A Few Notes on Interest Rate Swaps..
From the teachings of Andrew R Yong and Howard Corb..
Swaps
Contract among two counterparties to exchange periodic cash flows,
based on a notional principal value
Types
o
Interest Rate Swaps [Same Currency]
o
Coupon Swap - Fixed Floating Swap
o
Basis Swap – Floating Floating Swap [Basis = Both Float]
o
Inflation rate Swaps
o
Portfolio Swaps
o
Cross Currency Swaps
Motivation
Traditionally
if the interest rates were likely to fall, investors purchased a Bond. As the
rates fell, price increase would benefit investors. Today you could enter
floating for fixed interest rate swap – as rates fall investor would pay lower
floating rate in exchange for same high fixed rate.
o
Hedge Against Interest Rate Changes
o
Balance Sheet Management
o
Asset Hedging, Liability Hedging
o
Speculate on Interest Rate Changes
FiRe
Fixed - In case of likely fall, it is better to receive fixed.
Interest Rate Swaps
Coupon Swap
o
Is a Fixed Floating Swap
o
Most common is Semi Bond vs. Threes
o
One Stream typically Fixed Semi Bond, typically pays
Semi Annually at Fixed Rate on 30/360 basis.
E.g. client pays T5 + 21 semi-annually on 30/360 basis. T5 is the yield of on
the run 5 year Treasury. It
could pay Semi Annually on ACT/360 basis as well. We gotta lookup in the
Annual Money column in such a scenario.
o
Other Stream typically Floating Actual Money,
pays Quarterly at Floating Rate on ACT/ 360 basis. E.g. dealer pays 3mL quarterly on Act/360.
3mL is the 3 month LIBOR.
o
When floating side is 3mL we focus exclusively on the fixed rate.
Semi
Bond typically pays 30/360 (B3)
Actual
Money typically pays ACT/360 (M&A)
Basis Swap
o
Is a Floating Floating Swap
Definitions
Interest Rates, Bond Yield and Bond Price
Interest
Rate ↑ Bond Price↓ Bond Yield
↑
Interest
Rate ↓ Bond Price ↑ Bond Yield
↓
Bond Price says to
Interest Rate, Puck You I go the
other way
Yield says to Interest Rate, I move with you
Interest Rates usually rise because of the inflationary
expectations when economy is doing good. In such scenarios investors usually
have other investment alternatives which are more lucrative and people jump out
of bonds and flock to them. So when
interest rates rise the bond prices drop and yields go up.
Yield Curve
Relationship between future interest rates and time
Zero Coupon Bond
o
Does not pay interest at periodic intervals
o
It is issued at discount from its par value and
redeemed at par
o
Accumulated discount which is repaid represents
compound interest
o
A Graph of IRR of this bond vs Range of
Maturities is called Zero Coupon Yield
Curve
Forward Interest Rate
Rate at which the investors can re- invest his deposit after
a certain period in the future e.g. 6 month forward interest rate .
Forward Yield Curve
A graphical relationship of forward interest rates.
Spreads
Are typically quoted from dealers perspective.
Offer Side Spread
Spread at which the Dealer will receive
Fixed.
Bid Side Spread
Spread at which the Dealer will pay Fixed.
Offer Side Swap Rate
Mid Market Yield of relevant on the run treasury + offer
side spread
Bid Side Swap Rate
Mid Market Yield of relevant on the run treasury + Bid side
spread
US Treasury Publishing Frequency and Swap Rates calculation
Term
|
Swap Rate Calculation
|
2,3,5,7 Year Notes
|
Mid Yield from Monthly Auction + Swap Spread
|
10 Year Notes
|
Mid Yield from Quarterly Auction + Swap Spread
|
30 Year Bonds
|
Mid Yield from Quarterly Auction + Swap Spread
|
12 Year Note
|
Same swap rate as 10 [no rhyme
or reason to this]
|
All other e.g. 4,6,7,8,9,15,20,25 YR Notes
|
Linear Interpolation betn two adjacent OTR treasury yields
|
Prime Rate
o
Rate at which banks lend to favored customers [prime customers].
o
In US typically it is Fed Funds Rate + 300 basis points
o
Currently it is 3.25%
Fed Funds Rate
o
Overnight Interbank Rate
o
Fed sets the target 8 times a year
If yield = X% then future value of 1$ in 1 year will be
1/(1+x/100)
posted by Prashant Pachouri at 11:15 AM
|
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