Risk Management Hedging with Swaps 1 Copyright 2014 Diane Scott Docking.

Risk Management Hedging with Swaps

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Copyright 2014 Diane Scott Docking


Terminology, Conventions and Market Quotes

Fixed-Rate payer Pays fixed rate in the swap Receives floating rate in the swap Is considered the buyer of a swap Is long a swap; but Has entered into a short hedge

• Why?• You are E(i) to increase (want to be paying the FR);

therefore, Prices to decrease. Has constructed a position with the price

sensitivities of a longer-term liability and a floating-rate asset (ST Asset funded by a LT liability)

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Terminology, Conventions and Market Quotes

Floating-Rate payer Pays floating rate in the swap Receives fixed rate in the swap Is considered the seller of a swap Is short a swap; but Has entered into a long hedge

• Why?• You are E(i) to decrease (want to be paying the VR);

therefore, Prices to increase. Has constructed a position with the price

sensitivities of a longer-term asset and a floating-rate liability (LT Asset funded by a ST liability)

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Copyright 2014 Diane Scott Docking4

Plain Vanilla Interest Rate Swap


Plain Vanilla Swap:Interest Rate Debt or Revenue Swap

Involves periodic exchange of fixed-rate payments for floating-rate payments No actual transfer of principal, only interest payments on debt or

investment/loan contracts. Useful in managing interest rate gap problems in FIs

BEFORE SWAP

Firm 1Fixed rate assetsVariable rate liabilities

Firm 2Variable rate assetsFixed rate liabilities

AFTER SWAP

Firm 1Fixed rate assetsFixed rate liabilities

Firm 2Variable rate assetsVariable rate liabilities

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Concerned if interest rates decrease

Concerned if interest rates increase

Example: Analyzing & Constructing an Interest Rate Debt Swap

Town Bank and Country Bank have the following opportunities for borrowing in the

short-term (floating rate) and long-term (fixed rate) markets:

Town Bank Country Bank

Floating Rate T-bill + 1.0% T-bill + 2.0%

Fixed Rate 8% 10.5%

Town Bank has a positive gap and Country Bank has a negative gap.

1. Show how both banks can benefit from a swap in the sense of lowering their interest rate risk and their cost of funds. Assume any potential savings is split ⅔ to Town and ⅓ to Country.

2. Based upon your swap construction in #1, what is the net payover amount (in $) for the next 4 years given the following information:

Notional amount = $1,000,000

T-bill rates:

Year 1 = 6%; Year 2 = 8%; Year 3 = 3%; Year 4 = 10%


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Solution to Example: Analyzing & Constructing an Interest Rate Debt Swap

1.a) Need the opposite regarding desired payments

1.b) Need savings potential


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Given:

ISGAP is: Receive PayCountry Bank Negative: ISA<ISL

Town Bank Positive: ISA>ISL

Therefore Bank wants to:

L-T / FR S-T / VRCountry Bank 10.50% T + 2.0%Town Bank 8.00% T + 1.0%Premium Difference

Savings


1.c) LT premium > ST premium (usually is the required case)

So, YES a swap is possible between the two parties!

2.a) Allocate potential savings between the two parties. Assume any potential savings is split ⅔ to Town and ⅓ to Country.

Savings to Town: ⅔ x 1.50% = 1.00%

Savings to Country: ⅓ x 1.50% = 0.50%


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L-T / FR S-T / VRCountry Bank 10.50% T + 2.0%Town Bank 8.00% T + 1.0%Premium Difference 2.50% 1.00% 1.50%

Savings>


2.b) Construct the Swap


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1 (want LT) (want ST)Country Bank Town Bank

5 Borrow ST Borrow LT6 Pay FR Receive FR7 Receive VR Pay VR4 Costs w/ swap3 Costs w/o swap2 Savings

Swap Terms


2.c) Determine Payover rate, and who pays whom and when.

Payover rate = FR – VR under terms of the swap.

