Question

In: Finance

Describe the structure of a plain vanilla swap and describe how long and short positions can...

  1. Describe the structure of a plain vanilla swap and describe how long and short positions can be used to hedge risk for a firm. Be complete and support your answer with a graph.

Solutions

Expert Solution

Plain vanilla swap are the simple interest rate swaps. In this person A agrees to pay person B a predetermined, fixed rate of interest on the notional principal on specified dates for a specified period of time. Whereas, person B agrees to make payments based on the floating insterest rate to person A on the same notional principal on the specified dates and time period.

Let's take future contacts to undertand hedging.

The long positions in the market implies the action of purchasing futures and anticipating its value will increase over time.

And short position implies anticipating a fall in the price.

Heding is a process where therisk is offset. The investors use short and long position to hedge their risk.

For eg, an investor is in long position and the price of the future contract today is $100. He will expect the price to increase in future to $ 150, so he can earn a profit of $50. Howvever, if the price decreases to $50, then the investors incurs a loss of $50.

Now suppose, the investors is in short position, and futures price at $100. He anticipates the price will lower ta $50, so he could earn a profit. However, if the price increases, he will suffer losses.

In both these cases the opposite is beneficial to the other. Therfore, to hedge the risk, when the investor is in long position, he enters into a similar short position to offset the risk and vise versa.

The graph below justifies the above stated example of hedging through long and short position.


Related Solutions

Explain how a plain vanilla interest rate swap is constructed. Analyse the comparative advantage argument for...
Explain how a plain vanilla interest rate swap is constructed. Analyse the comparative advantage argument for the popularity of swaps. Support your analysis with a numerical example.
Consider a Plain Vanilla Interest Rate Swap agreement that AAA pays a fixed rate of 3%...
Consider a Plain Vanilla Interest Rate Swap agreement that AAA pays a fixed rate of 3% per annum and BBB pays LIBOR rate at the end of year for 3 years on a notional principal of $100m. In return, AAA receives LIBOR rate per annum and BBB receives a fixed rate of 3%. The LIBORs to be applied for cash flows are 2.8%, 3.3%, 3.5%. PMT LIBOR Cash Flow (floating) Cash Flow (Fixed) Cash Flow (Net) 1 2.8% 2 3.3%...
A plain vanilla interest swap has just been arranged between Muscat Electric Company and British Petroleum....
A plain vanilla interest swap has just been arranged between Muscat Electric Company and British Petroleum. Interest will be calculated on a semi-annual basis. Muscat  Electric Company  needs  a  Euro loan  to buy  equipment  for  its  new  project.  The loan is  required   for  5 years  and amount  is  5 million Euros.   Muscat Electric is  interested in  fixed rate  loan. Muscat electric agreed to pay 12% per year. British Petroleum  operates in  Oman.  BP   needs a  5 year   5 million  Euro Loan.  BP wants floating rate funds. BP agreed to pay LIBOR+1%.   The start date of the swap is 1st Jan 2019 Calculate the  exchange of cash flows between  the two parties...
Capital One Bank enters into a $10,000,000 quarterly‐pay plain‐vanilla interest rate swap as the fixed‐rate payer...
Capital One Bank enters into a $10,000,000 quarterly‐pay plain‐vanilla interest rate swap as the fixed‐rate payer at a swap rate of 6% based on a 360‐day year. The floating‐rate payer, First Bank, agrees to make payments at 90‐day LIBOR plus a 0.6% margin. The 90‐day LIBOR rate currently stands at 4%. LIBOR‐90 rates are as follows:  90 days from today = 4.5% 180 days from today = 5.1% 270 days from today = 5.6% 360 days from today = 6.0%...
Describe how you would replicate a plain vanilla stock call option using an asset-or-nothing option plus...
Describe how you would replicate a plain vanilla stock call option using an asset-or-nothing option plus a cash-or-nothing option. Assume that all three options are on the same underlying and have the same strike prices.
Focus and discuss the following. Short positions (of regular stocks): define and provide examples. Long positions...
Focus and discuss the following. Short positions (of regular stocks): define and provide examples. Long positions (of regular stocks): define and provide examples. Forwards: what are they and give examples of how you would use them. Futures: what are they, and give examples of how you would use them.
Design a Hypothetical Plan Vanilla Interest Rate Swap where there is a financial intermediary. Demonstrate how...
Design a Hypothetical Plan Vanilla Interest Rate Swap where there is a financial intermediary. Demonstrate how the swap has value to all parties (i.e., the fixed to floating, the floating to fixed and the financial intermediary). Determine the amount of benefit to each party in terms of annual interest rate savings, etc. Show the flow of funds at each interest payment date for all parties. Discuss the credit risk issues associated with such swaps. Indicate the risk should LIBOR increase...
describe with an example how a swap can be viewed as a portfolio of two bonds.
describe with an example how a swap can be viewed as a portfolio of two bonds.
Describe the following positions and under what market conditions will they have profits Long Straddle Long...
Describe the following positions and under what market conditions will they have profits Long Straddle Long Futures Short Put Short Call
Explain which option (i.e. put or call) positions (i.e. long or short) offers the most risk....
Explain which option (i.e. put or call) positions (i.e. long or short) offers the most risk. Explain how a firm’s equity can be compared to a call option. How does this help explain why managers may select riskier projects at the expense of bondholders?
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT