RiskManagementofFixedIncomePortfolios

N.Gershun
2
Duration:MeasuringtheSensitivityofBond
PricestoRateChanges
A.TheRoadmapAhead. Weareinterestedintworisks
relatedtotheownershipofbonds(investors
perspective)andhowtohedge(insureagainst)these
risks.Theyare:
(i)Interestratepricerisk:Thisisthepossibilitythat
interestratesmayrisecausingbondpricestodecline.
Allbondsaresusceptibletothisrisk.Itisclosely
involvedwithreinvestmentrisk.
a.Ariseininterestratesisalsoarisktoborrowers:
theiranticipatedfutureborrowingcostswillrise.We
willalsodealwithinterestrateriskfromthe
borrowersperspective.
3
(ii)Defaultrisk: Thisisthepossibilitythatthebonds
owner(thelender)maynotreceivehispromised
interestandprincipalpayments(eitheratall,oratthe
presettimes).Thisriskappliestoallbondsexceptthose
issuedbytheFederalAuthoritiesoftheestablished
OECDcountries.U.S.Treasuriesaredeemedtohave
zerodefaultrisk,forexample.
Wewillfirstconsiderinterestratepriceriskandits
mitigation.
4
Interestrateriskmanagement isnotonlyofconcernto
individualinvestors,butalsotofinancialinstitutions.
ConsiderahypotheticalPensionFund.
Assets Liabilities
20yr,10%couponbond perpetualbenefitsof$1,000peryear
value:$10,000 value:$10,000
(thetermstructureisflatat10%)
Assets Liabilities
20yr,10%couponbond perpetualbenefitsof$1,000peryear
value:$16,231 value:$20,000
ThePensionFundisnowinsolvent.
Nowsupposeinterestratesdeclineto5%
WhyIsInterestRateRiskmanagementImportant?
5
2.Asecondexample:ahypotheticalbank.
Howdidthishappen?
Thesetwobondpricesreactedverydifferentlytoarate
decline.Bothassetsandliabilitiesroseinvalue,butthe
valueoftheliabilitiesrosemuchfaster.
Assets LiabilitiesandEquity
$10,000,10yr. $9,500DD
loan@7% $500shareholderequity
$10,000 $10,000
(termstructureisflatat7%,semi-annualcompounding).
6
Now,supposeinterestratesriseto10%forallmaturities.
Assets LiabilitiesandEquity
$8130-- 7%, $9,500DD
10yr.loan $1,370shareholderequity
$8130 $8,130
Thebankisbankrupt.
7
Notethatforthepensionfund,itwasadeclinein
ratesthatledtobankruptcywhereasforthebankit
wasanincreaseinrates.
Theyareexamplesofadurationmismatch andit
isthemostcommonreasonforfinancialdistress
amongfinancialinstitutions.
Thenotionofduration isspecialized(tothebond
market)languageforbondpricesensitivitytoarate
change.
8
Intuitively,bondswithsteeperprice-ratecurveswillbemoreprice
sensitivetoratechanges,andthustheirslopesshouldbelargerin
absolutevalue.
Astherates
change,sodoes
theslopeofthe
price-rate
function.
Bondwithhighrate
sensitivity
Bondwithlowrate
sensitivity
Bond
Price
P
0
P
1
r
0
r
1
r
r
Bond
Price
IntuitionBehindDuration
Highdurationbondsareverysensitivetochangesinrates.
DurationofDiscountBonds
(i) Percentagepricechange:
0
0
P 1
T r.
P (1 r)

+
Thetimetomaturity,T,intheaboveexpression
issaidtobethebondsMacaulayduration,or
simplyitsduration;theexpression
D/(1+r)
isdefinedasthemodifiedduration,writtenD
M
.
(ii) Absolutepricechanges:
P0 -D
M
P0 r.
10
DurationofCouponBonds
Sinceanycouponbondcanbeexpressedasa
portfolioofdiscountbonds,thedurationofacoupon
bondiss theweightedaverageoftheprice
sensitivitiesofitsconstituentdiscountbonds.
t= 0 1 2... T
T
couponbond
t T
t 1 0 0
PV(C) PV(MV)
D t T
P P
=
| | | |
= +
| |
\ \

