1 Topic 8. Swaps 8.1Over-the-counter (OTC) Derivatives 8.2 Interest Rate Swap 8.3 Zero Curve 8.4 Forward Curve 8.5 Zero Delta 8.6 Forward Delta 8.7 DV01

2 8.1 OTC Derivatives 2012  Global OTC Derivative Gross Market Value: -- 25,392 Billion USD  HK GDP: Billion; times of Hong Kong!  US GDP: -- 15,684 Billion; -- 60% larger than the world largest economy !

3 8.1 OTC Derivatives

4 8.1 OTC Derivatives  The market for swaps has grown enormously, which has raised serious regulatory concerns regarding credit risk exposures.  Such concerns motivated reforms from global regulators, e.g., the Dodd Frank Wall Street Reform Act, central clearing & collateralizations  OTC swaps in order of mkt value : -- interest rate: 17,265 billion usd -- currency: 1, credit: 1, commodity: equity: 147

5 8.1 Interest Rate Swap  Swaps are different from most other derivatives Portfolio of forward contracts  Marked to market at coupon payment dates Intermediary should reduce counterparty risk  Interest rate swap as succession of forwards: For example, a long position in “payer” means: -- Swap buyer agrees to pay fixed-rate, -- Swap seller agrees to pay floating-rate  Purpose of interest rate swap: Allows swapping variable-rate income into fixed-rate (or vice versa) Better match the duration of assets and liabilities -- hedging

6 8.1 Interest Rate Swap  Agreement to exchange fixed for floating interest cash flows  A interest rate swap is quoted by the swap rate  Example: $100m 3.1% 1x10 LIBOR swap Bank ABank B Swap rate 3.1%, every 6m 3m Libor rate, every 3m

7 8.1 Interest Rate Swap Trade level specs:  Notional: 100 million us dollars  Trade date: 2012-Apr-9, today, the date the trade is transacted  Settlement date: 2012-Apr-11, 2bd after the trade date, trade is “live”  Swap effective date: 2013-Apr-11, after 1y, interests start to accrue  Swap expiry date: 2023-Apr-9, after 11y, interests end accruing Ex: $100m 3.1% 1x10 LIBOR swap

8 8.1 Interest Rate Swap Floating Leg:  Fixing: 3m USD LIBOR  Pay Freq: quarterly  Reset date: 2 bds before interest accrual period starts  DCT(Day count conventions) : Act/360  BDC(Business day conventions): LON holiday, modified following Ex: $100m 3.1% 1x10 LIBOR swap

9 8.1 Interest Rate Swap Fixed leg:  Fixed rate: 3.1% annualized  Pay freq: semiannually  DCT/BDC: 30/360, NY holidays, modified following Ex: $100m 3.1% 1x10 LIBOR swap

Interest Rate Swap Ex: $100m 3.1% 1x10 LIBOR swap

Interest Rate Swap Ex: $100m 3.1% 1x10 LIBOR swap

Interest Rate Swap

Interest Rate Swap Swap Rate – cout.  Discount factor is from the zero curve – RED  Forward LIBOR rate is from the forward curve – Blue

Zero Curve

Zero Curve

Zero Curve

Forward Curve

Forward Curve

Swap Sensitivity – Zero Delta

Swap Sensitivity – Forward Delta

Swap Sensitivity – DV01