Transcript forward contract

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth • W. Sean Cleary
Prepared by
Ken Hartviksen
CHAPTER 11
Forwards, Futures, and
Swaps
Lecture Agenda
•
•
•
•
•
•
Learning Objectives
Important Terms
Forward Contracts
Futures Contracts
Swaps
Summary and Conclusions
– Concept Review Questions
CHAPTER 11 – Forwards, Futures and Swaps
11 - 3
Learning Objectives
1.
2.
3.
4.
5.
The payoff associated with long and short positions in
forward contracts
How to price simple forward contracts and how interest rate
parity is a variation of the forward pricing relationship
The nature of futures contracts, and why they can be viewed
as the public market version of forward contracts
The mechanics of a basic interest rate swap and a basic
currency swap
The evolution of swap markets and how swaps can be used to
lower borrowing costs and to hedge interest rate or foreign
currency exposures
CHAPTER 11 – Forwards, Futures and Swaps
11 - 4
Important Chapter Terms
•
•
•
•
•
•
•
•
•
•
Basis risk
Clearing corporation
Commodity
Comparative advantage
Convenience yield
Cost of carry
Counterparties
Covering
Credit risk
Currency swap
•
•
•
•
•
•
•
•
Daily resettlement
Forward interest rate
Forward contract
Forward rate
agreement
Futures contract
Hedging
Initial margin
Interest rate swap
CHAPTER 11 – Forwards, Futures and Swaps
11 - 5
Important Chapter Terms…
• London Inter-Bank
Offered Rate (LIBOR)
• Long
• Maintenance margin
• Margin
• Margin call
• Naked position
• Net payments
• Notional amount
• Offsetting
• Open interest
• Plain vanilla interest
rate swap
• Settlement price
• Short
• Speculate
• Spot contract
• Storage costs
• Swap
• Total return swap
• Underlying assets
CHAPTER 11 – Forwards, Futures and Swaps
11 - 6
Derivative Securities
Defined
•
•
Derivative securities have price behaviours
that are derived from some other underlying
asset.
There are two basic types of derivative
securities:
1. Forwards, futures, and swaps (linear payoff
derivative contracts)
2. Options (non-linear payoff derivative contracts)
CHAPTER 11 – Forwards, Futures and Swaps
11 - 7
Derivative Securities
Relevance to Corporate Finance
•
•
Derivative securities offer corporations the tools to
manage pre-defined risks and/or capitalize on
comparative advantage.
Risks that can be mitigated through derivatives include:
–
–
–
Foreign exchange risk
Credit risk
Interest rate risk
NOTE: because it costs the firm money to engage in
derivative positions, the costs of these practices can be
thought of as ‘insurance premiums’ the firm is willing
to pay to reduce it’s overall exposure. (ie. To hedge)
CHAPTER 11 – Forwards, Futures and Swaps
11 - 8
Forward versus Spot Contracts
Basic Characteristics
• A spot contract is a price that is established today for
immediate delivery.
– Immediate delivery depends on the nature of the underlying
contract.
• A forward contract is a price that is established today for
future delivery.
– Can be specified for almost any future date because forward
contracts are custom contracts between two parties.
(Table 11 – 1 illustrates foreign exchange quotes for spot and forward delivery)
CHAPTER 11 – Forwards, Futures and Swaps
11 - 9
Forward Contracts
Basic Characteristics
Table 11-1 Foreign Exchange Quotes
Foreign Exchange Rates (Canadian dollars per foreign currency)
US ($)
GB (£)
JAP (¥)
Euro (€)
Spot
1.107
2.040
0.009721
1.3991
1 month
1.1063
2.0393
0.009754
1.4007
3 month
1.1044
2.0383
0.009821
1.4039
6 month
1.1017
2.0368
0.009920
1.4082
1 year
1.0971
2.0340
0.010116
1.4159
3 year
1.0697
n/a
n/a
n/a
5 year
1.0622
n/a
n/a
n/a
10 year
1.0312
n/a
n/a
n/a
Source: Data from Bank of Montreal (BMO) Nesbitt Burns, Globe and Mail , June 10, 2006.
