13
Swaps Chapter and Interest Rate Options
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2002 South-Western Publishing
Outline
Introduction 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
Introduction Immunizing
with interest rate swaps Exploiting 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:
asset liability
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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 BAs 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
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
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 (contd)
LIBOR 50 bp
Big Firm
8.05%
8.05%
Smaller Firm
LIBOR +100 bp
Bondholders
Bankers
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Plain Vanilla Swap
Plain Vanilla Swap Example
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
Plain Vanilla Swap Example
LIBOR -50 bp LIBOR -50 bp
Big Firm
8.05%
8.05%
Facilitator
8.20%
Smaller Firm
LIBOR +100 bp
Bondholders
Bankers
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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 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 swap fixed to floating rate swap
or
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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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Interest Rate Risk Management -Considerations
Interest
rate outlook over expected borrowing
horizon absoute interest rate levels and or yield curve shape credit or swap spreads
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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:
D gap
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Total Liabilities = D asset D liabilities Total assets
Immunizing With Interest Rate Swaps (contd)
A
positive duration gap means a banks 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 banks loans and holding cash equivalent securities instead interest rate swaps to close the duration gap
or
using
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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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Exploiting Comparative Advantage in the Credit Market
Credit Market Example
AAA Bank and BBB Bank currently face the following borrowing possibilities:
Firm AAA Fixed Rate Current 5-yr T-bond + 25 bp Current 5-yr T-bond + 85 bp 60 bp Floating Rate LIBOR
BBB
LIBOR + 30 bp
Quality Spread
30 bp
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Exploiting Comparative Advantage in the Credit Market
Credit Market Example (contd)
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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Exploiting Comparative Advantage in the Credit Market
Credit Market Example (contd)
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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Exploiting Comparative Advantage in the Credit Market
Credit Market Example (contd)
Treasury + 40 bp
AAA
Treasury + 25 bp
LIBOR
BBB
LIBOR +30 bp
Bondholders
Bondholders
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Exploiting Advantage Comparative in the Credit Market
Credit Market Example (contd)
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 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 (contd)
Cash
flows at origination: Euro Principal
Cdn Co.
Swap Dealer
C$ Principal
Fixed Rate Interest
C$
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Bondholders
Foreign Currency Swaps (contd)
Cash
flows at each settlement: Euro Fixed Rate
Cdn. Co.
Swap Dealer
C$ - Fixed Rate
C$ Fixed Rate Interest
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Foreign Currency Swaps (contd)
Cash
flows at maturity: Euro Principal
Cdn. Co.
Swap Dealer
C $ Principal
Retire C$ Issue
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Circus Swap
Introduction Swap
variations
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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
Cdn. Co.
Swap Dealer
Fixed C$ Interest
C$ - Fixed
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Bondholders
Circus Swap
Interest
rate swap to move from fixed euros to floating rate euros Euro Fixed
Cdn. Co. Swap Dealer
Euro Floating
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Circus Swap
Circus
swap with two counterparties (contd): Floating Rate Euros
Cdn. Co. Swap Dealer
Fixed C$ Interest
Fixed Rate C$
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Swap Variations
Deferred
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 todays interest rate conditions
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Deferred Swap
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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 todays fixed rates for a premium a deferred or forward swap is in effect 2 swaps
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Deferred Swap - Example
Pay 2 year Fixed
Pay 7 year Fixed
Swap Dealer
Pay BAs
ABC Co.
Receive BAs
Swap Dealer
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Deferred Swap - Example
...in two years time
Pay 7 year (5 years remaining) Fixed
ABC Co.
Receive BAs
Swap Dealer
Borrow Floating Rate BAs Bankers
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Deferred Swap 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
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Interest Rate Options
Most
of the trading done off the exchange floors interest rate options market is
The
Very large Highly efficient Highly liquid Easy to use
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Interest Rate Options
Growth in Interest Rate Options Notional Value
15
(Trillions)
10 5 0 1992 1993 1994 1995 1996 1997 1998 1999 2000
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Interest Rate Cap
An
interest rate cap
Is like a portfolio of European call options (caplets) on a...