Interest Rate Swaps Berk Ahishalioglu 06.04.2013

Presentation Overview Required Terminology Interest Swap Market Mechanics of Interest Rate Swaps Risks in Interest Rate Swaps Q&A Session

Interest Rate Swap Swap: A derivative instrument in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. NOT DEBT INSTRUMENT! Interest Rate Swaps Currency Swaps Credit Swaps Commodity Swaps Equity Swaps Interest Rate Swap: A transaction between two so-called counterparties in which fixed and floating interest-rate payments on a notional amount of principal are exchanged over a specified term. THE NOTIONAL AMOUNT ITSELF IS NEVER EXCHANGED!

Facts about Swap Market The majority of the swaps are traded over-the-counter (OTC). 70% of the global OTC derivatives markets is swaps. The outstanding amount of the interest rate swap is above 77% of all the international OTC derivative market Interest rate swap market is one of the largest and most liquid global financial markets.

Bank for International Settlements

Financial Intermediary In practice, the swap counterparties do not interact directly. A financial institution intervenes. Financial intermediary holds two separate swap contracts with each counterparty. It has two basic functions. It maintains the swap stock. Financial intermediary undertakes the interest rate risk for both counterparties.

Mechanics of Interest Rate Swaps Fixed-Rate Floating-Rate Company A 12% LIBOR+0.1% Company B 13.4% LIBOR+0.6% Company A and Company B have been offered the following rates per annum on a $20M 5-year loan. Calculate the relative gains (quality spread) between fixed and floating markets for A and B. Δfix= 13.4%-12%=1.4% (140b.p.) Δfloating=(LIBOR+0.6%)-(LIBOR+0.1%)=0.5 (50b.p.)

Mechanics of Interest Rate Swaps Comparative Advantage Theory One entity may have an advantage in fixed-rate markets. One entity may have an advantage in floating-rate markets. Comparative Advantage Theory is one of the main reasons for the rapid growth of the interest rate swaps. Which company has a comparative advantage in fixed-rate markets ? A or B ? 2) Calculate the comparative advantage gain. Comparative advantage gain= Δfix-Δfloating Comparative advantage gain=1.4%-0.5%=0.9% (90 b.p.)

Mechanics of Interest Rate Swaps Before Swap Agreement Company A borrowed $20 M at 12% fixed rate. Company B borrowed $20 M at LIBOR+0.6% floating rate. After Swap Agreement The terms offered to Company A by financial intermediary are as follows: Every six months, Company A will pay LIBOR to the intermediary. Every six months, the intermediary will pay 12% (annual rate) to Company A. The terms offered to Company B by financial intermediary are as follows: Every six months, Company B will pay 12.1% (annual rate) to the intermediary. Every six months, the intermediary will pay LIBOR to the Company B.

Mechanics of Interest Rate Swaps From Company A’s Perspective Annual Interest Rate Paid: 12%+LIBOR Annual Interest Rate Received: 12% Net Cost: 12%+LIBOR-12%=LIBOR Gain: Original Floating-Rate-Net Cost of Swap Agreement for Company A Gain: LIBOR+0.1%-LIBOR=0.1% (10 b.s.) From Company B’s Perspective Annual Interest Rate Paid: 12.1%+LIBOR+0.6% Annual Interest Rate Received: LIBOR Net Cost: 12.1%+LIBOR+0.6%-LIBOR=12.7% Gain: Original Fixed-Rate-Net Cost of Swap Agreement for Company B Gain: 13.4%-12.7%=0.7% (70 b.s.)

Mechanics of Interest Rate Swaps From Financial Intermediary’s Perspective Annual Interest Rate Paid: 12%+LIBOR Annual Interest Rate Received: 12.1%+LIBOR Gain: Annual Interest Rate Received-Annual Interest Rate Paid Gain: (12.1%+LIBOR)-(12%+LIBOR)=0.1% (10b.s.) Comparative advantage gain= 0.9% (90b.s.) Gain for Company A: 0.1% (10b.s.) Gain for Company B: 0.7% (70b.s.) Gain for Financial Intermediary: 0.1% (10b.s.) The difference in spreads provides an opportunity for both counterparties to reduce the cost of raising funds.

Potential Benefits of Interest Rate Swaps Reducing Borrowing Costs Matching Assets and Liabilities An asset swap permits the two financial institutions to alter the cash flow characteristics of its assets: from fixed to floating or from floating to fixed. A liability swap permits two institutions to change the cash flow nature of their liabilities Manage Interest Rate Risks

Risk/Return Profile of Counterparties to an Interest Rate Swap Interest Rates Decrease Interest Rates Increase Floating-Rate Payer Gain Loss Fixed-Rate Payer The value of an interest rate swap fluctuates with market interest rates.

Risks of Interest Rate Swaps Price Risk Warehousing Swaps: Arranging a swap contract with one counterparty without having arranged an offsetting swap with another counterparty. Credit Risk Exposure to the risk of failure of a counterparty. In swap contracts, there are two most basic forms of risk; these are price risk and credit risk.

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