CHAPTER 11 – Forwards, Futures and Swaps
Reflects the
importance of the
US as a Canadian
trading partner.
(Remember,
forward contracts
occur between
corporations and
their Canadian
banks.)
Reflects the time
value of
money…forward
rates the price
TODAY for future
delivery…so the
further away, the
lower the present
value.
11 - 10
Forward Contracts
Basic Characteristics
• Are bank instruments:
– There is no organized exchange (they are an OTC instrument)
– Requires that the customer have a banking relationship.
• Involves credit risk for the bank when investors suffer losses.
• Banks will only sell forward contracts for legitimate business
purposes.
• Will only sell up to a company’s approved credit limit.
• Consequently, forward contracts are used for hedging purposes by
firms wishing to mitigate exposure to specific risks.
– As customized instruments Forwards can be tailored to any
specific date in the future and for any amount of money.
– Contracts must be fulfilled.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 11
Using Forward Contracts
• Like all derivative securities, forward contracts
can be used theoretically to:
– Hedge – mitigate or eliminate risk.
– Speculate – make an educated guess about the
future value of something in hopes of profiting from it.
• Canadian banks, performing their transmission
of Monetary Policy role, will only provide
forward contracts for legitimate business
purposes (hedging purposes) …so speculative
purposes aren’t not supported.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 12
Using Forward Contracts
Speculating
• Speculation on a forward contract requires that
the investor NOT own the underlying asset.
– This is a ‘naked’ position – a position that leaves the
investor exposed to changes in the value of the
underlying asset.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 13
Using Forward Contracts
Hedging
• Hedging using a forward contract requires that
the investor have an opposite exposure to the
contract.
– This is a ‘covered’ position.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 14
Using Forward Contracts
Long and Short
• Long investing is owning an asset in the hopes it
will increase in value and the investor gains by
its capital appreciation.
– It is based on a bullish outlook (forecast increase) for
the underlying asset.
• Short investors owe something.
– It is based on a bearish outlook (forecast price
declines) for the underlying asset.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 15
Using Forward Contracts
Example of a Naked Long Position in the U.S. Dollar
•
A U.S. company can speculate on the exchange rate between the Canadian
and U.S. dollars:
(Companies often do this to offset (mitigate) exchange rate risk it is exposed to
as a normal course of its operations …for example, it expects to receive
$1million Canadian in accounts receivable one year from now ).
Initial Conditions
– Canadian dollar is at par with U.S.
– Both spot and 1-year forward rates are both at 1.0 (this implies a ratio of 1:1)
Action
– Canadian buys US $ 1.0 million forward
•
Obligates the investor to pay C$1million and receive U.S.$1million in one year.
Exposure
– Exposed to changes in the underlying asset US$ vis a vis the Canadian dollar
•
•
Long U.S. dollars
Short Canadian dollars
Payoffs
– U.S.$ rises against Canadian $ – investor gains (gains offset losses in dollars received from
accounts receivable)
– Canadian dollar rises against U.S.$ – investor looses (losses are offset by appreciated
Canadian dollars in accounts receivable)
(Payoffs from this position are illustrated in Figure 11-1)
CHAPTER 11 – Forwards, Futures and Swaps
11 - 16
Forward Contracts
Long Position in U.S. Dollars
11 - 1 FIGURE
The payoff is
linear.
profit
45 degree angle.
Passes through the
forward rate F.
F = 1.0
C$ 1.0 per US $
loss
CHAPTER 11 – Forwards, Futures and Swaps
If spot exchange
rate in the future
exceeds the
forward rate by
$0.01, then the
speculator earns
$0.01 profit for
every Canadian
dollar sold forward
for U.S. dollars.
