Every action involves risks. This applies to companies operating in the market and also in particular to credit institutions whose raison d'être lies in the assumption of risks.
Risk in the literal sense is grounded in a lack of awareness of the possibility of negative deviation from planned corporate goals.
To generate income and to be able to survive a company has to take risks. Such risks are different in nature and are therefore to be evaluated differently. Banks generate the majority of their income from interest-bearing business. Companies finance their borrowing requirements next to equity mainly through loans.
With regards to borrowing costs it is to be noted that corporate risk also shows a dependency between total capital and interest on debt. This is known as the leverage effect which in a negative scenario may be so large that the resulting losses can no longer be compensated.
The change in economic conditions, fluctuations of interest rates (IR) and exchange rates on the capital markets especially due to inflation at the beginning of the 70s and 80s were the trigger for the development of new financial instruments (see Appendix, Figures 7, 8 and 9). The financial industry constantly creates new financial products that make it possible to lower the volatility of interest rates and currencies and the associated potential for currency and interest rate risks to a minimum. One of these capital market tools to minimize risks in the changes shown linked to interest rate are the so called interest rate swaps.
The aim of this work is to explain how interest rate risks can be minimized with interest rate swaps. It will focus on the over the counter (OTC) interest rate swaps market.
In the first chapters this termpaper examine the historical development, basic model, trading platforms and different meaning for lenders and borrowers of interest rate swaps. Next, it will explain the valuation and calculation of interest rate swaps as well as the specific value drivers and approaches. In summary, it provides an overview of the different types of interest rate swaps while also taking a critical look at these derivatives.
Table of Contents
List of Figures
List of Tables
Abbreviations
1 Introduction
2 Basics of interest rate swaps
2.1 Reference rate and credit rating
2.2 Net present value (NPV) of interest rate swaps
2.3 Equilibrium of interest rate swaps
2.4 Sample calculation of an interest rate swap according to Perdion / Steiner
3 Genesis, classification of interest rate swaps and the need for risk mitigation of interest rates
3.1 Genesis of swaps
3.2 Classification of OTC swaps
3.3 Special interest rate risks in the lending business
4 Types of interest rate swaps
4.1 Coupon swap
4.2 Basis swap
4.3 Step up interest rate swaps
4.4 Amortisation interest rate swaps
4.5 Interest rate swaption
4.6 Forward interest rate swap
5 Conclusion
List of Literature and Sources
Appendix
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