© 2002 South-Western Publishing 1 Chapter 13 Swaps and Interest Rate Options.

© 2002 South-Western Publishing 1

Chapter 13

Swaps and Interest Rate Options

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Outline

Interest rate swaps Foreign currency swaps Circus swap Interest rate options

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Introduction

Both swaps and interest rate options are relatively new, but extensively used– In mid-2000, there was over $60 trillion

outstanding in interest rate swaps, foreign currency swaps, and other interest rate options

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Interest Rate Swaps

Hedging with interest rate swaps Immunizing with interest rate swapsExploiting comparative advantage in

the credit market

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Interest Rate Swaps

Popular with bankers, corporate treasurers, and portfolio managers who need to manage interest rate risk

A swap enables you to alter the level of risk without disrupting the underlying portfolio:

assetliability

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Interest Rate Swaps

The most common type of interest rate swap is the fixed for floating rate swap– One party makes a fixed interest rate payment to

another party making a floating interest rate payment

– Only the net payment is made (difference check)– The firm paying the floating rate is the swap seller– The firm paying the fixed rate is the swap buyer

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Interest Rate Swaps

Typically, the floating interest rate is linked to a market rate such as– LIBOR or– T-bill rates– BA’s in Canada

The swap market is standardized partly by the International Swaps and Derivatives Association (ISDA)– ISDA provisions are master agreements

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‘Plain Vanilla’ Swap – Hedging Interest Rate Risk

A plain vanilla swap refers to a standard contract with no unusual features or bells and whistles

The swap facilitator will find a counterparty to a desired swap for a fee or take the other side– A facilitator acting as an agent is a swap broker– A swap facilitator taking the other side is a swap

dealer (swap bank)

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Plain Vanilla Swap

The swap price is the fixed rate that the two parties agree upon

The tenor is the term of the swap The notional value determines the size of

the interest rate payments Counterparty risk refers to the risk that one

party to the swap will not honor its part of the agreement

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Plain Vanilla Swap

Plain Vanilla Swap Example

A large firm pays a fixed interest rate to its bondholders, while a smaller firm pays a floating interest rate to its bankers

The two firms could engage in a swap transaction which results in the larger firm paying floating interest rates to the smaller firm, and the smaller firm paying fixed

interest rates to the larger firm

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Plain Vanilla Swap - Motivations

Large firm with a strong credit rating takes advantage of it s borrowing capacity

and borrows fixed term in the bond market interest rate outlook - declining rates enters into a swap agreement to move to

floating rate debt but still leveraging its strong credit rating and borrowing capacity

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Plain Vanilla Swap - Motivations

Smaller firm with weaker credit rating no/minimal access to long term bond market due to

its relatively weak credit rating typically borrows floating rate from its bank(s) would like to fix its borrowing rate as part of its

risk management program can achieve its fixed rate objectives by entering

into a swap agreement

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Plain Vanilla Swap

Plain Vanilla Swap Example (cont’d)

Big Firm Smaller Firm

Bondholders Bankers

LIBOR – 50 bp

8.05%

8.05% LIBOR +100 bp

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Plain Vanilla Swap


A facilitator might act as an agent in the transaction and

charge a 15 bp fee for the service.

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Plain Vanilla Swap


Big Firm Smaller Firm

Bondholders Bankers

8.05% LIBOR +100 bp

Facilitator

LIBOR -50 bp

8.05% 8.20%

LIBOR -50 bp

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Plain Vanilla Swaps - Timing

Swaps can be entered into at same time the firm accesses the bond market - e.g. 5 year fixed rate bond issue immediately swapped into floating rate via a swap agreement

or A swap can be negotiated at any time over the life of

an existing borrowing e.g. 7 year bond issue two years prior - firm now expects interest rates to decline - 5 years remaining on the bond issue - firm enters into a 5 year fixed to floating rate swap

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Interest Rate Risk Management -Considerations

Interest rate outlook over expected borrowing horizon – Use swaps where the borrowing horizon is

longer term– use futures where the interest rate risk is short

term absolute interest rate levels and or yield

curve shape credit or ‘swap’ spreads

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Interest Rate Risk Management Considerations

Interest Rate Outlook– Floating rate alternative if outlook is lower– Fixed rate if outlook is higher

Absolute Levels and Yield Curve– Borrow fixed rate – premium but no risk– Borrow floating rate – at lower rates at shorter end

of the yield curve – but with interest rate risk

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Interest Rate Risk Management Considerations