11 - 17
Forward Contracts
Profit from a Long Forward Contract
– The profit (loss) from the long position is U.S. dollars
is equal to the difference between the future spot
price (ST) and the forward price (rate) F times the
number of contracts entered into (n):
[11-1]
Profit (loss) from long position  [ ST - F]  n
CHAPTER 11 – Forwards, Futures and Swaps
11 - 18
Using Forward Contracts
A Naked Short Position in the U.S. Dollar
• A naked short position in the U.S. dollar is
the opposite of the firm’s long position in
U.S. dollars.
• The company needs to sell U.S. dollars
forward for Canadian dollars.
(Payoffs from this position are illustrated in Figure 11-2)
CHAPTER 11 – Forwards, Futures and Swaps
11 - 19
Forward Contracts
Short Position in U.S. Dollars
11 – 2 FIGURE
The payoff from a
naked sale of U.S.
forward.
profit
F = 1.0
C$ 1.0 per US $
loss
[11-2]
Profit (loss) from short position  [ F  ST ]  n
CHAPTER 11 – Forwards, Futures and Swaps
If U.S. $1 million is
sold forward for
C$1.0 million, and
the Canadian dollar
depreciates to
C$1.20 then the
forward contract
loses money.
The profit (loss) of
the short position
is identically
opposite of the
long position.
11 - 20
Forward Contracts
Hedging
• Hedging is reducing the risk of adverse price
movement by taking an offsetting position in a
derivative to eliminate exposure to an
underlying price.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 21
Forward Contracts
Long and Short Forward Positions in U.S. Dollars
• As mentioned previously, Canadian banks will not
negotiate forward contracts for speculative purposes.
• So inherently, companies take ‘covered’ positions (not
naked ones) where they already have a given exposure,
and they wish to hedge (mitigate the risk in that
exposure)
• Figure 11 – 3 illustrates a the combined position of a firm
with a long US$ exposure of US $1million that buys a
forward contract to sell U.S. dollars forward for
Canadian dollars.
• The combined position is simply the sum…so the payoffs
are offsetting and the firm is insulated for foreign
exchange risk.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 22
Forward Contracts
Long and Short Forward Positions in U.S. Dollars
11 - 3 FIGURE
profit
Long Exposure
C$ 1.0 per US $
F = 1.0
Short Exposure
loss
CHAPTER 11 – Forwards, Futures and Swaps
The firm is
long
in the
Offsetting
underlying
long and
asset,
short so a
short
forward
exposures
contract
insulate the
gives
this net
firm for
position.
foreign
exchange
Long
US $
risk
duringis
exposure
the
whatlife of the
contract.
Canadian
exporters
face.
11 - 23
Forward Contracts
Exposures of the Bank Making the Market for Forward Contracts
•
•
•
•
Forward foreign exchange market is a bank market.
The bank sells forward contracts to its customers to
allow them to manage their foreign exchange exposure.
The banks are not buying and selling foreign exchange
for speculative purposes.
If the bank finds, however, that its has sold too many US
$ forward contracts so that it has now become exposed,
it can:
–
–
Enter the inter-bank market to offset its exposure by trading
with other banks, or
Synthetically create forward foreign exchange contracts using
the Interest rate parity (IRP) condition.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 24
Forward Contracts
Interest Rate Parity (IRP) Revisited
•
Equation 11 – 3 shows that the ratio of the
forward to the spot rate must equal the ratio of
one plus the interest rate in both markets.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 25
Interest Rate Parity (IRP)
IRP Condition
•
Equation 11 – 3 shows that the ratio of the forward to
the spot rate must equal the ratio of one plus the
interest rate in both markets.
[11-3]
•
F (1  k domestic )

S
(1  k foreign )
This equation can be rearranged to solve for the
forward rate (F ):
CHAPTER 11 – Forwards, Futures and Swaps
11 - 26
Interest Rate Parity (IRP)
Using Forward Contracts
•
The forward rate is the ratio of one plus the interest rate
in both markets times the spot rate.
