2 IntroductionThis report is to study the general mechanism of the newly traded financial instrument on the Swedish market - Nasdaq OMX Interest Rate Swap Future (NOIS), and to study how to value these contracts by help of Excel program.
3 BackgroundThe market for trading in interest-rate swaps has advanced in recent yearsThe rapid growth of the swap market point to the need for an exchange-listed futures contract to help participants in managing their risk exposures.The contract is cash settled on the expiration day against the NASDAQ OMX SEK Swap Fixing for the relevant tenor.
4 Theoretical Framework Interest-rate swapsThe London Interbank Offer Rate (LIBOR) is regarded as the floating rate in most interest rate swap agreements.This type of swaps could be used to transform a floating rate load loan into a fixed rate loan.Example: Suppose that company Alfa has arranged to borrow 100 million at LIBOR plus 10 is basis points. (One basis point is one hundredth of 1%, so the rate is LIBOR plus 0.1%), and suppose that company Beta has 100 million loan outstanding on and the company pays 5.2%.
5 Theoretical Framework Cash flows for each of them will look like as followings:So for the company Alfa, the swap can have the effect of transforming borrowings at a floating rate of LIBOR plus 10 basis points into borrowings at a fixed rate of 5.1%. and for the company Beta, the swap could have the effect of transforming borrowings at a fixed rate of 5.2% into borrowings at a floating rate of LIBOR plus 20 basis points.Cash flows for AlfaCash flows for BetaIt pays LIBOR + 0.1% to its outside lenders.1) It pays 5.2% to its outside lenders.It receives LIBOR under the terms of the swap.2) It pays LIBOR under the terms of the swap.It pays 5% under the terms of the swap3) It receives 5% under the terms of the swap.
7 Theoretical Framework Valuation of Interest-rate swapsValuation in terms of bond pricesVswap =Bfix – Bfl Vswap = Bfl – BfixValue of the floating rate bond todayVB(fl) = (L + K) e-r.tr is the LIBOR t is maturity
8 Theoretical Framework Valuation in terms of FRAsThe procedure isa.Use the LIBOR/swap zero curve to calculate forward rates for each of the LIBOR rates that will determine swap cash flows.b.Calculate swap cash flows on the assumption that the LIBOR rates will equal the forward rates.c.Discount these swap cash flows using the LIBOR/swap zero curve to obtain the swap value.
9 Theoretical Framework The present value of the difference between these interests payments are as followings:For the company who receive the Rk on the principal L:For the company who pays RK rather than receive, its value is similarly given byRk = The rate of interest agreed to in the FRARF = the forward LIBOR interest rate for the period times T1 and T2R2 = the continuously compounded riskless zero rate for a maturity T2L = the principal underlying the contract
10 Theoretical Framework Valuation of NOISValue of the long position:Value of the short position:r = traded raten= number of periodsN=number of contracts x nominal value
11 Valuation of NOISInspired by valuation of CBOT Interest rate swap futureBut Tick Size of CBOT is One half of one thirty-second of one point
12 ConclusionsInterest rate swap futures are highly effective tools for financial risk managers to hedge a wide variety of interest rate exposures. They virtually eliminate counterparty credit risk, allowing users to easily adjust swap rate exposure without tying up credit lines. Using Swap futures counterparty can eliminates the administrative costs and liabilities, Swap futures make synthetic swap rate exposure readily available to market participants who would prefer not to be directly involved in OTC swap transactions.
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