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Interest rate swap - Wikipedia
The fixed interest rate is tied to a zero coupon bond - a bond that pays no interest for the life of the bond, but is expected to make one single payment at maturity. In effect, the amount of the fixed-rate payment is based on the swap's zero coupon rate. The bondholder on the end of the fixed leg of a zero coupon swap is responsible for making one payment at maturity, while the party on the end of the floating leg must make periodic payments over the contract life of the swap.
However, zero coupon swaps can be structured so that both floating and fixed rate payments are paid as a lump sum. The counterparty that does not receive payment until the end of the agreement incurs a greater credit risk than it would with a plain vanilla swap in which both fixed and floating interest rate payments are agreed to be paid on certain dates over time. Valuing a zero coupon swap involves determining the present value of the cash flows using a spot rate or zero coupon rate. The spot rate is an interest rate that applies to a discount bond that pays no coupon and produces just one cash flow at maturity date.
The present value of each fixed and floating leg will be determined separately and summed together. Since the fixed rate payments are known ahead of time, calculating the present value of this leg is straightforward.
Apr 24, Most often, a short coupon is a bond's first coupon. However subsequent coupon payments will be paid normally and in full, following the. Feb 20, A zero coupon swap is an exchange of income streams in which the the floating rate leg, the implied forward rate must be calculated first.
To derive the present value of cash flows from the floating rate leg, the implied forward rate must be calculated first. The forward rates are usually implied from spot rates. The spot rates are derived from a spot curve which is built from bootstrapping , a technique that shows a sequence of spot or zero-coupon rates that are consistent with the prices and yields on coupon bonds.
Variations of the zero coupon swap exist to meet different investment needs. A reverse zero coupon swap pays the fixed lump-sum payment upfront when the contract is initiated, reducing credit risk for the pay-floating party. Under an exchangeable zero coupon swap , the party scheduled to receive a fixed sum at the maturity date can use an embedded option to turn the lump-sum payment into a series of fixed payments.
The initial guidance for the first coupon was set at Russian Federation: Just as with the first Coupon Matter survey in , slightly more than half were inspired to shop because they received a deal.
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Wealthy consumers crave coupon deals. The rate of return on the first coupon is expected to be at its floor of 11 per cent per annum. Corporate Briefs. Front-page ads up.
The first coupon was ceremoniously handed out to several police explorers, including year-old Vanessa Perplies. Therefore, the swap will be an asset to one party and a liability to the other. Swaps are marked to market by debt security traders to visualize their inventory at a certain time. Interest rate swaps expose users to many different types of financial risk.
Swaps which are determined on a floating rate index in one currency but whose payments are denominated in another currency are called quantos. In both cases, the PV of a general swap can be expressed exactly with the following intuitive formula:. Your Money. During the life of the swap the same valuation technique is used, but since, over time, both the discounting factors and the forward rates change, the PV of the swap will deviate from its initial value. It became more apparent with the — global financial crisis that the approach was not appropriate, and alignment towards discount factors associated with physical collateral of the IRSs was needed. Fixed leg versus fixed leg swaps are rare, and generally constitute a form of specialised loan agreement. Collateralised interest rate swaps expose the users to collateral risks.
Predominantly they expose the user to market risks. The value of an interest rate swap will change as market interest rates rise and fall. In market terminology this is often referred to as delta risk. Other specific types of market risk that interest rate swaps have exposure to are basis risks where various IBOR tenor indexes can deviate from one another and reset risks where the publication of specific tenor IBOR indexes are subject to daily fluctuation. Interest rate swaps also exhibit gamma risk whereby their delta risk increases or decreases as market interest rates fluctuate.
Uncollateralised interest rate swaps that are those executed bilaterally without a credit support annex CSA in place expose the trading counterparties to funding risks and credit risks. Funding risks because the value of the swap might deviate to become so negative that it is unaffordable and cannot be funded.
Credit risks because the respective counterparty, for whom the value of the swap is positive, will be concerned about the opposing counterparty defaulting on its obligations. Collateralised interest rate swaps expose the users to collateral risks.
Interest rate swap
Depending upon the terms of the CSA, the type of posted collateral that is permitted might become more or less expensive due to other extraneous market movements. Credit and funding risks still exist for collateralised trades but to a much lesser extent. Due to regulations set out in the Basel III Regulatory Frameworks trading interest rate derivatives commands a capital usage. Dependent upon their specific nature interest rate swaps might command more capital usage and this can deviate with market movements.
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Thus capital risks are another concern for users. Reputation risks also exist. The mis-selling of swaps, over-exposure of municipalities to derivative contracts, and IBOR manipulation are examples of high-profile cases where trading interest rate swaps has led to a loss of reputation and fines by regulators. Hedging interest rate swaps can be complicated and relies on numerical processes of well designed risk models to suggest reliable benchmark trades that mitigate all market risks.
The other, aforementioned risks must be hedged using other systematic processes. The market-making of IRSs is an involved process involving multiple tasks; curve construction with reference to interbank markets, individual derivative contract pricing, risk management of credit, cash and capital.
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The cross disciplines required include quantitative analysis and mathematical expertise, disciplined and organized approach towards profits and losses, and coherent psychological and subjective assessment of financial market information and price-taker analysis. The time sensitive nature of markets also creates a pressurized environment. Many tools and techniques have been designed to improve efficiency of market-making in a drive to efficiency and consistency.
In June the Audit Commission was tipped off by someone working on the swaps desk of Goldman Sachs that the London Borough of Hammersmith and Fulham had a massive exposure to interest rate swaps.
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When the commission contacted the council, the chief executive told them not to worry as "everybody knows that interest rates are going to fall"; the treasurer thought the interest rate swaps were a "nice little earner". The Commission's Controller, Howard Davies , realised that the council had put all of its positions on interest rates going down and ordered an investigation.
By January the Commission obtained legal opinions from two Queen's Counsel.
Although they did not agree, the commission preferred the opinion that is was ultra vires for councils to engage in interest rate swaps ie. The auditor and the commission then went to court and had the contracts declared void appeals all the way up to the House of Lords failed in Hazell v Hammersmith and Fulham LBC ; the five banks involved lost millions of pounds.
Many other local authorities had been engaging in interest rate swaps in the s.