“History teaches us that men and nations behave wisely once they have exhausted all other alternatives. ” Abba Eban Saunders & Cornett, Financial Institutions Management, 4 th ed. 1
Global Derivatives Markets as of June 2001 • Credit derivatives - $1 trillion in notional value worldwide • Interest rate derivatives - $65 trillion • Foreign exchange rate derivatives - $16 trillion • Equity derivatives -$2 trillion • By comparison, total on-balance sheet assets of all US banks was $5 trillion (as of Dec. 2000) and for Euro area banks $13 trillion. Global derivatives markets totaled approximately $84 trillion in notional value. Saunders & Cornett, Financial Institutions Management, 4 th ed. 2
Step-By-Step Hedging Using Interest Rate Swaps • Step 4: Implementation. – Long hedge (DG<0) – sell swaps (make floating rate payments). – Short hedge (DG >0) – buy swaps (make fixed rate payments). • Fixed for floating rate (plain vanilla) swap • Swap intermediary acts as credit guarantor, as well as broker and bookkeeper. Only net amounts exchanged on payment dates (not principal amounts). • Swaps are portfolios of forwards so there are no predetermined notional values (NV) or contract specifications as in exchange traded futures & Saunders & Cornett, Financial 3 options. Institutions Management, 4 th ed.
Example of Macrohedge Against Interest Rate Risk • Step 1: DA= 7. 5 yrs. DL=2. 9 yrs. A=$750 m L=$650 m. DG = 5 yrs. Assume a 25 bp increase in interest rates such that RS /(1+RS) = + 25 bp E -DGA RS /(1+RS) = -5($750 m)(. 0025) = - $9. 375 m Step 2: Loss of $9. 375 million in the market value of equity when interest rates unexpectedly increase by 25 bp. Saunders & Cornett, Financial Institutions Management, 4 th ed. 4
Macrohedge Example (cont. ) • Step 3: Perfect hedge would generate positive cash flows of $9. 375 million whenever spot rates increase 25 bp. Short hedge: buy fixed for floating rate swaps. • Step 4: Floating rate reprices each year (Dfloat=1). Fixed rate is equal to the 15 yr 8% coupon T-bond (Dfixed=9. 33). Swap -(DFixed –DFloat)NV Rswap /(1+Rswap) = -(9. 33 – 1)NV(. 0025) set = $9. 375 m = E NV = $450 million Buy $450 million of fixed for floating rate swaps in order to implement macrohedge to immunize against ALL interest rate risk Saunders & Cornett, Financial Institutions Management, 4 th ed. 5
Immunizing Against Interest Rate Risk Using Swaps • Interest rate shock drops out of final formula (as long as interest rates change by the same amount in spot and futures markets): For microhedge: NVswap = (DSPS)/(DFixed -DFloat) For macrohedge: NVswap = (DG)A/(DFixed - DFloat) Saunders & Cornett, Financial Institutions Management, 4 th ed. 6
The Total Return Swap • Swaps fixed loan payment plus the change in the market value of the loan for a variable rate interest payment (tied to LIBOR). • Figure 15. 5 shows the structure. • Table 15. 1 shows the cash flows if the fixed loan rate=12%, LIBOR=11%, and the loan depreciates 10% in value over the year (at swap maturity). Buyer of credit protection (the bank lender) receives 11% and pays out (12% - 10%) = 2% for a net cash inflow of 9%. Saunders & Cornett, Financial Institutions Management, 4 th ed. 7
Saunders & Cornett, Financial Institutions Management, 4 th ed. 8
Credit Default Swaps (CDS) • CDS specifies: – – Identity of reference loan Definition of credit event (default, restructuring, etc. ) Payoff upon credit event. Specification of physical or cash settlement. • July 1999: master agreement for CDS by ISDA • Swap premium = CS • Figure 15. 6 shows the cash flows on the CDS. Saunders & Cornett, Financial Institutions Management, 4 th ed. 9
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Pricing the CDS: Promoting Price Discovery in the Debt Market • Premium on CDS = PD x LGD = CS on reference loan • Decomposition of risky debt prices to obtain PD (see chapter 5): • Basis in swap market (CDS premium CS) because: – Noise and embedded options in risky debt prices. – Liquidity premium in debt market. – Default risk premiums in CDS market for counterparty default risk. Increase as correlations increase and credit ratings deteriorate. Table 15. 2. – High cost of arbitrage between CDS and debt markets. Saunders & Cornett, Financial Institutions Management, 4 th ed. 11
Table 15. 2 CDS Spreads for Different Counterparties Saunders & Cornett, Financial Institutions Management, 4 th ed. 12
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