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

More documents

Recommendations

Info

ABC also has three cash flows:1. It pays LIBOR plus 1.0 percent to its outside lender,2. It pays 6.0 percent fixed to XYZ, and3. It receives LIBOR flat from XYZ.For XYZ Life Insurance Company, its net funding cost in this transactionis LIBOR flat, which is lower than LIBOR plus 0.5 percent at which it canborrow in its own country. It also has achieved its objective by modifyingits asset/liability structure using derivatives. In this case, XYZ has shortenedits liability duration by entering the swap. Instead of paying 6.0 percentfixed, XYZ now pays LIBOR flat.For ABC Bank, its net funding cost in this transaction is 7.0 percent, whichis also lower than the rate of 7.5 percent at which it can borrow in its owncountry. It also has achieved its objective by modifying its asset/liabilitystructure using derivatives. In this case, ABC has extended its liabilityduration by entering the swap. Instead of paying LIBOR plus 1.0 percent,ABC now pays 7.0 percent fixed for 5 years. (You may assume that ABC hasa $100 million fixed rate five year loan portfolio and a $100 million 7-daydeposit portfolio. By entering into this swap, its interest rate risk or asset/liability maturity mismatch has largely reduced.)Coincidental!^ both ABC and XYZ reduce their funding cost by 0.5 percentCROSS CURRENCY SWAPSThe main difference between interest rate swaps and cross currency swapsis that cross currency swaps usually involve exchange and re-exchange ofprincipals whereas interest rate swaps do not. A typical cross currencyswap has three sets of cash flows: the initial exchange of principals at thebeginning, the exchange of interest payments during the contract period,and the re-exchange of principals at the end. The following diagrams illustratethe three sets of cash flows of a cross currency swap:Swaps
iAt inceptionCounterparty A¥ 10 billionUS$100 millionCounterparty BOn each settlement date(including maturity)Counterparty AUS$ (5) LIBOR^Counterparty BAtmaturityCounterparty Aof¥ 10 billioni ictf- 1 r\f•N:ii:•wCounterparty BThere are also cross currency swaps which do not involve exchange ofprincipals.VALUATION OF SWAPSAs an example, please consider an interest rate swap with the followingconditions:the notional amount is US$100 million;the term of the contract is five years;ABC pays XYZ 6 percent fixed and receives 6-month LIBOR;XYZ pays ABC 6-month LIBOR and receives 6 percent fixed; andinterest payments are settled semi-annually.We can make the above example a bit closer to our traditional bankingbusiness. If we assume exchange and re-exchange principals do exist (similarto cross currency swaps), the above example is the same as the following:ABC lends to XYZ US$100 million at 6-month LIBOR for five years; andXYZ lends to ABC US$100 million at a fixed rate of 6 percent for fiveyears.You can even consider that ABC has purchased a $100 million floating ratebond from XYZ and sold to XYZ a $100 million fixed rate bond for thesame terms.Swaps
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 42 and 43: Assuming that there is no transacti
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
Page 98 and 99:
in the US. Equally innovative, cred
Page 100 and 101:
THE VARIANCE-COVARIANCE METHODThe t
Page 102 and 103:
"cell" would have a cash flow expos
Page 104 and 105:
Daily profit and loss ranked in asc
Page 106 and 107:
of the market factor. Through this
Page 108 and 109:
3. Most value at risk models use hi
Page 110 and 111:
16ANDIn Chapter 5, we talked about
Page 112 and 113:
price) of 9,000. For this transacti
Page 114 and 115:
and the June 3-month futures rate i
Page 116 and 117:
needs to take the necessary busines
Page 118 and 119:
ief, the policies and procedures sh
Page 120 and 121:
The derivatives industry can be com
Page 122 and 123:
ANDONOFINTRODUCTION1. The Monetary
Page 124 and 125:
MANAGEMENT AND CORPORATE5. As the B
Page 126 and 127:
ensure that there is sufficient awa
Page 128 and 129:
15. Branches of foreign banks which
Page 130 and 131:
20. Where the institution considers
Page 132 and 133:
RISK MEASUREMENT25. Having identifi
Page 134 and 135:
) the tendency of the relevant mark
Page 136 and 137:
38. The measurement of the market r
Page 138 and 139:
market, credit and liquidity risk o
Page 140 and 141:
Consideration must be given to the
Page 142 and 143:
55. As noted earlier, the market or
Page 144 and 145:
changes in portfolio value;d) the r
Page 146 and 147:
66. A basic and essential safeguard
Page 148 and 149:
73. It is essential that the intern
Page 150 and 151:
Market liquidity risk is the risk t
Page 152 and 153:
Furthermore, contracts with the sam
Page 154 and 155:
There are three main VAR approaches
Page 156 and 157:
Options risk should be captured; ri
Page 158 and 159:
Annex D1. NOTIONAL OR VOLUME LIMITS
Page 160 and 161:
assumptions on which they are based
Page 162 and 163:
* There should be a unit independen
Page 164 and 165:
- the customer had specifically req
Page 166 and 167:
addition and deletion of operators,
Page 168 and 169:
• Profits and losses resulting fr
Page 170 and 171:
This book is due for return or rene
show all

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

Create successful ePaper yourself

Delete template?

Save as template?