Lecture 10: Derivatives III Currency & interest rate swaps

Galina A Schwartz

Department of Finance

University of Michigan

Business School

Plan of today’s lecture Midterm follow-up Levich, Chapter 13

Swaps are

derivative securities

redundant securities Main types of swap agreements Why do we have them?

[who could gain from them] What drives the demand for swaps?

Players & Terminology Players: Industry & Financial Companies, Re

[ – `The Usual suspects`] What drives the demand for swaps?

Capital controls Transaction costs Differences in parties’ comparative advantage

[Market segmentation & asymmetric information] Terms [Jargon]:

Plain vanilla swaps Exotic swaps

Swaps: market characteristics

Main types of swap agreements currency or interest rate fixed-rate or floating rate or fixed-floating interest rate swaps

Why do we have them? [who could gain from using them]

To hedge [hedgers] [reducing risks] To speculate [speculators] [capturing arbitrage opportunities]

Pricing the Swaps How do we price them?

Net present value approach Through calculating

the expected discounted cash flow Swap associated risks:

AsymmetricTime varying

Regulatory requirements Bank for International Settlements (BIS) imposed

capital requirements –A major development! BIS capital requirements:

Advantageous: Simple and easy to implement Transparent

Drawbacks [disadvantages]:No fine tuningregulatory costs

Summary of the Lecture

Main subject: swap agreements:[currency or interest rate]

Swaps are used for:Cheap [& Quick]

currency and interest rate risks management Why do we have them? Who uses them? How do we price them?

What is next (Lecture 11):

A follow-up of Prof. Honeyman’s lecture: International financial markets adjustment

to the coming technical innovations: Market power & efficiency scale: up or down? Efficiency: market completeness & pricing

mechanisms

What is next (continued)

Generalized transaction costs up or down?

[Generalized transaction costs:

-- overhead (par example infrastructure related) costs

-- the costs resulting from the risk of default

[direct and indirect (such as legal)]] Globalization: standard versus segmentation Scope for government intervention up or down?