Interest Rates Swap: Definition and Mechanism a. Corb H (2013), 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…
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 ...
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