1 TREASURY MANAGEMENT Chapter 14 Interest Rate Swap Swaps Two parties exchange recurring payments (most commonly) the feature of recurring payments distinguishes a swap from a forward contract but, some swaps involve only a single exchange (Thus, in practice it’s a swap if it is written up on swap documentation. That is, it’s a swap if it’s called a swap.) Similar to series of forward contracts Common types: interest rate, currency, equity, commodity This class introduces interest rate swaps Note: LIBOR is London In terbank Offered Rat e Fixed-Rate Payer Fixed-Rate Receiver Floating Rate (LIBOR) X Notional Principal Fixed Rate of 7.00% X Notional Principal Cash flow diagram of interest rate swap
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the feature of recurring payments distinguishes aswap from a forward contract
but, some swaps involve only a single exchange(Thus, in practice it’s a swap if it is written up on swapdocumentation. That is, it’s a swap if it’s called a swap.)
Payment Date: Following and ModifiedFollowing Business Day Convention
The following business (banking) day conventionstates that the payment date is the first followingday that is a business day.
The modified following business (banking) dayconvention states that the payment date is thefirst following day that is a business day, unlessthat day falls in the next calendar month. In thiscase only, the maturity date will be the firstpreceeding business day.
Most common market practice is to use theModified Following Business Day Convention, butthe Following Business Day Convention issometimes used (for example, in the confirmationabove)
Adjusted versus unadjusted
Example from the fixed leg of a swap:
Fixed rate 6%, 30/360, Modified Following,scheduled payment date is 15 April,
But, 15 April is Saturday
Modified Following ⇒ payment is made/received onMonday, 17 April
Question: How large is the interest payment?
Is it (180/360)×0.06×N ? (N = notionalamount of swap)
Or do we add 2 days to the payment period, i.e. isthe payment (182/360)×0.06×N ?
(If we add 2 days to this payment period, we wouldalso then subtract 2 days from the next paymentperiod)
Adjusted versus unadjusted
Unadjusted: shift payment date, but do not change theamount of the payment
payment = (180/360)×0.06×N
Interest payments on bonds are generally unadjusted, i.e. if thepayment date gets shifted due to a weekend or holiday, thepayment amount is not changed
Adjusted: shift payment date and change the interestaccrual (that is, change the amount of the payment)
payment = (182/360)×0.06×N
Most commonly, but not always, swap payments are adjusted.Swap payments might be unadjusted if the swap is intended toexactly hedge an underlying bond on which payments areunadjusted.
Discussion of the confirmation:Adjustment to floating rate option
Adjustment to floating rate option: if there is an adjustment to the floating
rate it usually comes in the form of adding or subtracting an amount, e.g.LIBOR + 40 basis points
in fact, the most common “adjustment” is no adjustment, i.e. LIBOR + 0 basispoints or “LIBOR flat”
In this deal, I have no idea why theadjustment comes in the form of dividing by 0.97
Confirmation: Notional amount
Notional amount (orprincipal):
Most commonly thenotional amount is justa number, e.g. $100million
In this swap thenotional amount variesover time because theswap was being usedto hedge a loan with aprincipal amount thatchanged over time asprincipal paymentswere made
Changes in notional amount reflect fact that:
(a) LEU borrowed $75 million(b) repaid $5 million on 15 Jan 1990
(c) Repaid $10 million on 15 Jan 1991
(d) Repaid the remaining $60 million on 15 Jan 1992
It is crucial to understand that the cash flow on say 7/17/89 is based on LIBOR observedon 4/13/89, …., cash flow on 1/15/92 is based on LIBOR observed on 10/11/91.
Days for Fraction Cash Flow Days for Fraction Cash Flow
Trade P ayment Reset Not ional LIBOR on Floating Float ing Due t o Floati ng Fi xed Fixed F ixed Due t o Fi xed Net C ashDate Date Date Amount reset date Payment Payment Payment Rate Payment Payment Payment Flow
For each maturity/tenor, the spread would be added to the yield on the “current” Treasury note of the same maturity. For example, if the dealer pays fixed on a 5 year swap, the fixed rate of theswap would be equal to the yield on the 5 year note plus 30 basis. If the dealer pays floating andreceives fixed, the fixed rate of the swap would be equal to the yield on the 5 year note plus 35basis points.
Swap Quotes from GovPX
(4.420+4.416)/2 + 0.51 = 4.928
Using a swap: A stylized example
Company issued a $200 millionfloating rate note with interestpayments based on 3-mo. LIBOR
What is going on in this transaction? Each swap has value = 0 on the trade date (that is, the
present value of the cash flows over the life of swap = 0)
Thus, PV of the net cash flows of the 2 swaps together = 0
But, cash flows over first 2 years (times 0.5, 1, 1.5, 2) > 0
Thus, the present value of the cash flows during the nextthree years (times 2.5, …, 5) must be < 0
Gibson has shifted income from years 3through 5 into years 1 and 2.
Remarks re the Gibson/BTtransaction
This transaction “worked” to shift income because the 5-year swap rate (7.12%) exceeded the 2-year swap rate(5.91%)
If the 2-year rate was greater than the 5-year rate, thenthe opposite positions in the swaps would achieve thesame effect
Gibson could shift as much income as it wanted byincreasing the notional principal of the swaps
Why might such a transaction be appealing to Gibson?
The transaction will not shift income if the swaps areaccounted for on a fair value or “mark-to-market” basis(but it will still shift cash flows, that is it will still beequivalent to borrowing)
Other swaps
Ordinary (“plain-vanilla”) swap: swapfixed for floating
Basis swap: swap one floating rate foranother
Currency swaps: the two legs aredenominated in different currencies
Both, either, or neither legs may be fixed
In a currency swap, principals typically areexchanged