Pricing RMB Interest Rate Swaps: Theory And Empirical Evidence

As international financial market are changing rapidly and financial derivativesare following each other in rapid succession, interest rate swap are now widelyadopted in business and in the world of finance, not only to lock in investment profitand manage interest-rate risk but also to hedge from price spread and reduce interestobligations. IRS has been a basic and effective financial instrument to manageinterest rate risk.Nowadays, with the rapid development of national interest rate swap market,transactions in interest rate swap are more and more active and the study on interestrate swap pricing has beome more and more important. Since the interest rate swappricing plays an important role not only in the development of inter-bank market butalso in the development of whole financial market, the study on interest rate swappricing is of profound theoretical and practical significance and has become a focusthese days.In this paper we review some pricing theory on interest rate swap,including thefundamental pricing theory of derivatives, the model of interest rate swap pricing andsome empirical analysis on interest rate swap pricing. Then we describe the propertiesof interest rate swap including structural properties and funtional properties, on whichthe pricing theory are based. The main part of this paper is to price the RMB interestrate swap with some pricing models.We take those RMB Interset Rate Swap between national banks as examples tobegin our empirical investigation, which are made up of 4 parts.First, in this paper we make an empirical investigation on the pricing model ofInterest Rate swap adopted by national banks(pricing under risk-free plus creditpremium): based on Zero Coupon Pricing Methodology, we carry out case simulationand price 2 interest rate swap which are based on the fixed interest rate for 1 yeardeposits and the market interest rate R007 under the circumstance of risk-free. We getan risk-free result and plus the credit premium of transaction parties to it, then we get the formula price of swap transaction. We compare market prices of interest rateswaps with formula prices. From those empirical results of 2 examles, we show thatthere is a great price differential between formular price and market price of RMBinterest rate swao based on 1 year deposits, that is to say, as for interest rate swapbased on non-market interest rate, its pricing is more easily influenced by manynon-market factors. We could also draw the conclusion that there are many problemsin the pricing modle adopted by our commercial banks such as: underestimating theloss of default risk from swap transaction partners. And because the system of creditrating of the opposite party and guaranty money or securities.is backward, the pricingof credit premium of transaction partners is very difficult.Second, in Chapter 5 we make an empirical investigation on the pricing model ofRMB interest rate swap adopted by banks(pricing under risk-free plus creditpremium): based on single-factor term structure modle. Through the single-factorterm structure modle, we fit the dynamic term structure of interest rate of interbankmarket, we price RMB interest rate swap based on market interest rate R007 underthe circumstance of risk-free, we get an risk-free result and plus the credit premium oftransaction parties to it, then we get the formula price of swap transaction. Theempirical results are still lower than that of market price.Third, aiming at the problems in those interest rate swap pricing modles adoptedby national banks, in chapter 6 we consider the default risk of transaction partieswhen pricing the RMB interest rate swap and through two-side default risks modlewe price RMB interest rate swap. We calculate the default probablility of transactionparties based on its bond yield and through two-side default risks modle we priceRMB interest rate swap. From the empirical results, we show that compared with theformula price of chapter 4 and chapter 5, the formula price of chapter 6 is strikinglyclose to the market price. It also could prove that the two sides default risk modle ismore effective than that those pricing modles adopted by national banks when pricingRMB interest rate swap. The pricing result suggests that method expatiated in thischapter can offer a quite effective method for interest rate swap pricing, and can bemade a pricing reference in the course of realistic transactions. Fourth, in chapter 7 we make a comprehensive analysis of the pricing results ofRMB interest rate swap. We show that the fitting to swap term structure through thetwo sides risks motile is the best, but there is still a price differential between swapquotation price and yield of financial bonds. Then we examine all relevant factorsaffecting the swap pricing and combined with the empirical results we claim some setof arbitraging strategy based on the price differential.In the finality, we make a brief discussion on the conclusion in this paper and thesuggestion to promote developments of RMB interest rate swap.