Evaluating Derivatives―Part II: Economic Value
January 15, 2015
In a previous blog, impact to earnings was discussed as it relates to derivatives and the insurance they can provide against a rising rate environment. While derivatives can be a good option for hedging interest rate risk, especially in today’s low rate environment, it is also important to consider how economic values are determined.
Because of the complexity of this topic, there will be a series of blogs so that we can keep them relatively short.
On day 1 of a swap transaction, the swap’s economic value will be zero, meaning the economic value will not reflect a gain or loss in the current rate environment. This value will change over time even if rates don’t change.
Why is the beginning base economic value zero? The present value of expected cash flows for both the fixed-rate party and the floating-rate party are assumed to be equal.
Using the swap example in Part I: Earnings, the party paying fixed starts with a large negative cash flow. In order for the present value of cash flows to be equal, the pay-fixed side would need to have positive cash flows at some point in the future.
For the example swap (pay fixed 2%), the math indicates that short-term rates would need to go up about 300 bps before the swap matures in order to offset the present value of the initial negative cash flow.
Derivatives analytics provided by The Yield Book® Software.
The expectation that rates go up needs to be understood since the results would be quite different if the implied rate path does not come true. This critical consideration will be addressed in more detail in future blogs.
We will also address questions such as:
- How do the value results differ from actual earnings?
- What could cause the values shown to not come true?