Swaps

Question 1

What risks are parties in a swap agreement are taking?

Answer 1

Long - agrees to pay fixed and obtain floating, therefore she will benefit from increase in IR / FX / equity prices

Question 2

Formula for swap fixed rate for a plain vanilla IR swap

Answer 2

C = (1 - Z_T)/(Z_1 + Z_2 + … + Z_T)T
Z_t = 1/(1 + R_t(t/T))
Formula is based on the idea of equivalence of the fixed-rate note and the floating-rate note that replicate the swap

Question 3

What is a swaption?

Answer 3

Option to enter an IR swap.

Notation is akin to FRAs - A:B - enter (B-A) swap at the end of A

Question 4

Valuation of swaptions

Answer 4

Cash flows equal interest savings from entering the swap - fixed-rate payments. Those are discounted based on the yield curve.

Question 5

What is the swap spread?

Answer 5

Difference between the swap rate and the rate on a Treasury note of the same maturity

Question 6

CDS basics

Answer 6

CDS buyer pays the CDS coupon - 1% for investment-grade securities, 5% for high-yield securities.
CDS spear depends of the credit quality of the underlying security, so difference between the spear and the coupon is payed at the initiation of a CDS.

Question 7

Payoff of a single-name CDS

Answer 7

Notional(1 - market value of the CTD bond).

CTD - cheapest bond of the same seniority as the CDS

Question 8

How it is determined that a credit event took place?

Answer 8

ISDA’s Determination Committee determines that. A supermajority vote (12+ members) is need to declare.

Question 9

Survival rate in CDS

Answer 9

SR_T = (1 + hazard_1)(1 + hazard_2)…*(1+ hazard_T)

Question 10

What the credit curve trade is about?

Answer 10

Buying and selling CDS on the same reference but with different maturities

Question 11

Effect of LBO on CDS

Answer 11

Leverage up -> more credit risk -> higher CDS spread

Question 12

Synthetic CDO

Answer 12

DCO built of CDS, not bonds