Interest Rates Swap: Definition and Mechanism - Assignment Example

? Interest Rates Swap: Definition and Mechanism a. Corb H , in his study defines Swap as a contractual agreement between two different parties to exchange payment over the course of time. An interest rate swap can be defined as when the stream of payment between two parties made in the same currency. According to him, Interest rate swaps are divided into two groups, fixed floating swap and basis swap. In basis swap, both the parties have to exchange currency at floating rates of interest where as in case of fixed floating swap one party has the privilege to use fixed rate of interest and other parties have to use floating rates of interest. The mechanism of interest rate swap is explained below with the help of a small example. Let consider to party A & be involved in the interest swap for a period of 5 years. The payment made by A will be calculated at 6% fixed interest rate where as for B the rate is calculated at 6 months floating. The principal let us consider as $10 million. Cash flows for the above case are described in the diagram below: Payment at the end of half year Period Fixed Rate Payments Floating rate Payment 8 months Libor Net cash from A to B 1 300000 337500 -37500 2 300000 337500 -37500 3 300000 337500 -37500 4 300000 325000 -25000 5 300000 325000 -25000 6 300000 325000 -25000 7 300000 312500 -12500 8 300000 312500 -12500 9 300000 312500 -12500 10 300000 325000 -25000 -2500000 b. Is hedging this portfolio necessary?  Hedging can be defined as a process which control or reduce the risk associated with any kind of trade. Hedging can be done taking into consideration of the market potion which may arrive in the future, which is exactly opposite to that of the present physical market condition in terms of price. Hedging the portfolio is a better option for the asset manager in view of long run profit making. At present there are a fixed rate SWAP in case of EURO market, and floating interest rate with bank of Ericaca for tenure of 1 year. However, If the central bank withdraws the support behind the asset price then there will be a chance of a decrease in the asset price. So to hedge to invest for a 1 year term will help the investor to get the profit. We can consider two different scenarios: if the asset price goes down in next one year or if the asset price goes up in next one year. In the first instance, if the asset price goes down the value of the contract will decrease, so the asset management company will incur loss in future transaction, but the purchase that he has to make will gain profit for him. On the other hand if the value of the asset increases over the year then at the end of the term, the asset manager will gain profit for his future transaction, but on the other hand to purchase the new asset he has to pay more hence there is a possibility of loss. So in both the cases there is a chance of loss which can be overruled by the profit of long term contract or hedge that the asset management company have take as a precaution. c. Is hedging this portfolio necessary without IRS? The portfolio would require hedging even without the IRS because of the German equities which belongs to the Euro region and needs hedging. The USD LIBOR lending is hedgined by the futures contract but the equities require further hedging with the help of long term futures. Reference Corb, H. (2013), Interest rates Swaps and other Derivatives, Columbia University Press. a) Credit default Swap or CDS can be defined as an agreement between seller and the buyer, in case of loan default. It is a financial swap agreement, where the buyer makes a series of payment to the seller and gets the payoff if the loan gets default. The concept was first invented by Blythe Masters of JP Morgan in the year 1994. According to Schutz (2012), it is an essential insurance contract to hedge the credit risk associated with any kind of loans. It is a kind of derivatives, the value of which depends on the possibility of a company defaulting. Schutz in his writing mentioned about the existence of two different kinds of payoff in case of any credit event. In first case, the owners return the bond equal to the par value of the payment due which known as physical settlement. In case of second type, the owner of the credit receives the difference of amount between the face value of the bond and the current market price as payment, where as the bond remains with the buyer. It is known as cash settlement. According to Schutz, the principal related to purchase of credit default swap is similar to that of purchasing an insurance policy as both of the instruments provide protection against any kind of casualties. (Schutz, 2012, p.3).The credit default swap market has blossomed over the years and now become a major part of the capital market. At the beginning it was only confined to different Banks but now other financial companies like insurance, mutual funds, pension funds, and hedge funds also started to get interested in the CDS market. Papadopoulos (2011), in his writing about the CDS discussed about the development of the CDS market in world economy. According to him, in the year 1998 and 1999, the International Swaps and Derivative Association figure out a standard contract credit default swap (CDS) to govern the OTC market. According to him as per the BIS report, the gross value of CDS market was increased from $133 billion in 2004 to $ 5.7 Trillion in 2008. But, during the world financial crisis in the year 2008, the CDS market faced a sharp fall, which was expected to get recovered by 2010.The reason mentioned by him behind the fall in the CDS market was re-pricing of the credit risk and increase in volatility of the financial market (Papadopoulos, 2011, p.2). b) The asset manager lends $50,000,000 to the bank at USD LIBOR rate. The bank B will be liable to pay at 0.67% (LIBOR rate) to A. The risk of default can be hedged by investing in derivatives. The hedging in this case can be done by options and futures. For instance, the asset manager should invest in futures contract of equivalent value in some strong currency other than dollar. Therefore the bank needs to pay back $50,000,000 (1+0.67) = $83500, 000 to the asset manager at the end of one year (Bank Rate, 2013). LIBOR has been considered as a standard benchmark to price loans at floating rates. Eurodollar futures can be an option since these are US Dollars held with the banks outside US. This can serve as a way to hedge against any change in future interest rates. c) Before understanding cost of hedging one should understand that in order to get high return the risk should also be high too. Yet even considering this situation, the return in reality could be negative for any period. One may assume here that the law of large numbers will be valid for a large number of periods and the law of large numbers will therefore apply. However one underlying assumption here is that the portfolio market is efficient and effectively priced or organized. Otherwise the scenario is different. Some risks can be avoided without any cost. When managed properly it is possible to reduce risk without giving up expected return if measured over the complete cycle of market. Bringing down risk by hedging at intervals or diversifying the risk might give higher returns. However this is with respect to full market cycle. In the short cycle, hedging might as well bring down the returns in different periods or during certain part of the cycle. This is because short term bulls and bears positions are not taken into consideration when the full cycle is considered. When stock holdings are hedged against the market vulnerabilities using futures or contracts the hedges play the role of interest bearing short sales. Normally reduction in market risks with help of hedging would not produce any fall in investment return. The return on a completely hedged investment position can be estimated as the return on the stocks held in the portfolio from which total return on the indices applied for hedging is deducted. The risk involved includes the possibility of short term interest rates being outdone by the market and valuations at a rise increasingly. For instance, if the implied interest rate is 5% and the major indices progress by 8% then there will be total return cut of 3% on yearly basis (Hussman, 2006). This would be the cost of hedging. In this case if the LIBOR increases by 1.5 % (say) and the interest implied by the futures contract is held constant and lies below the LIBOR rate then there will be return clip and this would be the cost of hedging the portfolio in this case of lending. In this case, the chance of undergoing this cost is practically nullified because the LIBOR is applicable for one year and it is unlikely for the LIBOR to drastically rise considering its nature. Such costs are more applicable in case of equities. References Bank Rate (2013), LIBOR, available at: http://www.bankrate.com/rates/interest-rates/libor.aspx (accessed on September 7, 2013) Hussman, J.P. (2006), Cost of Hedging, Hussman Funds, available at: http://www.hussmanfunds.com/wmc/wmc060306.htm (accessed on September 7, 2013) Papadopoulos P. (2011), Credit default Swap – Pricing, Valuation and investment applications, Germany, GRIN Verlag. Schutz, K. (2012), Credit Default Swaps and their Role in the Financial Crisis, Germany GRIN Verlag. Read More