Discussion — Lectures 19 & 20

This session covers Lecture 19: Interest Rate Swaps and Lecture 20: Credit Default Swaps

• Lecture 19 Notes
• Lecture 20 Notes

Part 4 of Lecture 19 is missing from Perry Mehrling's site and the YouTube playlist. Here's a direct link.

• Lecture 19 — Part 4: What is a Swap

Part 4 of Lecture 20 is cut short on Perry Mehrling's site and the YouTube playlist. For the full segment, watch through the Coursera site. Here's a direct link.

• Lecture 20 — Part 4: What is a Credit Default Swap (CDS)?

Lecture 19 works largely out of Stigum Chapter 19. Stigum defines interest-rate swaps as follows:

An interest-rate swap is a contract between two parties to pay and receive, with a set frequency, interest payments determined by applying the differential between two interest rates—for example, 5-year fixed and 6-month LIBOR—to an agreed-upon notional principal. (p. 869)

Mehrling uses our balance-sheet framework to explain the interest-rate swap, which is a derivative instrument that serves as an important building block for shadow banking. We build our understanding incrementally on familiar concepts such as repo and forward contracts. Selling an IRS is like borrowing in the repo market to finance the holding of a longer-term asset (corporate bond). But it's also like being long a portfolio of FRAs. A swap dealer is like a dealer in corporate bonds.

Lecture 20 covers credit default swaps (CDS). Selling CDS is equivalent to exposing yourself to the risk you would expose yourself to, and receiving the interest payments you would receive for buying and holding a risky security. Only if the underlying risky bond defaults do you have to pay the principal.

We use balance sheets to dissect three cases where CDS played a role in the 2008 financial crisis.

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