11
PortfoliosofBonds
Supposewemanagedaportfolioofbondsof
variousdurations.
Bythesamelogic(acouponbondisitselfsimplya
portfolioofdiscountbonds)aswehavejustused:
D
P
=w
1
D
1
+w
2
D
2
+...+w
N
D
N
w
i
=theproportionoftheportfoliostotalvalue
representedbybondsoftypei
D
i
= thedurationofbondsoftypei
durationofthe
portfolio
12
TheManagementofBondPortfoli Risk:
TheIntuition
1.Sinceinterestratesmaychange,thereisprice
riskinherentinholdingaportfolioofbonds.Ifrates
rise,inparticular,thevalueoftheportfoliowill
decline.
2.Therearemanywaystohedgebuttheyall
amounttothesamethingconceptually:append
totheportfolioothersecuritieswhoseprice
movements,inresponsetointerestrate
changes,areoppositetothoseofthesecurities
alreadypresent.
13
Immunization
Ifwewanttoprotectourselvesperfectly
againstsmall (!)interestratechanges:
M
HedgedPortfolio
D 0. =
Thismeansthatachangeinrateswillleaveour
hedgedportfoliosvaluelargelyunaltered:
lossesononepartwillbeoffsetbygainsinthe
other.
{ }
Hedged
original bond hedging
P .
,
porfolio securities
=
InsuringAgainstDefaultUsingCredit
DefaultSwaps
WhatisaCreditDefaultSwap?
1. Whentheexpressionswap isused,
thinkintuitivelyofthepurchaseorsaleof
insurance.
a.Inmoststandardinsurancearrangements:
(ii) Theinsuredpaysafixed cashflow the
insurancepremium
(ii) Thesellermakesavariable payment:the
valueoftheinsureditemifdisasterstrikes,and
zerootherwise.
b. CreditDefaultSwapsarenodifferentexceptthattheinsurableevent
thedisasteragainstwhichyouinsure isthedefaultofsomebond.
2. Aninvestorwhobuysabondmayalsobuyinsuranceagainsta
specificdefaultordefault-likeevent
a. forexample,thedefault-likeeventcouldbearatingscutbythe
ratingsagenciesfromaAAAratingtoaAArating.Itcouldalso (to
taketheextremesituation)representthebankruptcyoftheissuer.
b.- Theownerofthebond(insurancepurchaser)paysafixedstream
ofpaymentstotheinsurer;
- Theproviderofinsurance(insuranceseller)paysavariable
paymenttotheinsuredonlyifthereissomesortofadefault.
Insurers:AIG,HedgeFunds,Citibank
c. Thetimehorizoncanbeasmuchas5years.
ASimpleSingleNameCreditDefaultSwap
Thebuyerpaysanannualfeeorpremiumforparrecoverypayoutin
theeventofadefault/bankruptcy.
1. Themechanism:
Ifnodefault:
Ifdefault:
premiumonsomenotionalamount(say$100
MMfacevalueofGMACSeniorDebt)
creditriskisassignedtotheseller
Buyer
Seller
Buyer
Seller
{Bondsofparvalue
GMAC$100MM}
$100MMcash
2. Anextremecasewherethedefaultedbondisworthless.
Thepayofftothebuyeroftheinsurance,contingenton
default
0
Payoff
to
Buyer
Par
Value
P
bond
beinginsured
0
Payoff
toSeller
Par
Value
P
bond
beinginsured
Thebuyerhasessentially
purchasedaspecialput-style
option.
FeaturesofCDSsecurities
1. Theyareverydifficulttopriceconceptually.
Whymightthisbeso?
2. Thereisnoorganized,liquidmarketforthese
securitieswherereliablepricesmaybe
inferred,althoughtheywereboughtandsold
OTC.Withbondpricesfalling,theyhave
becomeToxicAssets.
3. Itisadifferentsenseofhedging thanwe
haveemployedpreviously.
DynamicImmunizationwithInterest
RateFuturesContracts
Introduction:
Adrawbacktoimmunizingviathedurationofbond
portfoliosistheneedtorebalanceinresponsetorate
shifts.Thismaycreatelargetransactioncostsasthe
numberofbondsboughtorsoldmayendupbeing
verylarge.Anotherway,inprinciple,istouse
interestratefuturescontractsofsometype.
19
20
TwoAdvantagesofImmunizingwith
InterestRateFutures
(i) thecompositionofthebondportfolioremain
