CHAPTER 9 INTEREST RATE DERIVATIVES MARKET

Learning objectives By the end of this chapter, you should be able to: Understand interest rates and the risk associated with them. Explain the hedging methods used to reduce the exposure to interest rate risk. Describe interest rate swaps. Apply the appropriate type of interest rate swaps. Identify the advantages and disadvantages of interest rate swaps.

INTEREST RATE Cost of borrowing money. Can be seen as profit over time due to financial instruments. Interest may change due to economic changes. Different types of loan offer different interest rate.

INTEREST RATE RISK Risk occurs when there are changes in the market interest rate. Borrowers are concerned with increasing interest rate. Lenders are concerned with decreasing interest rate. Lenders and borrowers can lend or borrows at fixed or floating rate.

INTEREST RATE RISKS INTEREST RATE BORROWER LENDER RISING FAVOURABLE TO USE FIXED RATE FAVOURABLE TO USE FLOATING RATE FALLING

HEDGING Definition A hedge is a position established in one market in an attempt to offset exposure to the change in the interest rate of an equal but opposite obligation in another market. Risk can be inherent to a business activities and specific to certain businesses. Some risks can be avoided through hedging.

HEDGING STRATEGIES Forward rate agreement (FRA) Forward rate agreement enables a company to protect itself against interest risk by fixing the effective rate of interest before the intended borrowing or deposit date. Interest rates futures (IRF) Interest rate futures (IRF) are used by companies to enter into speculative (or hedge) positions on changes in short-term interest rates. Interest rate options Interest rate options are used by investors, borrowers and traders to manage interest rate risk exposures. The product is available on payment of an upfront fee, called the premium.

HEDGING Interest rate swaps (IRS) An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party’s stream of cash flows based upon some notional principal amount of money, maturity, and interest rates. IRS can be used by hedgers to manage their fixed or floating assets and liabilities. As such, interest rate swaps are very popular and highly liquid instruments. Swaptions Swaptions are a hybrid derivative product that integrates the benefit of swaps and options. The buyer of a swaption has the right, but not the obligation, to enter an interest rate or currency swap during a limited period of time and at a specified rate.

CHARACTERISTICS OF IRS One of the largest components of the global derivatives market. Customised bilateral transactions where parties agree to exchange cash flows at fixed periodic intervals. Over the counter instruments (OTC). Each side of a swap is called a leg. Companies involved are known as counterparties.

Interest Rate Swaps (IRS) In a fixed-for-floating swap, one party pays an amount based on a fixed interest rate whereas the other party pays in exchange, an amount based on a floating interest rate. The size of the payment is determined by multiplying the interest rate with the “notional principal”. The notional principal is the principal amount on which interest payments are calculated. The notional principal remains unchanged over the maturity of the swap. In an IRS cash flows are swapped at fixed predetermined intervals over the tenor of the agreement. The fixed intervals, known as reset periods may be six monthly, quarterly, etc, whereas the tenor or maturity of the swap may be 5 or 10 years.

Interest Rate Swaps (IRS) Fixed 10% of RM100 mil Fixed Rate. Floating Payer Rate Payer 6 month KLIBOR +1% RM100 mil. The figure outlines the cash flows involved in a fixed-for-floating IRS of 5-year maturity and RM100 million notional principal. If the reset frequency is 6 months, then a total of 10 cash flow swaps will occur over the 5 years. The fixed rate payer, will pay an annualized 10% fixed rate while the floating rate payer, will pay 6 month KLIBOR +1%.

Interest Rate Swaps (IRS) The cash flow payment based on the interest rates will occur once every 6 months. Since the payments are to be made simultaneously, often the cash-flows are netted such that only a single payment occurs. As to who pays whom, would obviously depend on which rate is higher. If the floating rate; 6 month KLIBOR + 1% is higher than the fixed rate of 10% the floating rate payer pays the difference. If the floating rate is lower than 10%, then the fixed payer pays the difference. To see how this works, we examine two scenarios; first if the 6 month KLIBOR is at 6% at reset period and a second scenario where the 6 month KLIBOR is at 11.2%.

