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Swaps and Interest Rate Options
Chapter 13 Swaps and Interest Rate Options © 2002 South-Western Publishing
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Outline Interest rate swaps Foreign currency swaps Circus swap
Interest rate options
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Introduction Both swaps and interest rate options are relatively new, but extensively used In mid-2000, there was over $60 trillion outstanding in interest rate swaps, foreign currency swaps, and other interest rate options
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Interest Rate Swaps Hedging with interest rate swaps
Immunizing with interest rate swaps Exploiting comparative advantage in the credit market
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Interest Rate Swaps 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: asset liability
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Interest Rate Swaps 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
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Interest Rate Swaps Typically, the floating interest rate is linked to a market rate such as LIBOR or T-bill rates BA’s in Canada The swap market is standardized partly by the International Swaps and Derivatives Association (ISDA) ISDA provisions are master agreements
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‘Plain Vanilla’ Swap – Hedging Interest Rate Risk
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)
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Plain Vanilla Swap 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
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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 bankers 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
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Plain Vanilla Swap - Motivations
Large firm with a strong credit rating takes advantage of it s borrowing capacity and borrows fixed term in the bond market interest rate outlook - declining rates enters into a swap agreement to move to floating rate debt but still leveraging its strong credit rating and borrowing capacity
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Plain Vanilla Swap - Motivations
Smaller firm with weaker credit rating no/minimal access to long term bond market due to its relatively weak credit rating typically borrows floating rate from its bank(s) would like to fix its borrowing rate as part of its risk management program can achieve its fixed rate objectives by entering into a swap agreement
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Plain Vanilla Swap Example (cont’d)
LIBOR – 50 bp Big Firm Smaller Firm 8.05% 8.05% LIBOR +100 bp Bondholders Bankers
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Plain Vanilla Swap Example
A facilitator might act as an agent in the transaction and charge a 15 bp fee for the service.
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Plain Vanilla Swap Example
LIBOR -50 bp LIBOR -50 bp Big Firm Facilitator Smaller Firm 8.05% 8.20% 8.05% LIBOR +100 bp Bondholders Bankers
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Plain Vanilla Swaps - Timing
Swaps can be entered into at same time the firm accesses the bond market - e.g. 5 year fixed rate bond issue immediately swapped into floating rate via a swap agreement or A swap can be negotiated at any time over the life of an existing borrowing e.g. 7 year bond issue two years prior - firm now expects interest rates to decline - 5 years remaining on the bond issue - firm enters into a 5 year fixed to floating rate swap
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Interest Rate Risk Management -Considerations
Interest rate outlook over expected borrowing horizon Use swaps where the borrowing horizon is longer term use futures where the interest rate risk is short term absolute interest rate levels and or yield curve shape credit or ‘swap’ spreads
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Interest Rate Risk Management Considerations
Interest Rate Outlook Floating rate alternative if outlook is lower Fixed rate if outlook is higher Absolute Levels and Yield Curve Borrow fixed rate – premium but no risk Borrow floating rate – at lower rates at shorter end of the yield curve – but with interest rate risk
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Interest Rate Risk Management Considerations
Fixed to Floating interest rate swap Outlook for rates lower Steeper yield curve – lower rates at short end Absolute borrowing levels Credit/swap spreads Floating to Fixed interest rate swap Outlook for rates higher Flatter yield curve
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Swap Timing – Anticipating Interest Rate Changes
Interest rate changes need to be anticipated and swaps need to be negotiated ahead of the actual interest rate movement for the buyer to achieve the desired result
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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:
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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 or using interest rate swaps to close the duration gap …how would this be done?
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Exploiting Comparative Advantage in the Credit Market
Interest rate swaps can be used to exploit differentials in the credit market
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Exploiting Comparative Advantage in the Credit Market
Credit Market Example AAA Bank and BBB Bank currently face the following borrowing possibilities: Firm Fixed Rate Floating Rate AAA Current 5-yr T-bond + 25 bp LIBOR BBB T-bond + 85 bp LIBOR + 30 bp Quality Spread 60 bp 30 bp
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Exploiting Comparative Advantage in the Credit Market
Credit Market Example (cont’d) AAA Bank has an absolute advantage over BBB in both the fixed and the floating rate markets. AAA has a comparative advantage in the fixed rate market. The total gain available to be shared among the swap participants is the differential in the fixed rate market minus the differential in the variable rate market, or 30 bps.
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Exploiting Comparative Advantage in the Credit Market
Credit Market Example (cont’d) AAA Bank wants to issue a floating rate bond, while BBB wants to borrow at a fixed rate. Both banks will borrow at a lower cost if they agree to an interest rate swap. AAA Bank should issue a fixed rate bond because it has a comparative advantage in this market. BBB should borrow at a floating rate. The swap terms split the rate savings The current 5-yr T-bond rate is 4.50%.
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Exploiting Comparative Advantage in the Credit Market
Credit Market Example (cont’d) Treasury + 40 bp AAA BBB LIBOR Treasury + 25 bp LIBOR +30 bp Bondholders Bondholders
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Exploiting Comparative Advantage in the Credit Market
Credit Market Example (cont’d) The net borrowing rate for AAA is LIBOR – 15 bps The net borrowing rate for BBB is Treasury + 70 bps The net rate for both parties is 15 bps less than without the swap.
