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7 Interest Rate Risk

2 the interest rates are usually based on libor and

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Unformatted text preview: and will receive $rxA of interest at the fixed rate from F. 3) Neither F nor X is lending to the other, and the notional principal never changes hands; F and X are simply swapping income streams. Ec 174 INTEREST RATE RISK p. 13 of 17 b) Who does this? 1) Depository institutions (commercial banks, S&Ls, credit unions and other “thrifts”). • They pay short term (floating) interest rates on savings accounts and time deposits to attract depositors and obtain capital with which to make loans. • They make long- term fixed rate loans to businesses and home buyers. • When market rates rise, banks must raise rates they pay on deposits or else they will lose all their accounts. But they cannot change the fixed rates earned on their portfolio of loans outstanding. This caused the S&L crisis of 1979- 80. • Banks might like to swap fixed rate income streams from long- term loans for floating rate streams that will rise and fall with short- term deposit liabilities. 2) Managers of bond portfolios and pension funds invested in fixed- income securities. • These portfolios receive a relatively fixed stream of coupon interest earnings. • The managers might wish to keep the portfolio intact, but suspect that interest rates are about to rise. • If rates and YTM are about to rise, bond prices are about to fall, and a portfolio manager would like to sell the portfolio now and invest in short- term securities until bond prices fall, at which point they could switch back to longer term securities and lock in the higher yields. • Rather than incur transactions costs to sell all the bonds now and buy back later, the manager could enter a swap in which the portfolio pays a fixed rate (which it earns on its bonds) and receives a floating rate (expected to rise). 3) A corporation might have issued long- term bonds at a fixed rate of coupon interest. • If the corporation thinks that interest rates are about to fall, it would like to call back its bonds and refinance with a new issue at the lower rate. • If the bonds were not callable when originally issued, the financing from the new issue could buy back the old issue, but transactions costs will be very high. • Rather than incur high refi costs, the corp could enter a swap in which the corp pays a floating rate (expected to fall) and receives a fixed rate (which is used to pay its fixed- rate coupon interest obligations). c) A numerical example. rx = 2.757%/yr Table 5 – Two- Year Swap LIBOR Fl. CF Fix CF Net CF Date 1) X and L enter a 2- year rℓ (to F) (to X) (to X) interest rate swap on Feb 15 Feb ‘08 2.9694% 15, 2008. 15 Aug ‘08 3.1181% $148,470 $137,850 –$10,620 • The two- yr swap rate 15 Feb ‘09 1.7644% $155,905 $137,850 –$18,055 rx = 2.757%/yr. 15 Aug ‘09 ? $88,220 $137,850 $49,630 • Notional A = $10m. 15 Feb ‘10 ? ? $137,850 ? • Fl. rate rℓ = 6- month LIBOR at beginning of period. • Cash flows are paid at the end of the period. • Use discrete semiannual compounding. 2) Table 5 shows the payment schedule (for actual 6- mo...
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