unchangedanddurationadjustedusingthefutures
contracts.
(ii) transactionscostsoftradingfuturesaremuchless
thanbondtradingcosts.
Theseconsiderationsareespeciallyimportantwhen
thebondstradeinthin markets.
21
FuturesContracts
Afuturescontractisverysimilartoaforwardcontract
(thelanguagefuturesprice replacesthelanguage
forwardprice evenasthenumberisthesame),but
withthemarkingtomarketfeature.
Nomoneychangeshandsatsigning.
ThesecontractsforTreasurysecuritiesareexchange
traded(verylowtransactionscosts).
22
SummaryPointsRegardingFutures
Theyareexchangetraded
Theyaresettleddaily(markingtomarket)
Closingoutafuturespositioniseasilyaccomplishedby
enteringintoanoffsettingtrade.Mostcontractsare
closedoutthiswaypriortoexpiration.
Contractsnotclosedoutbeforematurityaresettledby
delivery(choiceofinstrumentanddateofdelivery).A
fewcontractsaresettledincash(e.g.,stockindex
futures).
23
DurationofFutures
Thefuturescontractitselfdoesnothaveaduration.
Thefuturesprice,however,anditssensitivitytorate
changesdependsonthedurationandyieldofthe
underlyingsecurityexpectedtoprevailatthe
contractmaturitydate.
24
HedgingwithFutures:AnExample
Hedge$10MportfolioofBondC
UseaT-BillFuturescontractcallingforthe
deliveryof$1MMfacevalueofT-billshaving90
daysremaininguntilmaturity.
=>DurationofT-BillFutures=90days,or.25
year.
25
HedgingwithFututures (cont.)
InstrumentsUsedintheAnalysis
Coupon Maturity Yield Price Duration
BondC 4% 15yrs 12% 455.13 9.60
T-BillFutures -- 1/4yr. 12% 970,873.00 .25
1, 000, 000
$970, 853 Futures Price
.12
1
4
| |
|
|
= =
| |
|
+
|
|
\
\
The$10mportfolioofBondCrepresents21,972bonds.
Objective:perfectlyhedgetheportfolioofCbonds.
26
Solution:
(i)V
p
=P
C
N
C
+FP
T-Bill
N
T-Bill
V
p
=portfoliovalue N
c
=#ofCbonds
P
C
=bondCprice N
T-Bill
=#ofT-billfutures
FP
T-Bill
=T-billfuturesprices
(ii)and:D
P
V
P
=D
C
P
C
N
C
+D
T-Bill
FP
T-Bill
N
T-Bill
V
P
=$10m N
C
=21,972
D
P
=0(desired) D
T-Bill
=.25years
D
C
=9.6years FP
T-Bill
=$970,873
P
C
=$455.13
Write(sellshort)395.5T-BillFuturescontracts
0=10M(9.6)+.25(970,873)N
T-bill
Now,assumeashiftintermstructurefrom12%to13%.
Therelevantpricesarenow:
P
C
=$418.39 FP
TBill
=
$1, 000, 000
$968, 523
.13
1
4
=
| |
+
|
\
Lossonportfolio =21,972P
c
=21,972x(418.39 455.13)
=- $807,251
GainsonFutures =- 395.5(968,523 970,873)
=$929,425;weareoverhedged,as
expected
28
OtherInstruments
1. T-billfuturesarenolongertraded.Attheshortendofthe
curve, theactionisnowallinEurodollarfutureswhich
havecashsettlementbasedon3monthLIBOR.
2. Considera10yearT-bondcontract.Thisisfor$100,000
facevalueofdeliverablebonds.Whatwoulddiffervis--
vistheabovecalculation?
29
TheEurodollarMarket
TheBasicsoftheEurodollarMarket
1.Whatisit?
AloanmarketforUS$denominatedborrowingandlending
(US$CDdepositsarereceivedandUS$denominatedloans
extended)basedoutsidetheUnitedStates.
ThisisalargerinterestratemarketthantheUSTreasury
market.
2.Whereisitbased?
ItisbasedprimarilyinLondon,butalsointheCayman
Islands,Tokyo,andHongKong.
Similaroffshoremarketsexistforothercurrencies,e.g.,the
pound,yen,etc.
30
HowDoBalancesGetCreated?
SupposeGeneralElectricreceives$1MMfromthesaleofa
transformeranddepositsthemoneyinacheckingaccountat
JPMorganChaseinNewYork.
Itmightthenpurchasea6-month$1MMEurodollarCDfrom
HSBCinLondonwhereitremainsasadollardeposit(not
exchangedintoanequivalentamountofpounds).
