Reading 54 - Swap Markets and Contracts

Question 1

What is the swap rate?

Answer 1

A fixed rate so that the present value of the floating rate payments is equal to the present value of the fixed rate payments.

***Determing the swap rate is equivalent to “pricing” the swap.

Question 2

What is a plain vanilla swap?

Answer 2

A fixed to floating interest rate swap.

Question 3

Annualized LIBOR spot rates today are:

R_90-day = 0.030

R_180-day = 0.035

R_270-day = 0.040

R_360-day = 0.045

You are analyzing a 1 yr swap with quarterly payments and a notional principal of $5,000,000.

Calculate:

• The fixed rate in % terms
• The quartly fixed payment in $

Answer 3

Question 4

What is a swaption?

***Critical Concept***

Answer 4

An option that gives the holder the right to enter into an interest rate swap.

Question 5

What is a payer swaption?

Answer 5

The right to enter into a specific swap at some date in the future as the fixed-rate payer at a rate specified in the swaption

Question 6

What is a receiver swaption?

Answer 6

The right to enter into a specific swap at some date in the future as the fixed-rate receiver at the rate specified in the swaption.

Question 7

What are the 3 primary uses of swaptions?

Answer 7

1. Lock in fixed rate
2. Interest rate speculation
3. Swap termination

Question 8

An investor exercises a receiver swaption of a 1 yr quarterly pay LIBOR based $1million swap with a fixed rate of 5% when the market rate on a current interest rate swap is 4%.

What is the fixed payment based on exercise rate??

Answer 8

Question 9

An investor exercises a receiver swaption of a 1 yr quarterly pay LIBOR based $1million swap with a fixed rate of 5% when the market rate on a current interest rate swap is 4%.

Calculate the fixed payment based on market rate?

Answer 9

Question 10

An investor exercises a receiver swaption of a 1 yr quarterly pay LIBOR based $1million swap with a fixed rate of 5% when the market rate on a current interest rate swap is 4%.

Calculate the extra interest per quarter……

Answer 10

Question 11

What is current credit risk?

Answer 11

The credit risk associated with the counterparty’s default on a payment currently due

Question 12

What is potential credit risk?

Answer 12

Reflects the future credit risk over the remaining term of the swap.

Question 13

Describe the degree of credit risk in a swap during the life of the swap (i.e. beginning, middle and end) …..

Answer 13

Beginning: Low

Middle: Highest

End: since few payments are left, credit risk is low again.

Question 14

Why is there increased credit risk for swaps that aren’t netted?

Answer 14

B/c the party that is owed in the swap transaction is owed the entire amount, not the difference as is done in netting.

Question 15

What is marking to market is regards to swaps?

Answer 15

Involves making a payment equal to the value of the swap at periodic settlement dates and repricing the swap by resetting the swap rate.

***This reduces credit risk.

Question 16

What is a swap spread?

Answer 16

The difference between the fixed rate on a swap and the yield on a default free security of the same maturity as the swap

**The spread indicates the avg credit risk in the global economy, not the credit risk on that particular swap

Question 17

What is a Basis Swap?

Answer 17

When both sides pay a floating rate.

Question 18

Does the party receiving variable rate payments expect interest rate to increase of decrease?

Answer 18

Increase.

They take variable rates b/c they expect them to be higher than the current market rates.

Question 19

Does the party receiving Fixed Rate Payments expect interest rate to increase of decrease?

Answer 19

Decrease.

They want to ‘lock in’ the high market rates now before they go lower.

Question 20

The payoff of a payer swaption is equivalent to what?

Answer 20

Put option on a bond

Question 21

The payoff of a receiver swaption is equivalent to what?

Answer 21

A call option on a bond