Chapter 30 OTHER DERIVATIVE MARKETS: SWAPS, CAPS, FLOOR, AND CREDIT DERIVATIVES

Interest Rate Swap zAn agreement whereby two parties agree to exchange periodic interest payments based on a notional principal amount. yfixed rate payer yfloating rate payer yreference rate xTreasury bills, LIBOR, commercial paper, bankers acceptances, CDs, federal funds rate, prime rate

Risk/Return Characteristics of a Swap

Interest Rate Swap Position zPosition in a package of forward contracts zPosition in a package of cash flows from buying and selling the cash instrument

Applications zAsset/Liability Management zDebt Issuance

Interest Rate Swap Market zInitial motivation was borrower exploitations of perceived credit arbitrage opportunities. zAn efficient market for altering cash flow characteristics of assets or liabilities. zCommercial banks and investment banking firms take positions in swaps.

Primary Determinants of Swap Spreads zSwap Spread ydifference between the swap’s fixed rate and the rate on a Treasury whose maturity matches that of the swap zKey Determinants yfor maturities of less than five years, it is the cost of hedging in the Eurodollar CD futures market yfor maturities of more than five years, it is largely driven by credit spreads in the corporate bond market

Other Factors Influencing the Level of Swap Spreads zThe level and shape of the Treasury yield curve zThe relative supply of fixed and floating- rate payers zThe level of asset-based swap activity zTechnical factors affecting swap dealers

Secondary Market for Swaps zSwap Reversal zSwap Sale or Assignment zSwap Buy-Back or Close-Out or Cancellation

Types of Interest Rate Swaps zPlain Vanilla Swaps zBullet Swap zAmortizing Swap zAccreting Swap zRoller Coaster Swap zBasis Rate Swap zConstant Maturity Swap

Swaptions zGrants the option buyer the right to enter into an interest rate swap at a future date. zTypes of Swaptions ypayer swaption yreceiver swaption

Interest Rate Caps and Floors zAn agreement between two parties in which one party, for an upfront premium, agrees to compensate the other if the reference rate is different from the strike rate. yInterest Rate Cap yInterest Rate Floor yStrike Rate zCombinations yInterest Rate Collar yCaptions yFlotions

Risk/Return Characteristics For a cap and floor, the situation is as follows:

Applications of Interest Rate Floors zLocking in an interest rate spread over the cost of funds while maintaining the opportunity to benefit from a rate decline. zEstablishing a lower bound on investment return while retaining the opportunity to benefit from a rate increase.

Credit Derivatives zManaging Interest Rate Risk yTreasury futures contracts, Treasury options, interest rate swaps, caps, and floors zManaging Credit Risk yCredit options yCredit forwards yCredit swaps

Credit Risk zDefault Risk yrisk that issuer will fail to satisfy the terms of the obligation zCredit Spread Risk yrisk that credit spread will increase zDowngrade Risk yrisk that an issue will be downgraded

Credit Derivatives zCredit Options yCredit options written on an underlying issue yCredit spread option zCredit Forward Contracts zCredit Swaps yCredit default swaps yTotal return swaps