Payover rate = 8.00% - T%

If T ____ 8%; a wash

If T ____ 8%; Town pays Country: (T% - 8%) x Notional Amount

If T ____ 8%; Country pays Town: (8% - T%) x Notional Amount


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What is the net payover amount (in $) for the next 4 years given the following information:

Notional amount = $1,000,000

T-bill rates:

Year 1 = 6%; Year 2 = 8%; Year 3 = 3%; Year 4 = 10%


Notional Amount= $1,000,000Year T-bill rate Net Payover Who pays Whom Amount

1 6% T < 8% Country pays Town = (8%-6%) x $1,000,000 =2 8% T = 8% a wash3 3% T < 8% Country pays Town = (8%-3%) x $1,000,000 =4 10% T > 8% Town pays Country = (10%-8%)x$1,000,000 =


Variable-Rate Payments at LIBOR + ½%

Fixed-Rate Payments at 9½%

Investors inFixed-Rate

Bonds Issuedby Quality Co.

Risky Co.Quality Co.

Fixed-RatePaymentsat 9%

Investors in Variable-RateBonds Issuedby Risky Co.

Variable-RatePayments

at LIBOR + 1%• Borrower with lower credit rating

pays fixed payments of borrower with higher credit rating, while

• Borrower with higher credit rating pays short-term floating rate of borrower with lower credit rating

Plain Vanilla Swap #2Quality Interest Rate Swap


Example: Analyzing & Constructing a Quality Interest Rate Swap

Risky Bank can borrow short-term at Prime + 1.75% and long-term at 11.50%. Safe Bank can borrow short-term at Prime and long-term at 9%.

Risky Bank wants to borrow long-term, but feels their long-term rate is too expensive. Safe Bank wants to borrow short-term and is always looking for a way to lower its short-term borrowing rate.

1. Could a swap be constructed between Risky and Safe Bank that would be advantageous to both? If so, how? What would be the potential savings?

2. Construct a swap. Assume any potential savings is split 2/3 to Risky Bank and 1/3 to Safe Bank.

3. What is the net payover rate and who will pay whom?


Solution to Example: Analyzing & Constructing a Quality Interest Rate Swap

Given: Need the opposite

LT rate ST rate Receive Pay (Debt)Safe Bank 9.00% P%Risky Bank 11.50% P + 1.75%

Therefore Bank wants to


Solution to Example: Analyzing & Constructing a Quality Interest Rate Swap (cont.)

1. Safe & Risky

A swap IS possible. Safe and Risky want the opposite, thereis a potential savings, and the LT premium is > than the ST premium.

L-T/Fixed rates S-T/Variable ratesRisky Bank 11.50% P + 1.75%Safe Bank 9.00% P%

Savings

>



2.1) (want LT) (want ST)

Risky Bank Safe Bank5) Borrow ST Borrow LT6) Pay FR Receive FR7) Receive VR Pay VR4) Costs w/ swap3) Costs w/o swap2) Savings

Assume savings split is 1/3 to Safe and 2/3 to Risky.



3. Payover rate = FR - VR = 9% - (P-0.25%) = 9.25% - PIf P = 9.25%, a washIf P > 9.25%, Safe pays Risky P% - 9.25%If P < 9.25%, Risky pays Safe 9.25% - P%

Regulation

The Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have implemented uniform guidelines that require banks to: establish internal guidelines regarding hedging activity establish trading limits disclose large contract positions that materially affect the risk to

shareholders and outside investors As of 2000 the FASB requires all firms to reflect the marked-to-market

value of their derivatives positions in their financial statements Prior to the Dodd-Frank Act, swap markets were governed by relatively

little regulation—except indirectly at FIs through bank regulatory agencies

The Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have implemented uniform guidelines that require banks to: establish internal guidelines regarding hedging activity establish trading limits disclose large contract positions that materially affect the risk to

shareholders and outside investors As of 2000 the FASB requires all firms to reflect the marked-to-market

value of their derivatives positions in their financial statements Prior to the Dodd-Frank Act, swap markets were governed by relatively

little regulation—except indirectly at FIs through bank regulatory agencies

18 Copyright 2014 Diane Scott Docking

Regulation

The Dodd-Frank Act of 2010 requires most OTC derivatives to be exchange-traded to ensure performance by all parties

The act also requires OTC derivatives be regulated by the SEC and/or the CFTC

The Dodd-Frank Act of 2010 requires most OTC derivatives to be exchange-traded to ensure performance by all parties

The act also requires OTC derivatives be regulated by the SEC and/or the CFTC

19 Copyright 2014 Diane Scott Docking

Risk Management Hedging with Swaps 1 Copyright 2014 Diane Scott Docking.

Documents

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