Funds Investing

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 »

A credit spread option is an option whose value/payoff depends on the change in credit spread for a reference obligation. It is critical in discussing credit spread options to define what the underlying is. The underlining can be either

1. a reference obligation, which is a credit-risky bond with a fixed credit spread, or
2. the level of the credit spread for a reference obligation

UNDERLYING IS A REFERENCE OBLIGATION WITH A FIXED CREDIT SPREAD

When the underlying is a reference obligation with a fixed credit spread, then a credit spread option is defined as follows:

Credit spread put option: An option that grants the option buyer the right, but not the obligation, to sell a reference obligation at a price that is determined by a strike credit spread over a referenced benchmark. Read the rest of this entry »

An interest-rate agreement is an agreement between two parties whereby one party, for an upfront premium, agrees to compensate the other at specific time periods if a designated interest rate, called the reference rate, is different from a predetermined level. When one party agrees to pay the other when the reference rate exceeds a predetermined level, the agreement is referred to as an interest-rate cap or ceiling. The agreement is referred to as an interest-rate floor when one party agrees to pay the other when the reference rate falls below a predetermined level. The predetermined interest-rate level is called the strike rate.

The terms of an interest-rate agreement include

1. The reference rate
2. The strike rate that sets the ceiling or floor
3. The length of the agreement
4. The frequency of settlement
5. The notional principal amount

Read the rest of this entry »