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Interest Rate Swaps, Swap Pricing, and Other Derivative Assets

Swaps and Interest Rate Options

- What is an interest rate swap?
- How do you immunize using interest rate swaps?
- What is a comparative advantage in credit market?
- What is a currency swap?
- What are interest rate collars, swaptions, and interest rate options?

Swap Pricing

- How swaps are priced?
- How are swaps used as forward contracts?
- What are implied forward rates?
- How are prices quoted?
- How are off-market swaps valued?
- How do you hedge against any shift in the yield curve?

Other Derivative Assets

- What are futures Options?
- How do you speculate with futures options?
- How do you hedge with futures options?
- How are futures options priced?
- What are warrants?
- How are warrants priced?

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Here are your answers

- What is an interest rate swap?

A swap is an agreement between two parties in which each of them commits to pay the other one an agreed interest rate on a principal for a given period of time. Swaps usually involve "exchanging" a fixed rate for a floating rate. For example, one party agrees to pay the other one annual rate of 5%, while the other one pays the Libor rate (whatever it is at the time of payment). In effect, the only party that pays at each period is the one that has to make the highest payment. For example, if A has to B 120,000 and B has to pay A 100,000, then A pays 20,000 to B.

- How do you immunize using interest rate swaps?

Let's say you've taken a loan at a floating rate. If the rate goes up, this will hurt you. In order to immunize from this, you can enter a swap in which you receive that floating rate and pay a fixed rate. Now, you've effectively transformed your floating rate loan into a fixed rate loan (or at least have hedged a fraction of the rate risk)

- What is a comparative advantage in credit market?

Usually firms have the option of taking credit (loans) either at a fixed rate or at a floating rate. However, two different firms usually have different *relative* costs of one rate in terms of the other one. Firms with excellent credit score (AAA) usually have a comparative advantage in the floating rate market; while firms with a not so good score usually have a comparative advantage in the fixed rate market. This difference can be exploited with a swap in a way that benefits both companies, please refer to the previous swaps questions set I answered for you.

- What is a currency swap?

A currency swap is similar to the regular swap, but the payments from each firm to the other one are made in different currencies. For example, let's say we have a UK firm that needs to borrow dollars, and a US firm that needs to borrow pounds. Yet the UK firm can get a better rate in pounds while the US firm can get a better rate in dollars. If they ...

Solution Summary

In this 1,537 word solution, interest rate swaps are explained, as well as a discussion on interest rate options, swap pricing, and other derivative assets.

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