FRM Powerpoints 2011 Unit IIC Swap Contracting

FRM Powerpoints 2011 Unit IIC Swap Contracting - II. Tools...

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II. Tools and Applications of Market Risk Management C. Swap Contracting
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Version: January 3, 2011 Unit II.C p. 2 of 46 Characteristics of Swaps o A swap is a transaction between two parties in which each party agrees to pay the other a series of cash flows at specific dates over a specific period of time. At least one set of cash flows is based on the outcome of a random factor, such as an interest rate, exchange rate, stock price, or commodity price. The other set of cash flows can be random or fixed. o Our focus is on interest rate and currency swaps
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Version: January 3, 2011 Unit II.C p. 3 of 46 Characteristics of Swaps (cont.) o A currency swap is an agreement between two parties for each party to pay the other a series of cash flows in different currencies. One party pays in one currency and the other in another currency. The cash flows are in the form of interest payments and many currency swaps can include principal payments. Each set of interest payments can be at a fixed or floating rate. o An interest rate swap is an agreement between two parties for each party to make to the other a series of interest payments. The payments are made in the same currency. At least one set of payments is at a floating rate, while the other can be at a floating or fixed rate. The principal payments are never exchanged.
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Version: January 3, 2011 Unit II.C p. 4 of 46 Characteristics of Swaps (cont.) o Basic concepts n Notional principal n Payment dates (settlement dates); settlement periods n Termination date n Strictly OTC n Widely used (the most widely used derivative) n First swap was in 1981 between IBM and the World Bank
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Version: January 3, 2011 Unit II.C p. 5 of 46 Characteristics of Swaps (cont.) o Terminating a swap For example, say you enter into a swap with counterparty A to pay LIBOR and receive a fixed rate of F with counterparty A. To offset that swap, you enter a new swap with counterparty B to receive LIBOR and pay a fixed rate of G. Your cash flows are On the first swap with counterparty A: Pay LIBOR Receive fixed rate of F On the second swap with counterparty B: Pay fixed rate of G Receive LIBOR Credit risk remains If B is your original counterparty, you can do an offset.
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Version: January 3, 2011 Unit II.C p. 6 of 46 Characteristics of Interest Rate Swaps o Plain vanilla (or just vanilla swap) Consider the following scenario. XYZ Corporation is currently engaged in a floating-rate loan, paying LIBOR + 250 basis points. It would prefer a fixed rate- loan, perhaps because it expects interest rates to increase. It can easily convert the floating-rate loan into a fixed-rate loan by engaging in a swap. Suppose the swap dealer offers the swap at the rate of R. That is, XYZ can enter into the swap, paying R and receiving LIBOR. Combined with the loan, XYZ effectively pays R + 250 basis points, a fixed rate.
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Version: January 3, 2011 Unit II.C p. 7 of 46 Characteristics of Interest Rate Swaps (cont.) o (Plain) vanilla swap Typical Interest Rate Swap Used to Synthetically Convert
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This note was uploaded on 02/28/2012 for the course FIN 7400 taught by Professor Donchance during the Fall '11 term at LSU.

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FRM Powerpoints 2011 Unit IIC Swap Contracting - II. Tools...

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