BUS307 Topic 9 - Topic 9 Interest Rate Swaps&amp FRNs BUS307 Commercial Banking OVERVIEW This topic is primarily concerned with interest rate swaps

BUS307 Topic 9 - Topic 9 Interest Rate Swaps&amp FRNs...

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Topic 9 Interest Rate Swaps & FRNs BUS307 Commercial Banking
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OVERVIEW This topic is primarily concerned with interest rate swaps. These involve the exchange of a sequence of fixed-rate payments that resemble the payments from a bond for a sequence of floating rate payments that resemble the interest payments from a floating rate note. The features of bonds have been covered extensively in previous topics. The features of floating rate instruments however, will be discussed briefly.
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OVERVIEW Interest rate swaps are used by banks to hedge exposures to interest rate changes. This may be achieved on a micro level by hedging their exposure to a particular liability, or on a macro level by hedging their total interest rate exposure. Major international banks may also perform the role of swap dealer by running a ‘swap book’ by offering both sides of a swap to counterparties.
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FLOATING RATE INSTRUMENTS Floating rate bonds and loans Defined as coupon bonds or loans with payment tied to a market rate of interest such as T-bill rate, LIBOR , or bank bill rate (BBR). Characteristics of Floaters Price Stability – Consider a 15% coupon rate bond with 5 years to maturity and face value of $1,000 and interest paid annually. 150 150 150 150 1150 ! ! ! ! ! ! 0 1 2 3 4 5 If the discount rate is 15% then the price of the bond equals $1,000. If the discount rate changes to 10% and the bond is a fixed rate then the price of the bond equals approximately $1,189.
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FLOATING RATE INSTRUMENTS If the discount rate changes to 10% and the bond is a variable rate then the price of the bond equals approximately $1,000. The price of a floating rate instrument returns to exactly par at the interest reset date. The price is therefore equal to the par value discounted at the current market interest rate over the period to the next reset.
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FLOATING RATE INSTRUMENTS Duration – After reset, the floater’s duration will equal the remaining time to reset. Examine two strategies rolling over of T-bills and the alternative of purchasing a floater. Strategy 1: Rolling over T-bills every 90 days or 0.25 year. $1,000 $1,000(1+r 0 ) $1,000(1+r 1 )  _______________________________________________________________________________ __ 0.25 0.50
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FLOATING RATE INSTRUMENTS Strategy 2: Purchase of a floater $1,000 $1,000(r 0 ) $1,000(r 1 ) ___________________________________________________ 0.25 0.50 Since the net cash flows are identical then duration at the beginning of each roll over is 0.25 years
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INTEREST RATE SWAPS Features of an interest rate swap: Both parties exchange periodic cash flows based on: Notional principal amount Market interest rates ‘Plain vanilla’ swap trades a fixed interest rate for a floating interest rate In practice only net cash flows are paid.
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