Scenario 1: 6 month KLIBOR = 6% The payment obligation for each party is as follows: Fixed Rate Payer: [10% x RM100,000,000] / 2 = RM5,000,000 Floating Rate Payer: [(6%+1) x RM100,000,0000] / 2 = RM3,500,000 Since the fixed rate payer’s obligation is higher by RM1,500,000 he pays this amount. The netted cash flow will be: Fixed Rate Floating Rate Payer RM1,500,000 (net difference) Payer

Scenario 1: 6 month KLIBOR = 11.2% With changed floating interest rate, the payment obligation would now be: Fixed Rate Payer: [10% x RM100m] / 2 = RM5,000,000 Floating Rate Payer: [(11.2%+1) x RM100m] / 2 = RM6,100,000 Here, since the floating rate payer’s obligation is higher, he has to pay the net amount of RM1,100,000. Now the cash flow will be: Fixed Rate Floating Rate Payer RM1,100,000 (net difference) Payer

Two Important Factors… First, the notional principal is never exchanged. Second, only the net difference is paid. Thus, at any reset period, there will be a cash flow if the two rates are unequal. Since the fixed rate payer’s obligation is known up front, it is the changes in the floating interest rate; that will determine the direction and quantum of payments.

Swap Terminology Fixed rate payer : The Counterparty in swap agreement who pays based on a fixed interest rate. Floating rate payer : Counterparty who pays based on a floating interest rate. Reset Frequency : The time interval over which the floating rate is reviewed and reset. Reference Rate : The market interest rate on which the Floating Rate Payer's payment will be based ‑ typically an interbank rate like KLIBOR, LIBOR, T-bill rate etc. Notional Principal : The principal amount on which interest payment amounts are determined. Notional amount is never exchanged, only the interest amounts based on it.

ILLUSTRATION A Ltd borrows US$50 million at a floating interest rate of LIBOR plus a credit spread of 0.5% payable in 5 years. At the same time, B Ltd borrows US$50 million at a fixed interest rate of 9% payable also in 5 years. A Ltd and B Ltd may agree to swap their liabilities whereby A will pay B a fixed interest at 9% and B may pay A a floating rate of LIBOR plus 0.5%.

Interest Rate Swaps (IRS) Generally, banks and financial institutions will act as the intermediaries to these counterparties. (and make large amount of profits from these transactions).

ILLUSTRATION 8% Syarikat Super Syarikat Duper Floating rate Fixed Rate KLIBOR + 0.5% Originally Borrow Originally Borrow KLIBOR +0.5% Fixed Rate 8%

PURPOSE OF SWAPS Generally swaps are used for financing and managing of assets and liabilities. It also has other benefits like: Reduce their exposure to changes in the interest rates on a particular transaction. Lower their net expected costs of borrowing with respect to bonds. Manage their exposure to the changing market conditions in advance of anticipated issuance of bonds. Achieve more flexibility in meeting the overall financial objectives that cannot be achieved in conventional markets. Obtain customized cash flows to match the required payment obligations or revenue projections.

TYPES OF SWAPS Fixed-to-floating rate swap The fixed-to-floating rate swaps in the same currency are used to convert a fixed rate asset (lending) or liability (borrowing) to a floating rate asset or liability and vice versa. This type of swap is better known as plain vanilla swap. Floating-to-fixed The floating-to-fixed rate swaps are used to convert a floating rate asset or liability to a fixed rate asset or liability. Floating-to-floating rate swap The floating-to-floating rate swaps in the same currency are used to hedge against the spread between two indexes widening or narrowing. Here, parties try to profit from the differences in the swap spreads. This type of swap is better known as basis swap.

APPLICATION OF IRS Arbitraging Differences in opinions regarding the creditworthiness of companies can to a certain extent, affect the cost and will lead to mispricing. And, it is this mispricing that companies are trying to arbitrage. Hedging Borrowers will hedge against a hike in interest rate to avoid paying high financing cost, and the lenders will try to hedge against a falling interest rate to avoid low yield from its investments. Interest rate swaps enable the counterparties to hedge against the increase and decrease in interest rates.

