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Chapter 7

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005

7.1

Nature of Swaps

A swap is an agreement to exchange cash flows at specified future times according to certain specified rules

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005

7.2

3 . Copyright © John C. and Other Derivatives 6th Edition.An Example of a ³Plain Vanilla´ Interest Rate Swap An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million Next slide illustrates cash flows Options. Futures. Hull 2005 7.

50 ±2. Copyright © John C.10 +0.45 7.50 ±2. Hull 2005 .4% +2.80 +2. 5.50 ±2.5. 2006 Mar. 2004 Mar.5. 2006 Sept.25 +0.3% 5. 5. 2005 Sept.75 +2.5.2% 4.95 ±2.Cash Flows to Microsoft (See Table 7. and Other Derivatives 6th Edition. page 151) ---------Millions of Dollars--------LIBOR FLOATING Date Mar.50 ±2.4 FIXED Net Cash Flow Cash Flow Cash Flow Options.5.50 ±2. Futures. 2005 Mar. 2007 Rate 4.40 ±0.30 +0.1.8% 5. 5.10 +2.50 ±0.6% 5.40 +2.65 +2.15 +0.5% 5. 2004 Sept.9% 6.

Typical Uses of an Interest Rate Swap Converting a liability from fixed rate to floating rate floating rate to fixed rate Converting an investment from fixed rate to floating rate floating rate to fixed rate 7. and Other Derivatives 6th Edition. Futures. Hull 2005 .5 Options. Copyright © John C.

Hull 2005 7.2% Intel MS LIBOR+0.Intel and Microsoft (MS) Transform a Liability (Figure 7. Copyright © John C. page 152) 5% 5.2.6 . Futures. and Other Derivatives 6th Edition.1% LIBOR Options.

page 153) 4. LIBOR MS LIBOR+0. and Other Derivatives 6th Edition.2% 5.I.4. Copyright © John C.015% Intel LIBOR F. Futures.1% Options.Financial Institution is Involved (Figure 7.7 . Hull 2005 7.985% 5.

Hull 2005 7.8 . Copyright © John C. Futures.Intel and Microsoft (MS) Transform an Asset (Figure 7. and Other Derivatives 6th Edition.7% Intel LIBOR-0.3. page 153) 5% 4.2% LIBOR MS Options.

5. Futures.I.015% 4. LIBOR MS Options.Financial Institution is Involved (See Figure 7.2% LIBOR F. Copyright © John C.7% Intel LIBOR-0. Hull 2005 7. and Other Derivatives 6th Edition.985% 5. page 154) 4.9 .

and Other Derivatives 6th Edition.045 6.35 6. Hull 2005 7.225 6.65 6.47 6. page 155) Maturity 2 years 3 years 4 years 5 years 7 years 10 years Bid (%) 6. Futures.370 6.3.490 6.850 Options.21 6.10 .03 6.68 6.87 Swap Rate (%) 6.Quotes By a Swap Market Maker (Table 7.06 6.51 6. Copyright © John C.665 6.83 Offer (%) 6.39 6.24 6.

0% 5.20% Floating 6-month LIBOR + 0.11 . and Other Derivatives 6th Edition. Copyright © John C. Futures.The Comparative Advantage Argument (Table 7.4.00% Options. page 157) AAACorp wants to borrow floating BBBCorp wants to borrow fixed Fixed AAACorp BBBCorp 4.30% 6-month LIBOR + 1. Hull 2005 7.

6. Copyright © John C. Futures.12 . Hull 2005 7.The Swap (Figure 7. and Other Derivatives 6th Edition. page 158) 3.95% 4% AAACorp BBBCorp LIBOR+1% LIBOR Options.

page 158) 3.93% 4% AAACorp 3.13 . LIBOR BBBCorp LIBOR+1% LIBOR Options.7. and Other Derivatives 6th Edition. Hull 2005 7. Futures.97% F. Copyright © John C.I.The Swap when a Financial Institution is Involved (Figure 7.

Copyright © John C.0% and 5.2% rates available to AAACorp and BBBCorp in fixed rate markets are 5-year rates The LIBOR+0.14 . Futures.Criticism of the Comparative Advantage Argument The 4. Hull 2005 7. and Other Derivatives 6th Edition.3% and LIBOR+1% rates available in the floating rate market are sixmonth rates BBBCorp¶s fixed rate depends on the spread above LIBOR it borrows at in the future Options.

The Nature of Swap Rates Six-month LIBOR is a short-term AA borrowing rate The 5-year swap rate has a risk corresponding to the situation where 10 six-month loans are made to AA borrowers at LIBOR This is because the lender can enter into a swap where income from the LIBOR loans is exchanged for the 5-year swap rate 7. and Other Derivatives 6th Edition.15 Options. Copyright © John C. Futures. Hull 2005 .

