Solution for Financial Institutions, Instruments and Markets 8th Edition Chapter 21, Problem 1

by Christopher Viney, Peter Phillips
780 Solutions 21 Chapters 101727 Studied ISBN: 9781743079959 Finance 5 (1)

Chapter 21, Problem 1 : 1. (a) A trader expects interest rates to...

1. (a) A trader expects interest rates to increase. Rather than take a position in the bond market, the trader decides to use interest rate swaps to carry out the trade. What position would a trader with this set of expectations take in the interest rate swaps market?

(b) How would the trader’s position change if, instead of expecting interest ratesto increase, the trader expected interest rates to decline?


Step-By-Step Solution

1(a) When interest rates are expected to increase, bond prices are expected to decline. The trader could take a short position in the bond markets. However, interest rate swaps may also be used to take a position consistent with these expectations. The trader would enter a fixed-for-floating interest rate swap. The trader will usually find that a larger position can be taken in the interest rate swaps market with less capital than would be required to form a trade based on the same expectations in the bond market.

(b)If the trader expects interest rates to decline, the trader expects bond prices to increase. A trade could be entered into on the bond market with the purchase of bonds. As before, the interest rates swaps market may be a more attractive place to act on an expectation of interest rate changes. If the trader expects interest rates to decline, the trader would enter a floating-for-fixed interest rate swap.


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