[11-4]
•
•
(1  k domestic )
F
S
(1  k foreign )
The current spot rate S is observable
The two inflation rates can be estimated using each
country’s statistical reports.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 27
Pricing Forward Contracts
Interest Rate Parity Condition
– IRP is a special case for pricing forward contracts.
– The general condition is that investors can create a
forward position in a storable commodity by buying it
spot and holding it for future delivery.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 28
Pricing Forward Contracts
The General Condition – Storable Commodity Pricing Model
–
–
–
The general condition is that investors can create a forward position in
a storable commodity by buying it spot and holding it for future
delivery.
The only difference between the spot price (S) and forward (F) should
be the costs of carry (interest costs on financing the purchase and
storage costs).
Important terms:
•
•
•
•
Commodity – something traded based solely on price, because it is
undifferentiated and can be traded without requiring physical examination.
Storage costs – the price charged for holding a commodity for future
delivery
Convenience yield – the benefit or premium derived from holding the asset
rather than holding a derivative.
Cost of carry – the total cost of buying a commodity spot and then carrying
it or effecting physical delivery when the forward contract expires (this
includes both storage costs and financing costs)
CHAPTER 11 – Forwards, Futures and Swaps
11 - 29
Pricing Forward Contracts
Commodity Pricing Model
–
The Commodity Pricing Model is equation 11 – 5 and shows
that the cost of carry links the Forward and Spot prices:
[11-5]
F  (1  c)  S
Where:
c = the cost of carry, as percentage of S, over the period in question.
S = spot price
F = forward price
CHAPTER 11 – Forwards, Futures and Swaps
11 - 30
Futures Contracts
The Mechanics of Futures Contracts
• Futures contracts are a standardized exchange-traded
contract in which the seller agrees to deliver a
commodity to the buyer at some point in the future.
• Organized futures exchanges with standardized futures
contracts:
– Reduce credit risk through:
• Clearing corporation being the counterparty in all transactions
• margin requirements (both initial and maintenance margins) and
• daily mark-to-market daily resettlement.
– Allow the contract features and volumes to be reported
– Allow the futures positions to be liquid (executing offsetting
transaction to cancel the futures position) increasing the
flexibility in their use.
CHAPTER 11 – Forwards, Futures and Swaps
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Futures Contracts
Futures Contracts Markets
•
The term of the contract is set by individual exchanges.
•
Delivery months are
–
–
–
–
•
•
•
•
Standardized underlying asset so that even if delivery rarely takes place,
people know what they are getting.
The exchange sets how much of the asset is traded in each contract. (ie.
The notional amount)
For financial futures, most exchanges follow the lead of the
major markets in Chicago:
–
–
•
March
June
September
December
Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange (CME)
Commodity futures trading in Canada is concentrated on the
Winnipeg Commodity Exchange (WCE)
Financial futures trading is concentrated since 2000 on the
Montreal Exchange (ME) in Canada.
CHAPTER 11 – Forwards, Futures and Swaps
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Futures Contracts
Futures Exchanges
•
•
•
Formal exchanges develop the market in
futures contracts.
There is significant competition across
exchanges, however, some are separated by
different time zones.
Competition is a source of innovation:
– New types of contracts are developed
– As interest declines or needs change, some die out.
•
Interest in Financial futures has grown
dramatically as companies learn to hedge their
risk exposures through these instruments.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 33
Futures Contracts
Types of Futures
•
Commodity futures include:
–
–
–
•
Financial futures
–
•
Traditional agricultural products such as corn, wheat, hogs, etc.
