week5_1 - 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 swaps and their applications in risk management
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FN263 Derivatives and Risk Weeks 5 SWAP
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Introduction In today’s lecture, we will focus on “Plain Vanilla” Interest Rate Swaps Understand swap terminology and how they work How to design a SWAP based on the argument of comparative advantage
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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 of changing the basis of a commitment: Cross currency Cross instrument Cross interest basis
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Introduction to Swaps In terms of interest rates: A swap can enable a company to change a floating rate asset or liability into one bearing a fixed rate without having to close the underlying position There is no exchange of principal, the parties only exchange the cash flows 4% semi annual against 6 month Libor
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Introduction to Swaps The life of the swap is the swap term or swap tenor. A single-payment swap = a forward contract Thus they can be viewed as a series of forward contracts settled in arrears: swap payments are made at the end of the period (when interest is due)
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example
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Interest Rate Swap an agreement to exchange interest-related payments in the same currency from fixed rate into floating rate (or vice versa), or from one type of floating to another. New or existing debt can be swapped Usually the underlying rate is LIBOR.
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Interest Rate Swap Under interest rate swap One party will agree to pay the “fixed rate” The other to receive this fixed rate and pay the “floating rate”. The movement of funds is a net transfer of interest rate payments between the two parties on pre- specified dates. The underlying loan or investment is untouched, although the interest payments are calculated on this agreed but un-exchanged principal amount Because there is no exchange of principal credit exposure is limited.
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Typical Uses of an Interest Rate Swap Converting a liability from fixed rate to floating rate floating rate to fixed rate Converting an investment from fixed rate to floating rate floating rate to fixed rate
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