1. Economics 434 Financial Markets Professor Burton University of Virginia Fall 2015 November 5, 2015

2. Fixed Income, So Far & Coming Attractions Present Value: Concept & Calculations Default Free Securities – Bills, Notes, and Bonds – Duration risk Defaultable Securities – Yield Curve – ABS Yet to be covered – The Swaps Market – CDS – Mortgages November 5, 2015

3. Swaps They are exactly what the name implies: a swap of one thing for another “Plain-Vanilla” Swap – Party A has variable rate debt; Party B has “fixed” rate debt – Party A assumes debt payments of B and Party B assumes debt payments of A If either defaults, swap terminates immediately and reverts back to original debt obligation November 5, 2015

4. But, generally, a “swap” can be anything for anything else Examples – Equity Swaps Party A has emerging market equity portfolio Party B has US large cap portfolio Parties A and B swap the “economics” of their portfolio for the other’s portfolio – Meaning: during the term of the swap Party B receives the returns of emerging market equity and Party A receives the returns of US large cap portfolio – When swap is terminated, original portfolios (updated) are back to original owners November 5, 2015

5. Risks of Swap Market Often Overstated by Media Notional Amount of Swap is principal But risk is a spread risk, not a principal risk November 5, 2015

6. Credit Default Swaps This is actually a form of insurance Originally applied to corporate bonds – Issuer of CDS agrees to take a defaulted bond as their own and pay all remaining payments as scheduled to bond buyer who purchased CDS “protection” But, CDS generally can apply to any debt, including bank loans, ABS tranches, municipal bonds, etc. November 5, 2015

7. CDS Played a Role in 2008 Collapse Goldman Sachs had purchased large amounts of CDS’s from AIG As defaults and threat of defaults materialized after Lehman collapse, AIG was not going to be able to “mark-to-market” their CDS swaps. If that was the case, the fear was that GS would then fail Federal Reserve provided $ 100 billion in cash to AIG the day after Lehman failed November 5, 2015