Energy products
Base metals
S&P index / BAs/Canada bonds/S&P TSX 60 index
Other
–
–
–
Weather derivatives
Futures contracts on real estate
Futures contracts on the consumer price index (CPI)
(See Table 11 – 2 for a useful summary)
CHAPTER 11 – Forwards, Futures and Swaps
11 - 34
Futures Contracts and Markets
Basic Characteristics
Table 11- 2 Futures Contracts and Markets
Exchange
Underyling Asset
Commodities
Wheat/oats/soybeans
Cattle/pigs/lumber
Crude oil/heating oil/natural gas
Cotton/orange juice
Gold/silver/copper
Lead/nickel/tin
Canola/western barley/wheat
Financial Futures
Treasury notes and bonds/DJIA
S&P index/Nikkei225 / C$ / € / £
BAs/Canada bonds/TSX/S&P 60 index
German bonds/European equities
Chicago Board of Trade (CBOT)
Chicago Mercantile Exch. (CME)
New York Merchantile Exchange
NY Cotton Exchange
The Commodity Exchange (Comex)
London Metal Exchange (LME)
Winnipeg Commodity Exchange
CBOT
CME
Montreal Exchange
Euronext/Liffe
Other
Weather derivatives
CHAPTER 11 – Forwards, Futures and Swaps
CME
11 - 35
Futures Contracts
Marked to Market Process
The Marked to market process helps to limit
exposure to credit risk for the exchange.
– All futures contracts are marked to market each day.
– All profits and losses on a futures contract are
credited to investors’ accounts every day to calculate
their equity position.
•
•
If the equity position increases, these profits can be
withdrawn.
When the equity position drops below the maintenance
margin (usually 75% of the initial margin) the investor will
receive a margin call and be forced to contribute more
money to increase the equity position.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 36
Trading/Hedging with Futures Contracts
Example of a Bond Portfolio Manager
•
•
•
A fixed-income portfolio manager holds a diversified portfolio
of bonds that are predominantly Canadas.
The manager believes interest rates will rise, causing the
each bond price to fall.
The manager can:
1. Sell bonds and hold cash till the threat of rising interest rates pass, or
until the change in rates has occurred, and then repurchase the bonds
2. Sell long term bonds and replace with shorter term bonds (reducing the
portfolio duration and thereby limiting the losses if interest rates rise)
3. Hold the portfolio and use a short hedge (short position in a futures
contract in government bonds) …the losses in the portfolio will be
offset by gains on the short hedge.
–
–
The third alternative is often the best one, because buying and selling
bonds will incur transactions costs and upset the structure of the portfolio.
If the hedge cannot be perfectly constructed the portfolio will be exposed to
basis risk because losses on the long portfolio may not be exactly offset by
the short future position.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 37
Futures Contracts and Markets
Summary of Forward and Future Contracts
• Forward and Future Contracts serve the same
purpose.
• Forward contracts offer more flexibility because
they are customized OTC contracts.
• Forward contracts, however, face additional
risks:
– Not actively traded (created by a bank for customers)
– Possess credit risk
Differences are listed in Table 11 – 3 on the following slide.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 38
Forwards versus Futures
Table 11- 3 Forwards versus Futures
Forwards
Futures
Contracts
Customized
Standardized
Trading
Dealer or OTC markets
Exchanges
Default (credit risk)
Important
Unimportant - guaranteed by clearinghouse
Initial deposit
Not required
Initial margin and maintenance margin required
Settlement
On maturity date
Marked to market daily
CHAPTER 11 – Forwards, Futures and Swaps
11 - 39
Swaps
Defined
•
Is an agreement between two parties, called
counterparties, to exchange cash flows in the
future.
– No formal exchange to guarantee performance, so
the arrangement involves a dealer or OTC market
and there is credit risk.
– Have evolved into a bank instrument, with banks or
swap dealers serving as intermediaries.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 40
Swaps
Interest Rate Swaps
• An interest rate swap is:
– An exchange of interest payments on a principal amount in
which borrowers switch loan rates.
– Often this involves one counterparty trading fixed loan payments
for variable rate loan payments.
