Inv Lecture 4.pdf-Investments Prof. Andr...
Inv_Lecture_4.pdf-Investments Prof. Andrea Buraschi Lecture 4
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Inv Lecture 4.pdf-Investments Prof....
Inv_Lecture_4.pdf-Investments Prof. Andrea Buraschi Lecture 4
##### Page 33
Why is LIBOR so important?
Easiest defaultable rate: the rate at which highly rated
commercial banks can borrow and lend
Short
term interest rate benchmarks
Overnight, 1 Week, 1
12 Months
Why is it the benchmark? Difficult to manipulate
Vast majority of interest rate derivatives and many bond
Floating rates on bonds, forwards and swaps

##### Page 34
Euro
Off
shore deposit rates, set by BBA, exist for a number of other
currencies:
Pound Sterling, Japanese Yen, Swiss Franc, Canadian Dollar, Australian
Dollar, Euro.
There are also deposit rates set in other localities: TIBOR
(Tokyo interbank offered rate), etc.

##### Page 35
LIBOR is Defaultable
Deposits are not guaranteed by FDIC
If there is a banking crises…
Example: Japanese banking system
LIBOR should always (or almost always) be higher than
Treasury rates.
Difference between them is the TED spread
Treasury over Eurodollar
Measure of health of banking sector?

##### Page 36
Historical Time series
0
2
4
6
8
10
12
14
16
18
20
1980-01
1984-01
1988-01
1992-01
1996-01
2000-01
2004-01
2008-01
Fed Funds
3M Tbill
LIBOR

0
1
2
3
4
5
1980-01
1984-01
1988-01
1992-01
1996-01
2000-01
2004-01
2008-01

LIBOR and 9/11
1.75
2.25
2.75
3.25
3.75
4.25
4.75
5.25
1-Aug
11-Aug
21-Aug
31-Aug
10-Sep
20-Sep
30-Sep
10-Oct
20-Oct
30-Oct
Overnight
1-Week
1-Month
3-month

##### Page 39
How to model defaultable rates?
Model defaultable rates in a manner similar to equities: adjust
discount rates.
If we let r
t
denote the default
free rate, then the defaultable rate
R is given by: R
t
=r
t
+s
t
s is the spread and is given equal to s
t
=L
t
h
t
L is the amount of par value lost
h is the probability of default.
(next class) are longer
dated versions.

##### Page 40
Summary
Forward rates as an interest rate risk hedge
LIBOR as a benchmark for defaultable rate
Forward rates allow us to remove interest rate risk over a given
period in the future: m periods ahead for n periods
What if we want to be able to remove such risks on a regular
basis?
Solution: swaps (next class)

##### Page 41
Finance Deparment
End of first part

##### Page 42
Fixed Income – Lecture 4 (part 2)
Part 2:
Interest rate swaps

##### Page 43
Swaps
An interest rate swap is an agreement between two parties to
exchange period cash flows
One party pays a fixed rate and receives a floating rate
The other party pays floating and receives fixed.
Uses
Allows them to manage their asset/liability structure.
A tool for hedging risk and speculation
You can swap anything (as Enron has showed us).

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