Derivatives and Alternative Investments Coursework

Derivatives and Alternative Investments - Coursework Example If the swaps market were less liquid than it is, market mortgage lenders would find it more difficult and expensive to manage the interest rate risk of the prepayment option in fixed rate mortgages (Greenspan 2004). The extensive use of interest rate swaps means that volatility of the swap spread can affect a large range of market participants, as they rely on a stable relationship between the interest rate swap rate and other interest rates in using swaps for their hedging objectives. For this reason, trading activity that would stabilize the swap spread performs a useful role in ensuring that market participants can rely on the market for their trading and hedging needs. By market convention, the fixed-rate payer that has a long swap position in a fixed/floating interest rate swap is called the taker or buyer of the swap, while the floating-rate payer that has a short swap position in the fixed/floating interest rate swap is called the provider or seller of the swap. The fixed-rate payer and the floating-rate payer of an interest rate swap are called the counterparties of the swap. ... For instance, a fall in the market prices of the fixed/floating interest rate swaps will make the existing swap contract a liability to the counterparty with a long swap position and an asset to the counterparty with a short swap position. Conversely, a rise in the market prices of the fixed/floating interest rate swaps will bring a gain to the counterparty with a long swap position and a loss to the counterparty with a short swap position. Financial managers should be able to determine at any time the market values of the individual swap contracts held by their firms, if they want to manage the swap positions of their firms in a prudent fashion. In the following, we shall develop and discuss models for determining the market values of existing long and short swap positions. Credit risk and interest rate or market risk are the two major types of risk inherent in an interest rate swap position. In this section, some brief comments on the credit risk are followed by a more detailed exa mination of the interest rate risk. Since interest rate swaps are private contractual agreements between two counterparties, they are of course subject to a credit or default risk: the counterparty might not meet its interest payment obligation. However, it should be pointed out that the credit risks in interest rate swaps are relatively unimportant for two reasons. First, because entering into an interest rate swap agreement is a voluntary market transaction performed by two counterparties, a counterparty’s credit standing must be acceptable to the other counterparty If one counterparty’s credit standing has not reached the par, then a letter of credit from a