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Notes On Swaps - Liabilities of a money center bank 5-year...

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SWAPS Definition: A swap is an agreement between two parties to exchange specified periodic cash flows in the future based on some underlying instrument or price (e.g., in a bond or note). Exmp: Interest rate, currency, credit risk, commodity, equity swaps. Interest Rate Swaps An interest rate swap is a succession of forward contracts on interest rates (e.g. arranging four forward rate agreements is similar to a four-year swap). It allows the parties long term protection (sometimes as long as 15 years). Swaps reduce the need to roll over contracts such as futures. The swap buyer agrees to make a number of fixed interest rate payments based on a principal contractual amount (notional principal) on periodic settlement dates to the swap seller. The swap seller in return agrees to make floating rate payments tied to some interest rate to the swap buyer on the same periodic settlement dates. Exmp: Assets of a money center bank : Floating rate loans (Indexed to LIBOR)
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Unformatted text preview: Liabilities of a money center bank: 5-year medium-term notes with fixed coupons Risk: Decreasing interest rates (which would decrease assets leaving liabilities constant) Solution: Transform the fixed rate liabilities to floating-rate liabilities. On-BS: Attract deposits that are indexed to LIBOR rate. Off-BS: Sell an interest rate swap. Make floating rate payments. OTHER INSTITUTION: Thrift institution: Assets of the thrift institution: Fixed interest rate mortgages Liabilities of the thrift institution: Short-term CDs (that needs to be rolled over at the current market rate) Risk: Increasing interest rates (which would increase the burden of the liabilities leaving assets constant) Solution: Transform the floating rate liabilities to fixed rate liabilities. On-BS: Issue long-term notes with same maturity as mortgages. Off-BS: Buy a swap. Enter into an agreement to make fixed-rate payments....
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