Interest Rate Derivative Market 15

Chapter Objectives Describe the types of interest rate swaps available Describe the risks of swaps Identify other commonly used interest rate derivative instruments Describe the globalization of swap markets

Background Definition: Interest rate swap is an agreement between two parties to exchange one set of interest rate payments for another Usually an exchange of a stream of fixed-rate interest payments for floating-rate payments Characteristics Over-the-counter trading—coordinated and negotiated by financial institution Contracts less standardized than other derivatives like futures and options

Provisions of a Swap The notional principal value to which the interest rates are applied to calculate 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

Background Payments equal the differential multiplied by the notational amount used to calculate payments No payment of notional principal Payments made based on net amounts Swaps used to manage risk or to speculate Market imperfections help explain the existence of swaps If used for speculation, can involve losses

Background Example of two financial institutions, one in the U.S and one in Europe used to illustrate swap concepts A U.S. financial institution with liabilities more rate-sensitive than assets is affected adversely by rising interest rates A European financial institution has access to long-term, fixed-rate funds but makes floating rate loans and has the opposite exposure as compared to U.S. institution

Exhibit 15.1 An Interest Rate Swap Short-T erm Deposits Long-T Fixed-Rate erm Loans U.S. Depositors Borrowers European Financial Institution U.S. Financial Interest on Deposits Fixed Interest Payments on Loans Fixed Interest Payments Floating Interest Payments Fixed-Rate Long-T erm Deposits Floating-Rate Loans Interest on Deposits Floating Interest Payments on Loans

Background If interest rates increase and the U.S. and foreign institution negotiate a swap, the U.S. institution gets higher interest payments as rates rise to help offset the increased cost of funds If interest rates decline then the foreign institution makes lower interest payments to the U.S. which helps offset the lower interest payments the European institution receives on loans

Background Both institutions limit the potential benefits they might receive if rates moved in their favor—a hedge U.S. bank forgoes potential benefits from rate declines European bank forgoes any potential benefits from rate increases Different kinds of swaps are possible which vary in the degree to which they cover the interest exposure and allow institutions to capture benefits if rates move in their favor

Participation by Financial Institutions Institutions including banks, pension funds and insurance companies exposed to interest rate risk use swaps to manage it Intermediaries match up firms Charge fees May provide a credit guarantee, for a fee Dealer Takes a counterparty position to serve clients Results in risk exposure unless it has an offsetting swap with another client

Types of Interest Rate Swaps Plain vanilla swap involves periodic exchange of fixed-rate payments for floating-rate payments Basic exchange of payments for the U.S. and European institution given in the example information LIBOR or London Interbank Offer Rate used as the as the index

Exhibit 15.3 Plain Vanilla Swap Scenario of Declining Interest Rates Scenario of Rising Interest Rates Floating Inflow Payments Level of Interest Payments Fixed Outflow Payments Level of Interest Payments Fixed Outflow Payments Floating Inflow Payments 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 End of Y ear End of Y ear

Types of Interest Rate Swaps A forward swap is an exchange of interest payments that does not begin until some future point in time Used if an institution is currently insulated against rate risk but anticipates risk beginning at a future time Swap period is delayed but institution locks in future terms Locks in at the prevailing rates based on expectations about future interest rates

Exhibit 15.5 Forward Swap a a End of Y ear End of Y ear Scenario of Rising Scenario of Declining Interest Rates Floating Inflow Payments Interest Rates Fixed Outflow Payments Fixed Outflow Payments Level of Interest Payments Level of Interest Payments Floating Inflow Payments at This T Forward Swap Is Arranged ime Forward Swap Is Arranged at This T ime T Swapping of Payments Begins at This ime Swapping of Payments Begins at This T ime 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 End of Y ear End of Y ear

Types of Interest Rate Swaps Callable swaps are a swap option that allows counterparty with fixed payments to terminate prior to maturity U.S. institution in the example could terminate swap if rates decline and then capture the benefits Party with the right to terminate pays a premium in the form of a higher fixed rate May also involve a termination fee

Exhibit 15.6 Callable Swap a a a End of Y ear End of Y ear Scenario of Rising Floating Inflow Payments Scenario of Declining Interest Rates Interest Rates Fixed Outflow Payments* Fixed Outflow Payments* Floating Inflow Payments Level of Interest Payments Level of Interest Payments Option is exercised to terminate the swap at this time, because interest rate trend is downward. 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 End of Y ear End of Y ear

Types of Interest Rate Swaps Putable swaps allow the counterparty with floating-rate payments to terminate prior to maturity European institution in the example could terminate swap if rates increase and then capture the benefits Party with the right to terminate pays a premium in the form of a higher fixed rate May also involve a termination fee

Exhibit 15.7 Putable Swap a a End of Y ear End of Y ear Scenario of Rising Scenario of Declining Interest Rates Interest Rates Floating Inflow Payments Fixed Outflow Payments * Fixed Outflow Payments * Floating Inflow Payments Level of Interest Payments Level of Interest Payments Option is exercised by recipient of fixed outflow payments to terminate the swap at this time, because interest rate trend is upward. 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 End of Y ear End of Y ear

Types of Interest Rate Swaps Extendable swaps allow the fixed-for-floating party to extend the swap period Benefits from the ability to extend a current swap rather than negotiate a new swap at the prevailing market rates in existence when the initial swap matures This feature involves a higher price May have to pay fees if swap is extended

Exhibit 15.8 Extendable Swap Scenario of Rising Floating Inflow Payments Scenario of Declining Interest Rates Interest Rates Fixed Outflow Payments Fixed Outflow Payments Floating Inflow Payments Level of Interest Payments Level of Interest Payments At this time, the institution would likely extend the swap period. At this time, the institution would likely decide not to extend the swap period. 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 End of Y ear End of Y ear