APPLICATION OF IRS Speculating Interest rate swaps can be used to estimate the future movements of interest rates. By speculating, it is hoped that companies would gain when the interest rate actually changes.

Arbitraging - Illustration Harta Ltd and Property Ltd are presently borrowing at the following interest rate: Notice that there are differences in spreads between the fixed rate market and floating rate market for both firms. Neither of the market has priced the credit risk differential correctly. This has led to mispricing. It is these differences that we are going to arbitrage. Harta Ltd intends to borrow at a floating rate and Property wants to borrow at a fixed rate. It is safe to assume that Harta Ltd has a higher credit rating since it can borrow at cheaper costs. A bank is planning to arrange a swap and wishes to keep a spread of 25 basis points. Fixed Floating Harta 6% LIBOR + 0.5% Property 7% LIBOR + 0.75%

Arbitraging - Illustration Best for Harta; fixed rate since the company get 1% lower than Property compare to floating rate ( 0.25% lower) Best for Property; Floating rate coz it manage to get 0.25% higher than Harta compare to fixed rate (1% higher) HOWEVER; Harta Ltd intends to borrow at a floating rate and Property wants to borrow at a fixed rate. It is safe to assume that Harta Ltd has a higher credit rating since it can borrow at cheaper costs. Fixed Floating Harta 6% LIBOR + 0.5% Property 7% LIBOR + 0.75% Difference 1% 0.25%

Harta will borrow directly from bank at LIBOR + 0 Harta will borrow directly from bank at LIBOR + 0.5% and Property borrow directly from bank at 7%. A bank is planning to arrange a swap and wishes to keep a spread of 25 basis points. IRS Harta pay Property floating rate and Property pay Harta Fixed rate.

Arbitraging - Illustration _________________ Harta Ltd Property Ltd Cost if borrowed directly LIBOR + 0.50% 7 % Cost of borrowing with IRS LIBOR + 0.75% 6%___ Gain/(Loss) (0.25%) 1% Transfer of Loss 0.25% (0.25%) Net - 0.75% Less: Payables to bank (0.25%) Net gain 0.50% Sharing of gain 0.25% 0.25% The counterparties will end up paying: Harta Limited LIBOR + 0.5 - 0.25 = LIBOR + 0.25 Property Limited 7% - 0.25 = 6.75%

Arbitraging - Illustration Alternatively, the sharing of gains can be calculated as follows: Gains to be shared between companies: = 1% - 0.25% = 0.75% Less: Payables to bank 0.25% Net gain 0.50% Sharing of gain = 0.50%/2 = 0.25% each Fixed Floating Harta 6% LIBOR + 0.5% Property 7% LIBOR + 0.75% Difference 1% 0.25%

Arbitraging - Illustration Harta Ltd and Property Ltd are presently borrowing at the following interest rate: Best rate for Hatch – fixed Latch – Floating But, Hatch prefer floating and Latch prefer fixed Fixed Floating Hatch 5% KLIBOR + 0.15% Latch 6.5% LIBOR + 0.775%

Arbitraging - Illustration _________________ Hatch Ltd Latch Ltd Cost if borrowed directly KLIBOR + 0.15% 6.5 % Cost of borrowing with IRS LIBOR + 0.775% 5%___ Gain/(Loss) (0.625%) 1.5% Transfer of Loss (0.625%) Net - 0.875% Less: Payables to bank - Net gain 0.8750% Sharing of gain 0.4375% 0.4375% The counterparties will end up paying: Hatch Limited KLIBOR – 0.2875 Latch Limited 6.5% - 0.4375 = 6.0625%

Problem 4 Fixed Floating Ozzy 6.5 KLI + 0.375 Wolly 7.125 KLI + 0.675 Difference 0.625 0.3 Alternatively, the sharing of gains can be calculated as follows: Gains for each company: 0.1625 % (assuming principal = 1M) RM162500 – RM75000 = RM87500 Effective Cost Ozzy – KLI + (0.375 – (0.1625-0.075) Wolly – 7.125 – (0.1625-0.075)

Hedging Interest Rate Risk with IRS There are three common ways by which IRS is used to manage rate risk: (i) to hedge against rising rates (borrowers) (ii) to hedge against falling rates (lenders) and (iii) to manage asset – liability duration gaps.

