Saunders & Cornett, Financial Institutions Management, 4th ed. 1 “History teaches us that men and nations behave wisely once they have exhausted all other.

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Saunders & Cornett, Financial Institutions Management, 4th ed. 1 “History teaches us that men and nations behave wisely once they have exhausted all other alternatives.” Abba Eban

Saunders & Cornett, Financial Institutions Management, 4th ed. 2 Global Derivatives Markets as of June 2001 Credit derivatives - $1 trillion in notional value worldwide Interest rate derivatives - $65 trillion Foreign exchange rate derivatives - $16 trillion Equity derivatives -$2 trillion By comparison, total on-balance sheet assets of all US banks was $5 trillion (as of Dec. 2000) and for Euro area banks $13 trillion. Global derivatives markets totaled approximately $84 trillion in notional value.

Saunders & Cornett, Financial Institutions Management, 4th ed. 3 Step-By-Step Hedging Using Interest Rate Swaps Step 4: Implementation. –Long hedge (DG<0) – sell swaps (make floating rate payments). –Short hedge (DG >0) – buy swaps (make fixed rate payments). Fixed for floating rate (plain vanilla) swap Swap intermediary acts as credit guarantor, as well as broker and bookkeeper. Only net amounts exchanged on payment dates (not principal amounts). Swaps are portfolios of forwards so there are no predetermined notional values (NV) or contract specifications as in exchange traded futures & options.

Saunders & Cornett, Financial Institutions Management, 4th ed. 4 Example of Macrohedge Against Interest Rate Risk Step 1: D A = 7.5 yrs. D L =2.9 yrs. A=$750m L=$650m. DG = 5 yrs. Assume a 25 bp increase in interest rates such that  R S /(1+R S ) = + 25bp  E  -D G A  R S /(1+R S ) = -5($750m)(.0025) = - $9.375m Step 2: Loss of $9.375million in the market value of equity when interest rates unexpectedly increase by 25 bp.

Saunders & Cornett, Financial Institutions Management, 4th ed. 5 Macrohedge Example (cont.) Step 3: Perfect hedge would generate positive cash flows of $9.375 million whenever spot rates increase 25 bp. Short hedge: buy fixed for floating rate swaps. Step 4: Floating rate reprices each year (D float =1). Fixed rate is equal to the 15 yr 8% coupon T-bond (D fixed =9.33).  Swap  -(D Fixed –D Float )NV  R swap /(1+R swap ) = -(9.33 – 1)NV(.0025) set = $9.375m =  E NV = $450 million Buy $450 million of fixed for floating rate swaps in order to implement macrohedge to immunize against ALL interest rate risk

Saunders & Cornett, Financial Institutions Management, 4th ed. 6 Immunizing Against Interest Rate Risk Using Swaps Interest rate shock drops out of final formula (as long as interest rates change by the same amount in spot and futures markets): For microhedge: NV swap = (D S P S )/(D Fixed -D Float ) For macrohedge: NV swap = (DG)A/(D Fixed - D Float )

Saunders & Cornett, Financial Institutions Management, 4th ed. 7 The Total Return Swap Swaps fixed loan payment plus the change in the market value of the loan for a variable rate interest payment (tied to LIBOR). Figure 15.5 shows the structure. Table 15.1 shows the cash flows if the fixed loan rate=12%, LIBOR=11%, and the loan depreciates 10% in value over the year (at swap maturity). Buyer of credit protection (the bank lender) receives 11% and pays out (12% - 10%) = 2% for a net cash inflow of 9%.

Saunders & Cornett, Financial Institutions Management, 4th ed. 8

9 Credit Default Swaps (CDS) CDS specifies: –Identity of reference loan –Definition of credit event (default, restructuring, etc.) –Payoff upon credit event. –Specification of physical or cash settlement. July 1999: master agreement for CDS by ISDA Swap premium = CS Figure 15.6 shows the cash flows on the CDS.

Saunders & Cornett, Financial Institutions Management, 4th ed. 10

Saunders & Cornett, Financial Institutions Management, 4th ed. 11 Pricing the CDS: Promoting Price Discovery in the Debt Market Premium on CDS = PD x LGD = CS on reference loan Decomposition of risky debt prices to obtain PD (see chapter 5): Basis in swap market (CDS premium  CS) because: –Noise and embedded options in risky debt prices. –Liquidity premium in debt market. –Default risk premiums in CDS market for counterparty default risk. Increase as correlations increase and credit ratings deteriorate. Table –High cost of arbitrage between CDS and debt markets.

Saunders & Cornett, Financial Institutions Management, 4th ed. 12 Table 15.2 CDS Spreads for Different Counterparties