Fixed to Floating interest rate swap – Outlook for rates lower– Steeper yield curve – lower rates at short end – Absolute borrowing levels– Credit/swap spreads

Floating to Fixed interest rate swap– Outlook for rates higher– Flatter yield curve– Absolute borrowing levels– Credit/swap spreads

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Swap Timing – Anticipating Interest Rate Changes

Interest rate changes need to be anticipated and swaps need to be negotiated ahead of the actual interest rate movement for the buyer to achieve the desired result

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Immunizing With Interest Rate Swaps

Interest rate swaps can be used by corporate treasurers to adjust their exposure to interest rate risk

The duration gap is:

sliabilitieassetgap Dassets Total

sLiabilitie TotalDD

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Immunizing With Interest Rate Swaps (cont’d)

A positive duration gap means a bank’s net worth will suffer if interest rates rise– The treasurer may choose to move the duration

gap to zero This could be accomplished by selling some of the

bank’s loans and holding cash equivalent securities instead

or using interest rate swaps to close the duration gap…how would this be done?

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Exploiting Comparative Advantage in the Credit Market

Interest rate swaps can be used to exploit differentials in the credit market

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Credit Market Example

AAA Bank and BBB Bank currently face the following borrowing possibilities:

Firm Fixed Rate Floating Rate

AAA Current 5-yr

T-bond + 25 bp

LIBOR

BBB Current 5-yr

T-bond + 85 bp

LIBOR + 30 bp

Quality Spread 60 bp 30 bp

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Credit Market Example (cont’d)

AAA Bank has an absolute advantage over BBB in both the fixed and the floating rate markets. AAA has a comparative advantage in the fixed rate market.

The total gain available to be shared among the swap participants is the differential in the fixed rate market minus the differential in the variable rate market, or 30 bps.

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AAA Bank wants to issue a floating rate bond, while BBB wants to borrow at a fixed rate. Both banks will borrow at a lower cost if they agree to an interest rate swap.

AAA Bank should issue a fixed rate bond because it has a comparative advantage in this market. BBB should borrow at a floating rate. The swap terms split the rate savings 50-50. The current 5-yr T-bond rate is 4.50%.

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AAA BBB

Bondholders Bondholders

Treasury + 40 bp

LIBOR

Treasury + 25 bp LIBOR +30 bp

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The net borrowing rate for AAA is LIBOR – 15 bps

The net borrowing rate for BBB is Treasury + 70 bps

The net rate for both parties is 15 bps less than without the swap.

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Foreign Currency Risk

1971 – the Breton Woods Agreement was suspended by global monetary leaders

Currencies previously tied to the price of gold and to the $US now floated freely

The result- currency volatility and currency risk 1972 – CME began trading currency futures 1981 – Salomon Bros brokered the first currency swap

between the World Bank and IBM (German marks Swiss francs)

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Foreign Currency Risk Today

‘Euro’ volatility Weakening US dollar Strengthening Canadian dollar (other ‘resource

currencies)– Impacted Canadian firms and individual investors – E.g. oil & gas producers selling commodities

denominated in $US and Canadian investors investing in US securities

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Foreign Currency Swaps

In a currency swap, two parties

– Exchange currencies at the prevailing exchange rate

– Then make periodic interest payments to each other based on a predetermined pair of interest rates, and

– Re-exchange the original currencies at the conclusion of the swap

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Foreign Currency Swaps (cont’d)

Cash flows at origination:

Euro Principal

C$ PrincipalCdn. Co. Swap Dealer

Bondholders

C$Fixed RateInterest

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Cash flows at each settlement:

Euro Fixed Rate

C$ - Fixed RateCdn. Co. Swap Dealer

C$ Fixed RateInterest

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Cash flows at maturity:

Euro Principal

C $ PrincipalCdn. Co. Swap Dealer

Retire C$Issue

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Circus Swap

Combining both interest rate and currency swaps

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Circus Swap

A circus swap combines an interest rate and a currency swap

– Involves a plain vanilla interest rate swap and an ordinary currency swap

– Both swaps might be with the same counterparty or with different counterparties

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Circus Swap

Interest associated with original currency swap

Euro - Fixed

C$ - Fixed

Cdn. Co. Swap Dealer

Bondholders

Fixed C$ Interest

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Circus Swap

Interest rate swap to move from fixed euros to floating rate euros

Euro Fixed

Euro Floating


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Circus Swap

Circus swap with two counterparties = net position of:

Floating Rate Euros

Fixed Rate C$


Fixed C$

Interest

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Swap Variations

Deferred or ‘forward’ swap Floating for floating swap Amortizing swap Accreting swap

