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Lecture Financial institutions, instruments and markets (4/e): Chapter 20 - Christopher Viney

Chapter 20 - Interest rate swaps and currency swaps. In this chapter, students will be able to understand how interest rate and currency swaps operate, outline the various risks associated with swaps. | Chapter 20 Interest Rate Swaps and Currency swaps Websites: http://www.bis.org http://www.afma.com.au Learning Objectives Understand how interest rate and currency swaps operate Outline the various risks associated with swaps Chapter Organisation 20.1 Introduction 20.2 Interest Rate Swaps 20.3 Currency Swaps 20.4 Credit and Settlements Risks Associated with Swaps 20.5 Summary 20.1 Introduction Turnover in the Australian swap market in 2000/01 was AUD1.47 trillion Swaps may be used to hedge interest risk and exchange rate risk Swaps also enable investors and borrowers to obtain a lower cost of funds or a higher yield Chapter Organisation 20.1 Introduction 20.2 Interest Rate Swaps 20.3 Currency Swaps 20.4 Credit and Settlements Risks Associated with Swaps 20.5 Summary 20.2 Interest Rate Swaps Organised between borrowing parties The two parties swap their interest payment obligations No transfer of the principal amount Both parties benefit from the swap Example: Table 20.1 outlines the . | Chapter 20 Interest Rate Swaps and Currency swaps Websites: http://www.bis.org http://www.afma.com.au Learning Objectives Understand how interest rate and currency swaps operate Outline the various risks associated with swaps Chapter Organisation 20.1 Introduction 20.2 Interest Rate Swaps 20.3 Currency Swaps 20.4 Credit and Settlements Risks Associated with Swaps 20.5 Summary 20.1 Introduction Turnover in the Australian swap market in 2000/01 was AUD1.47 trillion Swaps may be used to hedge interest risk and exchange rate risk Swaps also enable investors and borrowers to obtain a lower cost of funds or a higher yield Chapter Organisation 20.1 Introduction 20.2 Interest Rate Swaps 20.3 Currency Swaps 20.4 Credit and Settlements Risks Associated with Swaps 20.5 Summary 20.2 Interest Rate Swaps Organised between borrowing parties The two parties swap their interest payment obligations No transfer of the principal amount Both parties benefit from the swap Example: Table 20.1 outlines the current cost of funds for two borrowers Firm A has a credit advantage in both markets 20.2 Interest Rate Swaps (cont.) 20.2 Interest Rate Swaps (cont.) Strategy Firm A borrows in fixed market, where it has comparative advantage (i.e. 12%) Firm B borrows in other market (i.e. floating) at BBSW + 1.70%. One possible swap arrangement B pays A a fixed rate of 13.60% A pays B a floating rate of BBSW + 1.70% Figure 20.1 illustrates the flow of funds and benefits of this interest rate swap 20.2 Interest Rate Swaps (cont.) 20.2 Interest Rate Swaps (cont.) The majority of swaps require the involvement of an intermediary e.g. merchant bank, that often seeks an offsetting ‘matched swap’ i.e. It enters into opposite swap transactions to offset its net swap exposure, making a profit through a spread between the rates Figures 20.2 and 20.3 in the textbook illustrate an intermediated interest rate swap 20.2 Interest Rate Swaps (cont.) 20.2 Interest Rate Swaps (cont.) Rationale for the existence of .