Tail Risk Killers: How Math, Indeterminacy, and Hubris Distort Markets

CHAPTER 33For Those about to Swap (We Salute You)

Interest-rate swaps exist to hedge interest-rate risk. For example, a bond investor typically takes a position financed at a floating prime rate. If this floating rate rises, he or she is put in a tough spot where he or she has to liquidate his or her position. The same logic applies for any business that finances its outlays at a floating rate. If these rates rise too much, the company could go out of business. Swaps enable one to hedge interest-rate risk at every point on the yield curve. Even though they exist as a hedge, they also can be used to speculate on interest-rate movements. Everyday sensible reasoning using directly observed data leads to an understanding of the true nature of risks ...