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Chapter 30 – Swaps and More

Chapter 30 – Swaps and More. Interest Rate Swaps Objective: Control Interest Rate Risk What is Interest Rate Risk? It is the loss incurred by a company (i.e. bank) when interest rates change Example, a bank is lending long term but borrowing short term

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Chapter 30 – Swaps and More

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  1. Chapter 30 – Swaps and More • Interest Rate Swaps • Objective: Control Interest Rate Risk • What is Interest Rate Risk? • It is the loss incurred by a company (i.e. bank) when interest rates change • Example, a bank is lending long term but borrowing short term • If short term rates increase over the set long-term rates, payment stream from loans is insufficient to meet interest promise to investors, loss $$$ • This was the case in the 80s with many Savings and Loan Associations

  2. Chapter 30 – Swaps and More • Mechanics of an Interest Rate Swap • Fixed Payment Stream “exchanged” with a Floating Payment Stream • Party A has a fixed stream (Savings and Loan with a set of Mortgages) • Party B has a floating stream (Insurance company with investment portfolio in floating rate bonds) • Party A and Party B swap payoff streams… • Only the difference changes hands

  3. Chapter 30 – Swaps and More • Numbers of the mechanics of swap • Notional Amount of the Swap $50 Million • Fixed flow 8% • Floating flow LIBOR plus 2.5% • If LIBOR at 4%: • Fixed at $4,000,000 • Floating at $3,250,000 • If LIBOR at 7% • Fixed at $4,000,000 • Floating at $4,750,000 • Payment flow is $750,000 to counter-party

  4. Chapter 30 – Swaps and More • Swap is series of Forward/Futures Contracts • Benefits of Swap over Forward • One time negotiation vs. negotiation of all forward contracts • Longer maturities than futures • Liquid Secondary Market • Lock in a spread profit against liability of the company • Why didn’t the two parties just contract correctly in the first place? • Availability of Contracts, Competition, and Arbitrage Across Markets

  5. Chapter 30 – Swaps and More • Development of the Market • Bankers first were brokers • Bankers taking positions to finish swaps (difference in party notional amounts) • Bankers moving to dealers • Bankers acting solely as dealers as spreads narrow through competition • Bankers active dealers with standing quotes • Floating Rates matched with available Fixed Rates by Banks

  6. Chapter 30 – Swaps and More • Secondary Markets for Swaps • Getting Out of the Contract • Swaptions • The option to swap • Interest Rate Caps and Floors • An options contract • Seller and Buyer Positions • Option on an Option • Captions and Flotions

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