Swaps related to CR

[syaiful]

David, :lol:

Suppose you enter into an interest rate swap where you are receiving floating and paying fixed. Which of the following is true? (circle two)

(a) Your credit risk is greater when the term structure is upward sloping than when it is downward sloping.
(b) Your credit risk is greater when the term structure is downward sloping than when it is upward sloping.
(c) Your credit risk exposure increases when interest rates decline unexpectedly.
(d) Your credit risk exposure increases when interest rates increase unexpectedly.

The ans is (a) & (d).

David, could you explain briefly why the ans is (a) & (d), also if the question is vice versa (receiving Fixed, paying Floating).

 

[David Harper CFA FRM]

Hi Ipul,

(do you mind me asking, what is the source? I am just curious b/c the two-answer is interesting...but you don't get an explain?. Thanks!)

First, what is credit risk in this context? It is an increase in the positive value (positive exposure) of the position.

Assume you are receive floater:
Regarding (d), if rates increase, your fixed obligation is the same, but you are now aniticipating the receipt of higher floating coupons. The swap is worth more to you; it's value/exposure increases to you.

Regarding (a), this is harder but makes much more sense if we recall the IRS can be viewed as 2 forward rate agreeements. As recieve floating, you expect to receive coupons per the sequence of forward rates. If the term structure is upward sloping, this also implies (an even steeper) upward sloping forward curve. That means: to average out, you are getting (or expecting) smaller coupons sooner and larger coupons later in the swap. Early in swap, you are more exposed as you are making net payments (i.e., fixed - receipt of smaller) and you need to wait for (fixed - receip of larger owing to higher forward rates implies by upward sloping term structure)
David

 

[syaiful]

Hi David,

i got it from Jhon Hull's question bank, it's only have the answers key without the explanation.

do you think (b) & (c) is the ans of receiving Fixed, Paying Floating ?

 

[David Harper CFA FRM]

Hi Ipul,

yes, I do think (b) and (c) are true for the "other side" of the trade:

(b) early cash flows are net negative to pay floater under inverted term structure
(c) interest rate declince implies (receive fixed - pay floating) goes up

David

 

[sucheta_isi]

David,

I got the following question from Jorion:

Ques: Which of the following positions has the same exposure to interest rates as the receiver of the floating rate on a standard interest rate swap?
a. Long a floating-rate note with the same maturity
b. Long a fixed-rate note with the same maturity
c. Short a floating-rate note with the same maturity
d. Shorting a fixed-rate note with the same maturity

Answer given is d.

My question is WHY NOT a?

Please explain.

 

[David Harper CFA FRM]

Hi sray,

It could be (a) plus (d) but not (a) alone, so you have a point but ....
We want to follow Hull in pricing the swap
(see http://www.bionicturtle.com/premium/spreadsheet/3.d.1_hull_swaps/)
as two bonds. To receive floating is to be (i) long a floating rate bond plus (ii) short a fixed rate bond, so (a) + (d) would be valid.

But in regard to interest rate exposure, that should trigger "duration" for us.
And the floater has ~ 0 duration (or really, time to next coupon, but we generally round to 0) becuase, just as in the Hull's pricing exerice, it will have a price = par at the next coupon (it's coupons will fluctuate with the discount rate). So the interest rate exposure of the swap recieve floating counterparty is:

long the floating rate bond = ~0
+ short the fixed rate bond = duration

... so only (d) or (d+a) can mimic this exposure but not (a) alone

David

 

[sucheta_isi]

David,

This one is from FRM Exam 2000(Question 55)

BO enters into a 5 year swap contract with M Co. to pay LIBOR in return for a fixed 8% rate on a principal of $100 MM.Two years from now, the market rate on the 3 year swaps at LIBOR is 7%. At this time M Co. declares bankruptcy and defaults on its swap obligation. Assume that the net payment is made only at the end of each year for the swap contract period. What is the market value of the loss incurred by BO as a result of the default?

I was trying to solve this using Bond methodology.

But I have some questions:

At the end of 2nd year do we need to assume that BO has already paid its floating part to MCo.?
Basically we need to find the value of the Fixed bond B(Fix) two years from now? Am I right?

The fixed amount (in MM) that BO was supposed to get( but lost) is

8(at the end of 2 years, no need to be discounted),
8(at the end of 3 years, need to be discounted),
8(at the end of 4 years, need to be discounted),
100+ 8(at the end of 35years, need to be discounted)
Am I right?


sray

 

[David Harper CFA FRM]

Hi sray,

Since this is a previous exam question and I am trying to build out our library, I input the answer into a version of the interest rate swap valuation XLS. Please see:
http://forum.bionicturtle.com/viewthread/2665/

The upper panel shows the solution as two bonds. The question is looking for you to assume, if you want to approach as "two bonds:"
at the end of two years, three flows remain:
Year +1: (i.e., 3rd of 5 years): $8
Year +2 (4th of 5 years): $8
Year +3 (5th of 5 years): $8 + 100 notional = $108; (i.e., the notional is not exchanged but under the two-bond approach we would include it)

David