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by Carl Pellegrini    Mon, Nov 7, 2005, 02:24 PM


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Sudden changes in the political, economic or policy environment may result in a significant mispricing of swap yield sensitive securities, such as corporate debt, mortgage-backed securities, as well as other fixed income securities and derivatives. The FED has recently been very public concerning mounting inflation pressures. The investor has been continually led to believe than inflation was not a big concern of the FED; and therefore, a policy move against inflation was not expected. Well, what you observe in the charts above is the markets’ reaction to changing expectations.

The swap market is used by non-financial firms in the management of the interest rate risk of their corporate debt. Financial firms use the swap market intensively in hedging the mismatch in the interest rate risk of their assets and liabilities. Interest rate swap contracts allow both borrowers and lenders to tailor the characteristics of their cash flows. The swap spread is a function of the short rate not just because the short rate is needed to discount the cash flows of a swap contract but also because the short rate plays a first order role in a corporation decision to hedge its interest rate risk. When interest rates fall, the duration of Mortgage Backed Securities falls; therefore, to increase duration, the hedgers usually enter into a swap contract to receive a fixed swap rate. The reverse is true when interest rates rise. The liquidity of the swap market underpins the residential mortgage market in the United States, providing real benefits to the household sector. Without the aid of the swap market, mortgage lenders would find it more difficult and expensive to manage the interest rate risk of the prepayment option in fixed rate mortgages.

Interest rate swaps are the largest derivative contracts, in terms of amount outstanding, in the world. Swap rates are used as a benchmark for pricing other fixed income securities and derivatives. Previously, Treasuries were the main vehicle for hedging; however, when the government retired debt in the late 1990s, hedgers increasingly turned to the swap market. In spite of the importance of the swap market, we still lack a solid understanding of the time series dynamics of the swap spreads. These spreads have experienced wild fluctuations, varying from a low of about 25 basis points to more than 150 basis points. The extensive use of interest rate swaps means that volatility of the swap spread can affect a large range of market participants, as they rely on a stable relationship between the interest rate swap rate and other interest rates in using swaps for their hedging objectives
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