The over-the-counter (OTC) market uses a wide range of swaps, including interest rate swaps, credit default swaps, asset swaps, and currency swaps, to reduce risks. Swaps are generally derivative contracts that allow two private parties—typically businesses and financial institutions—to exchange the cash flows or liabilities from two different financial instruments.
The simplest swap available is a plain vanilla swap, which is frequently used to protect against exposure to floating interest rates. Interest rate swaps are a type of plain vanilla swap. Floating interest payments are changed into fixed interest payments (and vice versa) by interest rate swaps.
In an interest rate swap, the two parties are frequently referred to as counterparties. Typically, the counterparty using a floating rate makes payments using benchmark interest rates like the London Interbank Offered Rate (LIBOR). Payments from counterparties with fixed interest rates are compared to U S. Treasury Bonds. .
For a variety of reasons, including the desire to alter the nature of the assets or liabilities in order to guard against anticipated adverse interest rate movements, two parties may choose to enter into an interest rate swap. Like the majority of derivative instruments, standard swaps start out with no value. However, due to changes in factors affecting the value of the underlying rates, this value fluctuates over time. Swaps are zero-sum instruments, like all derivatives, so any positive value increase to one party is a loss to the other.
LIBOR is being phased out as a result of recent scandals and concerns about its reliability as a benchmark rate. The Secured Overnight Financing Rate (SOFR), as opposed to LIBOR, will gradually replace it by June 30, 2023, according to the Federal Reserve and UK regulators. After December 31, 2021, the LIBOR one-week and two-month USD LIBOR rates will cease to be published as part of this phase-out. .
Interest Rate Swaps With An Example
Define what the expiration day is.
This question may be asked by a hiring manager to determine your familiarity with fundamental financial concepts. Provide the definition for an expiration date. Provide any significant restrictions that could have an impact on the expiration date, if applicable.
“The expiration date refers to the day that a contract expires,” as an example For instance, futures and options contracts expire on the final Thursday of the expiration month. For instance, if a contract expires in February 2022 and February 28 falls on a Friday, then the expiration date is Thursday, February 27.
However, its important to remember holidays may affect expiration dates. The expiration day falls on the trading day prior to any non-trading days or other holidays. The expiration date would change to the Wednesday before Thanksgiving, for instance, if the expiration day fell on Thanksgiving. “.
11 derivatives interview questions
Here are a few illustrations of derivatives interview questions and sample responses:
What’s the process for settling contracts?
This query may be used by a hiring manager to gauge your familiarity with working with contracts. Your response might aid them in picturing you carrying out regular duties for the position. Give an explanation of the procedure for settling contracts, and think about citing a personal instance of a time when you have already done so.
Example response: “All futures and options contracts should be settled in cash each day. In a similar vein, it is crucial to settle all contracts before or on the date of expiration. This is due to the possibility that the contract’s money or money options could expire and become worthless on their expiration date. “.
The Distinct Nature of Rates Trading
If you intend to rotate there or join full-time, one thing to keep in mind about rates trading is that it is quite a different environment from the rest of the floor.
The market for rates is still largely dominated by humans as opposed to algorithms that carry out client trades because it is very liquid and flow-oriented. Practically speaking, this means that the rates desk is constantly a bit chaotic with a lot of talking, shouting, moving books around constantly via future contracts, etc.
Rates are a great place to be if you want to feel truly “in the markets.” Regardless of the bank you work for, it is an area that automation is unlikely to further affect and has a lot of client traffic.
Another advantage of rates is that they naturally revolve around government bonds, which results in very low risk-weighted asset (RWA) makeup, as we discussed when talking about regulation in sales and trading.
Practically speaking, this means that a trader can hold numerous Treasury securities, futures, TIPS, or swaps on their book without requiring the company to hold back significant amounts of capital against these. Therefore, one could argue that the rates desk is one of the best places to be on the trading floor on a risk-adjusted basis because traders can still generate significant PnL there.
Additionally, as a salesperson, you engage in very active client interactions with very sizable transaction sizes. This is a very reliable seat to have on the floor because a salesperson in sales and trading will receive a portion of the flow they bring to the desk.
Of course, the fact that there isn’t much volatility in the core rates products is one of the reasons why banks and regulators alike feel comfortable allowing traders to have large books.
The reality is also that regulators understand how important it is for large sell-side banks to have big rates books, because they are the predominate provider of liquidity. At year-end and quarter-end in recent years weve seen rates markets dry up quite a bit as rotations occur, which has reinforced how important it is to have deep, liquid, actively-traded markets in treasuries, TIPS, and swaps.
This is a long-winded way of saying that if you enjoy the qualities of rates-products, the floor at almost any major investment bank is a great place to work.
Below are some rates-specific interview questions. Here is a rather lengthy list of general sales and trading interview questions if you’re looking for them. These are the kinds of inquiries you might encounter if you apply for a fixed placement at a bank like J P. Morgan (see J. P. ) or are submitting an application to become a full-time analyst
Dont worry about getting any questions that are too complex. Before starting, nobody expects you to be an absolute expert in everything.
As a trader, you will spend the majority of your first few years on the job learning, offering assistance, and gradually integrating yourself into one of the silos described above. Your primary responsibilities during your first few years on the sales side of the desk will be to learn, assist, and gradually assume some responsibility for client management (and engage in more direct communication with the traders).
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Question 2: How many different issues of treasury notes and bonds are in circulation at any given time?
By definition, there are 24 two-year, 36 three-year, 60 five-year, 84 seven-year, 40 ten-year, and 120 thirty-year treasuries. This is a problem with rates trading at any level of automation; there are 364 different securities with various maturities that will most likely be issued with various coupons and that will have various yields and prices.
Many people mistakenly equate rates with stocks, believing that every 2-year note is identical to an Apple common share. This is simply not the case; bonds quickly get quirky!.
FAQ
How do you explain interest rate swaps?
An agreement between two parties to swap one stream of interest payments for another over a predetermined time period is known as an interest rate swap. Swaps are derivative contracts and trade over-the-counter.
What are the two primary reasons for swapping interest rates?
An interest rate swap occurs when two parties exchange (i. e. Future interest payments based on a predetermined principal amount are swapped. Interest rate swaps are primarily used by financial institutions to manage credit risk, speculate, and hedge against losses.
What is interest rate swap with example?
A contract establishing an exchange of interest payments between two parties is known as an interest rate swap. The most typical interest rate swap contract calls for Party A to pay Party B according to a fixed interest rate, and Party B to reimburse Party A according to a floating interest rate.
How do you calculate interest rate swap?
We equalize the present values of the interest due on each loan, then solve for R to determine the swap rate R. Alternatively put, the Present Value of Interest on the Variable Rate Loan equals the Present Value of Interest on the Fixed Rate Loan. Solving gives R = 0. 05971.
