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most common swap; suppose a corporation borrows from a bank at a
floating rate. it would prefer a fixed rate, which would enable it to
better anticipate its cash flow needs in making its interest payments.
the corporation can effectively convert its floating-rate loan to a
fixed-rate loan by adding a swap
forward rate agreement: interest rate forward contract; one party, the
long, agrees to pay a fixed interest payment at a future date and
receive an interest payment at a rate to be determined at expiration; 3 x
6 frA expires in three months and the underlying is a Eurodollar
deposit that begins in three months and ends three months later, or six
months from now
a swap is an OTC derivative contract in which two parties agree to
exchange a series of cash flows whereby one party pays a variable series
that will be determined by underlying asset or rate and the other party
pays either a variable series determined by a different underlying
asset or a rate or a fixed series
typically priced by forming a hedge involving the underlying asset and
a derivative such that the combination must pay the risk-free rate and
do so for only one derivative price
when a portfolio of mortgages is assembled into an ABS; commonly, but
not always, the credit risk has been reduced or eliminated, perhaps by a
CDS
when derivatives are combined with other derivatives or underlying assets
large currency derivative market; options, forwards, futures, and swaps are widely used
a commitment for one party, the long, to buy a currency at a fixed price from the other party, the short, at specific date
standardized; conducted in a public market; homogenous; have a
secondary market giving them an element of liquidity; have a
clearinghouse, which collects margins and settles gains and losses daily
to provide a guarantee against default; regulated at the federal
government level
credit default swap: a derivative contract between two parties, a
credit protection buyer and a credit protection seller, in which the
buyer makes a series of cash payments to the seller and receives a
promise of compensation for credit losses resulting from the default of a
third party; conceptually a form of insurance; sellers of CDSs
(oftentimes banks or insurance companies) collect periodic payments and
are required to pay out if a loss occurs from the default of a third
party
based on the net difference between the underlying rate and the
agreed-upon rate, adjusted by the notional principal and the number of
days in the instrument on which the underlying rate is based
the right to buy; consistent with a bullish point of view
a financial institution that makes a market in forward contracts and other derivatives
collateralized debt obligations (collateralized bond obligations and
collateralized loan obligations) do not traditionally have much
prepayment risk but they do have credit risk and oftentimes a great deal
of it; the CDO structure allocates this risk to tranches (senior,
mezzanine, junior)
combination of the derivatives and the underlings; should earn the risk-free rate
equity margin accounts involve the extension of credit. an investor
deposits part of the cost of the stock and borrows the remainder at a
rate of interest. with futures margin accounts, both parties deposit a
required minimum sum of money, but the remainder of the price is not
borrowed
specialized versions of forward contracts that have been standardized
and that trade on a futures exchange; offer an element of liquidity and
protection against loss by default
"Going private" transaction - private equityThe bonds issued to
finance an LBO are usually high yield bonds that receive low quality
ratings and must offer high couponsTypically includes equity, bank debt,
and high yield bondsLow leverage in target company is attractive
contracts in which the underlying is $1,000,000 of a U.S. Treasury bill
buyer; purchaser of the derivative; owns (holds) the derivative and holds the long position
the right to sell; consistent with a bearish point of view
allow trading the risk without trading the instrument itself (risk
management); price discovery (futures market); lower transaction costs;
greater liquidity; require less capital to trade
when the call option value is positive and equal to St - X
modern futures markets primarily originated in Chicago out of a need
for grain farmers and buyers to be able to transact for delivery at
future dates for grain that would in the interim, be placed in storage
can be based on zero-coupon bonds or on coupon bonds, as well as
portfolios of indices based on them; must expire before the bonds
maturity
one of the most popular categories of underlings; derivatives on
individual stocks are primarily options; index derivatives in the form
of options, forwards, futures and swaps are very popular
credit derivative in which the credit protection buyer holds a bond or
loan that is subject to default risk and issues its own security (the
credit-linked note) with the condition that if the bond or loan it holds
defaults, the principal payoff on the credit-linked note is reduced
accordingly. Thus the buyer of the credit-linked note effectively
insures the credit risk of an underlying reference security
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