© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ■describe the types of interest rate swaps ■describe interest rate caps ■describe credit default swaps (CDS) ■describe currency swaps 15 Swap Markets Chapter Objectives 1

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest rate swap An interest rate swap is an arrangement whereby one party exchanges one set of interest payments for another. The provisions of an interest rate swap include: ■ The notional principal value to which the interest rates are applied to determine the interest payments. ■ The fixed interest rate. ■ The formula and type of index used to determine the floating rate. ■ The frequency of payments, such as every six months or every year. ■ The lifetime of the swap. 2

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background ■An example of a swap is an agreement to exchange 11 percent fixed-rate payments for floating payments at the prevailing one-year Treasury bill plus 1 percent based on $30 million notional principal. ■Swap payments are usually netted. ■The market for swaps is facilitated by over-the-counter trading rather than trading on an organized exchange. 3

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background Use of Swaps for Hedging  Financial institutions in the U.S. with more interest rate sensitive liabilities than assets were adversely affected by increasing interest rates.  Financial institutions such as commercial banks, savings institutions, insurance companies, and pension funds that are exposed to interest rate movements commonly engage in swaps to reduce interest rate risk. 4

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background Use of Swaps for Speculating  When the swap is used for speculating rather than for hedging, any loss on the swap positions will not be offset by gains from other operations. 5

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 15.2 Participation of Financial Institutions in Swap Markets 6

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Plain Vanilla Swaps Plain Vanilla Swaps (fixed-for-floating swap)  Fixed-rate payments are periodically exchanged for floating-rate payments.  Example: Bank of Orlando on page 413, fixed rate of 9% for floating of LIBOR+1%, notional principal is $100 million. (Exhibits 15.3 & 15.4)) 7

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 15.4 Possible Effects of a Plain Vanilla Swap Agreement (Fixed Rate of 9 Percent in Exchange for Floating Rate of LIBOR + 1 Percent) 8

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 15.3 Illustration of a Plain Vanilla (Fixed- for-Floating) Swap 9

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest rate swap application 1 Converting a fixed-rate asset into a floating-rate asset Savings and loans associations accept deposits and lend those funds for long-term mortgages. Deposits are usually short-term and the rates adjust to the market quickly. Mortgage loans are usually borrowed at a fixed rate for a long time. floating-rate liabilities vs. fixed-rate assets risk from rising rates 10

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest rate swap application 1 ■A bank lends $1 million for five 9% with annual payment. ■It pays a deposit rate that equals LIBOR minus 1%. ■It will lose money if LIBOR exceeds 10%. 11

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest rate swap application 1 ■Before interest rate swap 12 Bank Depositors Mortgagor Floating: LIBOR - 1% Fixed: 9%

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest rate swap application 1 ■After interest rate swap 13 BankSwap Dealer Depositors Fixed: 9% Floating: LIBOR Mortgagor Floating: LIBOR - 1% Fixed: 9%

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest rate swap application 2 (transform liability cost from floating to fixed) Two years ago Microsoft arranged a 5-year loan of $100 million at LIBOR+0.1%. Now it expects that LIBOR will rise in the following years. A three-year swap between Microsoft and swap dealer: Microsoft pays the dealer 5% p.a. on notional principal of $100 million, and the dealer pays LIBOR. Interest cost: - (LIBOR+0.1%) to lender + LIBOR under swap - 5% under the swap - 5.1% 14

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest rate swap application 3 (transform liability cost from fixed to floating) Two years ago Intel arranged a 7-year $100 million loan on which it pays 5.2%. Now it expects that interest rates will decline in the following years. A five-year swap between swap dealer and Intel: the dealer pays Intel 5% p.a. on notional principal of $100 million, and Intel pays LIBOR. Interest cost - 5.2% to its lenders - LIBOR under swap + 5% under the swap = - (LIBOR+0.2%) 15

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest rate swap application 4 (transform asset return from fixed to floating) Microsoft invested $100 million bonds issued by IBM that provides interest at 5 % p.a. over the next three years. Now it expects that the interest rates will rise in the following years. A three-year swap between Microsoft and a swap dealer: Microsoft pays the dealer 5% p.a. on notional principal of $100 million, and the dealer pays LIBOR. Investment return + 5 % on the IBM bonds + LIBOR under swap - 5% under the swap + LIBOR 16

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Forward Swaps  Involves an exchange of interest payments that does not begin until a specified future time.  Useful for financial institutions or other firms that expect to be exposed to interest rate risk at some time in the future.  Example of Detroit Bank on page 414 (Exhibit 15.5). If the bank waits until then to negotiate a swap, the fixed rate will likely be higher. 17

