week7 - Derivatives and Risk Weeks 7 SWAP Introduction In...

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Derivatives and Risk Weeks 7 SWAP
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Introduction In today’s lecture, we will discuss the value of the swap and credit risk in SWAPs.
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Risk associated with Swap For a receive floating swap, Market risk is encountered when interest rates fall , resulting in a loss of swap market value. Credit risk is encountered when interest rates rise , resulting in a gain of swap market value and hence a potential credit loss if the counterparty fails. The counterparty might default on its obligations and fail to make a payment as it falls due. The size of the Credit risk depends on the length of the remaining term of the swap, and on interest rates.
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Risk associated with Swap For a receive fixed swap, market risk is encountered when interest rates rise , resulting in a loss of swap market value. credit risk is encountered when interest rates fall , resulting in a gain of swap market value and hence a potential credit loss if the counterparty fails
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Nature of Swap Credit Risk It is important to recognize that because no principle (the actual loan amount) is exchanged the credit risk is restricted to the possibility that the other party will stop exchanging interest payments. Meaning that; If an interest rate swap is used to speculate on movements , default by one party will deprive the other of the opportunity of speculative profits. If the swap is being used to hedge an interest rate exposure default by the other party will leave the exposure unhedged.
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The Role of Banks as Intermediaries Swaps are over the counter instruments (OTC); meaning they are negotiated and not exchanged, though Swap Futures do exist and are traded upon. Many Banks use swaps to hedge their own interest rate risk A number of Banks also specialise as intermediaries in the swaps market; Arranging Swaps between two other parties Or act a principle. i.e. as one of the parties in a swap with a customer.
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Swaps and concentration Risk The concentration risk is the risk that describe how much exposure that a bank has to any one particular counterparty. It is a sense of how many eggs you have in a particular basket.
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