1 Lecture #28 Swaps and Interest Rate Options

2

3 Outline Introduction Interest rate swaps Foreign currency swaps Circus swap Interest rate options

4 Introduction Both swaps and interest rate options are relatively new, but very large – In mid-2000, there was over $60 trillion outstanding in interest rate swaps, foreign currency swaps, and other interest rate options

5 Interest Rate Swaps Introduction Immunizing with interest rate swaps Exploiting comparative advantage in the credit market

6 Introduction Popular with bankers, corporate treasurers, and portfolio managers who need to manage interest rate risk A swap enables you to alter the level of risk without disrupting the underlying portfolio

7 Introduction (cont’d) The most common type of interest rate swap is the fixed for floating rate swap – One party makes a fixed interest rate payment to another party making a floating interest rate payment – Only the net payment is made (difference check) – The firm paying the floating rate is the swap seller – The firm paying the fixed rate is the swap buyer

8 Introduction (cont’d) Typically, the floating interest rate is linked to a market rate such as LIBOR or T-bill rates The swap market is standardized partly by the International Swaps and Derivatives Association (ISDA) – ISDA provisions are master agreements

9 Introduction (cont’d) A plain vanilla swap refers to a standard contract with no unusual features or bells and whistles The swap facilitator will find a counterparty to a desired swap for a fee or take the other side – A facilitator acting as an agent is a swap broker – A swap facilitator taking the other side is a swap dealer (swap bank)

10 Introduction (cont’d) Plain Vanilla Swap Example A large firm pays a fixed interest rate to its bondholders, while a smaller firm pays a floating interest rate to its bondholders. The two firms could engage in a swap transaction which results in the larger firm paying floating interest rates to the smaller firm, and the smaller firm paying fixed interest rates to the larger firm.

11 Introduction (cont’d) Plain Vanilla Swap Example (cont’d) Big FirmSmaller Firm Bondholders LIBOR – 50 bp 8.05% LIBOR +100 bp

12 Introduction (cont’d) Plain Vanilla Swap Example (cont’d) A facilitator might act as an agent in the transaction and charge a 15 bp fee for the service.

13 Introduction (cont’d) Plain Vanilla Swap Example (cont’d) Big FirmSmaller Firm Bondholders 8.05%LIBOR +100 bp Facilitator LIBOR -50 bp 8.05%8.20% LIBOR -50 bp

14 Introduction (cont’d) The swap price is the fixed rate that the two parties agree upon The tenor is the term of the swap The notional value determines the size of the interest rate payments Counterparty risk refers to the risk that one party to the swap will not honor its part of the agreement

15 Immunizing With Interest Rate Swaps Interest rate swaps can be used by corporate treasurers to adjust their exposure to interest rate risk The duration gap is:

16 Immunizing With Interest Rate Swaps (cont’d) A positive duration gap means a bank’s net worth will suffer if interest rates rise – The treasurer may choose to move the duration gap to zero This could be accomplished by selling some of the bank’s loans and holding cash equivalent securities instead

17 Immunizing With Interest Rate Swaps (cont’d) Using the bank’s balance sheet, we can algebraically solve for the proportion of the firm’s assets to be held in cash so that the duration gap is zero:

18 Exploiting Comparative Advantage in the Credit Market Interest rate swaps can be used to exploit differentials in the credit market

19 Exploiting Comparative Advantage in the Credit Market Credit Market Example AAA Bank and BBB Bank currently face the following borrowing possibilities: FirmFixed RateFloating Rate AAACurrent 5-yr T-bond + 25 bp LIBOR BBBCurrent 5-yr T-bond + 85 bp LIBOR + 30 bp Quality Spread60 bp30 bp

20

21

22

Source: 23 © 2004 South-Western Publishing