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Lecture11 - Swaps and Risk Management Instructor Dr QU...

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11-1 Swaps and Risk Management Instructor : Dr. QU Baozhi Phone : (852) 27887312 Email: [email protected] Office : P7407
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11-2 Overview The market for swaps has grown enormously and this has raised serious regulatory concerns regarding credit risk exposures. Such concerns motivated the BIS risk-based capital reforms. Generic swaps in order of quantitative importance: interest rate, currency, credit, commodity and equity swaps.
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11-3 Interest Rate Swaps Interest rate swap as succession of forwards. Swap buyer agrees to pay fixed-rate Swap seller agrees to pay floating-rate. Purpose of swap Allows FIs to economically convert variable-rate instruments into fixed-rate (or vice versa) in order to better match the duration of assets and liabilities. Off-balance-sheet transaction.
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11-4 Plain Vanilla Interest Rate Swap Example Consider a money center bank that has raised $100 million by issuing 4-year notes with 10% fixed coupons. On asset side: C&I loans linked to LIBOR. Duration gap is negative. D A - kD L < 0 Second party is a savings bank with $100 million in fixed-rate mortgages of long duration funded with CDs having duration of 1 year. D A - kD L > 0
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11-5 Example (continued) Savings bank can reduce duration gap by buying a swap (taking fixed-payment side). Notional (dollar) value of the swap is $100 million. Maturity is 4 years with 10% fixed-payments. Suppose that LIBOR currently equals 8% and bank agrees to pay LIBOR + 2%.
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11-6 Fixed-Floating Rate Swap Short-term assets (C&I indexed loans) Long-term liabilities (4-year, 10%) Long-term assets (Fixed-rate Mortgages) Short-term liabilities (1-year CDs) 10% fixed LIBOR+2% Money Center Bank Savings Bank
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11-7
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