Thismoney,asidefromanyreserverequirementHSBCmay
wishtoimposeonitself,canthenbeloanedouttofirmswho
wishtotakeout$denominatedloans.
ThisentiresystemoftakingdollardepositsinLondonand
lendingthemprimarilyfromLondonisreferredtoasthe
Eurodollarmarket.
31
EvolutioninEurodollarMarketSize
inbillionsofUS$ofinternationalbankclaims
0
5000
10000
15000
20000
25000
30000
1
9
6
4
1
9
7
6
1
9
8
2
1
9
9
1
1
9
9
3
1
9
9
5
1
9
9
7
1
9
9
9
2
0
0
1
2
0
0
3
2
0
0
5
2
0
0
7
Gross
Net
32
TheNatureoftheLoansMadeinthe
EurodollarMarket
Exclusivelyfloatingrateloans,withaninterestratereset
periodofatmost6months.
Loansinthismarketaregenerallyextendedonlytofirst
tierindustrialfirmsandfinancialinstitutions.
Thedurationoftheloans,whicharetheassetsofthe
banks,isatmost0.5year.
Theborrowerbearsallassociatedinterestraterisk.
33
ThisMarketisBenchmarkedbyLIBOR
(theLondonInterbankOfferRate)
1. Liboristherateatwhichlargebanksoperatinginthe
Eurodollarmarketextendloanstooneanother.Itisarate
forwhichtheborrowingbankmaydefault(oneofthese
bankscouldconceivablyfailandnotdischargeisloan
commitmentstoanotherbank.Thispossibilityisno
longerremote).
2.ManymarketsarebenchmarkedfromtheLiborrate.
Thismeansthatmanyotherloans/bondsissuedallover
theworldhavetermsthatallowtheirinterestratetobe
resetevery6monthsatarateequaltothe6monthLibor
rateforthat6monthperiodplussomepremiumor
spread.
34
TEDSpread
HowlargeisthedefaultpremiumonLIBOR?It
canbemeasured:
TEDspread:6-monthLIBORminus6-
monthTreasury
35
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2
9/30/05 12/14/05 2/27/065/13/067/27/06 10/10/06 12/24/063/9/075/23/078/6/0710/20/071/3/083/18/086/1/08
TEDspread1/2006- 3/2008
36
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
3-M TED spread in
2008
37
FloatingRate:AnExample
AmountofLoan:$100MM
Terms:LIBOR+50basispoints(.5%)
6Mo.
LIBOR.02
Rate:
.025 .031 .033
t=0 ...
(6mo.) (1yr.) (1.5yr.) (2yr.)
Loanrates: .025
.030 .036 .038
EndofPeriod
Paymentby
Borrower:
2.5M 3M 3.6M 3.8M
(paymentsaremadeatendoftheperiod)
37
38
HowDoBorrowersHedge
TheirInterestRateRisk?
Eurodollarfuturesandforwardcontractsrepresent
availabletoolsforthispurpose.
Whatifaborrowerwishestoremovethisriskona
regularbasis?
Aswapcontractaccomplishesthis.
39
40
HedgingwithEurodollarFutures
TheconceptisidenticaltotheprioruseofT-billfutures:
theinvestordesiringtohedgemustwriteEurodollar
futuresintheappropriatenumbers.Thesewritten
contactswillbecomemorevaluableasratesrise(prices
fall).Asidefromafewdetails/conventionsof
measurement,thecalculationsmimicthoseofT-bill
futures.
41
HowtheEurodollarFP(FuturesPrice)isto
beInterpreted
1. Asof1/27/09,11:27AM,wehavethefollowinginformation:
FuturesPrices2/28/08
April00 last open high low vol.
expirationdate
offutures
contract
98.895 98.915 98.915 178
2. SupposewetransactedforonecontractatthecurrentFP.
t=0 T(April09)
FP=98.895
Weinterpret98.895asidentifyingthe(annualized!)forward3month
LIBORraterelativetoApril2009asbeing
100 98.895=1.105%,or.01105(1.105%).
Thecontractamountis$1,000,000for3months.
T+.25
April
Libor
.25
f .01105 =
42
Supposeyousigned(wentlong)inafuturescontractwhen
FP=98.895,andduringthelifeofthecontract,theFPrises
to99(forwardLIBORfallsto1%);then:
Longpositionreceives(1,000,000)(.00105)(.25)=
+$262.50
Shortpositionreceives: (1,000,000)(.00105)(.25)=
$262.50.
(Thereisonlycashsettlement.)
99 98.895
100