• A plain vanilla interest rate swap is:
– The fixed for floating interest rate swap denominated in one
currency.
• Table 11 – 4 illustrates a plain vanilla interest rate swap
between counterparties A and B and is structured to
benefit both parties equally. This is rarely the case.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 41
Swaps
Example of an Interest Rate Swap
Table 11- 4 An Interest Rate Swap
Quotes
A
B
(AAA)
(BBB)
Floating
LIBOR + 0.25
LIBOR + 0.75
Fixed
10.8
12.0
Initial
Floating
Fixed
Swap
- (LIBOR + 0.75)
-10.8
B pays A fixed and A pays B floating
+10.9
- 10.9
- LIBOR
+ LIBOR
Net
- (LIBOR - 0.10)
- 11.65
Saving
0.35%
0.35%
CHAPTER 11 – Forwards, Futures and Swaps
11 - 42
Swaps
Comparative Advantage
• Comparative advantage is:
– A benefit that one firm has relative to another.
– Any firm offered a good deal in floating rate funds but
doesn’t need them should borrow them anyway and
use a swap to exchange it for what is needed and
lock in the financing advantage.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 43
Swap Arrangements
Challenge and Response
• In swap arrangements, counterparties are often ‘unequal’
partners to the contract.
– One counterparty may be AAA rated…the other BBB
• There is credit risk and it is borne by the higher rated
counterparty.
– AAA may have to honour its own and the other interest obligations if
BBB defaults.
• Strategies to control credit risk include:
– Set-off rights in the swap agreement allowing the other party to stop
making payments if the other party defaults
– Net payments – instead of exchanging total interest amounts, only the
difference between the two streams are exchanged and structuring the
payments into sub-periods (every six months)
(Table 11 – 5 illustrates a Net Payments swap structure over time)
CHAPTER 11 – Forwards, Futures and Swaps
11 - 44
Interest Rate Swaps
Table 11- 5 Interest Rate Swap Net Payments
Floating Pay Fixed Pay
(%)
(%)
Period
LIBOR (%)
1
8.0
-4.00
+5.45
+ 1.45
2
9.0
-4.50
+5.45
+ 0.95
3
9.80
-4.90
+5.45
+ 0.55
4
11.00
-5.50
+5.45
- 0.05
5
12.00
-6.00
+5.45
- 0.55
CHAPTER 11 – Forwards, Futures and Swaps
Net Pay (%)
11 - 45
The Evolution of Swap Markets
Currency Swaps
• Currency swaps require exchange of all cash flows.
• Currency swaps permit the firms to adjust their foreign
exchange exposure.
– This means that there is increased credit risk…but it presents
opportunities.
• The first swap was a currency swap between IBM and the
World Bank.
– This swap was motivated by comparative advantage
– It was a primary market transaction – both IBM and the World Bank
used it to raise new capital cheaply.
– Once swaps became standardized, it became possible to constantly
change the nature of the institution’s liability stream.
• Today currency swaps have become a bank market through
their links to the forward foreign exchange market.
– The bank is capable of executing a secondary market transaction with
itself as the counterparty because a currency swap can be though of as
a series of forward transactions.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 46
The Evolution of Swap Markets
Swap Rate
• Standardization has helped to grow the swap market.
• Interest rate swaps have also become a bank market
through standardization.
– Floating rates are fixed against LIBOR
– Fixed rates are fixed against the government bond rate
• The choice of rate depends on whether it is a five year, 10 year or
other maturity contract.
• This becomes the swap rate.
• The swap rate is the rate of the fixed portion of a swap
which is used for quoting swaps.
