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