| |
|
\
43
Supposeatsomepoint,theFPfallsto97(forwardLIBOR
risesto3%,annualized);then,
Longpositionreceives(1,000,000)(.01895)(.25)=
$4737.50
97 98.895
100

| |
|
\
Shortpositionreceives:
(1,000,000)(. 01895)(.25)=$4737.50.
Aswithanyofourhedginginstruments(T-bonds,T-bill
futures),shortpositionsinEurodollarfuturesincreasein
valueasratesrise.
44
Example:HedgingaBondPortfolio
with3-MonthLIBORFutures
1. Supposethetermstructureisflat.TheTermstructure
ofLIBORrates andtheforwardLIBORcurve would
beessentiallyflataswell.
2. AnExample:
Youown$10MofbondsofD=6whentheinterestrate
(LIBOR)environmentisflatatr = 5.14%.Youare
concernedthatratesmayriseby.5%.Hedgeyour
positionwithEurodollarfutures.
45
Whatisyourestimatedlossifyoudonothedge?
P P
D 6
V V r 10(.005)
(1 r) (1.0514)

=
+
$285, 334 =
46
Perfectly hedgingusingEurodollarfutures
meansD
P
=0.
P P 1 1 1 EDF EDF
V D n PD n D $1, 000, 000 = +
EDF
0 10MM 6 n (.25) (1, 000, 000 = +
EDF
10MM 6
n 240 contracts; i.e.,
(.25) (1MM)

= =
write240contracts.
you receive gains
and losses relative
to $1 MM
47
Supposeratesdoriseasfeared.
Approximatelossonportfolio= $285,334
Gainonfutures:
- (240)(1,000,000)(.25)(-.005)= +$300,000
+$15,000
Weareslightlyoverhedged,astheoryremindsusmustbethe
case.
.94.36 94.86
100

