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1 CHAPTER 15 Interest Rate Derivative Markets

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2 CHAPTER 15 OVERVIEW This chapter will: A. Describe the plain vanilla interest rate swaps B. Explain the risks of interest rate swaps

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Swaps A Swap is an agreement in which two counterparties contractually agree to exchange sequences of cash flows over a certain time period according to a predetermined rule. Participants: Firms, swap dealers, swap brokers.

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Interest Rate Swap (plain vanilla) One counterparty agrees to pay a sequence of fixed- rate interest payment and to receive a sequence of floating-rate interest payment on the same currency. The floating rate could depends on LIBOR. Usually, the determination of floating rate occurs at one settlement date, with payment occurring at the next settlement date. Exchange net of interest, not the principal.

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example (p.406) The bank of Orlando has negotiated a plain vanilla swap in which it will exchange fixed payment of 9% for floating payments equal to LIBOR plus 1 percent at the end of each of the next five years. Assume the notional principal is $100 million. Draw the cash flow tables under two scenarios. 5

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Exhibit 15.4 Possible Effects of a Plain Vanilla Swap Agreement (Fixed Rate of 9 Percent in Exchange for Floating Rate of LIBOR + 1 Percent) Scenario I

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Exhibit 15.4 Possible Effects of a Plain Vanilla Swap Agreement (Fixed Rate of 9 Percent in Exchange for Floating Rate of LIBOR + 1 Percent) Scenario II

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Motivation for Swap Converting a fixed-rate asset into a floating- rate asset Savings and loans associations accept deposits and lend those funds for long-term mortgages usually with a fixed rate. Deposits are usually short-term and the rates adjust to the market quickly. These financial institutions can use interest swap to hedge the risk of floating rate.

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Limitation of Swap Not publicly traded ( “over-the-counter product”) Creditworthiness of the counterparty is important Difficulty in finding a willing counterparty Swap cannot be altered or terminated without agreement of both parties.

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Pricing of Interest Rate Swaps Pricing an interest swap means to determine the fixed rate (swap rate) that is appropriate for the terms of the swap. The determination of the fixed rate bases on the term structure of interest rates (spot rates and forward rates), using NPV method and simulation techniques.

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11 Other factors in Pricing Interest Rate Swaps Availability of Counterparties Credit and Sovereign Risk

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Homework Assignment 10 Chapter 15 Questions and Applications: 1,4,7 Problems: 1. 12

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