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FT Guide to Banking by Glen Arnold

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22

Swaps and options

Swaps, options, caps and floors are used by banks in great volume every working day. This chapter outlines these important derivatives.

Swaps allow you to exchange a series of future cash payment obligations. For example, you could have a seven-year loan agreement whereby you pay a series of interest amounts based on whatever the six-month LIBOR is at the time. Obviously, the concern you have is that LIBOR might jump to a much higher level at some point in the seven years, which might jeopardise your firm. One solution is to agree with a counterparty for it to pay you LIBOR every six months if you pay its fixed interest rate obligations – an interest rate swap.

Credit default swaps, invented only in the 1990s, allow ...

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