Flashcards
Ch 7: Swaps
Cards in this deck (10)
- 1Swap- OTC agreement between 2 parties to exchange a set of cash flows at specified future times
- Used for hedging and speculation - 2ConfirmationLegal agreement specifying the swap terms:
- Dates when the cash flows are exchanged
- Way in which cash flows are calculated - 3Interest rate swap- Swap buyer agrees to pay fixed-rate interest and receive floating-rate interest on a notional principal (L) over period T
- LIBOR is the floating rate (semi-annual floating-rate payments are calculated using LIBOR as at 6 mths before payment date)
- Day-count convention: actual/360 for floating and 30/360 for fixed - 4Market makers- Large financial institutions (banks) act as market makers
- Reduces counterparty risk for parties
- Swap rate = average of bid and offer fixed rates
- Usually structured so market maker earns 3-4 bps - 5Use of interest rate swapsConverting a liability from:
- Fixed rate to floating rate
- Floating rate to fixed rate
Converting an asset from:
- Fixed rate to floating rate
- Floating rate to fixed rate - 6Comparative advantage argument: criticism- Difference in spreads across fixed and floating rate-markets appears to contradict no-arbitrage principle
- However this is not an anomaly, and swap is not a risk-free arbitrage
- In the floating-rate market, lender has the opportunity to reprice credit risk every 6 months => floating-rate spread is lower - 7Valuation of swaps using bonds- Swap is a portfolio of opposite positions in a fixed and a floating rate bond
- On each payment date, value of the floating-rate bond resets to par
- Value on a non-payment date = PV (face value + next floating payment) - 8Swap rates and LIBOR- Swap rate = interest earned by consecutive lending to banks
- E.g. 5-year swap rate is an interest rate with credit risk corresponding to the situation where 10 consecutive six-month loans are made to AA borrowers at LIBOR => can enter swap to exchange the LIBOR income for the 5-year swap rate - 9Swap rates and par yield- Swap rate = par yield for a coupon bond with same maturity
- At inception, swap value = 0 =>
B(fix) = B(fl) = L
- Since swap rate is the coupon rate in the fixed coupon bond, swap rate = par yield
- E.g. 5-year semi-annual swap rate is the par yield (coupon rate) for a 5-year semi-annual coupon bond, which sells at par - 10Overnight indexed swap (OIS) rate- Fixed rate for a period is exchanged for geometric average of the overnight fed fund rates => closer to the risk-free rate
- Since credit crisis, OIS rate has been used as the discount rate instead of LIBOR
- Why: govt bond yields are too low for risk-free rates; banks hold them for regulatory purposes (drives up demand and reduces yield); more favourable tax treatment
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- Business/Economics (BFC3340: Derivatives 2) Flashcards on Ch 7: Swaps, created by Melina Mackey on 04/10/2019.
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- Melina Mackey
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