16 Options.Using Swap Rates to Bootstrap the LIBOR/Swap Zero Curve Consider a new swap where the fixed rate is the swap rate When principals are added to both sides on the final payment date the swap is the exchange of a fixed rate bond for a floating rate bond The floating-rate rate bond is worth par. The fixed-rate bond must therefore also be worth par This shows that swap rates define par yield bonds that can be used to bootstrap the LIBOR (or LIBOR/swap) zero curve 7. Futures. Copyright © John C. Hull 2005 . The swap is worth zero. and Other Derivatives 6th Edition.

Futures. they can be valued as a portfolio of forward rate agreements (FRAs) 7. Hull 2005 .Valuation of an Interest Rate Swap that is not New Interest rate swaps can be valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bond Alternatively.17 Options. Copyright © John C. and Other Derivatives 6th Edition.

Hull 2005 7. Futures.18 . and Other Derivatives 6th Edition.Valuation in Terms of Bonds The fixed rate bond is valued in the usual way The floating rate bond is valued by noting that it is worth par immediately after the next payment date Options. Copyright © John C.

Hull 2005 7. Futures. Copyright © John C.19 . and Other Derivatives 6th Edition.Valuation in Terms of FRAs Each exchange of payments in an interest rate swap is an FRA The FRAs can be valued on the assumption that today¶s forward rates are realized Options.

Copyright © John C.000. Futures. and Other Derivatives 6th Edition.000 & receive 8% on a US$ principal of $15.000 every year for 5 years Options. Hull 2005 7.20 .An Example of a Currency Swap An agreement to pay 11% on a sterling principal of £10.000.

and Other Derivatives 6th Edition.21 . Hull 2005 7. Futures. Copyright © John C.Exchange of Principal In an interest rate swap the principal is not exchanged In a currency swap the principal is usually exchanged at the beginning and the end of the swap¶s life Options.

60 ±0. and Other Derivatives 6th Edition. page 166) Dollars Pounds £ $ ------millions-----±15.60 ±0. Copyright © John C.00 +10.60 ±0.70 Year 2004 2005 2006 2007 2008 2009 Options.60 í10.7. Hull 2005 7.22 .00 +0. Futures.60 ±0.70 +15.70 +0.70 +0.70 +0.The Cash Flows (Table 7.

Typical Uses of a Currency Swap Conversion from a liability in one currency to a liability in another currency Conversion from an investment in one currency to an investment in another currency Options. Futures. Copyright © John C.23 . and Other Derivatives 6th Edition. Hull 2005 7.

24 .Comparative Advantage Arguments for Currency Swaps (Table 7.0% AUD 12.6% 13. and Other Derivatives 6th Edition. Copyright © John C.8. page 167) General Motors wants to borrow AUD Qantas wants to borrow USD USD General Motors Qantas 5. Futures.0% Options. Hull 2005 7.0% 7.

Futures. Copyright © John C. and Other Derivatives 6th Edition. currency swaps can be valued either as the difference between 2 bonds or as a portfolio of forward contracts Options. Hull 2005 7.Valuation of Currency Swaps Like interest rate swaps.25 .

26 . Hull 2005 7. Copyright © John C.4) consisted of 6 FRAs The ³fixed for fixed´ currency swap in our example (slide 7.Swaps & Forwards A swap can be regarded as a convenient way of packaging forward contracts The ³plain vanilla´ interest rate swap in our example (slide 7. Futures. and Other Derivatives 6th Edition.22) consisted of a cash transaction & 5 forward contracts Options.

Futures.27 Options. and Other Derivatives 6th Edition. Hull 2005 . Copyright © John C.Swaps & Forwards (continued) The value of the swap is the sum of the values of the forward contracts underlying the swap Swaps are normally ³at the money´ initially This means that it costs nothing to enter into a swap It does not mean that each forward contract underlying a swap is ³at the money´ initially 7.

Credit Risk A swap is worth zero to a company initially At a future time its value is liable to be either positive or negative The company has credit risk exposure only when its value is positive Options. Hull 2005 7.28 . Futures. and Other Derivatives 6th Edition. Copyright © John C.

cross currency interest rate swaps. diff swaps. constant maturity swaps. volatility swaps««. amortizing swaps. equity swaps. Copyright © John C. swaptions. extendable swaps. compounding swaps. accrual swaps.29 . Options.. commodity swaps. step up swaps. and Other Derivatives 6th Edition.Other Types of Swaps Floating-for-floating interest rate swaps. puttable swaps. LIBOR-in-arrears swaps. forward swaps. Futures. Hull 2005 7.

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