Chapter 30

1. Chapter 30 OTHER DERIVATIVE MARKETS: SWAPS, CAPS, FLOOR, AND CREDIT DERIVATIVES

2. Interest Rate Swap • An agreement whereby two parties agree to exchange periodic interest payments based on a notional principal amount. • fixed rate payer • floating rate payer • reference rate • Treasury bills, LIBOR, commercial paper, bankers acceptances, CDs, federal funds rate, prime rate

3. Risk/Return Characteristics of a Swap

4. Interest Rate Swap Position • Position in a package of forward contracts • Position in a package of cash flows from buying and selling the cash instrument

5. Applications • Asset/Liability Management • Debt Issuance

6. Interest Rate Swap Market • Initial motivation was borrower exploitations of perceived credit arbitrage opportunities. • An efficient market for altering cash flow characteristics of assets or liabilities. • Commercial banks and investment banking firms take positions in swaps.

7. Primary Determinants of Swap Spreads • Swap Spread • difference between the swap’s fixed rate and the rate on a Treasury whose maturity matches that of the swap • Key Determinants • for maturities of less than five years, it is the cost of hedging in the Eurodollar CD futures market • for maturities of more than five years, it is largely driven by credit spreads in the corporate bond market

8. Other Factors Influencing the Level of Swap Spreads • The level and shape of the Treasury yield curve • The relative supply of fixed and floating-rate payers • The level of asset-based swap activity • Technical factors affecting swap dealers

9. Secondary Market for Swaps • Swap Reversal • Swap Sale or Assignment • Swap Buy-Back or Close-Out or Cancellation

10. Types of Interest Rate Swaps • Plain Vanilla Swaps • Bullet Swap • Amortizing Swap • Accreting Swap • Roller Coaster Swap • Basis Rate Swap • Constant Maturity Swap

11. Swaptions • Grants the option buyer the right to enter into an interest rate swap at a future date. • Types of Swaptions • payer swaption • receiver swaption

12. Interest Rate Caps and Floors • An agreement between two parties in which one party, for an upfront premium, agrees to compensate the other if the reference rate is different from the strike rate. • Interest Rate Cap • Interest Rate Floor • Strike Rate • Combinations • Interest Rate Collar • Captions • Flotions

13. Risk/Return Characteristics For a cap and floor, the situation is as follows:

14. Applications of Interest Rate Floors • Locking in an interest rate spread over the cost of funds while maintaining the opportunity to benefit from a rate decline. • Establishing a lower bound on investment return while retaining the opportunity to benefit from a rate increase.

15. Credit Derivatives • Managing Interest Rate Risk • Treasury futures contracts, Treasury options, interest rate swaps, caps, and floors • Managing Credit Risk • Credit options • Credit forwards • Credit swaps

16. Credit Risk • Default Risk • risk that issuer will fail to satisfy the terms of the obligation • Credit Spread Risk • risk that credit spread will increase • Downgrade Risk • risk that an issue will be downgraded

17. Credit Derivatives • Credit Options • Credit options written on an underlying issue • Credit spread option • Credit Forward Contracts • Credit Swaps • Credit default swaps • Total return swaps