48
TheNotionofaSWAP
1. ForwardContractsallowborrowerstoremoveinterestrateriskovera
specificfuturetimeperiod,sayiperiodsaheadfornperiods.
Asaresult,wemustcontinuallysignsuchcontractsifwewishto
removelongtermriskonaregularbasis.Aconvenientwaytodothisis
viaaSWAP.
SWAPSandtheEurodollarMarket:a
ThirdPerspectiveonInterestRateRisk
Management
a.ThisisimportantbecauseEurodollarloansarefloatingrate
loans.
b.Standardforwardcontractsinthismarketare3x3 or3x6
meaningthattheforwardcontractlocksinarateforin3
monthsfromthe3monthsfollowingorin3monthsforthe6
monthsfollowing.
49
InterestRateSWAP:Definition
AninterestrateSWAPisanenforceableagreement
betweentwopartiestoexchangecashflowsperiod
byperiod.
- Onepartypaysafixedratepaymentandreceivesa
variablefloatingratepayment.Thispartyistheinsured.
- Thecounterpartypaysthefloatingrateandreceives
thefixedratepayment.Thispartybearstherisk.
Theseratesareappliedtoanagreed-uponfixed
notional amount.Theresultingpaymentsarewhat
isexchanged.
50
UsesofSWAPS
1.Theusesofsuchinstrumentsarethreefold:
theygiveaccesstofixedorfloatingratecapital
markets
theyallowparticipantstomanagetheir
asset/liabilitystructuremoreeffectively
theyprovideatoolforhedginginterestraterisk
LOANS
8%
BANK
pays7%
SWAPDEALER
receives6mo.LIBOR
51
Assets Liabilities
$100MM $100MM
10yearloanat8% 6mo.CDsat5%
Every6monthstheBankhastorefinancetheCDs,whoseratesaretypicallytiedto
LIBOR.
Suppose,forsimplicity,theCDrateistheLIBORrate.ConsideraSWAPwherebythe
Bankexchangestheirvariableliabilityforafixedrateliabilityat7%.
Nowthebankonlyhastoworryaboutthecreditrisk oftheborrowerandthe
SWAPdealer.
DEPOSITORS
Example:ManagingAssetsandLiabilities
ConsideraBankwithaverysimplebalancesheet:
52
2. Whowantsfloating?
Whowantsfixed?
SWAPScanbethoughtofasinsuranceagainstratechanges.
Wantstoreceivevariableandpaya
fixedpayment
Wantstoreceivefixedandpay
variable
a.SpeculatorswhobelieveEurodollar
rateswillrise
Speculatorswhobelieverateswill
fall
b.Bankswhichhavefixedrateloans
(mortgages)butvariablerateobligations
(CDs)
Bankswhichhavevariablerate
assets(mortgages)andwantto
reduceriskinthispartoftheir
portfolio
c.Firmswithvariablerateloans,yet
steadycashflowstreams(e.g.,drug
firms;industrialfirms)
Firmswithvariablestreamsof
incomebutwhohavefixed
obligationsandwanttoreduce
risk
53
TheMechanismofaSWAP
1.Whatactuallyisswapped?Itisonlythefixedandfloatingratepayments
themselves(coupons) onagivennotionalprincipal thatare
exchanged.
2. TimeHorizon:specifiedbytheSWAPcontract.Inprincipalitcanbefor
anytimeperiod:1year,5years,10years,etc.
3.ExampleofaSWAPcontract:
XpaysY:10%fixedrateperyearonanotional$50M
YpaysX:6monthLIBORrateadjustedevery6months.
Paymentsarethusexchangedevery6months:
XpaysY:$50M=$2.5million(fixedrate).
YpaysX:50Mx6monthLIBORrate(whichvaries floating
rate)
ThefixedrateisknownastheSWAPrate.
10
2
| |
|
\
54
HowIstheSWAPRateDetermined?
ItisthatratewhichequatesthePVofthetwopaymentstreams. Itis
computedastheresultofathreestepprocedure:
