Interest Rate Risk - LIBOR and swap rates
5 important questions on Interest Rate Risk - LIBOR and swap rates
What is an interest rate swap?
An interest rate swap is a derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice-versa), or from a floating rate to another. Such a swap can be used for hedging or speculation.
Describe a typical interest rate swap.
Counterparty A pays a fixed rate (the swap rate) to counterparty B, while receiving a floating rate indexed to a reference rate (e.g. EURIBOR). By market convention, the counterparty paing the fixed rate is called the ' payer', and the party receiving the fixed rate is called the ' receiver'.
Define the so called asset/liability mismatch.
The asset/liability mismatch occurs when the financial terms of an institution's assets and liabilities do not correspond. Several types of mismatches are possible. a bank could have substantial long-term assets (such as fixed-rate mortgages) but short-term liabilities, such as deposits.
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How can banks reduce the asset/liability mismatch (in the case of a deposit/mortgage mismatch)?
The most direct way is to ensure that the maturities of the assets on which interests are earned and those of the liabilities on which interests are paid are matched. They have to act on interest to make certain maturities more attractive.
How can we extend the LIBOR yield curve beyond 1 year?
1. Create a term structure of interest rates showing the rate of interst at which a AA-rated company can borrow today for the coming 1,2,3 years.
2. Create a yield curve to represent the future short term borrowing rates for AA-rated companies. (usual approach).
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