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Swap Contracts, Convertible Securities, and Other Embedded Derivatives. Innovative Financial Instruments. Dr. A. DeMaskey. Chapter 25. OTC Interest Rate Agreements. Forward-Based Interest Rate Contracts Forward Rate Agreements Interest Rate Swaps Option-Based Interest Rate Contracts

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swap contracts convertible securities and other embedded derivatives

Swap Contracts, Convertible Securities, and Other Embedded Derivatives

Innovative Financial Instruments

Dr. A. DeMaskey

Chapter 25

otc interest rate agreements
OTC Interest Rate Agreements
  • Forward-Based Interest Rate Contracts
    • Forward Rate Agreements
    • Interest Rate Swaps
  • Option-Based Interest Rate Contracts
    • Caps and Floors
    • Collar
    • Swap Options
forward based interest rate contracts
Forward-Based Interest Rate Contracts
  • Forward Rate Agreement (FRA)
    • two parties agree today to a future exchange of cash flows based on two different interest rates
    • one of the cash flows is tied to a fixed rate
    • the other is determined at a later date (floating rate)
    • LIBOR is frequently used as the floating rate index
    • Single settlement date
forward based interest rate contracts4
Forward-Based Interest Rate Contracts
  • Interest Rate Swaps
    • multiple exposure dates could be hedged using a series of FRAs
    • swap contract is a prepackaged series of forward contracts to buy or sell LIBOR at the same fixed rate
    • priced off the LIBOR forward yield curve, but quoted off the Treasury bond yield curve
      • fixed rate side is
        • the yield of a Treasury bond with a comparable maturity, and
        • a risk premium term known as the swap spread
forward based interest rate contracts5
Forward-Based Interest Rate Contracts
  • Interest Rate Swaps
    • fixed and floating rate payments

Where fixed rate is typically the current yield on the U.S. Treasury

note (T-note yield + x bps).

Where floating rate used is typically the London Interbank Borrowing

Rate (LIBOR + x bps).

swap example
Swap Example
  • Consider a 3-year swap in which every 6 months:
    • Firm B pays Firm A a 5% annual fixed rate
    • Firm A pays Firm B the prevailing 6-month LIBOR
    • Notional amount is $100,000,000
solution
Solution

Swap is entered into at time 0.

how are swaps used
How Are Swaps Used?
  • To transform a liability
    • convert floating-rate loan to fixed-rate loan (or vice versa)
  • To transform an asset
    • convert fixed rate paying asset to one paying floating rate (or vice versa)
transforming a liability
Transforming a Liability
  • A firm has 3 years left on its $100 million loan at LIBOR + 0.80
  • The firm wants to convert this floating rate loan to a fixed rate loan
  • To accomplish this, the firm enters into the following swap:
    • It pays 5% fixed and receives LIBOR
    • Net cost = LIBOR + 0.80 + 5.0 - LIBOR

= 5.8%

transforming an asset
Transforming an Asset
  • Suppose a firm owns a portfolio of bonds that pays a fixed rate of 4.70%
  • The firm whishes to convert this to a floating rate
  • So, it enters into the following swap:
    • Pays 5% fixed and receives LIBOR
    • Net return = 4.70 - 5.00 + LIBOR

= LIBOR - 0.30

option based interest rate contracts
Option-Based Interest Rate Contracts
  • Cap agreement
    • a series of cash settlement interest rate options, typically based on LIBOR
  • Floor agreement
    • makes settlement payments only when LIBOR is below the floor rate
option based interest rate contracts12
Option-Based Interest Rate Contracts
  • Collars
    • combination of a cap and a floor
    • long in one and short in the other
    • cap-floor-swap parity occurs when the combination are at the same rates and have a net zero initial cost
    • can be viewed as a pair of option positions
option based interest rate contracts13
Option-Based Interest Rate Contracts
  • Swap Options (“Swaptions”)
    • the right but not obligation to enter into an interest rate swap having a predetermined fixed rate at some later date
    • Types:
      • Receiver swaption
      • Payer swaption
swap contracting extensions
Swap Contracting Extensions
  • Currency swaps
    • denominated in different currencies
  • Equity index-linked swaps
    • based on a variable debt rate and an equity index
  • Commodity swaps
    • fixes the price of a commodity over a certain period
    • hedge exposures to commodity prices
warrants and convertible securities
Warrants and Convertible Securities
  • Warrants
    • equity option issued by the company whose stock serves as the underlying asset
    • if exercised, the company will create new shares of stock to give to the warrant holder
warrants and convertible securities16
Warrants and Convertible Securities
  • Convertible securities
    • owner has right but not obligation to convert the existing investment into another
    • Convertible preferred stock
      • convertible into common stock
      • conversion value
    • Convertible bonds
      • viewed as a regular bond plus an option to exchange the bond for a number of shares of common stock
other embedded derivatives
Other Embedded Derivatives
  • Structured notes
  • Dual currency bonds
  • Equity index-linked notes
  • Commodity-linked bull and bear bonds
  • Swap-linked notes
the internet investments online
www.altivest.com

www.calamos.com

www.goldmasachs.com/qa/

www.dir.co.jp/InfoManage/datarsc.html

www.optionscentral.com

www.optionsanalysis.com

www.netservers.com/~waldemar/wl.html

The InternetInvestments Online