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 »
Let’s illustrate the mechanics of a standard single-name credit default swap. Assume that the reference entity is the ABC Corporation and the reference obligation is the ABC Subordinated Debenture due 2110. The swap premium—the payment made by the protection buyer to the protection seller —is 550 basis points. If a credit event occurs, the protection seller pays the protection buyer the notional amount of the contract. In our illustration, we will assume that the notional amount is $10 million.
The notional amount is not the par value of the reference obligation. For example, suppose that a bond issue is trading at 73.53 (par value being 100). If a portfolio manager owns $13.6 million par value of the bond issue and wants to protect the current market value of $10 million (approximately equal to 73.53% of $13.6 million), then the portfolio manager will want a $10 million notional amount. If a credit event occurs, the portfolio manager will deliver the $13.6 million par value of the bond and receive a cash payment of $10 million. Read the rest of this entry »
Valuing Caps and Floors
The arbitrage-free binomial model can be used to value a cap and a floor. This is because, as previously explained, a cap and a floor are nothing more than a package or strip of options. More specifically, they are a strip of European options on interest rates. Thus to value a cap the value of each period’s cap, called a caplet, is found and all the caplets are then summed. The same can be done for a floor.
To illustrate how this is done, we will once again use the binomial interest-rate tree to value an interest rate option. Consider first a 5.2%, three-year cap with a notional amount of $10 million. The reference rate is the one-year rates in the binomial tree. The payoff for the cap is annual.
Exhibit 25-12 shows how this cap is valued by valuing the three caplets. The value for the caplet for any year, say year X, is found as follows. First, calculate the payoff in year X at each node as either zero if the one-year rate at the node is less than or equal to 5.2%, or the notional principal amount of $10 million times the difference between the one-year rate at the node and 5.2% if the one-year rate at the node is greater than 5.2%
Then, the backward induction method is used to determine the value of the year X caplet. Read the rest of this entry »
There are two ways that a swap position can be interpreted: (1) as a package of forward/ futures contracts, and (2) as a package of cash flows from buying and selling cash market instruments.
Package of Forward Contracts Consider the hypothetical interest-rate swap described earlier to illustrate a swap. Let’s look at party X’s position. Party X has agreed to pay 10% and receive six-month LIBOR. More specifically, assuming a $50 million notional principal amount, X has agreed to buy a commodity called six-month LIBOR for $2.5 million This is effectively a six-month forward contract in which X agrees to pay $2.5 million in exchange for delivery of six-month LIBOR. If interest rates increase to 11%, the price of that commodity (six-month LIBOR) is higher, resulting in a gain for the fixed-rate payer, who is effectively long a six-month forward contract on six-month LIBOR. The floating-rate payer is effectively short a six- month forward contract on six-month LIBOR. There is therefore an implicit forward contract corresponding to each exchange date. Read the rest of this entry »
In an interest-rate swap, two parties (called counterparties) agree to exchange periodic interest payments. The dollar amount of the interest payments exchanged is based on a predetermined dollar principal, which is called the notional principal amount. The dollar amount that each counterparty pays to the other is the agreed-upon periodic interest rate times the notional principal amount. The only dollars that are exchanged between the parties are the interest payments, not the notional principal amount. In the most common type of swap, one party agrees to pay the other party fixed-interest payments at designated dates for the life of the contract. This party is referred to as the fixed-rate payer. The other party, who agrees to make interest rate payments that float with some reference rate, is referred to as the floating-rate payer. The frequency with which the interest rate that the floating-rate payer must pay is called the reset frequency. Read the rest of this entry »
A total return swap in the fixed-income market is a swap in which one party makes periodic floating-rate payments to a counterparty in exchange for the total return realized on a reference obligation or a basket of reference obligations. A total return payment includes all cash flows that flow from the reference obligations as well as the capital appreciation or depreciation of those reference obligations. When the reference obligation is a bond market index, the swap is referred to as a total return index swap.
The party that agrees to make the floating payments and receive the total return is referred to as the total return receiver; the party that agrees to receive the floating payments and pay the total return is referred to as the total return payer.
Notice that in a total return swap, the total return receiver is exposed to both credit risk and interest-rate risk. For example, the credit risk spread can decline (resulting in a favorable price movement for the reference obligation), but this gain can be offset by a rise in the level of interest rates. Read the rest of this entry »
The interest-rate swap was developed in late 1981. By 1987, the market had grown to more than $500 billion (in terms of notional principal amount). What is behind this rapid growth? As our asset/liability application earlier demonstrated, an interest-rate swap is a quick way for institutional investors to change the nature of assets and liabilities or to exploit any perceived capital market imperfection. The same applies to borrowers such as corporations, sovereigns, and supranationals.
In fact, the initial motivation for the interest-rate-swap market was borrower exploitation of what were perceived to be “credit arbitrage” opportunities because of differences between the quality spread between lower- and higher-rated credits in the U.S. and Eurodollar bond fixed-rate market and the same spread in these two floating- rate markets. Basically, the argument for swaps was based on a well-known economic principle of comparative advantage in international economics. Read the rest of this entry »
In addition, the composition of equity funds changed during the 1990-2000 period. According to Strategic Insight, broader investment objectives such as growth and growth & income experienced a decrease of 7.7 percentage points in share of equity funds during the decade. The decrease was offset by an increase in more specialized funds, with higher management fees, such as sector funds and international funds. In particular, emerging market and country funds went from a half-percent share of funds 110P available in 1990 to almost 3% in 2000. At the same time, there was a substantial increase in lower management fee products such as index funds, which were almost nonexistent in 1989.
2. Number of funds During the 1990s, fund choices grew alongside assets at a rapid pace as the number of mutual funds increased from around 3,000 to over 8,000.
Implications of this tremendous increase in the number of funds for management fees depend on the resulting trends in average and median fund size, as shown in Table 2 (which defines a fund to include each class of a multi-class fund). Read the rest of this entry »
Greed is one of the most difficult sins to manage because it is always there. We invest to make money, and every promising investment raises the possibility of making a significant amount of money. We wouldn’t be human if part of us didn’t dream a bit about what might be. Good investors, though, keep that part of themselves in a controlled, isolated environment. If you are particularly vulnerable to the sin of greed, you’ll do likewise. Specifically, you’ll do some or all of the following:
- Invest slowly, knowledgably, and logically. Speed, ignorance, and reflex are the greedy investor’s enemies. Force yourself to move relatively slowly before making an investing decision, even when you’re certain that even a moment’s delay could cost you thousands. In the vast majority of cases, delaying your decision for a short period of time won’t hurt. In most instances, it helps because it gives you a bigger window of time in which you can think, reflect, learn, and talk about an investment. Greed preys on people who just react. When I say invest knowledgably, I mean do your homework. Learn about the fund’s or stock’s performance historically. Compare the fund or stock to the appropriate index or benchmark. Read as many reports as you can related to the investment. Don’t worry that your delay makes you spend an extra 50 cents a share because in the long run it won’t make a difference. Finally, logical investing means reasoning out your investment decision. When you hear a great tip or read something that makes you believe you’ve found a great fund that will make you millions, step back and write down the logical steps that have led you to this conclusion. Specifically:
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