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Add the Financial Intermediary

Add the Financial Intermediary - 4 Exchange of Principal...

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Add the Financial Intermediary Now add a financial institution who demands a spread of 4bps. Design a swap that makes AAA and BBB better off. 1
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Valuation of an Interest Rate Swap Interest rate swaps can be valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bond. Alternatively, they can be valued as a portfolio of forward rate agreements (FRAs). We will use only the first approach. 2
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Valuation in Terms of Bonds The fixed rate bond is valued in the usual way. To value the floating rate bond we don’t know all the future values of LIBOR so we don’t know the future payments. The trick is to remember that immediately after a payment, the value of a floating rate bond is its face value. 3
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An Example of a Currency Swap An agreement to pay 5% on a sterling principal of £10,000,000 & receive 6% on a US$ principal of $18,000,000 every year for 5 years
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Unformatted text preview: 4 Exchange of Principal • In an interest rate swap the principal is not exchanged • In a currency swap the principal is exchanged at the beginning and the end of the swap 5 The Cash Flows (Table 7.5, page 176) Year Dollars Pounds $------millions------2010 –18.00 +10.00 2011 +1.08 –0.5 2012 +1.08 –0.5 2013 +1.08 –0.5 2014 +1.08 –0.5 2015 +19.08 –10.5 £ 6 Valuation of Currency Swaps • Like interest rate swaps, currency swaps can be valued either as the difference between 2 bonds or as a portfolio of forward contracts. • We will value using bonds. 7 Credit Risk • A swap is worth zero to a company initially. • At a future time its value is liable to be either positive or negative. • The company has credit risk exposure only when its value is positive. • Credit risk arises because the counterparty may default. 8...
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Add the Financial Intermediary - 4 Exchange of Principal...

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