week5 - Derivatives and Risk Weeks 5-7 SWAP Learning...

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Derivatives and Risk Weeks 5-7 SWAP

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Learning Outcomes By the end of this part of the module, you should be able to: Understand the swaps and its applications in risk management
FN263 Derivatives and Risk Weeks 5 SWAP

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Introduction In today’s lecture, we will discuss SWAP. We will focus on Plain Vanilla” Interest Rate Swap How to design a SWAP based on comparative How to design a SWAP based on comparative advantage argument advantage argument
What is a Swap?

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Introduction to Swaps A swap is a contract calling for an exchange of payments, on one or more dates, determined by the difference in two prices A swap provides a means to hedge a stream of risky payments A swap can be regarded as a convenient way of packaging forward contracts
Introduction to Swaps The life of the swap is the swap term or swap tenor. A single-payment swap = a forward contract To cover the very short time period: Sterling overnight index swaps (SONIA rates) and Euro overnight index swaps (ECONIA rate) settled in arrears: swap payments are made at the end of the period (when interest is due)

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Review Rolling Interest rate Suppose we will borrow £100 million in 6 months for a period of 2 years by rolling over the total every 3 months 8 unknown quarterly borrowing rates with each time £100 r 1 =? r 2 =? r 3 =? r 4 =? r 5 =? r 6 =? r 7 =? r 8 =? 0 6 9 12 15 18 21 24 27 £100 £100 £100 £100 £100 £100 £100 £100
Review Rolling Interest rate Two alternatives to hedge the interest rate risk Strip: hedge each unknown quarterly borrowing rate individually Means: enter into eight separate £100 million FRAs for each 3- month period One 6x9 FRA, one 10x12FRA, one 1x3 (next year) FRA, one 4x6 FRA, one 6x9 FRA, one 10x12 FRA, one 1x3 (in year 2) FRA, one 4x6 FRA. (each with £100 million) Strip requires the existence of FRA far into the future.

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Review Rolling Interest rate Two alternatives to hedge the interest rate risk This also means: £100 for 8 quarters, £100 for 7 quarters, £100 for 6 quarters, £100 for 5 quarters, £100 for 4 quarters, £100 for 3 quarters, £100 for 2 quarters, and £100 for 1 quarter Stack: enter 6-month FRA for £800 million. Each quarter enter into another FRA decreasing the total by \$100 each time Stack is more feasible but suffers from basis risk The quarterly borrowing costs in distant quarters may not move perfectly with borrowing costs in near quarters r 1 =? r 2 =? r 3 =? r 4 =? r 5 =? r 6 =? r 7 =? r 8 =? 0 6 9 12 15 18 21 24 27 £100 £100 £100 £100 £100 £100 £100 £100
SWAP V.S. Rolling Interest rate forward SWAP is to construct a product that allows multiple fixing for some long time period with re-fixings or rollovers every 3 months on predetermined dates. Similar to a series of sequential FRAs such as Strip

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This note was uploaded on 04/21/2011 for the course BUSINESS AAF001-1 taught by Professor Dr.tony during the Spring '11 term at University of Bedfordshire.

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week5 - Derivatives and Risk Weeks 5-7 SWAP Learning...

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