Flashcards in BKM Chapter 23 Deck (23)

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1

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Primary use for interest rate futures

(BKM - 23)

### to hedge interest rate risk

2

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Price value of a basis point (PVBP) for the portfolio

(BKM - 23)

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sensitivity of portfolio value to changes in interest rates

= change in price per basis point change in portfolio yield

= -D* * change in y * value of the portfolio / change in basis points for portfolio yield

3

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Basis point value in percentage terms

(BKM - 23)

### 0.01%

4

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Futures contract

(BKM - 23)

### agreement to buy/sell an asset at a future date for a price set today

5

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Price value of a basis point (PVBP) for futures contract

(BKM - 23)

### PVBP(futures) = -D* * change in delivery yield * price of futures * contract multiplier / change in basis points for portfolio yield

6

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Contract multiplier for PVBP(futures)

(BKM - 23)

### contract multiplier = contract par value / futures price par value

7

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Change in delivery yield for PVBP(futures)

(BKM - 23)

### change in delivery yield % = change in portfolio yield % * (change in delivery yield bps / change in portfolio yield bps)

8

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How to hedge interest rate risk using futures contracts

(BKM - 23)

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take the opposite position in the hedge vehicle

>> w/a long position in the portfolio, portfolio value will decrease when interest rates increase

>> to hedge, sell short futures contracts which will increase in value when interest rates increase

9

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Cross-hedging

(BKM - 23)

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occurs when the hedge vehicle is a different asset (sector) than the one being hedged (ex: treasury vs. corporate bonds)

most hedging is cross-hedging

10

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Cross-hedging and risk

(BKM - 23)

### cross-hedging is NOT risk-free because there can be slippage

11

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Slippage in cross-hedging

(BKM - 23)

### differences in yield across sectors (ex: treasury vs. corporate bonds)

12

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Swaps & most common types (2)

(BKM - 23)

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multiperiod extensions of forward contracts

types:

1. foreign exchange swaps

2. interest rate swaps

13

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Foreign exchange swaps

(BKM - 23)

### exchange of currencies on several future dates

14

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Interest rate swaps

(BKM - 23)

### exchange a series of cash flows b/w a fixed and floating interest rate (exchange of fixed vs. variable CFs)

15

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Notional principal

(BKM - 23)

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principal amount used to calculate swap payments

>> describes the size of the swap agreement, but not actually a loan of $$

16

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Role of swap dealer in swap agreements

(BKM - 23)

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intermediary b/w parties that takes a neutral position on interest rates, but profits from the bid-ask spread

*bears the credit risk of both parties of the swap

17

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LIBOR

(BKM - 23)

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London Interbank Offerred Rate = rate banks borrow at from each other in the Eurodollar market

most commonly used short-term interest rate for swap agreements

18

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Primary benefit of interest rate swaps

(BKM - 23)

### ability to quickly & cheaply exchange fixed and floating rate positions or b/w currencies without high transaction costs

19

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Interest rate parity (definition & formula)

(BKM - 23)

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requires investors be indifferent to interest rates from different countries (o/w investors could profit from exchanging currencies & collecting interest)

F(t) = forward exchange rate(t) = current spot exchange rate * [( 1 + held interest rate) / (1 + desired interest rate)]^t

20

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Exchange rate for currency swaps & how to solve for it

(BKM - 23)

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constant exchange rate

solve for exchange rate, F*, that sets the PV(swap payments) = PV(independent forward agreements)

21

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Credit risk in interest rate swaps

(BKM - 23)

### any default results in a loss equal to the difference b/w fixed rate and floating rate obligations

22

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Hedge ratio (H)

(BKM - 23)

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# of contracts to buy/sell in a hedge position

H = PVBP(portfolio) / PVBP(futures)

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