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Topic 8. Swaps

8.1 Over-the-counter (OTC) Derivatives

8.2 Interest Rate Swap

8.3 Zero Curve

8.4 Forward Curve

8.5 Zero Delta

8.6 Forward Delta

8.7 DV01

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8.1 OTC Derivatives

2012

Global OTC Derivative Gross Market Value:

-- 25,392 Billion USD

HK GDP:

-- 263 Billion;

-- 96 times of Hong Kong!

US GDP:

-- 15,684 Billion;

-- 60% larger than the world largest economy !

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8.1 OTC Derivatives

http://www.bis.org/statistics/otcder/dt1920a.pdf

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8.1 OTC Derivatives

The market for swaps has grown enormously, which has raised serious regulatory concerns regarding credit risk exposures.

Such concerns motivated reforms from global regulators, e.g.,

the Dodd Frank Wall Street Reform Act,

central clearing & collateralizations

OTC swaps in order of mkt value :

-- interest rate: 17,265 billion usd

-- currency: 1,955

-- credit: 1,187

-- commodity: 328

-- equity: 147

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8.1 Interest Rate Swap

Swaps are different from most other derivatives Portfolio of forward contracts

Marked to market at coupon payment datesIntermediary should reduce counterparty risk

Interest rate swap as succession of forwards: For example, a long position in “payer” means: -- Swap buyer agrees to pay fixed-rate, -- Swap seller agrees to pay floating-rate

Purpose of interest rate swap:Allows swapping variable-rate income into fixed-rate (or vice versa)Better match the duration of assets and liabilities -- hedging

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8.1 Interest Rate Swap

Agreement to exchange fixed for floating interest cash flows

A interest rate swap is quoted by the swap rate

Example: $100m 3.1% 1x10 LIBOR swap

Bank A Bank B

Swap rate 3.1%, every 6m

3m Libor rate, every 3m

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8.1 Interest Rate Swap

Trade level specs:

Notional: 100 million us dollars

Trade date: 2012-Apr-9, today, the date the trade is transacted

Settlement date: 2012-Apr-11, 2bd after the trade date, trade is “live”

Swap effective date: 2013-Apr-11, after 1y, interests start to accrue

Swap expiry date: 2023-Apr-9, after 11y, interests end accruing

Ex: $100m 3.1% 1x10 LIBOR swap

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8.1 Interest Rate Swap

Floating Leg:

Fixing: 3m USD LIBOR

Pay Freq: quarterly

Reset date: 2 bds before interest accrual period starts

DCT(Day count conventions) : Act/360

BDC(Business day conventions): LON holiday, modified following

Ex: $100m 3.1% 1x10 LIBOR swap

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8.1 Interest Rate Swap

Fixed leg:

Fixed rate: 3.1% annualized

Pay freq: semiannually

DCT/BDC: 30/360, NY holidays, modified following

Ex: $100m 3.1% 1x10 LIBOR swap

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8.1 Interest Rate Swap

Ex: $100m 3.1% 1x10 LIBOR swap

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8.1 Interest Rate Swap

Ex: $100m 3.1% 1x10 LIBOR swap

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8.1 Interest Rate Swap

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8.1 Interest Rate Swap

Swap Rate – cout.

Discount factor is from the zero curve – RED

Forward LIBOR rate is from the forward curve – Blue

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8.1 Zero Curve

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8.1 Zero Curve

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8.1 Zero Curve

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8.1 Forward Curve

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8.1 Forward Curve

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8.1 Swap Sensitivity – Zero Delta

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8.1 Swap Sensitivity – Forward Delta

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8.1 Swap Sensitivity – DV01