Irwin/McGraw-Hill 1 Swaps Chapter 26 Financial Institutions Management, 3/e By Anthony Saunders

Irwin/McGraw-Hill 2 Introduction n Market for swaps has grown enormously n Serious regulatory concerns regarding credit risk exposures Motivated BIS risk-based capital reforms Growth in exotic swaps such as inverse floater generated controversy (e.g., Orange County, CA). n Generic swaps in order of quantitative importance: interest rate, currency, commodity.

Irwin/McGraw-Hill 3 Interest Rate Swaps n Interest rate swap as succession of forwards. Swap buyer agrees to pay fixed-rate Swap seller agrees to pay floating-rate. n Purpose of swap Allows FIs to economically convert variable- rate instruments into fixed-rate (or vice versa) in order to better match assets and liabilities.

Irwin/McGraw-Hill 4 Interest Rate Swap Example Consider money center bank that has raised $100 million by issuing 4-year notes with 10% fixed coupons. On asset side: C&I loans linked to LIBOR. Duration gap is negative. D A - kD L < 0 Second party is savings bank with $100 million in fixed-rate mortgages of long duration funded with CDs having duration of 1 year. D A - kD L > 0

Irwin/McGraw-Hill 5 Example (continued) Savings bank can reduce duration gap by buying a swap (taking fixed-payment side). Notional value of the swap is $100 million. Maturity is 4 years with 10% fixed-payments. Suppose that LIBOR currently equals 8% and bank agrees to pay LIBOR + 2%.

Irwin/McGraw-Hill 6 Realized Cash Flows on Swap n Suppose realized rates are as follows End of YearLIBOR 1 9% 2 9% 3 7% 4 6%

Irwin/McGraw-Hill 7 Swap Payments End of LIBORMCBSavings Year+ 2%PaymentBank Net 111%$11$ Total

Irwin/McGraw-Hill 8 Off-market Swaps n Swaps can be molded to suit needs Special interest terms Varying notional value »Increasing or decreasing over life of swap. Structured-note inverse floater »Example: Government agency issues note with coupon equal to 7 percent minus LIBOR and converts it into a LIBOR liability through a swap.

Irwin/McGraw-Hill 9 Macrohedging with Swaps n Assume a thrift has positive gap such that  E = -(D A - kD L )A [  R/(1+R)] >0 if rates rise. Suppose choose to hedge with 10-year swaps. Fixed- rate payments are equivalent to payments on a 10- year T-bond. Floating-rate payments repriced to LIBOR every year. Changes in swap value DS, depend on duration difference (D 10 - D 1 ).  S = -(D Fixed - D Float ) × N S × [  R/(1+R)]

Irwin/McGraw-Hill 10 Macrohedging (continued) n Optimal notional value requires  S =  E -(D Fixed - D Float ) × N S × [  R/(1+R)] = -(D A - kD L ) × A × [  R/(1+R)] N S = [(D A - kD L ) × A]/(D Fixed - D Float )

Irwin/McGraw-Hill 11 Pricing an Interest Rate Swap n Example: Assume 4-year swap with fixed payments at end of year. We derive expected one-year rates from the yield curve treating the individual payments as separate zero-coupon bonds and iterating forward.

Irwin/McGraw-Hill 12 Currency Swaps n Fixed-Fixed Example: U.S. bank with fixed-rate assets denominated in dollars, partly financed with £50 million in 4-year 10 percent (fixed) notes. By comparison, U.K. bank has assets partly funded by $100 million 4-year 10 percent notes. Solution: Enter into currency swap. n Fixed-Floating currency swaps.

Irwin/McGraw-Hill 13 Credit Swaps n Credit swaps designed to hedge credit risk. n Total return swap n Pure credit swap Interest-rate sensitive element stripped out leaving only the credit risk.

Irwin/McGraw-Hill 14 Credit Risk Concerns n Credit risk concerns partly mitigated by netting of swap payments. n Netting by novation When there are many contracts between parties. n Payment flows are interest and not principal. n Standby letters of credit may be required.