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

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Assuming that there is no transaction cost, at the inception of a swap transaction,the market value of both sides of the transaction is zero. The reason isobvious - in a liquid and generally efficient market, nobody can take advantageof its counterparty or else the counterparty will transact the deal with someoneelse. Swap pricing is the process of setting the fixed rate so that the presentvalue of cash flows of the swap is initially zero. Credit spread will then addto one side of the swap to reflect the credit quality of the counterparty.During the life of the swap, if the yield curve (in particular, this impliedforward rates) remains unchanged, the market values for both sides arealways zero. However, say, after one year, the current market fixed rate fora new four year interest rate swap is 7 percent. The swap would have anegative mark-to-market (M-T-M) value to XYZ and a positive M-T-Mvalue to ABC. This is because XYZ has a contract with ABC to receive fixedrate of 6 percent and pay LIBOR for four more years while everyone elsein the market can enter into a swap contract to receive fixed rate at 7percent and pay LIBOR for four years. But unless XYZ defaults, its contractwith ABC remains legally binding for four more years.Using the present value cash flow concept, we can calculate the loss for XYZ:8 $3,500,000 8 $3,000,000Z £ = $3,436,978t=l (1+0.035)' t=l (1+0.035)*(There are 8 settlements remaining in the contract. $3,500,000 and$3,000,000 are the semi-annual fixed interest payments at 7 percent and 6percent respectively.)If you have an HP I2C financial calculator, you can do the following tocalculate the M-T- M loss for XYZ in the above transaction:$100 million : FV8 :N3 :PMT3.5 : iPV = -96,563,022Loss = $100,000,000 - $96,563,022 = $3,436,978Swaps
The loss for XYZ is the gain for ABC. You can easily see that ABC is ata position just opposite to XYZ. It has the benefit of paying 6 percent fixedfor four more years while the market rate for a similar transaction is 7percent.In the above example, a simple approach is used to demonstrate the M-T-Mcalculation. Sophisticated market participants would create a new zerocoupon curve to discount the cash flows at each settlement point.Nevertheless, the concept of present value cash flow is still the same.CREDIT RISK OF SWAPSThe principles that govern the management of credit risk of swaps are thesame as other traditional banking business. Nevertheless, the measurementof the exposure of a swap is more complicated.The credit risk of a swap is the swap's current exposure, which is thereplacement cost or the current M-T-M value, if positive, plus its futurereplacement cost. This is the so-called "current exposure method". Thecurrent exposure method is not just an appropriate method for measuringcredit risk of swaps. It is recommended by the Basle Committee and theG-30 for measuring credit risk of all derivatives.The current exposure is straightforward. It is just the current M-T-M valueof a swap position if positive. If the M-T-M value is negative, the holder ofthe position does not have current credit exposure. This is because creditdefault occurs when a counterparty does not fulfill its financial obligation. Itwill not default if it has a financial instrument with a positive market value.Conservative market participants usually assign a zero value for an instrumentwhose M-T-M value is negative unless there is a bilateral netting agreement.The measurement of the future replacement cost or the "potential exposure"of a swap or a derivative instrument is quite complicated. It usually needsSwaps
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 36 and 37: 5In this chapter, we will discuss w
Page 38 and 39: often complain that there is too mu
Page 40 and 41: ABC also has three cash flows:1. It
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
Page 86 and 87: MULTI-CLASSIn 1983, Freddie Mac int
Page 88 and 89: 13What is a hedge? According to the
Page 90 and 91: management to enter into swap and o
Page 92 and 93:
transaction. For this criterion to
Page 94 and 95:
CREDIT DEFAULT SWAPThe simplest for
Page 96 and 97:
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
Page 170 and 171:
This book is due for return or rene
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