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Finance 319 Lecture 04.02.01

Finance 319 Lecture 04.02.01. Course Website http://www.citi.umich.edu/u/galka/319 Galina Albert Schwartz Department of Finance University of Michigan Business School. Plan of Today’s Lecture. Homework Levich, Chapter 13 Swap agreements are derivative securities

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Finance 319 Lecture 04.02.01

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  1. Finance 319 Lecture 04.02.01 Course Website http://www.citi.umich.edu/u/galka/319 Galina Albert Schwartz Department of Finance University of Michigan Business School Lecture notes Finance 319

  2. Plan of Today’s Lecture • Homework • Levich, Chapter 13 • Swap agreements are derivative securities redundant securities • Main types of swap agreements • Why do we have them? [who could gain from them] • What drives the demand for swaps? Lecture notes Finance 319

  3. Players & Terminology • Players: Industry & Financial Companies, Regulators & Central Banks [ – `The Usual suspects`] • Terms [Jargon]: • Plain vanilla swaps & Exotic swaps • Netting agreement & net exposure [Levich, p. 509] • Main types of swap agreements [Levich, p. 476] • currency or interest rate • fixed-rate or • floating rate or • fixed-floating interest rate swaps Lecture notes Finance 319

  4. An example: IBM & World Bank • Millman, p. 179: How IBM & World Bank circumvented Swiss and German government controls [ see also Levich, pp. 483 – 485, & Box 13.1] • 1981: Interest rates: • US $ about 17% • Swiss Francs -- 8% • German Marks -- 12% • 1987 creation of “swaption” [Millman, p. 181]. The volume is 20$ billion in one year Lecture notes Finance 319

  5. Swaps: market characteristics • Why to have swaps? [& who gains from using them] [Levich, pp. 489 – 492] • Hedgers [to reduce risks] • Speculators [to capture arbitrage opportunities • Examples of Speculations, Millman, pp. 182 -183 • Dell: • 1991 yearly earnings were $52 million • 1992: currency contracts for over $1 billion a week • Albany International: • 1988 – $ 4 Million loss on a swap • 1989 - $14 Million profit Lecture notes Finance 319

  6. Pricing the Swaps • What drives the demand for swaps? • Capital controls • Transaction costs • Differences in parties’ comparative advantage, [Levich, pp. 482 –483] [Market segmentation & asymmetric information] • How do we price them? • Net present value approach • Via calculation of the expected discounted cash flow • Risks associated with Swaps are: • Asymmetric • Time varying Lecture notes Finance 319

  7. Regulatory requirements • 1988: Bank for International Settlements (BIS) imposed capital requirements [Levich, pp. 507- 507, Table 13.7] • BIS capital requirements are determined as Notational swap value X Conversion factor X Risk weights • Advantageous: Simple & easy to implement; Transparent • Risk weights [Levich, p. 507] • Conversion factors [Table 13.7, Levich, p. 507] • Notational swap value • Drawbacks [disadvantages]: • No fine tuning • regulatory costs Lecture notes Finance 319

  8. Summary of the Lecture • Main subject: swap agreements: [currency or interest rate] • Swaps are used for: Cheap [& Quick] currency and interest rate risks management • Why do we have them? • Who uses them? [corporations] • How to price them? [NPV] Lecture notes Finance 319

  9. Next two lectures • Portfolio management • Bonds (ch. 14), 04.04.01 • Equity (ch. 15), 04.08.01 • To read: Levich, ch. 14 – 15 • New Technology & the Resulting Trends in Industrial Organization of International Financial Markets Lecture notes Finance 319

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