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Deferred Swap

In a deferred swap (forward start swap), the cash flows do not begin until sometime after the initiation of the swap agreement

Motivation - desire to manage future interest rate risk but reflecting today’s interest rate conditions

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Deferred Swap - Example

ABC corporation has a required borrowing 2 years from now

interest rate outlook is for rates trending upward

deferred swap could lock in today’s fixed rates for a premium

a deferred or forward swap is in effect 2 swaps

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ABC Co.Swap Dealer

SwapDealer

Pay 7 year Fixed

Receive BA’s

PayBA’s

Pay 2 yearFixed

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ABC Co. SwapDealer

Pay 7 year (5 years remaining)Fixed

Receive BA’s

...in two years time

Bankers

BorrowFloating

Rate BA’s

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Deferred Swap -

Rate is established today and ‘deferred’ for a period of time

Dealer factors in the ‘cost of carry’ in offering the deferred 5 year rate (one swap)

Considerations– interest rate outlook– time frame– cost of carry - the cost of the ‘hedge’

steep yield curve - higher cost of carry flat yield curve - minimal cost of carry

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Floating for Floating Swap

In a floating for floating swap, both parties pay a floating rate, but with difference benchmark indices

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Amortizing Swap

In an amortizing swap, the notional value declines over time according to some schedule

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Accreting Swap

In an accreting swap, the notional value increases through time according to some schedule

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Interest Rate Options

Interest rate cap Interest rate floor Calculating cap and floor payoffs Interest rate collar Swaption

………similar instruments available on commodities such as oil and gas

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Most of the trading done off the exchange floors

The interest rate options market is– Very large– Highly efficient– Highly liquid– Easy to use

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Growth in Interest Rate OptionsNotional Value

0

5

10

15

1992 1993 1994 1995 1996 1997 1998 1999 2000

(Tril

lions

)

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Interest Rate Cap

An interest rate cap

– Is like a portfolio of European call options (caplets) on an interest rate

On each interest payment date over the life of the cap, one option in the portfolio expires

– Is useful to firms with floating rate liabilities– Caps the periodic interest payments at the

caplet’s exercise price

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Interest Rate Cap (cont’d)

Long interest rate cap (exercise price 7%)

$ Payoff

Option expires worthless

7%Floating Rate

Payoff

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Interest Rate Cap (cont’d)

Short interest rate cap (exercise price 7%)

$ Payoff


7%Floating Rate

Payout

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Interest Rate Floor

An interest rate floor– Is related to a cap in the same way that a put is

related to a call– like a portfolio of European put options

(floorlets) on an interest rate On each interest payment date over the life of the cap,

one option in the portfolio expires

– Is useful to firms with floating rate assets– Puts a lower limit on the periodic interest

payments at the floorlet’s exercise price

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Interest Rate Floor (cont’d)

Long interest rate floor (exercise price 6.5%)

$ Payoff


6.5%Floating Rate

Payoff

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Interest Rate Floor (cont’d)

Short interest rate floor (exercise price 6.5%)

$ Payoff


6.5%Floating Rate

Payout

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Calculating Cap and Floor Payoffs

There are no universally acceptable terms to caps and floors – OTC instruments customized to meet needs of both parties

However, frequently the terms provide for the cash payment on an in-the-money caplet or floorlet to be based on a 360-day year

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Calculating Cap and Floor Payoffs (cont’d)

Cap payout formula:

If the benchmark rate is less than the exercise price, the payout is zero

…..all in borrowing cost will be hedged at the strike price plus the option premium

price) striking-rate (benchmark360

periodpayment in days value)(notionalpayout cap

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Calculating Cap and Floor Payoffs (cont’d)

Floor payout formula:

rate)benchmark - price (striking360

periodpayment in days value)(notionalpayoutfloor

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Interest Rate Collar

An interest rate collar is simultaneously long an interest rate cap and short an interest rate floor

Sacrifices some upside potential in exchange for a lower position cost– Premium from writing the floorlets reduces

position costs

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Interest Rate Collar (cont’d)

$ Payoff

k2

Floating RateInflow

Outflow k1

No payout

Long cap

Short floor

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Swaption

A swaption is an option on a swap Can be either American or European style A payer swaption (put swaption) gives its

owner the right to pay the fixed interest rate on a swap

A receiver swaption (call swaption) gives its owner the right to receive the fixed rate and pay the floating rate

© 2002 South-Western Publishing 1 Chapter 13 Swaps and Interest Rate Options.

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