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djquackkquackk
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Posts: 4
Joined: November 22nd, 2010, 1:12 am

basic interest rate swaps questions

February 5th, 2011, 1:20 pm

hello. i had two questions. firstly, i've tried researching online, but could only find very technical papers on this - what's the importance of the forward curve, and why is it downward sloping for greater maturities.also, what are the balance sheet implications of an interest rate swap?thank you
 
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Martinghoul
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Joined: July 18th, 2006, 5:49 am

basic interest rate swaps questions

February 5th, 2011, 1:58 pm

Antti Ilmanen's "Understanding the Yield Curve" series can help with your first question. As to the second, swaps are, generally, off-balance sheet products, or, rather, they used to be in the pre-crisis world. In today's mkt, swaps consume balance sheet, since they're normally over-collateralized.
 
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djquackkquackk
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Posts: 4
Joined: November 22nd, 2010, 1:12 am

basic interest rate swaps questions

February 5th, 2011, 3:00 pm

thank you.I understand that the book is mark-to-marketed daily using the closing data, but you say they consume balance sheet - how? do you mean the cash flows being set into the assets/liabilities of the bank?
Last edited by djquackkquackk on February 4th, 2011, 11:00 pm, edited 1 time in total.
 
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Martinghoul
Posts: 3256
Joined: July 18th, 2006, 5:49 am

basic interest rate swaps questions

February 5th, 2011, 3:21 pm

QuoteOriginally posted by: djquackkquackkthank you.I understand that the book is mark-to-marketed daily using the closing data, but you say they consume balance sheet - how? do you mean the cash flows being set into the assets/liabilities of the bank?Well, I suppose it depends on what sort of institution owns this balance sheet. For example, for me, every swap I do is overcollateralized, i.e. I have to post a certain extra amount of collateral to the cpty up front, regardless of the swap PV (called "initial margin" or "independent amount"). That, obviously, eats into my balance sheet. If we're talking about a bank, I imagine it depends on their margin arrangements with a central clearer, such as LCH, and also the regulatory framework. I am not an expert on how banks, in the brave new world, deal with this.
Last edited by Martinghoul on February 4th, 2011, 11:00 pm, edited 1 time in total.
 
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unkpath
Posts: 289
Joined: January 13th, 2004, 8:44 pm

basic interest rate swaps questions

February 6th, 2011, 3:14 pm

I am not sure what you mean by importance of the forward curve? It is really just another representation of the the term structureof the characteristics of a debt market of a certain quality as a function of time. In other words some measure of debt as a functionof time. You can pick many and convert between them. Forward rates are important because they establish a link between spotstarting zero rates of various maturities, i.e. they basically state that in order for there to be no arbitrage among spot starting zerorates of different maturities, that is what future debt must yield. I second that the 7 papers by Ilmanen are good, although somewhat dated.Regarding your second question, you need to read up a bit on yield curve phenomenology. One characterization of the global yield curve is that it is controlled by a balance of inflation expectations and rate convexity in the long end (modulo some risk premia and other effects? The heck I know...). Anyway, so imagine you plot bond or swap convexity as a function of maturity, you will find that longer maturity instruments are a more strongly convex functions of their yield. So longer maturity instruments are from the perspectiveof convexity more desirable to hold. That awareness by the market "explains" (does it really?) why prospective investors are willing to pay an extra premium for such longer maturity instruments, i.e. they are "happy" (are they?) to hold such securities, swaps, etc...for a lower yield. In yield space, rate curves therefore often are downward sloping as a function of the term in the long end.QuoteOriginally posted by: djquackkquackkhello. i had two questions. firstly, i've tried researching online, but could only find very technical papers on this - what's the importance of the forward curve, and why is it downward sloping for greater maturities.also, what are the balance sheet implications of an interest rate swap?thank you
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