Lecture7_SwapII - NBA 6730: Derivative Securities Lecture...

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1 NBA 6730: Derivative Securities Lecture 7: Interest Rate Swaps 09/16/2010 George Gao NBA6730-Derivative Securities I 2 Agenda An interest rate swap is a financial contract between two counterparties who exchange future cash flows on fixed- rate vs. floating-rate interests , according to a pre-arranged formula. We study interest rate swaps in this lecture. Mechanics of interest rate swaps Why interest rate swaps Pricing and valuation of interest rate swaps
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2 NBA6730-Derivative Securities I 3 (1) “Plain Vanilla” Interest Rate Swap Interest rate swap terms negotiated in Mar 2007: Microsoft is a fixed-rate payer: it agrees to pay Intel an interest rate of 5% per annum on a principal of $100M Intel is a floating-rate payer: it agrees to pay Microsoft the 6-month LIBOR rate on the same principal The interest payments are exchanged every 6 months The 5% interest rate is quoted with semiannual compounding The maturity of this contract is 3 years Notional amount: $100M principal (NOT to be exchanged) Intel Microsoft 5% LIBOR NBA6730-Derivative Securities I 4 (2) Mechanics of Interest Rate Swap Cash flows to Microsoft in this 3-year interest rate swap NOTE: the 6-month LIBOR observed in March is used as a floating rate to calculate the interest payment in September. Date 6-Month LIBOR Rate Floating CF Received Fixed CF Paid Mar 2007 4.2% Sep 2007 4.8% $100 ൈ ૝. ૛% 2 ൌ$2 .1 $100 ൈ 5% 2 ሺ$2.5ሻ Mar 2008 5.3% $100 ൈ ૝. ૡ% 2 ൌ$2 .4 $100 ൈ 5% 2 ሺ$2.5ሻ Sep 2008 5.5% $100 ൈ ૞. ૜% 2 ൌ $2.65 $100 ൈ 5% 2 ሺ$2.5ሻ Mar 2009 5.6% $2.75 ( $2.5 ) Sep 2009 5.9% $2.80 ( $2.5 ) Mar 2010 $2.95 (
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3 NBA6730-Derivative Securities I 5 (3) Market of Swaps Most of the market is over-the-counter (OTC) Parties tend to want specific, tailor made products Exchange traded products are less common, but do exist (e.g., interest rate swap futures on CBOT) Global OTC derivatives (in trillions of US dollars) NBA6730-Derivative Securities I 6 (4) Why Undertake a Swap? Firms AAA and BBB can borrow at these rates: Firm AAA has an absolute advantage in both fixed-rate and floating-rate borrowing markets Higher credit rating Absolute advantage is not what motivates a swap The comparative advantage is what motivates a swap AAA’s comparative advantage: fixed-rate borrow –1 . 2 % better off in fixed rate, 0.7% better off in floating rate BBB’s comparative advantage: floating-rate borrow –1 . 2 % worse off in fixed rate, 0.7% worse off in floating rate Fixed rate Floating rate Firm AAA 10.0%
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4 NBA6730-Derivative Securities I 7 (4) Why Undertake a Swap? The comparative advantage is 0.5%
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Lecture7_SwapII - NBA 6730: Derivative Securities Lecture...

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