BKM Chapter 23

Question 1

Primary use for interest rate futures

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Answer 1

to hedge interest rate risk

Question 2

Price value of a basis point (PVBP) for the portfolio

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Answer 2

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

Question 3

Basis point value in percentage terms

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Answer 3

0.01%

Question 4

Futures contract

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Answer 4

agreement to buy/sell an asset at a future date for a price set today

Question 5

Price value of a basis point (PVBP) for futures contract

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Answer 5

PVBP(futures) = -D* * change in delivery yield * price of futures * contract multiplier / change in basis points for portfolio yield

Question 6

Contract multiplier for PVBP(futures)

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Answer 6

contract multiplier = contract par value / futures price par value

Question 7

Change in delivery yield for PVBP(futures)

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Answer 7

change in delivery yield % = change in portfolio yield % * (change in delivery yield bps / change in portfolio yield bps)

Question 8

How to hedge interest rate risk using futures contracts

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Answer 8

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

Question 9

Cross-hedging

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Answer 9

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

Question 10

Cross-hedging and risk

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Answer 10

cross-hedging is NOT risk-free because there can be slippage

Question 11

Slippage in cross-hedging

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Answer 11

differences in yield across sectors (ex: treasury vs. corporate bonds)

Question 12

Swaps & most common types (2)

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Answer 12

multiperiod extensions of forward contracts

types:
1. foreign exchange swaps
2. interest rate swaps

Question 13

Foreign exchange swaps

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Answer 13

exchange of currencies on several future dates

Question 14

Interest rate swaps

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Answer 14

exchange a series of cash flows b/w a fixed and floating interest rate (exchange of fixed vs. variable CFs)

Question 15

Notional principal

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Answer 15

principal amount used to calculate swap payments

> > describes the size of the swap agreement, but not actually a loan of $$

Question 16

Role of swap dealer in swap agreements

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Answer 16

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

Question 17

LIBOR

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Answer 17

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

Question 18

Primary benefit of interest rate swaps

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Answer 18

ability to quickly & cheaply exchange fixed and floating rate positions or b/w currencies without high transaction costs

Question 19

Interest rate parity (definition & formula)

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Answer 19

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

Question 20

Exchange rate for currency swaps & how to solve for it

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Answer 20

constant exchange rate

solve for exchange rate, F*, that sets the PV(swap payments) = PV(independent forward agreements)

Question 21

Credit risk in interest rate swaps

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Answer 21

any default results in a loss equal to the difference b/w fixed rate and floating rate obligations

Question 22

Hedge ratio (H)

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Answer 22

of contracts to buy/sell in a hedge position

H = PVBP(portfolio) / PVBP(futures)

Question 23

Swap CF in interest rate swaps

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Answer 23

Swap CF = notional principle * (rate received - rate paid)