Hull Chapter 7 - Swaps
Define notional principle:
Amount of principle in an interest rate swap upon which the parties agree to pay interest. It is called notional because the parties never actually exchange the principle amount.
What is an interest rate swap?
An agreement for one company to pay cash flows equal to interest at a predetermined fixed rate on a notional principle for a predetermined number of years. In return it receives interest at a floating rate on the same notional principal for the same period of time.
Define fixed-rate payer and floating rate payer:
Two parties in an interest rate swap: 1. Fixed-rate payer - is party that pays the agreed upon rate 2. Floating payer - party that pays LIBOR
What are two approaches for valuing interest rate swaps?
1. View it as a the difference between two bonds 2. View it as a portfolio of Forward Rate Agreements
What types of financial instruments can market makers use to hedge interest rate swaps?
Bonds, forward rate agreements, and interest rate futures
What is the swap rate?
It is the average of the bid and offer fixed rates.++++++++++++
What is an currency swap?
Involves exchanging interest and payments in one currency for principal and interest payments in another.
How can a interest rate swap be valued as a portfolio of Forward Rate agreement?
It can be viewed as a bunch of forward rate agreement, one for each future period. Plus one certain exchange associated with the exchange that happens in the current period.
What is a swap?
It is an over-the-counter agreement between two companies to exchange cash flows in the future.
What is one argument that is used to explain the popularity of interest rate swaps?
Some companies have a comparative advantage in getting financing or assets from the fixed or floating markets. Therefore a company may enter into an initial agreement based on the market it has a comparative advantage, but transform it to its preferred type using s swap.
What is the rationale for the apparent comparative advantage which makes interest swaps useful?
The LIBOR rate plus and additional risk load is the rate offered for 6 months at a time. The risk load can be changed in the future if the risk of default changes. However the fixed rate cannot be changed and bakes in this additional default risk by having a higher spread then shown by the 6 month floating rates.
What is the relationship between the swap rate and the LIBOR rate?
The swap rate is equivalent to the situation where consecutive LIBOR loans are made to AA rated companies for a number of periods that matches the duration of the swap.
Define a fixed-for-fixed interest rate swap?
This is an interest rate swap where both interest rate amounts are fixed.
What is the name of the legal agreement underlying a interest rates swap?
a confirmation
What is the total apparent gain in any interest rate swap?
a-b, where a is the difference between the fixed rates and b is the difference between the variable rates.
What could cause there two be true comparative advantages in currency swaps?
there might be tax advantageous for companies to borrow in a certain currency
