Lecture 10: Derivatives III Currency & interest rate swaps Galina A Schwartz Department of Finance University of Michigan Business School

Plan of today’s lecture n Midterm follow-up n Levich, Chapter 13  Swaps are derivative securities redundant securities  Main types of swap agreements  Why do we have them? [who could gain from them]  What drives the demand for swaps?

Players & Terminology n Players: Industry & Financial Companies, Re [ – `The Usual suspects`] n What drives the demand for swaps?  Capital controls  Transaction costs  Differences in parties’ comparative advantage [Market segmentation & asymmetric information] n Terms [Jargon]:  Plain vanilla swaps  Exotic swaps

Swaps: market characteristics  Main types of swap agreements  currency or interest rate  fixed-rate or  floating rate or  fixed-floating interest rate swaps  Why do we have them? [who could gain from using them]  To hedge [hedgers] [reducing risks]  To speculate [speculators] [capturing arbitrage opportunities]

Pricing the Swaps  How do we price them?  Net present value approach  Through calculating the expected discounted cash flow  Swap associated risks:  Asymmetric  Time varying

Regulatory requirements n Bank for International Settlements (BIS) imposed capital requirements – A major development! n BIS capital requirements:  Advantageous:  Simple and easy to implement  Transparent  Drawbacks [disadvantages]:  No fine tuning  regulatory costs

Summary of the Lecture  Main subject: swap agreements: [currency or interest rate]  Swaps are used for: Cheap [& Quick] currency and interest rate risks management  Why do we have them?  Who uses them?  How do we price them?

What is next (Lecture 11): n A follow-up of Prof. Honeyman’s lecture:  International financial markets adjustment to the coming technical innovations:  Market power & efficiency scale: up or down?  Efficiency: market completeness & pricing mechanisms

What is next (continued)  Generalized transaction costs up or down? [Generalized transaction costs: -- overhead (par example infrastructure related) costs -- the costs resulting from the risk of default [direct and indirect (such as legal)]]  Globalization: standard versus segmentation  Scope for government intervention up or down?