Step1:Computethefloatingratepaymentsusingtheforward
LIBORrates.Thesearetheno-arbitrageratesintheEurodollar
market.
Step2:DiscountthefloatingratepaymentsusingtheLIBORterm
structure toobtainthepresentvalueoftheexpectedfloatingrate
payments.
Step3:AdjusttheFixedRatetobringaboutequalityinthetwo
presentvalues.
ThisisanNPV=0procedurewithintheuniverseofLIBORsecurities.It
thuscostsnothing, asidefromtransactionsfees,toenterintosuch
contracts.
TheKeyIngredient:theForwardLIBORTermStructure
55
AnExample:ComputingtheSWAPRate
Considera1.5yearSWAPwiththreepaymentsexchanged.NotionalAmount
$100M.AlthoughLIBORratesareavailableonlyuptooneyear,forward
LIBORratesareavailablefromBloombergorReuterssinceLIBORforward
contractsaretraded.
Weneed
1.85% 2.2% 2.72% (annualized)
LIBOR
.5
r ,
LIBOR
.5 .5
f ,
LIBOR
1 .5
f ,
float
.5
C
float
1
C
float
1.5
C
Thus,
float
.5
C
LIBOR
.5
r
$100M $.925 MM
2
| |
=
|
\
float
1
C
LIBOR
.5 .5
f
$100M $1.1 MM
2
| |
=
|
\
float
1.5
C
LIBOR
1 .5
f
$100M $1.36 MM
2
| |
=
|
\
=
=
=
Thesearetheexpected noarbitrage-- floatingratepayments.
t= 0 .5 1 1.5
56
Problem:LIBORspotratesareavailableonlyuptooneyear.
However,knowledgeoftheforwardratesallowsus,inaworldof no
(LIBOR)arbitrage,toconstructtheconsistentsetofcorresponding
spotrates.
ThisisanothersenseofBootstrapping exceptthatitusesforward
ratestoconstructspotrates.
LIBOR
.5 .5
f
2
LIBOR
1 .5
f
2
LIBOR
.5
r
2
LIBOR
1
r
2
LIBOR
1.5
r
2
LIBOR
.5
r .0185
1 1 1.00925
2 2
| |
| |
+ = + =
| |
\
\
57
2
LIBOR LIBOR LIBOR
1 .5 .5 .5
r r f
1 1 1
2 2 2
| | | || |
+ = + +
| | |
\ \ \
=
( )
Libor
1
.022
1.00925 1 1.02035 r .022049
2
| |
+ = =
|
\
3
LIBOR LIBOR LIBOR LIBOR
1.5 .5 .5 .5 1 .5
r r f f
1 1 1 1
2 2 2 2
| | | || || |
+ = + + +
| | | |
\ \ \ \
.022 .0272
(1.00925) 1 1
2 2
| || |
+ +
| |
\ \
=
3
LIBOR
Libor
1.5
1.5
r
1 1.03423 r .02256
2
| |
+ = =
|
\
58
3
Libor
1.5
r
1
2
| |
+
|
\
Thus,thevalueofthefloatingpaymentsis:
2
Libor
1
r
1
2
| |
+
|
\
FLOAT
.925MM 1.1MM 1.36MM
PV
(1.00925) (1.02035) (1.03423)
= + +
=3.376MM
Lastly,wecomputetheSWAPrate,wherewediscountthefixed
paymentsatthesametermstructureofLIBORrates:LetSdenote the
swapcashpayment
PV
FIXED
=
3 2 3
LIBOR
LIBOR LIBOR
.5
1 1.5
t 1
S S S
r
r r
1
1 1
2
2 2
1.00925 1.02035 1.03423
=
(

+ +
(

| |
| | | |
+ (
+ + |
| |
( \

\ \

64748 64748 64748

3.376MM=2.9377S
=>S=1.149MM.
Thisisa6month cashflow.Onanannualbasis:
S=2(1.1498)=2.298MM
Onanannualizedratebasis,thisisequivalentto
Thisistheswaprate.Itisanoarbitrageratewithinthescopeof
theLIBORfamilyofrates.
2.298 MM
2.298%
100 MM
=
59
60
1. ConsideranN-yearSWAP
2. DurationofFixedside
- SamedurationasanN-yearbondwithcouponrateS
3. DurationofFloatingside
- AlwayshaveaPVof$100.Intuition:wheninterestincreases,
youreceivemoreinterest,butalsodiscountmore.Theeffect
offsetseachother.
- Durationoffloatingside:0.
4. Receivefixed/payfloatingSWAPhasapositiveduration.
5. Receivefloating/payfixedSWAPhasanegativeduration.
6. SWAPcanhedgeinterestrateriskviadurationadjustment,just
likeanN-yearbond.
DurationofaSWAP
61