Types of Interest Rate Swaps Zero-coupon-for-floating swaps involve a fixed-rate payer that makes a single payment at the maturity of the swap Floating-rate payer makes periodic payments An example is a U.S. institution with short-term deposits funding zero coupon bonds The risk is that an interest rate increase causes the bond prices to fall and increases the cost of funds on the liability side of the balance sheet

Exhibit 15.9 Zero-Coupon-For-Floating Swap Single Lump-Sum Fixed Outflow Payment Scenario of Rising Scenario of Declining Interest Rates Interest Rates • A Single Lump-Sum Fixed Outflow Payment Floating Inflow Payments Floating Inflow Payments Level of Interest Payments Level of Interest Payments 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 End of Y ear End of Y ear

Types of Interest Rate Swaps Rate-capped swaps exchange fixed-rate payments for floating-rate payments that are capped and involve up-front fees Example of U.S. and European firm European firm may want to limit its possible payments with the cap and know what its maximum payments will be U.S. firm may believe rates will not go above cap and if they do, swap’s effectiveness is limited

Exhibit 15.10 Rate-Capped Swap Scenario of Rising Purple Line Reflects Floating Inflow Payments If a Cap Did Not Exist Scenario of Declining Interest Rates Interest Rates Cap Floating Inflow Payments Based on Cap Cap Level Level Fixed Outflow Payments Fixed Outflow Payments Floating Inflow Payments Payer of Fixed Outflow Payments Receives Premium at This T ime for Agreeing to Cap Agreeing to Cap Payer of Fixed Outflow Payments Receives Premium at for This T ime 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 End of Y ear End of Y ear

Types of Interest Rate Swaps Equity swaps involve the exchange of interest payments for payments linked to the degree of change in a stock index Example Company with a fixed 7% interest rate Swaps a fixed rate for rate of appreciation in an index over a period of time If index appreciates by 9% a year, differential is 2% For use by portfolio managers

Other Types of Interest Rate Swaps Rate swaps to accommodate financing needs Corporations with varied debt ratings swap fixed for floating interest payments Swap parties benefit from considerable differential in capital market rates for parties Brokered by financial institutions who may bear credit or default risk Tax swaps Firm with expiring loss carryforwards swaps with Firm expects future losses but has large gains from operations this year

Exhibit 15.11 Interest Rate Swap Risky Co. Quality Co. Variable-Rate Payments at LIBOR + ½% Fixed-Rate Payments at 9½% Fixed-Rate Payments at 9% V ariable-Rate Payments at LIBOR + 1% Investors in Fixed-Rate Bonds Issued by Quality Co. Investors in V ariable-Rate Bonds Issued by Risky Co.

Risk of Interest Rate Swaps Basis risk is the chance that the index does not move in perfect tandem with the floating-rate instruments Credit risk exists because one of the firms may not meet its payment obligations but this is minimized If counterparty 1 defaults it does not make a required payment Counterparty 2 would stop all subsequent payments

Risk of Interest Rate Swaps Credit risk concerns exist for those that guarantee swaps Regulators are considering how to respond Large growth in swaps market so this concern will receive continued attention Sovereign risk is the potential adverse effect from a country’s political conditions that could prevent one party from fulfilling its obligations

Pricing Interest Rate Swaps Prevailing market interest rates determine swap rates Availability of counterparties influences pricing If there are numerous potential counterparties it increases the chance of negotiating favorable terms This will change as economic conditions change Credit and sovereign risk also influence prices

Factors Affecting the Performance of Interest Rate Swaps Swap performance is affected by several underlying forces Indicators monitored by participants in the swaps markets include any that would affect interest rates U.S. economic conditions International economic conditions Monetary and fiscal policy

Interest Rate Caps, Floors, and Collars Interest rate caps offer payments in periods when a specified interest rate index exceeds a specified ceiling interest rate Payments based on the amount by which the interest rate exceeds the cap times the notational principal Fee paid up front Purchaser is an institution adversely affected by rate increases while seller expects stable or declining future rates

Interest Rate Caps, Floors, and Collars Interest rate floors offer payments in periods when a specified interest rate index falls below a specified floor rate. Used to hedge against lower interest rates Seller gets the up-front fee but has an ongoing obligation to make payments if the rate falls below the floor

Interest Rate Caps, Floors, and Collars Collar involves the simultaneous purchase of an interest rate cap and sale of an interest rate floor Cap generates payments if interest rates rise Use fee from selling floor to buy the cap If rates drop, the institution has the ongoing obligation created by the sale of the interest rate floor

Globalization of Swap Markets Counter-parties for interest rate swaps extends beyond United States, where interest rate changes may vary Manufacturing corporations from various countries also engage in swaps Interest rate swaps are denominated in many currencies Lack of information and credit risk concerns reduced if intermediaries back payments

Globalization of Swap Markets Currency swap is an arrangement in which currencies are exchanged at specified foreign exchange rates and at specified intervals Used by firms to hedge their risks from foreign currency exposure caused by inflows and outflows denominated in different currencies Currency swaps available in several variations and may involve intermediaries

Globalization of Swap Markets Hedging bond payments with currency swaps involves Firm 1 issuing a bond denominated in euros to fund its euro operations Firm 1 receives euros in the course of business that would be used to repay the bonds Investors in the euro market do not know Firm 1 very well Firm 1 swaps with Firm 2, a company that wants to issue dollar debt but is not well known by investors who buy dollar-denominated debt

Globalization of Swap Markets Risks of currency swaps involve the same risks as other interest rate swaps Basis risk occurs if using a related currency or if price movements are not perfectly correlated Credit risk Sovereign risk