673_Swaps - SWAPS NBA 673 February 14, 2006 1 Introduction...

Info iconThis preview shows pages 1–8. Sign up to view the full content.

View Full Document Right Arrow Icon
1 SWAPS NBA 673 February 14, 2006
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
2 Introduction A financial swap is a contract between 2 counterparties , to exchange a series of cash payments. A swap contract specifies: The [interest rate applicable to] each cash payment; The currency for each cash payment,; The payments’ time table; The provisions to deal with default; Other relevant issues. The first swap was negotiated in 1981. The market is now measured in hundreds billions of dollars of notional.
Background image of page 2
3 Basic Scenario for a Swap Basic scenario for swaps: A party wants to hedge some risks or transform the nature of some cash flows. Goes to a swap dealer (“swap facilitator” or a “swap bank”) which creates a customized OTC contract to meet client needs. The bank then “warehouses the swap”: combines it with other swaps, uses interest rate derivatives to hedge residual risk exposure until it finds offsetting swaps. Huge market size suggests tremendous demand for swaps. But narrow spreads between receiving and paying rates reveal intense competition among dealers.
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
4 Interest Rate Swap Consider a simple, generic (“plain vanilla”) interest rate swap . Counterparties A and B agree on a notional principal which never changes hands but is used for calculations. A agrees to make fixed semiannual payments to B, the size of which is determined by a known fixed rate of interest on the notional principal. B agrees to make floating rate payments to A every 6 months, the size of which is based on a semiannual floating interest rate on the same notional principal. Payments are made in the same currency. They are netted and a counterparty pays the difference owed.
Background image of page 4
5 Example: Plain Vanilla Swap Swap on a $35 million notional principal. Party A makes a fixed payment every 6-months at 7.19% per annum. Party B pays LIBOR + 30 basis points Current 6-month LIBOR rate is 6.45% per annum.
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
6 Example: Plain Vanilla Swap (cont’d) Fixed rate is usually quoted on a semiannual bond equivalent yield basis. A pays every 6 months (Notional Principal) × (Days in Period/365) × (Interest Rate/100) = ($35,000,000) (182/365) (0.0719) = $1,254,802.74.
Background image of page 6
7 Example: Plain Vanilla Swap (cont’d) Floating side is quoted on a money market yield basis. B pays every 6 months
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 8
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 09/28/2008 for the course NBA 6730 taught by Professor Janosi,tibor during the Spring '06 term at Cornell University (Engineering School).

Page1 / 24

673_Swaps - SWAPS NBA 673 February 14, 2006 1 Introduction...

This preview shows document pages 1 - 8. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online