Introduction to Securitization

KEY POINTS OF THE CHAPTER

• The types of OTC interest rate derivatives commonly used in securitizations are interest rate swaps, interest rate caps, and interest rate corridors.

• OTC derivatives expose the SPV to counterparty risk.

• In an interest rate swap, the two counterparties agree to exchange periodic interest payments based on some notional amount and some reference rate (typically LIBOR).

• An interest rate swap allows an SPV to transform the nature of the SPV’s cash flows and interest rate exposure.

• There are two economic interpretations of an interest rate swap: (1) a package of forward/futures contracts and (2) a package of cash flows from buying and selling cash market instruments.

• There are different types of swaps that are used in securitization transactions: (1) plain vanilla swap, (2) amortizing swap, and (3) basis swap.

• In a plain vanilla swap the notional principal remains unchanged during the life of the swap with one party paying a fixed rate and the other party a floating rate based on a reference rate.

• In an amortizing swap the notional amount declines over time based on either a predetermined amortization schedule, actual collateral balance, or the actual bond balance

• In a basis swap both parties pay a floating rate based on different reference rates.

• An interest rate swap is used in securitization transactions to alter the cash flow characteristics of the assets (liabilities) to match the characteristics of the liabilities (assets).

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