Hedging Rising Interest Rates Suppose a borrower, Sykt. ABC, has a 5 year, RM10 million loan from Maybank. Maybank charges an interest based on 6 month KLIBOR + 2% payable semi annually. Sykt. ABC obviously has interest rate exposure. The firm’s funding costs will increase as 6 month KLIBOR rises. Given these circumstances, the logical way for Sykt. ABC to manage the rate risk would be through a IRS. Sykt. ABC should enter the swap as the fixed rate payer and floating rate receiver. If the notional principal and reset frequency are structured to match the underlying position that it has with Maybank, then Sykt. ABC would have perfectly hedged it’s interest rate risk.

Hedging against Rising Rates with IRS Fixed Rate 8% Syarikat ABC IRS Counterparty 6 month KLIBOR Floating 6 month KLIBOR + 2% Maybank In the IRS, Syarikat ABC pays an annualized fixed rate of 8% every 6 months on RM10 million notional. [(0.08 x RM10m)/2] In exchange it receives a cash flow equivalent to the prevailing spot 6 month KLIBOR rate on RM10 million notional. [(6 month KLIBOR x RM10m)/2]

Hedging against Rising Rates with IRS Sykt. ABC protects itself from rising interest rates because it’s increased payments to Maybank will be offset by the increased payments it receives from the counterparty as interest rates rising. Since both the receivable from the counterparty and the payable to Maybank are referenced on 6 month KLIBOR, Sykt. ABC’s inflows from the swap offset the outflow to Maybank. With the IRS, Sykt. ABC has effectively turned its floating rate payable into a fixed rate. Effectively a 10% annualized fixed rate loan. (8% to swap counterparty and 2% spread over KLIBOR to Maybank).

Hedging against Falling Interest Rates Given the above example; it should be easy to see what needs to be done to hedge against falling interest rates. One should do the opposite of what Sykt. ABC did in the above IRS. That is, enter into an IRS as the floating rate payer, and a fixed rate receiver.

PRICING OF INTEREST RATE SWAPS When valuing interest rate swaps, managers may have to forecast and make estimation on certain variables they consider as factors affecting the price of a swap. Most of the time, this will involve using extrapolation and other techniques to derive the estimates. As such, different managers may value a swap differently.

RISKS ASSOCIATED WITH INTEREST RATE SWAPS Interest rate risks This type of risk originates from changes in the floating rate. In a plain vanilla fixed-to-floating rate swap, the party which pays the floating rate benefits when rates fall. Credit risk Contracts that represent agreements between two parties, such as swaps, always involve credit risks. Counterparties must make payments periodically. There are possibilities that one party may not be able to fulfill its obligation exposing the other party to risk.

RISKS ASSOCIATED WITH INTEREST RATE SWAPS Market risk Market risk arises from the possible movements on a variable associated with the swap instrument, such as interest rates and exchange rates, that makes the value of the swap negative for one of the parties involved in it. Sovereign risk Sovereign risk is the risk associated with the country in whose currency a swap is being considered. Sovereign risk covers political stability or the possibility of exchange controls being introduced. Sovereign risk can lead to credit risk in a currency swap.

GLOBALISATION Interest Rate Swaps in Different Currencies With globalization the process of swapping will not only apply to interest rates but will also include the currencies of countries involved in a transaction. Interest Rate Swaps in Different Currencies The types of currency-interest swaps are as follows: (i) Fixed-to-floating rate swap, different currencies (ii) Fixed-to-fixed rate swap, different currencies (iii) Floating-to-floating rate swap, different currencies Currency Swaps A currency swap is a contract in which two counterparties exchange a specific amount of two different currencies, exchange interest payments in two currencies over the term of the swap and re-exchange the principal at maturity.