Saturday, November 1, 2014

IRS intuitively - an orange a day (with wrong intuitino

Selling an IRS is like signing a 2-year contract to supply oranges monthly (eg: to a nursing home) at a fixed price.

Subsequently orange price rises, then nursing home is happy since they locked in a low price. Orange supplier regrets i.e. suffers a paper loss.

P241 [[complete guide]] -- orange county sold IRS (the oranges) when the floating rate (orange price) was low. Subsequently, in 1994 Fed increased the target overnight FF rate, which sent shock waves through the yield curve. This directly lead to higher swap rates. Equivalently, the increased swap rate indicates a market expectation of higher fwd rates. We know each floating rate number on each upcoming reset date is evaluated as a FRA rate i.e. a fwd-starting loan rate.

The higher swap rate means Orange County had previously sold the floating stream (i.e. the oranges) too cheaply. They lost badly and went bankrupt.

It's crucial to know the key parameters of the context, or you hit paradoxes and incorrect intuitions:

Coming back to the fruit illustration. Some beginners may feel that rising fruit price is good for the supplier, but wrong. Our supplier already signed a 2Y contract, so the rising price doesn't help.

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