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options futures derivatives

# options futures derivatives - Lecture 5(Ch7 Swaps Basic...

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Lecture 5: (Ch7) Swaps Basic Principles A swap is an agreement to exchange cash flows at specified future times according to certain specified rules. A forward contract can be viewed as an example of a swap – Whereas a forward contract is equivalent to the exchange of cash flows on just one future date, swaps typically lead to cash flow exchanges on several future dates. LIBOR . The floating rate in most interest rate swap agreements is the London Interbank Offered Rate. o Interest rate at which a bank is prepared to deposit money with other banks in the Eurocurrency market. Interest Rate Swaps Most common; “plain vanilla” interest rate swap. Fixed-for-floating agreement. Notional principal . When the principal itself is not exchanged, it is termed notional principal . May be used to: o Transform an asset Transform an asset earning a fixed rate of interest into an asset earning a floating rate of interest o Transform a liability Transform a floating rate loan into a fixed rate loan Financial intermediary . It is unlikely that two companies will contact a financial institution at the same time and want to take opposite positions in exactly the same swap. Financial institutions act as market makers. o The average of the bid and offer fixed rates is known as the swap rate . Day Count Issues As it is a US money market rate, the 6-month LIBOR is quoted on an actual/360 basis.

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In general, a LIBOR-based floating -rate cash flow on a swap payment date is calculated as LRn/360 o Where L is the principal, R is the relevant LIBOR rate, and n is the number of days since the last payment date. The fixed rate is usually quoted as actual/365 or 30/360 . It is not therefore directly comparable with LIBOR because it applies to a full year To make rates approximately comparable, either: o Multiply 6-month LIBOR rate by 365/360, or o Multiply Fixed rate by 360/365 Confirmations A confirmation is the legal agreement underlying a swap and is signed by representatives of the two parties. The confirmation specifies that the following business day convention is to be used and that the US calendar determines which days are business days and which days are holidays. Comparative Advantage Argument Common argument for popularity of swaps comparative advantage. Consider the use of an interest rate swap to transform a liability. Some companies have comparative advantage in fixed-rate markets, whereas other companies have a comparative advantage in floating-rate markets. To obtain a new loan, it makes sense for a company to go to the market where they have a comparative advantage then make a swap for what the company wants. Argument Criticism
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options futures derivatives - Lecture 5(Ch7 Swaps Basic...

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