So far we have merely described an interest-rate swap and looked at its characteristics. Here we illustrate how they can be used in asset/liability management. Other types of interest-rate swaps have been developed that go beyond the generic or “plain vanilla” swap described and we describe these later.
An interest-rate swap can be used to alter the cash flow characteristics of an institution’s assets so as to provide a better match between assets and liabilities. The two institutions we use for illustration are a commercial bank and a life insurance company. Read the rest of this entry »
Earlier we provided two interpretations of a swap: (1) a package of futures/forward contracts, and (2) a package of cash market instruments. The swap spread is determined by the same factors that influence the spread over Treasuries on financial instruments (futures/forward contracts or cash) that produce a similar return or funding profile. As we explain subsequently, the key determinant of the swap spread for swaps with maturities of five years or less is the cost of hedging in the Eurodollar CD futures market. For longer maturity swaps, the key determinant of the swap spread is the credit spreads in the corporate bond market. Read the rest of this entry »
To a certain extent, all investors react to good or bad news regarding the market. Investing gluttons, however, overreact. They are so hungry for action, they respond to the rumor of a merger or the hint of regulatory move by buying and selling. They become so worked up at the hint of bad news involving a stock they’re holding that they reflexively sell; they become so eager for profit at possible good news that they immediately buy.
The irony is that these gluttons think they’re getting a jump on the market, but in reality, they’re lagging behind it. Stocks can often move before the first trade by 5 percent on good or bad news. As a result, investors that use good or bad news as a trigger for a trade usually are dealing with unfavorable price movement. They deceive themselves into thinking that by reacting quickly to a news report about a stock or a broader economic trend, they are going to get a jump on other investors. In reality, they are lagging behind the market as well as other investors who make less frequent but more strategic investing decisions. Read the rest of this entry »
