Interest Rate Swap Market zInitial motivation was borrower exploitations of perceived credit arbitrage opportunities. zAn efficient market for altering cash flow characteristics of assets or liabilities. zCommercial banks and investment banking firms take positions in swaps.
Primary Determinants of Swap Spreads zSwap Spread ydifference between the swap’s fixed rate and the rate on a Treasury whose maturity matches that of the swap zKey Determinants yfor maturities of less than five years, it is the cost of hedging in the Eurodollar CD futures market yfor maturities of more than five years, it is largely driven by credit spreads in the corporate bond market
Other Factors Influencing the Level of Swap Spreads zThe level and shape of the Treasury yield curve zThe relative supply of fixed and floating- rate payers zThe level of asset-based swap activity zTechnical factors affecting swap dealers
Secondary Market for Swaps zSwap Reversal zSwap Sale or Assignment zSwap Buy-Back or Close-Out or Cancellation
Swaptions zGrants the option buyer the right to enter into an interest rate swap at a future date. zTypes of Swaptions ypayer swaption yreceiver swaption
Interest Rate Caps and Floors zAn agreement between two parties in which one party, for an upfront premium, agrees to compensate the other if the reference rate is different from the strike rate. yInterest Rate Cap yInterest Rate Floor yStrike Rate zCombinations yInterest Rate Collar yCaptions yFlotions
Risk/Return Characteristics For a cap and floor, the situation is as follows:
Applications of Interest Rate Floors zLocking in an interest rate spread over the cost of funds while maintaining the opportunity to benefit from a rate decline. zEstablishing a lower bound on investment return while retaining the opportunity to benefit from a rate increase.
Credit Risk zDefault Risk yrisk that issuer will fail to satisfy the terms of the obligation zCredit Spread Risk yrisk that credit spread will increase zDowngrade Risk yrisk that an issue will be downgraded
Credit Derivatives zCredit Options yCredit options written on an underlying issue yCredit spread option zCredit Forward Contracts zCredit Swaps yCredit default swaps yTotal return swaps