Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries

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5In this chapter, we will discuss what a swap is, its related concepts, and themechanism of interest rate swaps, cross currency swaps and other types of swaps.WHAT is A SWAP?When we talk about swaps, we usually talk about interest rate swaps andcross currency swaps. These are so called generic or basic swaps. Ingeneral, a generic swap is a contract in which two parties agree to exchangeperiodic payments within an agreed time period. Other generic swapsinclude contracts which involve exchanging baskets of securities orcommodities. There are also non-generic swaps. They usually containvariations of generic swaps and other derivative instruments.WHY FINANCIAL INSTITUTIONS SWAP?The concept of a swap is quite simple. It is no more complicated thanswapping things between two parties. If I have commodity A that I do notneed, you have commodity B that you do not need, and we both need theother's commodity, the best solution is to exchange (swap) these twocommodities at a reasonable pre-determined price. Please see example below:ABC Bank's asset/liability structure is liability sensitive (this is a bankers'jargon which means that the liabilities are re-priced faster than theassets) because the duration (it means the term-to-maturity here) of itsdeposits is shorter than the duration of its loans. This creates a mismatchbetween its assets and liabilities. In order to balance this mismatch, ABCBank can do two things: (I) extend its liability duration by offering onlylonger-term deposits or shorten its asset duration by making only shortertermloans or floating rate loans; and/or (2) utilise risk management tools(derivatives) to modify its asset/liability structure.Swaps
It is not practical to actually change a bank's asset or liability duration b>intentionally lending short or borrowing long. This may prove to be morecostly. The practical way to extend its liability duration or shorten itsasset duration is to utilise risk management tools, such as swaps toaccomplish this task. We will discuss this arrangement in detail later.XYZ Life Insurance Company's asset/liability structure is asset sensitive.It collects insurance premiums from policy holders each month for manyyears and pays them out when the policy expires (usually in tens ofyears) or when the insured is dead. This also creates a mismatch betweenassets and liabilities. Its situation is just the opposite of ABC Bank.Therefore, XYZ Life Insurance Company and ABC Bank can come toan agreement to swap something in order to balance their asset/liabilitystructures.THE HISTORY OF SWAPSThe idea of financial swap was created in the UK as a means of circumventingforeign-exchange controls in the 1970s, which were intended to prevent anoutflow of British capital. At that time, the British Government imposedtaxes on foreign-exchange transactions involving the British pounds to makeoutflow of capital more expensive in order to induce domestic investment.During that period, companies frequently used back-to-back loans to avoidsuch taxes. The mechanism of back-to-back loans is: they involved twocompanies domiciled in two different countries. One company agreed toborrow funds in its own country and then lend those borrowed funds tothe other company. The second company, in return, borrowed funds in itsown country and then lent them to the first company. By doing so, bothcompanies were able to access the foreign capital market without formalexchanges of currencies and thus avoided paying any foreign exchange taxesThis simple arrangement later developed into more sophisticated crosscurrency swaps and interest rate swaps with banks and investment housesas middle men to bridge counterparties who needed these arrangements(This may be a good example to prove to the free-market advocates, whcSwaps
Page 2 and 3: THE UNIVERSITY OF HONG KONGLIBRARIE
Page 4 and 5: VI- . .7 « i8^p ! ««^^OOSHSlVCJ
Page 6 and 7: Ever since derivatives took centre-
Page 8 and 9: denominator, value at risk, which c
Page 10 and 11: the kind of information that superv
Page 12 and 13: This book is a team effort of the H
Page 14 and 15: While most market participants defi
Page 16 and 17: of this investment is 6.32 percent
Page 18 and 19: Mathematically, the relation betwee
Page 20 and 21: $10,000. (For simplification of pre
Page 22 and 23: Hong Kong does go up and the HSI ri
Page 24 and 25: 3OF ATHEPRICING OF A FORWARD CONTRA
Page 26 and 27: COST OF CARRYIn the above example,
Page 28 and 29: interest rate swap rates. From thes
Page 30 and 31: Borrowers, on the other hand, usual
Page 32 and 33: Again we use our method of having t
Page 34 and 35: ates, the forward rate for the peri
Page 38 and 39: often complain that there is too mu
Page 40 and 41: ABC also has three cash flows:1. It
Page 42 and 43: Assuming that there is no transacti
Page 44 and 45: simulation techniques and mathemati
Page 46 and 47: The calculation of credit risk proc
Page 48 and 49: The payments are exchanged every th
Page 50 and 51: the reference rate. When this type
Page 52 and 53: Effectively this is just a 2-year s
Page 54 and 55: This measure of duration is referre
Page 56 and 57: analysis, it also has its shortcomi
Page 58 and 59: Percentage change in price due to d
Page 60 and 61: 8OFOptions are generally perceived
Page 62 and 63: OPTION'S PAYOFF PATTERNWhat about a
Page 64 and 65: Volatility is the most important fa
Page 66 and 67: fANDTrading options becomes more po
Page 68 and 69: You need to hold 7 shares of stock
Page 70 and 71: di = [ln(IOO/IOO) + (0.06 + O.P/2)
Page 72 and 73: is10In the previous chapter, we dis
Page 74 and 75: stock will go up in the near future
Page 76 and 77: If the stock price of A continues t
Page 78 and 79: OF AN11In the previous two chapters
Page 80 and 81: at-the-money option approaches its
Page 82 and 83: 12Mortgage-backed securities (MBS)
Page 84 and 85: NEGATIVE CONVEXITYFor MBS, there is
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MULTI-CLASSIn 1983, Freddie Mac int
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13What is a hedge? According to the
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management to enter into swap and o
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transaction. For this criterion to
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CREDIT DEFAULT SWAPThe simplest for
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APPLICATION OF CREDIT DERIVATIVESYo
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in the US. Equally innovative, cred
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THE VARIANCE-COVARIANCE METHODThe t
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"cell" would have a cash flow expos
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Daily profit and loss ranked in asc
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of the market factor. Through this
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3. Most value at risk models use hi
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16ANDIn Chapter 5, we talked about
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price) of 9,000. For this transacti
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and the June 3-month futures rate i
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needs to take the necessary busines
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ief, the policies and procedures sh
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The derivatives industry can be com
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ANDONOFINTRODUCTION1. The Monetary
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MANAGEMENT AND CORPORATE5. As the B
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ensure that there is sufficient awa
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15. Branches of foreign banks which
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20. Where the institution considers
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RISK MEASUREMENT25. Having identifi
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) the tendency of the relevant mark
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38. The measurement of the market r
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market, credit and liquidity risk o
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Consideration must be given to the
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55. As noted earlier, the market or
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changes in portfolio value;d) the r
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66. A basic and essential safeguard
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73. It is essential that the intern
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Market liquidity risk is the risk t
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Furthermore, contracts with the sam
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There are three main VAR approaches
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Options risk should be captured; ri
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Annex D1. NOTIONAL OR VOLUME LIMITS
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assumptions on which they are based
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* There should be a unit independen
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- the customer had specifically req
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addition and deletion of operators,
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• Profits and losses resulting fr
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This book is due for return or rene
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