Global derivatives market a historical perspective.

1. Saunders & Cornett, Financial Institutions Management, 4th ed. 1 “History teaches us that men and nations behave wisely once they have exhausted all other alternatives.” Abba Eban

2. Saunders & Cornett, Financial Institutions Management, 4th ed. 2 Global Derivatives Markets as of June 2001 Credit derivatives - $1 trillion in notional value worldwide Interest rate derivatives - $65 trillion Foreign exchange rate derivatives - $16 trillion Equity derivatives -$2 trillion By comparison, total on-balance sheet assets of all US banks was $5 trillion (as of Dec. 2000) and for Euro area banks $13 trillion. Global derivatives markets totaled approximately $84 trillion in notional value.

3. Saunders & Cornett, Financial Institutions Management, 4th ed. 3 Step-By-Step Hedging Using Interest Rate Swaps Step 4: Implementation. Long hedge (DG<0) – sell swaps (make floating rate payments). Short hedge (DG >0) – buy swaps (make fixed rate payments). Fixed for floating rate (plain vanilla) swap Swap intermediary acts as credit guarantor, as well as broker and bookkeeper. Only net amounts exchanged on payment dates (not principal amounts). Swaps are portfolios of forwards so there are no predetermined notional values (NV) or contract specifications as in exchange traded futures & options.

6. Step 4: Floating rate reprices each year (Dfloat=1). Fixed rate is equal to the 15 yr 8% coupon T-bond (Dfixed=9.33). Swap  -(DFixed –DFloat)NVRswap /(1+Rswap) = -(9.33 – 1)NV(.0025) set = $9.375m = E NV = $450 million Buy $450 million of fixed for floating rate swaps in order to implement macrohedge to immunize against ALL interest rate risk

9. Figure 15.5 shows the structure.

12. Identity of reference loan

13. Definition of credit event (default, restructuring, etc.)

14. Payoff upon credit event.

15. Specification of physical or cash settlement.

16. July 1999: master agreement for CDS by ISDA

17. Swap premium = CS

20. Decomposition of risky debt prices to obtain PD (see chapter 5):

21. Basis in swap market (CDS premium  CS) because:

22. Noise and embedded options in risky debt prices.

23. Liquidity premium in debt market.

24. Default risk premiums in CDS market for counterparty default risk. Increase as correlations increase and credit ratings deteriorate. Table 15.2.