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Unformatted text preview: EC372 Bond and Derivatives Markets Topic #8: Swap contracts & swap markets R. E. Bailey Department of Economics University of Essex Outline Contents 1 Swap contracts 1 2 Why swaps occur: ‘comparative advantage’ 3 2.1 Example: plain vanilla interest rate swap . . . . . . . . . . . . . . . . . . . . . . . . 3 2.2 Example: foreign exchange (currency) swap . . . . . . . . . . . . . . . . . . . . . . 5 3 Risks associated with swaps 7 4 Valuation of swaps 7 5 Metallgesellschaft: A Case Study 7 Reading: Economics of Financial Markets , chapter 17 1 Swap contracts Swaps: examples • Simple example (currency swap): – A and B agree that 6 months from now A will pay £1m to B in return for $1.44m – This trivial currency swap is a forward contract – Swaps are almost always for a sequence of exchanges – Swaps are often expressed as interest rate flows • More realistic example (currency swap): – Current exchange rate: £1=$1.60 – Sterling interest rate: £10%, Dollar interest rate $9% – Swap agreement: £10% on £20m for $9% on $32m – Notional principal = £20m – £1m = 1 2 × 10% × £20m swapped for $1.44m = 1 2 × 9% × $32m, every 6 months • Intermediary: swaps are commonly arranged by an intermediary • Swaps are Over The Counter, OTC, ‘tailor-made’ for the parties 1 Swaps, continued • Plain vanilla interest rate swap: – fixed interest rate payments are exchanged for a stream of floating interest payments – Floating rate determined according to an agreed rule, e.g. LIBOR+40b.p. – Interest rate swap ≡ sequence of forward contracts: – ‘long’ swaps fixed in return for floating rate – ‘short’ swaps floating in return for fixed rate • Credit Default Swap (CDS): – A makes regular payments to B – A receives nothing from B , unless default occurs on a ‘specified asset’ (e.g. a bond) – If A holds the specified asset, the CDS is an ‘insurance policy’ against bond default – Naked CDS: A does not hold the specified asset – speculation on default of the specified asset? Credit default swap : more detail In a typical credit default swap one party makes regular payments but receives nothing in return unless default occurs on an asset specified in the contract. In the event of default, the first party (that made the sequence of payments) receives a lump-sum amount from the counterparty, and the swap terminates. Thus a credit default swap is a form of insurance contract for which each regular payment is effectively a premium and ‘default’ is the contingency against which insurance is obtained. More formally, suppose that the parties to the swap are identified as companies A and B . A third company (or sovereign state), C , has issued a debt instrument, C-bonds, which are risky in the sense that C might renege on some aspect of the bond contract (e.g. fail to make coupon payments or the repay the principal). A credit default swap could specify that (i) A pays an agreed amount to B every six months during the life of the...
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This note was uploaded on 03/15/2012 for the course EC 372 taught by Professor R.e.bailey during the Spring '12 term at Uni. Essex.
- Spring '12
- Comparative Advantage