1. 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. 2 8.1 OTC Derivatives 2012  Global OTC Derivative Gross Market Value: -- 25,392 Billion USD  HK GDP: -- 263 Billion; -- 96 times of Hong Kong!  US GDP: -- 15,684 Billion; -- 60% larger than the world largest economy !

3. 3 8.1 OTC Derivatives http://www.bis.org/statistics/otcder/dt1920a.pdf

4. 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: 1,955 -- credit: 1,187 -- commodity: 328 -- equity: 147

5. 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. 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. 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 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. 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

10. 10 8.1 Interest Rate Swap Ex: $100m 3.1% 1x10 LIBOR swap

11. 11 8.1 Interest Rate Swap Ex: $100m 3.1% 1x10 LIBOR swap

12. 12 8.1 Interest Rate Swap

13. 13 8.1 Interest Rate Swap Swap Rate – cout.  Discount factor is from the zero curve – RED  Forward LIBOR rate is from the forward curve – Blue

14. 14 8.1 Zero Curve

15. 15 8.1 Zero Curve

16. 16 8.1 Zero Curve

17. 17 8.1 Forward Curve

18. 18 8.1 Forward Curve

19. 19 8.1 Swap Sensitivity – Zero Delta

20. 20 8.1 Swap Sensitivity – Forward Delta

21. 21 8.1 Swap Sensitivity – DV01