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 15.5 Illustration of a Forward Swap 18

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Callable Swaps  Gives the party making the fixed payments the right to terminate the swap prior to its maturity.  It allows the fixed-rate payer to avoid exchanging future interest payments if it desires. (Exhibit 15.6) 19

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 15.6 Illustration of a Callable Swap 20 do not exercise the option exercise the option

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Putable Swaps  Gives the party making the floating-rate payments the right to terminate the swap.  A putable swap allows the institution to terminate the swap in the event that interest rates rise (Exhibit 15.7) 21

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 15.7 Illustration of a Putable Swap 22 exercise the optiondo not exercise the option

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Extendable Swaps  Contains a feature that allows the fixed-for-floating party to extend the swap period.  The terms of an extendable swap reflect a price paid for the extendibility feature.  Example of Cleveland Bank on page 416 (Exhibit 15.8). 23

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 15.8 Illustration of an Extendable Swap 24

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Zero-Coupon-for-Floating Swaps  The fixed-rate payer makes a single payment at the maturity date of the swap agreement, and the floating- rate payer makes periodic payments throughout the swap period.  The fixed-rate payer may has large holdings of zero- coupon bonds that will mature after 7 years and has become concerned that interest rates will rise over time, which increases its cost of funds (Exhibit 15.9). 25

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 15.9 Illustration of a Zero-Coupon-for- Floating Swap 26

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Rate-Capped Swaps  Involves the exchange of fixed-rate payments for floating-rate payments that are capped. (Exhibit 15.10) 27

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit Illustration of a Rate-Capped Swap 28

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Equity Swaps  Equity Swaps - Involves the exchange of interest payments for payments linked to the degree of change in a stock index.  Example: fixed 7% for S&P500 index return each year over a four-year period. 29 Party AParty B S&P500 return Fixed 7%

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Risks of Interest Rate Swaps  Basis risk: The interest rate of the index used for an interest rate swap will not necessarily move perfectly in tandem with the floating-rate instruments of the parties involved in the swap. Basis risk prevents the interest rate swap from completely eliminating the financial institutions exposure to interest rate risk.  Credit risk that a firm involved in an interest rate swap will not meet its payment obligations.  Sovereign risk that reflects potential adverse effects resulting from a country’s political conditions. 30

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Rate Caps  Offers payments in periods when a specified interest rate index exceeds a specified ceiling (cap) interest rate.  The payments are based on the amount by which the interest rate exceeds the ceiling, multiplied as usual by the notional principal specified in the agreement.  The buyer of a cap is a financial institution that would be adversely affected by rising interest rates.  The seller of a cap receives the fee and is obligated to provide payments when rates exceed the ceiling rate. 31

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit Illustration of an Interest Rate Cap 32 Example: Buffalo Savings Bank on page 423, a fee of 4% of notional principal at $60 million, interest rate ceiling of 10%, LIBOR is the index

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Credit Default Swaps  A privately negotiated contract that protects investors against the risk of default on particular debt securities.  The main participants in the CDS market are commercial banks, insurance companies, hedge funds, and securities firms.  One party is the buyer, who is willing to provide periodic (usually quarterly) payments to the other party, the seller.  The seller receives the payments from the buyer but is obligated to reimburse the buyer par value if the securities specified in the swap agreement default. 33

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Credit Default Swaps Payments on a Credit Default Swap  When economic growth is strong, the payments required on most CDS should be relatively low because the default risk is usually low.  When economic conditions are weak, the payments required on most CDS should be relatively high because the default risk is high. 34

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Development of the CDS Market  Credit default swaps were created in the 1990s as a way to protect bondholders from default risk.  Over time, CDS contracts were adapted to protect investors that purchased mortgage-backed securities.  As the housing market began to weaken in 2006, investors purchased CDS contracts as protection against the default of these mortgage-backed securities.  During the credit crisis, many MBS defaulted; this generated large profits for the buyers of CDS contracts and major losses for the sellers.  When Lehman Brothers went bankrupt in September 2008, it did not cover all of its CDS obligations. Thus, many financial institutions that had purchased CDS contracts from Lehman were not protected. 35

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Currency Swaps  Arrangements whereby currencies are exchanged at specified exchange rates and at specified intervals.  Example of Springfield on page 431 (Exhibit 15.16).  How does the cash flow chart look like? 36

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Homework Assignment 13 Chapter 15 ■Questions and applications: 1, 7, 10. ■Problems: 1, 2. 37