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Chapter 9

Chapter 9. Swaps and Interest Rate Derivatives. INTEREST RATE AND CURRENCY SWAPS. I. INTEREST RATE AND CURRENCY SWAPS A. INTEREST RATE SWAPS 1. Definition an agreement between 2 parties to

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Chapter 9

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  1. Chapter 9 Swaps and Interest Rate Derivatives

  2. INTEREST RATE AND CURRENCY SWAPS • I. INTEREST RATE AND CURRENCY SWAPS • A. INTEREST RATE SWAPS • 1. Definition • an agreement between 2 parties to • exchange US$ interest payments for a specific maturity on an agreed notional amount.

  3. HOW THE CLASSIC SWAP WORKS • a. Notional principal: a reference amount used only to calculate interest expense but never repaid. • b. Maturities: less than 1 to over 15 years

  4. THE CLASSIC SWAP • 2. Types • a. Coupon swap • b. Basis swap • 3. LIBOR: the most important reference rate in a swap • 4. Swap Usage: • To reduce risk potential and costs.

  5. THE CURRENCY SWAP • B. Currency Swaps • 1. Definition • two parties exchange foreign currency- • denominated debt at periodic intervals. • 2. Purpose: similar to parallel loan

  6. THE CURRENCY SWAP • 3. Differences of a Currency Swap: • a. Currency swap is not a loan • b. No interest expense; no balance sheet entry • c. The right to offset any non-payment is more firmly established

  7. THE CURRENCY SWAP • 4. Similarities between Interest Rate and • Currency Swaps • a. Avoid exchange rate risk • b. Exchange rate is only a reference to • determine amounts exchanged • 5. Economic Benefits of Swaps • when arbitrage prohibited, they provide • long-term financing.

  8. II. INTEREST RATE FORWARDS AND FUTURES Forward and futures contracts: - three types used to manage interest rate risk A. Forward forwards B. Forward rate agreements C. Eurodollar futures

  9. INTEREST RATE FORWARDS AND FUTURES Forward forwards • 1. a contract that fixes an interest rate today on a future loan or deposit. • 2. Contract conditions: • - specific interest rate • - principal amount of future loan • - start and ending dates of future interest rate period

  10. INTEREST RATE FORWARDS AND FUTURES Forward rate agreements (FRAs) 1. cash-settled 2. over-the-counter forward contract 3. company fixes an interest rate applied to a specified future interest period on a notional amount.

  11. INTEREST RATE FORWARDS AND FUTURES Eurodollar Futures 1. A cash-settled futures contract for a 3- month eurodollar deposit paying LIBOR 2. Contracts traded on: a. Chicago Mercantile Exchange b. London International Financial Futures Exchange c. Singapore International Monetary Exchange

  12. III. STRUCTURED NOTES • Interest-bearing securities whose interest payments are determined by reference to a formula set in advance and adjusted on specific reset dates.

  13. STRUCTURED NOTES • Inverse Floaters • a floating-rate instrument whose interest rate moves inversely with market interest rates.

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