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Inv Lecture 4.pdf
Inv_Lecture_4.pdf
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Inv Lecture 4.pdf-Investments Prof. Andrea Burasch...
Inv_Lecture_4.pdf-Investments Prof. Andrea Buraschi Lecture 4
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
issuances are linked to LIBOR
Floating rates on bonds, forwards and swaps
Page 34
Euro
‐
(insert your favorite currency)
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
Page 37
TED Spread
0
1
2
3
4
5
1980-01
1984-01
1988-01
1992-01
1996-01
2000-01
2004-01
2008-01
Page 38
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.
The TED spread is one example of a spread, and swap spreads
(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
Gives indirect access to fixed or floating capital markets
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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