L3 - Comparative Advantage of Swaps and the main participants in the IRS market Flashcards
1
Q
What are the advantages that IRS are built on?
A
- At the core, IRS are a derivative instrument built on the premise of comparative advantage
- there are other possible advantages:
- information asymmetries may exist in capital markets or thec two parties may simply have different risk profiles - but one of the most common benefits are derived from the comparative advantages in different credit markets
2
Q
What is the difference between absolute and comparative advantage?
A
- Absolute and comparative advantages largely influence how and why nations and business devote resources to the production of particular goods
- Absolute advantages –> describes a scenario in which one entity can manufacture a product at a higher quality and a faster rate from greater profit than another competing business or country can accomplish
- comparative advantage –> differs in that it takes into consideration the opportunity costs involved when choosing to manufacture multiple types of goods with limited resources
3
Q
Example of comparative advantage?
A
- comparative advantage –> referring to the ability of an entity to produce a good or service at a lower opportunity cost than another entity. This idea is centred on relative efficiency, not absolute.
- during a single hour of labour, A can either plant 5 trees or 10 bushes. during the same hour, B can either plant two trees or eight bushes - A is absolutely more efficient that B in planting either type of plant.
4
Q
Absolute and relative advantage applied to credit market?
A
- Popular explanation of the reasons behind swap agreements
- Firm A has an ABSOLUTE ADVANTAGE if it can obtain better rates in both the fixed and the floating rate markets
- Firm A has a RELATIVE ADVANTAGE in one market if the difference between what A pays more than fir B in the floating (fixed rate) market is less that the difference between what A pays more than B in the fixed-rate (floating rate) market
5
Q
In a IRS what ar ethe Financing decisions the two firms would make?
A
- There are two decisions that the corporations face:
- Do they want to pay fixed or floating?
- Should they borrow fixed or floating rate?
- These two decisions need not have the same answer
- Due to the swap markets, the corporations do not have to borrow floating rates if they want to pay to floating. they can borrow fixed rates, and the swap into floating,
- in general, the market the corporations should borrow in is the one where they have a comparative advantage i.e. where they can get the best deal in relative terms.
6
Q
What would company A pick (who has a relatively fixed advantage)?
A
- A is either paying 4% or LIBOR - 1%
- to calculate the cheaper borrowing cost we set what we would pay in each case equal to each other –> by rearranging we can get an inequality for the unknown (in the case of the field rate)
- The cost of saving is 0.25%
7
Q
What would company B pick (who has a relatively fixed advantage)?
A
- B will only enter into the swap with A if he can benefit from it in some way too
- DIAGRAM IS WRONG –> we received LIBOR and pay fixed
- FIXED must be less than 4.6%
- If the fixed rate is 4.35% company B saves 0.25%. So both A and B have a 50/50 split of the 50 bps comparative advantage that has at the start!
- 1.2 -0.7 = 0.5
8
Q
How can you estimate the comparative advantage in the IRS swap?
A
- Suppose that Firm C has a good credit rating and can borrow at a fixed rate of 5% or a floating rate of LIBOR + 1%
- Firm D has a somewhat less excellent credit rating and can borrow at a fixed rate of 7% or a floating rate of LIBOR + 2.5%
- Both firms wish to borrow 10,000,000 for 3 years and C would rather borrow a floating rate and D would prefer to borrow at a fixed rate.
- What are the comparative advantages and total gains that they both could attain if they engaged in a swap contract?
- Fixed = (7-5) = 2% –> Alpha comparative adantage
- Floating = (LIBOR +2.5%) - (LIBOR +1%) = 1.5% –> Alpha comparative advantage
- A;[ha with borrow fixed due to higher comparative advantage
- the difference in the credit spread between the two markets is 2 - 1.5 = 0.5%
Some cases the better rated company wants to receive more than 50% of the comparative advantage.
9
Q
What is the relevance of the IRS in the derivative market?
A
- At around ten times the world GDP, the goal OTC derivative market is a very disable part of the financial system
- By accounting for around 60% of the total gross notional volume of OTC derivatives, the largest single segment is IRSGiven the very active trading, major dealer’s total gross notional IRS exposures many time exceed their capital
- Interest Rate Swaps are the most traded OTC derivative contracts, both as notional amounts and as gross market value.
- In 2019 there was a massive spike in the use of IRS like derivatives ($4 trillion notional)
- $2 trillion was due to Overnight Interest rate swaps
10
Q
Who are the agents involved in IRS?
A
- Reporting Dealers
- Other Financial Institutions –> Commercial banks and other investment banks that are not primary dealers in this market
- Non-financial customers
- Related party trades
- Central counterparties –> clearinghouses –>
- before 2008 contract were bilateral OTC but after the crash, it was seen how important it was needed to reduce counterparty risk.
- only a select few club member banks can use the clearing house to trade these contracts - so how can a smaller bank trade it
- Enter a bilateral contract to the ‘club member bank’ for them to trade on your behalf (more expensive than the banks pay to the central counterparties)
11
Q
What is the Reporting dealers role in the IRS market?
A
- Reporting dealer are mainly large commercial and investment banks and securities houses that:
- (i) participate in the interdealer market and/or
- (ii) have an active business with large customers, such as large corporate firms, governments and nonreporting financial institutions; in other words, reporting dealers are institutions that actively buy and sell currency and OTC derivatives both for their own account and/or in meeting customer demand.
- In practice, reporting dealers are often those institutions that actively or regularly deal through electronic platforms, such as EBS or Reuters dealing facilities
12
Q
What are the role of other financial institutions in the IRS market?
A
- Other financial institutions are typically regarded as foreign exchange and interest rate derivatives market end-users.
- They mainly cover all other financial institutions, such as smaller commercial banks, investment banks and securities houses, and mutual funds, pension funds, hedge funds, currency funds, money market funds, building societies, leasing companies, insurance companies, other financial subsidiaries of corporate firms and central banks.
13
Q
Who are the non-financial customers in the IRS market?
A
Non-financial customers.
- Any counterparty other than those described above, i.e. mainly non-financial end users, such as corporations and non-financial government entities.
- May also include private individuals who directly transact with reporting dealers for investment purposes, either on the online retail trading platforms operated by the reporting dealers or by other means (e.g., giving trading instructions by phone)
- Tend to swap there credit position of financial credit risk?
14
Q
What are related party trades in the IRS market?
A
- Related party trades. Transactions between desks and offices, transactions with branches and subsidiaries, and transactions between affiliated firms.
- These trades are included regardless of whether the counterparty is resident in the same country as the reporting dealer or in another country. Back-to-back trades that involve the transfer of risk from the sales desk to another affiliate are included.
- However, trades conducted as back-to-back deals and trades to facilitate internal bookkeeping and internal risk management within the same sales desk (i.e., reporting dealer) are excluded.
15
Q
What are the most popular IRS instruments and currencies?
A
Turnover in US dollar-denominated contracts reached $3.3 trillion in April 2019, accounting for about half of total turnover in all currencies, as in the 2016 survey.
