7Lecture8interestrateriskIV

E da dl la a r1r 61 which option to use concern

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Unformatted text preview: te a call -C –E +B C E C B B B B B B E +C –B +E 59 Put Options on Bonds Buy a Put P Write a Put -P-B+E E B B B B E B +P-E+B 60 Example-Bank (mln) Assets 100 Liabilities Equity 90 10 Duration of Assets = 5 yrs, Duration of Liabilities= 3 yrs Current rate = 10%, Δ Equity if Expect the interest rates to increase by 1%? ΔE = - [DA - DL * (L/A)] *A *Δr/(1+r) 61 Which Option to use? Concern? Lose $ if rates increase Position in the option Market Rule : Make $ in the option Mkt if rates increase Write a Call Buy Put B(r) B(r) B(r) B(r) As rate increases, Price decreases 62 D. Hedging using Interest Rate Swaps • Agreement between two parties to exchange, over a fixed horizon, cash flows accruing on a notional principal amount • underlying debt or asset not swapped Two major types: Interest Rate Swap exchange of fixed interest rate payments with floating rate payments Currency Swap exchange of one currency’s interest rate and principal cash flows for another’s 64 Interest Rate Swaps Terminology swap buyer agrees to make fixed interest payments and receive floating interest payments swap seller agrees to make floating interest payments and receive fixed interest payments Either side could actually deal with dealer The...
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