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Flashcards in BKM Chapter 23 Deck (23)
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Primary use for interest rate futures

(BKM - 23)

to hedge interest rate risk


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

(BKM - 23)

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


Basis point value in percentage terms

(BKM - 23)



Futures contract

(BKM - 23)

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


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


Contract multiplier for PVBP(futures)

(BKM - 23)

contract multiplier = contract par value / futures price par value


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)


How to hedge interest rate risk using futures contracts

(BKM - 23)

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



(BKM - 23)

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


Cross-hedging and risk

(BKM - 23)

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


Slippage in cross-hedging

(BKM - 23)

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


Swaps & most common types (2)

(BKM - 23)

multiperiod extensions of forward contracts

1. foreign exchange swaps
2. interest rate swaps


Foreign exchange swaps

(BKM - 23)

exchange of currencies on several future dates


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)


Notional principal

(BKM - 23)

principal amount used to calculate swap payments

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


Role of swap dealer in swap agreements

(BKM - 23)

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



(BKM - 23)

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


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


Interest rate parity (definition & formula)

(BKM - 23)

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


Exchange rate for currency swaps & how to solve for it

(BKM - 23)

constant exchange rate

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


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


Hedge ratio (H)

(BKM - 23)

# of contracts to buy/sell in a hedge position

H = PVBP(portfolio) / PVBP(futures)


Swap CF in interest rate swaps

(BKM - 23)

Swap CF = notional principle * (rate received - rate paid)