Interest Rate Swaps Financial Markets, Day 3, Class 4 Jun Pan Shanghai Advanced Institute of Finance (SAIF) Shanghai Jiao Tong University April 20, 2019 Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 1 / 26
Outline Pricing of Interest-Rate Swaps. Using Interest-Rate Swaps. OTC Derivatives. Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 2 / 26
Modern Finance Financial Markets, Day 3, Class 4 Jun Pan Interest Rate Swaps 3 / 26 4 2 0 0 1 9 Mortgage 0 6 1 9 8 2 0 9 5 0 1 5 1 First Stock 2 8 9 9 2 1 Backed 3 1 9 Investments and Index Futures 8 0 9 0 1 8 3 0 6 Securities 0 Capital Structure 5 6 1 0 2 1 9 (Fannie (Modigliani and Miller) 8 9 2 2 1 1 Two-Fund 19 WorldCom 8 0 9 Mae) 0 7 4 0 Financial 6 0 Separation Scandal 5 7 79 2 2 1 Crisis 9 (Tobin) 9 2 19 01 1 Enron 9 85 0 OTC Derivatives 1 6 0 6 20 Scandal 5 8 3 19 8 Interest 1 19 7 9 2 0 9 Rate 8 00 CAPM Rise of Dot-Com 0 1 55 6 1 64 1 Swaps 0 (Sharpe) Junk Bonds Peak 9 20 77 2 19 987 1 (Michael Stock 1998 1999 9 Dodd-Frank 9 Efficient Markets 4 1 Milken) 10 20 6 Market 5 5 Hypothesis 6 9 Index Mutual 7 Crash 988 1 LTCM European 3 1 19 (Samuelson, Fama) 9 Funds (Bogle) 1 1 Crisis Sovereign 66 5 1 9 5 19 S&L Bailout Crisis 7 01 9 2 1 7 9 Asian 8 01 Collapse of 9 9 1 2 52 9 6 9 Crisis 4 2 8 7 Junk Bonds 1 Trade 1 9 7 1 9 2 51 1 1 7 9 First Credit 0 War 90 0 9 Mutual Funds 1 99 2 Portfolio 6 1 3 TIPS Derivatives 8 Study (Jensen) 7 3 7 1 Theory 0 19 1 9 1 1 First US Options (CDS) 1 9 2 6 9 0 (Markowitz) 3 9 0 9 6 7 Exchange, CBOE Chinese 2 9 1 1 9 9 95 1 4 1 6 2 1 9 7 1 9 Stock 7 2 1 0 1 Option Pricing Theory 1 7 1 9 1 9 5 0 0 Trump 1 9 2 9 Market 5 (Black, Scholes, Merton) Birth of Index 2 9 1 1 Crash Funds (McQuown) 9 4 9 9 3 9 1 Large Derivatives Losses
Interest Rate Swap Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 4 / 26
Treasury and Swap Curves, November 13, 2012 Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 5 / 26
Treasury and Swap Curves, April 2007 Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 6 / 26
LIBOR Spread Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 7 / 26
Swap Curve Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 8 / 26
Treasury Curve Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 9 / 26
Swap Spread Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 10 / 26
Exposure to counterparty risk rating requirements for their counterparties. Weaker counterparties Jun Pan Interest Rate Swaps Financial Markets, Day 3, Class 4 tightened in the event of a downgrading. collateral requirements. The collateral requirements are normally would be denied access to the swap market or experience very tight Most participants in the market and dealer banks have minimum At inception swaps have no value. The counterparty for which the cash or Treasury bonds) proportional to the value of the swap. a negative value has to deliver an amount in collateral (most usually (monthly or even daily between swap dealers), the counterparty with counterparty credit risk. Marked to the market on a regular basis The practice of posting collateral are used to limit the potential counterparty equal to the value of the swap. swap value becomes positive has a credit exposure on the other 11 / 26
Swap spreads: Swap Rate - Treasury Rate What are the possible determinants of the Swap Spreads? Treasury supply Counterparty risk Credit risk three-month general collateral term repo (secured borrowing). Liquidity convenience yield of treasury bonds Mortgage backed securities (MBS) and hedging activities Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 12 / 26 ▶ The spread of three-month LIBOR (unsecured borrowing) over ▶ The AA credit spreads ▶ On-ofg-the-run treasury bond yield difgerential
Swap spread = swap rate - yield of on-the-run treasury: Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 13 / 26
Negative Swap Spreads after Lehman Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 14 / 26
MBS Negative Convexity Hedging Because of the prepayment options given to homeowners/mortgage borrowers, mortgage-backed securities (MBS) have negative convexity. Interest rates fall: MBS duration shortens; need to buy back duration. Hedging with IR swaps: add receive-fjxed or terminate pay-fjxed. Interest rates increase: MBS duration increases; need to sell duration. Hedging with IR swaps: add pay-fjxed. Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 15 / 26
Mortgage-Backed Security, Yield and Duration Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 16 / 26
Treasury, Yield and Duration Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 17 / 26
Relation between Duration and Yield Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 18 / 26
Risk Management Derivatives, Fannie Mae 2010 10K Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 19 / 26
Interest Rate Sensitivity of Net Portfolio, Fannie Mae 2014 Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 20 / 26
MBS Footprint on Swaps The developments in the markets are such that swaps have behaved far more effjciently than Treasurys as a hedging instrument for MBS. Most of these hedging activities center around 5-10yr IR Swaps. The sharp increase of 10yr rates in summer 2003 resulted in a sudden increase in MBS duration. As a result, there were increasing amount of fjxed-payers, efgectively putting a selling pressure on the “swap bond.” This resulted in a temporary spike in the 10yr swap spread (a footprint of MBS hedging on the swap market). Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 21 / 26
LIBOR/Swap Spread in 2003 Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 22 / 26
The Global OTC Derivatives Market The global OTC derivatives market had its beginning in the mid-1980s. Over the past 30 years, it has grown into an important part of the global fjnancial markets, allowing business to manage and hedge fjnancial risk. By far, the most important segment of this market is interest-rate product. As such, most of the hedging activities on interest rate risk have migrated from Treasury bonds to interest rate swaps. In addition, it also provides derivatives on currency, credit, equity, and commodities. Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 23 / 26
OTC Derivatives, Amounts Outstanding Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 24 / 26
OTC Derivatives, Market Value Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 25 / 26
Derivatives Usage Financial Markets, Day 3, Class 4 Interest Rate Swaps Jun Pan 26 / 26
Recommend
More recommend
