A framework for risk

12.6  Trading forwards

12.7  Risk and P&L attribution

12.8  DOL convexity correction to a FX forward price

13  A Skewed Perspective of the World: FX Options

13.1  Starting from the end (market standards for offshore FX options)

13.1.1  Weightlifting

13.1.2  Reversal of fortune

13.1.3  The locals are friendly

13.1.4  Thin tails wagging the dogs

13.1.5  The couple, decoupled

13.2  Back to the beginning (What is different in onshore FX options?)

13.2.1  Uncertain smile

13.2.2  Fixing the averaging

13.2.3  I’d risk everything

13.2.4  Look in the mirror

13.3  Risk management

13.4  Risk and P&L attribution

14  Some Cash Is Better Than Nothing – What You Need to Know about Cash Products

14.1  Local government bonds

14.1.1  Floating to the top – LFTs

14.1.2  The name of the game – LTNs and NTN-Fs

14.1.3  Making it real – NTN-Bs

14.1.4  Living fossils – NTN-As

14.1.5  Reading the fine print

14.2  Local corporate bonds

14.3  Local funding practices

14.4  Offshore government and corporate bonds

14.5  Liquidity (or lack thereof)

14.6  The Brazilian repo market (Compromissadas)

15  Index of Choice … Inflation-Linked Products and Curves

15.1  Government inflation-linked bonds

15.2  Inflation-linked swaps

15.2.1  IGPM and IPCA publication

15.2.2  IGPM and IPCA swaps payoff

15.2.3  Dirty and clean rates … again

15.2.4  Trading conventions for IGPM and IPCA swaps. Are they liquid?

15.2.5  IPCA swaps pricing – the market approach

15.2.6  IPCA swaps pricing – the foreign currency analogy approach and why it’s complicated

15.2.7  IPCA swaps pricing – the IPCA forwards calibration approach

15.2.8  IPCA index forwards interpolation without seasonality

15.2.9  Adding seasonality

15.2.10  Joint calibration of IPCA curve with NTN-B bond quotes (reduced by asset-swap spread) and IPCA swap rate quotes

15.2.11  The IGPM market

15.3  Exchange traded inflation-linked Futures

16  Microstructure of the Listed Derivatives

16.1  Microstructure: concepts

16.2  Can durations be estimated?

16.3  What happens in practice?

16.4  What is the importance of the tick size?

16.5  The model with uncertainty zones (Robert and Rosenbaum)

16.5.1  Description of the model

16.5.2  What can we do with this model?

16.6  DOL

16.7  DI

17  Unlucky End: On the Obsolescence of Products and Books

References

Index