BKM Chapter 23 Flashcards
Primary use for interest rate futures
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to hedge interest rate risk
Price value of a basis point (PVBP) for the portfolio
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sensitivity of portfolio value to changes in interest rates
= change in price per basis point change in portfolio yield
= -D* * change in y * value of the portfolio / change in basis points for portfolio yield
Basis point value in percentage terms
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0.01%
Futures contract
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agreement to buy/sell an asset at a future date for a price set today
Price value of a basis point (PVBP) for futures contract
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PVBP(futures) = -D* * change in delivery yield * price of futures * contract multiplier / change in basis points for portfolio yield
Contract multiplier for PVBP(futures)
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contract multiplier = contract par value / futures price par value
Change in delivery yield for PVBP(futures)
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change in delivery yield % = change in portfolio yield % * (change in delivery yield bps / change in portfolio yield bps)
How to hedge interest rate risk using futures contracts
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take the opposite position in the hedge vehicle
> > w/a long position in the portfolio, portfolio value will decrease when interest rates increase
to hedge, sell short futures contracts which will increase in value when interest rates increase
Cross-hedging
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occurs when the hedge vehicle is a different asset (sector) than the one being hedged (ex: treasury vs. corporate bonds)
most hedging is cross-hedging
Cross-hedging and risk
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cross-hedging is NOT risk-free because there can be slippage
Slippage in cross-hedging
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differences in yield across sectors (ex: treasury vs. corporate bonds)
Swaps & most common types (2)
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multiperiod extensions of forward contracts
types:
1. foreign exchange swaps
2. interest rate swaps
Foreign exchange swaps
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exchange of currencies on several future dates
Interest rate swaps
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exchange a series of cash flows b/w a fixed and floating interest rate (exchange of fixed vs. variable CFs)
Notional principal
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principal amount used to calculate swap payments
> > describes the size of the swap agreement, but not actually a loan of $$
Role of swap dealer in swap agreements
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intermediary b/w parties that takes a neutral position on interest rates, but profits from the bid-ask spread
*bears the credit risk of both parties of the swap
LIBOR
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London Interbank Offerred Rate = rate banks borrow at from each other in the Eurodollar market
most commonly used short-term interest rate for swap agreements
Primary benefit of interest rate swaps
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ability to quickly & cheaply exchange fixed and floating rate positions or b/w currencies without high transaction costs
Interest rate parity (definition & formula)
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requires investors be indifferent to interest rates from different countries (o/w investors could profit from exchanging currencies & collecting interest)
F(t) = forward exchange rate(t) = current spot exchange rate * [( 1 + held interest rate) / (1 + desired interest rate)]^t
Exchange rate for currency swaps & how to solve for it
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constant exchange rate
solve for exchange rate, F*, that sets the PV(swap payments) = PV(independent forward agreements)
Credit risk in interest rate swaps
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any default results in a loss equal to the difference b/w fixed rate and floating rate obligations
Hedge ratio (H)
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of contracts to buy/sell in a hedge position
H = PVBP(portfolio) / PVBP(futures)
Swap CF in interest rate swaps
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Swap CF = notional principle * (rate received - rate paid)
