Prepaid swaps are swaps whereby the counterparties agree to a pre-determined value for the swap. Prepaid swaps are exposed to: 1. Credit Risk 2. Market Risk 3. Financial Risk With respect to credit risk, although there is an agreed upon value of the swap, the swap holder is faced with the risk that the counterparty will default or not provide delivery. Market risk relates to the change in swap prices over time due to interest rate changes as well as commodity price changes. As the value goes up and down until maturity, the prepaid price may be larger or smaller than the value at any given time. Financial Risk is the opportunity cost associated with rising interest rates. Should rates rise after establishing a pre-paid swap, the swap holder could be faced with a prepaid price that was too high and would have been better off investing the proceeds into a treasury bill at the higher rate. Financially Settled Swaps Credit risk is 0 at initiation because they have settled the payoffs upfront. Financially settled swaps are still subject to Market and Financial Risk. In addition, as the swap ages (moves away from intiation) a small amount of credit risk still exists due to fluctuations in interest rates/commodity prices, albeit much lower than that of prepaid swaps.
If I am paying the fixed price in a commodity swap, and I want to hedge this position later, I take the short position in another swap (and receive the fixed price). Now I’m left with interest rate risk (and credit risk). To hedge the int rate risk, I enter into a FRA and receive the variable rate? Is this the long position in the FRA?
TooOld4This Wrote: ------------------------------------------------------- > If I am paying the fixed price in a commodity > swap, and I want to hedge this position later, I > take the short position in another swap (and > receive the fixed price). > > Now I’m left with interest rate risk (and credit > risk). To hedge the int rate risk, I enter into a > FRA and receive the variable rate? Is this the > long position in the FRA? if you entered into offseting swap you are only faced with credit risk and not interest rate risk and that is only if you are not closing swaps with the same counter party
CSK, Not true, think of it this way, you have both a long and short position, that means price of commodity doesn’t matter anymore. We agree on that. However, because of the way swaps are priced (as averages of forward prices), you’re +ve on some payoff dates and -ve on others. The key is you’ve locked yourself into a fixed aggregate value at given interest rates. Now change those rates, and your fixed value will also change (even if it was a perfect hedge and your fixed value was zero). I think Schweser has an example of this.
comp_sci_kid Wrote: ------------------------------------------------------- > if you entered into offseting swap you are only > faced with credit risk and not interest rate risk > > and that is only if you are not closing swaps with > the same counter party That is correct… entering into an offseting position will eliminate interest rate risk and financial risk but you’re still susceptable to credit risk.
TooOld4This Wrote: ------------------------------------------------------- > CSK, > > Not true, think of it this way, you have both a > long and short position, that means price of > commodity doesn’t matter anymore. We agree on > that. > > However, because of the way swaps are priced (as > averages of forward prices), you’re +ve on some > payoff dates and -ve on others. The key is you’ve > locked yourself into a fixed aggregate value at > given interest rates. Now change those rates, and > your fixed value will also change (even if it was > a perfect hedge and your fixed value was zero). I > think Schweser has an example of this. if it is not a perfect hedge (your net fixed is different from zero), then yes, sorry, i didnt realize what you were asking
OK, I dug out my L2 flashcards…sigh, things were so much easier then… But now I confused myself. If I only have a long swap position, paying fixed prices, then interest rates rising will hurt me. In this case, the appropriate interest hedge is the LONG postion on the FRA since FRA pays off when int rates rise. But if I hedged out my long swap already, leaving myself credit and interest rate risk, I’m not sure it’s the long FRA I want because interest is implicit in what I’m paying AND in what I’m receiving. Any bright minds want to tackle this one?
TooOld4This Wrote: ------------------------------------------------------- > OK, I dug out my L2 flashcards…sigh, things > were so much easier then… > > But now I confused myself. If I only have a long > swap position, paying fixed prices, then interest > rates rising will hurt me. In this case, the > appropriate interest hedge is the LONG postion on > the FRA since FRA pays off when int rates rise. if you are pay fixed, rise in interest rates will be to your advantage, so to hedge it you short FRA > > But if I hedged out my long swap already, leaving > myself credit and interest rate risk, I’m not sure > it’s the long FRA I want because interest is > implicit in what I’m paying AND in what I’m > receiving. Any bright minds want to tackle this > one? if you enter into another swap, you are just ended up with a stream of fixed payments (either making or receiving) and then depending on if you are receiving (you go long FRA to hedge) or making (you go short FRA to hedge), dunno if it makes sense but that is how i see it (again it will be a series of FRA not just one FRA)
If you pay fixed and receive Floating - and interest rates rise, this is Good
In the first example, I’m in a prepaid commodity swap not an interest rate swap. The way I see it, I’ve priced a swap assuming I’m getting a certain rate on my money. If rates go up, I’ve lost.
oh ok, wasnt paying attention.
TooOld4This Wrote: ------------------------------------------------------- > In the first example, I’m in a prepaid commodity > swap not an interest rate swap. The way I see it, > I’ve priced a swap assuming I’m getting a certain > rate on my money. If rates go up, I’ve lost. yes, if rates goes up you lost
Prepaid swaps are exposed to: 1. Credit Risk 2. Market Risk 3. Financial Risk Are Credit Risk and Market Risk two types of Financial Risks?
deriv108 Wrote: ------------------------------------------------------- > Prepaid swaps are exposed to: > > 1. Credit Risk > 2. Market Risk > 3. Financial Risk > > > Are Credit Risk and Market Risk two types of > Financial Risks? From the definition given by the first poster, it looks more like interest rate risk.
Market risk = financial risk (interest rates, exchange rates, equity price, commodity price) credit risk = financial risk (default of counterparty) Be careful on credit risk vs settlement risk…tricky: credit risk is a financial risk, but settlement in a non-financial risk (you are paying as the other is defaulting)
its called Herstatt son