Lecture 10: Derivatives III Currency

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Lecture 10 Derivatives III Currency interest
rate swaps

• Galina A Schwartz
• Department of Finance
• University of Michigan
• Business School

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Plan of todays 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?

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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

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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

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Pricing the Swaps

• How do we price them?
• Net present value approach
• Through calculating
• the expected discounted cash flow
• Swap associated risks
• Asymmetric
• Time varying

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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 tuning
• regulatory costs

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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?

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What is next (Lecture 11)

• A follow-up of Prof. Honeymans lecture
• International financial markets adjustment
• to the coming technical innovations
• Market power efficiency scale up or down?
• Efficiency market completeness pricing
  mechanisms

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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?