Table 11 – 6 revisits the previous interest rate swap assuming a swap rate of 10.65%
CHAPTER 11 – Forwards, Futures and Swaps
11 - 47
Percent Interest Rate Swap
The Swap Rate
Table 11- 6 Percent Interest Rate Swap
Quotes
A
B
(AAA)
(BBB)
Floating
LIBOR + 0.25
LIBOR + 0.75
Fixed
10.8
12.0
Initial
- (LIBOR + 0.75)
Floating
Fixed
Swap
-10.8
The
Swap
rate
B pays A fixed and A pays B floating
+10.65
- 10.65
- LIBOR
+ LIBOR
Net
- (LIBOR - 0.15)
- 11.40
Saving
0.10%
0.60%
CHAPTER 11 – Forwards, Futures and Swaps
11 - 48
Integration of the Swap and Forward
Markets
– Interest rate swaps are found around the world.
– Table 11 – 7 gives swap rates for the euro, U.S.
dollar and the pound sterling for June 7, 2006.
– Swap rates follow the full spectrum of the yield curve
from 1 year to 30 years.
•
•
This allows swaps to manage interest rate exposure.
It also links swaps to forward rate agreements (FRAs)
– A FRA is an agreement that uses forward rates to manage a
firm’s exposure to interest rate risk; agreements to borrow or
lend at a specified future date at an interest rate that is fixed
today.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 49
Interest Rate Swap Quotes
Table 11-7 Interest Rate Swap Quotes
Euro (€) Current
US ($) Current
UK (£) Current
1 year
3.41%
5.41%
4.95%
2 year
3.61%
5.38%
5.30%
3 year
3.73%
5.38%
5.08%
5 year
3.87%
5.43%
5.09%
7 year
4.00%
5.50%
5.07%
10 year
4.16%
5.57%
5.00%
12 year
4.24%
5.61%
4.96%
15 year
4.34%
5.66%
4.90%
20 year
4.44%
5.70%
4.80%
25 year
4.48%
5.71%
4.70%
30 year
4.49%
5.71%
4.62%
Fixed Rate
Source: Data from CLP Structured Finance, June 7, 2006.
CHAPTER 11 – Forwards, Futures and Swaps
11 - 50
Swaps
Evolution of Swap Markets
– Integration of swap markets with the forward market
has fueled expansion of the market
– Firms wanting to change a floating rate liability into a
fixed rate liability simply calls their bank and
executes the interest rate swap as a secondary
market transaction executed against a line of credit.
– Creating swaps is a key component of the services
provided by major banks for their corporate clients.
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Swaps
Recent Developments
•
The focus of the text is on major vehicles used to
manage interest and currency exposure:
–
–
•
Interest rate swaps
Currency swaps
Other swap opportunities exist and evolve including the
total return swap especially between private sector
counterparties:
–
The more specialized the swap:
•
•
–
•
The less tradable it is
The greater the counterparty risk
Only standardized swaps are done with banks.
An Example is the Total Return Swap.
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Recent Developments in Swaps
Total Return Swap
Total return swap is an exchange of an interest rate
return for the total return on for the total return on
an equity index plus or minus a spread.
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Summary and Conclusions
In this chapter you have learned:
– How to diagnose long and short positions in foreign
currency and how these positions can be hedged by using
forward foreign currency contracts.
– How interest rate parity can be used to derive forward
interest rates and how banks could create synthetic
securities
– Future contracts can be viewed as the public version of
forward contracts.
– How swap markets operate and can be used to hedge
interest rate or foreign currency exposures.
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Internet Links
• Bank of Canada Website: www.bankofcanada.ca
• Financial Engineering News Website:
www.fenews.com
• Department of Finance Canada Website:
www.fin.gc.ca
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Copyright
Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
permitted by Access Copyright (the Canadian copyright licensing
agency) is unlawful. Requests for further information should be
addressed to the Permissions Department, John Wiley & Sons
Canada, Ltd. The purchaser may make back-up copies for his or her
own use only and not for distribution or resale. The author and the
publisher assume no responsibility for errors, omissions, or
damages caused by the use of these files or programs or from the
use of the information contained herein.
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