Understanding Interest Rate Swaps: Mechanics, Applications, and Market Dynamics
This chapter delves into interest rate swaps, a vital component of derivative markets. It describes the mechanics of swaps where two parties exchange periodic interest payments based on a notional principal. Key topics include the role of fixed and floating rate payers, applications in asset/liability management, and the determinants of swap spreads. The chapter also covers various types of swaps, including plain vanilla and swaptions, as well as the mechanisms of interest rate caps and floors. Additional insights into risk characteristics and credit derivatives ensure a comprehensive understanding.
Understanding Interest Rate Swaps: Mechanics, Applications, and Market Dynamics
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Presentation Transcript
Chapter 30 OTHER DERIVATIVE MARKETS: SWAPS, CAPS, FLOOR, AND CREDIT DERIVATIVES
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
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
Applications • Asset/Liability Management • Debt Issuance
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.
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
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
Secondary Market for Swaps • Swap Reversal • Swap Sale or Assignment • Swap Buy-Back or Close-Out or Cancellation
Types of Interest Rate Swaps • Plain Vanilla Swaps • Bullet Swap • Amortizing Swap • Accreting Swap • Roller Coaster Swap • Basis Rate Swap • Constant Maturity Swap
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
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
Risk/Return Characteristics For a cap and floor, the situation is as follows:
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.
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
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
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
