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 »

UNDERLYING IS A CREDIT SPREAD ON A REFERENCE OBLIGATION

When the underlying for a credit spread option is the credit spread for a reference obligation over a referenced benchmark, then the payoff of a call and a put option are as follows:

Credit spread call option:

payoff =

(credit spread at exercise — strike credit spread) x notional amount x risk factor

Credit spread put option:

payoff =

(strike credit spread — credit spread at exercise) x notional amount x risk factor

The strike credit spread (in decimal form) is fixed at the outset of the option. The credit spread at exercise (in decimal form) is the credit spread over a referenced benchmark at the exercise date.

The risk factor is equal to

risk factor = 10,000 x percentage price change for 1-basis-point change in rates for the reference obligation 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 »