25 - Chapter Twenty FIVE Swaps Chapter Outline Introduction...

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Chapter Twenty FIVE Swaps Chapter Outline Introduction Interest Rate Swaps Realized Cash Flows on an Interest Rate Swap Macrohedging with Swaps Currency Swaps Fixed-Fixed Currency Swaps Fixed-Floating Currency Swaps Credit Swaps Total Return Swaps Pure Credit Swaps Swaps and Credit Risk Concerns Summary Appendix 25A: Pricing an Interest Rate Swap Pricing a Swap: An Example 65
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Solutions for End-of-Chapter Questions and Problems: Chapter Twenty Six 1. Explain the similarity between a swap and a forward contract. A forward contract requires delivery or taking delivery of some commodity or security at some specified time in the future at some price specified at the time of origination. In a swap, each party promises to deliver and/or receive a pre-specified series of payments at specific intervals over some specified time horizon. In this way, a swap can be considered to be the same as a series of forward contracts. 2. Forward, futures, and option contracts had been used by FIs to hedge risk for many years before swaps were invented. If FIs already had these hedging instruments, why do they need swaps? Although similar in many ways, the following distinguishing characteristics cause the instruments to be differentiated: (a) The swap can be viewed as a portfolio of forward contracts with different maturity dates. Since cash flows on forward contracts are symmetric, the same can be said of swaps. This is in contrast to options, whose cash flows are asymmetric (truncated either on the positive or negative side depending upon the position). (b) Options are marked to market continuously, swaps are marked to market at coupon payment dates, and forward contracts are settled only upon delivery (at maturity). Therefore, the credit risk exposure is greatest under a forward contract, where no third party guarantor exists as in options (the options clearing corporation for exchange-traded options) and swaps (the swap intermediary). (c) The transactions cost is highest for the option (the nonrefundable option premium), next for the swap (the swap intermediary's fee), and finally for the forward (which has no up-front payment). (d) Swaps also have a longer maturity than any other instrument and provide an additional opportunity for FIs to hedge longer term positions at lower cost. Moreover, since the package of forward contracts mirrors debt instruments, the swap provided FIs with a hedge instrument that is attractive and less costly than separate forward contracts. (e) Finally, the introduction of a swap intermediary reduces the credit risk exposure and the information and monitoring costs that are associated with a portfolio of individual forward contracts. 3.
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This note was uploaded on 10/25/2010 for the course FIN 398 taught by Professor Ray,jackson during the Spring '10 term at UMass Dartmouth.

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25 - Chapter Twenty FIVE Swaps Chapter Outline Introduction...

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