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Foreign Currency Risk 1971 – the Breton Woods Agreement was suspended by global monetary leaders Currencies previously tied to the price of gold and to the $US now floated freely The result- currency volatility and currency risk 1972 – CME began trading currency futures 1981 – Salomon Bros brokered the first currency swap between the World Bank and IBM (German marks Swiss francs)
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Foreign Currency Risk Today
‘Euro’ volatility Weakening US dollar Strengthening Canadian dollar (other ‘resource currencies) Impacted Canadian firms and individual investors E.g. oil & gas producers selling commodities denominated in $US and Canadian investors investing in US securities
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Foreign Currency Swaps
In a currency swap, two parties Exchange currencies at the prevailing exchange rate Then make periodic interest payments to each other based on a predetermined pair of interest rates, and Re-exchange the original currencies at the conclusion of the swap
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Foreign Currency Swaps (cont’d)
Cash flows at origination: Euro Principal C$ Principal Cdn. Co. Swap Dealer Fixed Rate Interest C$ Bondholders
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Foreign Currency Swaps (cont’d)
Cash flows at each settlement: Euro Fixed Rate C$ - Fixed Rate Cdn. Co. Swap Dealer C$ Fixed Rate Interest
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Foreign Currency Swaps (cont’d)
Cash flows at maturity: Euro Principal C $ Principal Cdn. Co. Swap Dealer Retire C$ Issue
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Circus Swap Combining both interest rate and currency swaps
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Circus Swap A circus swap combines an interest rate and a currency swap Involves a plain vanilla interest rate swap and an ordinary currency swap Both swaps might be with the same counterparty or with different counterparties
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Circus Swap Interest associated with original currency swap Cdn. Co.
Euro - Fixed C$ - Fixed Cdn. Co. Swap Dealer Fixed C$ Interest Bondholders
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Circus Swap Interest rate swap to move from fixed euros to floating rate euros Euro Fixed Euro Floating Cdn. Co. Swap Dealer
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Circus Swap Circus swap with two counterparties = net position of:
Floating Rate Euros Fixed Rate C$ Cdn. Co. Swap Dealer Fixed C$ Interest
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Swap Variations Deferred or ‘forward’ swap Floating for floating swap
Amortizing swap Accreting swap
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Deferred Swap In a deferred swap (forward start swap), the cash flows do not begin until sometime after the initiation of the swap agreement Motivation - desire to manage future interest rate risk but reflecting today’s interest rate conditions
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Deferred Swap - Example
ABC corporation has a required borrowing 2 years from now interest rate outlook is for rates trending upward deferred swap could lock in today’s fixed rates for a premium a deferred or forward swap is in effect 2 swaps
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Deferred Swap - Example
Pay 7 year Fixed Pay 2 year Fixed Swap Dealer ABC Co. Swap Dealer Pay BA’s Receive BA’s
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Deferred Swap - Example
...in two years time Pay 7 year (5 years remaining) Fixed ABC Co. Swap Dealer Receive BA’s Borrow Floating Rate BA’s Bankers
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Deferred Swap - Rate is established today and ‘deferred’ for a period of time Dealer factors in the ‘cost of carry’ in offering the deferred 5 year rate (one swap) Considerations interest rate outlook time frame cost of carry - the cost of the ‘hedge’ steep yield curve - higher cost of carry flat yield curve - minimal cost of carry
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Floating for Floating Swap
In a floating for floating swap, both parties pay a floating rate, but with difference benchmark indices
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Amortizing Swap In an amortizing swap, the notional value declines over time according to some schedule
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Accreting Swap In an accreting swap, the notional value increases through time according to some schedule
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Interest Rate Options Interest rate cap Interest rate floor
Calculating cap and floor payoffs Interest rate collar Swaption ………similar instruments available on commodities such as oil and gas
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Interest Rate Options Most of the trading done off the exchange floors
The interest rate options market is Very large Highly efficient Highly liquid Easy to use
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Interest Rate Options
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Interest Rate Cap An interest rate cap
Is like a portfolio of European call options (caplets) on an interest rate On each interest payment date over the life of the cap, one option in the portfolio expires Is useful to firms with floating rate liabilities Caps the periodic interest payments at the caplet’s exercise price
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Interest Rate Cap (cont’d)
Long interest rate cap (exercise price 7%) $ Payoff Payoff Option expires worthless Floating Rate 7%
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Interest Rate Cap (cont’d)
Short interest rate cap (exercise price 7%) $ Payoff Option expires worthless Floating Rate 7% Payout
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Interest Rate Floor An interest rate floor
Is related to a cap in the same way that a put is related to a call like a portfolio of European put options (floorlets) on an interest rate On each interest payment date over the life of the cap, one option in the portfolio expires Is useful to firms with floating rate assets Puts a lower limit on the periodic interest payments at the floorlet’s exercise price
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Interest Rate Floor (cont’d)
Long interest rate floor (exercise price 6.5%) $ Payoff Payoff Option expires worthless Floating Rate 6.5%
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Interest Rate Floor (cont’d)
Short interest rate floor (exercise price 6.5%) $ Payoff Option expires worthless Floating Rate 6.5% Payout
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Calculating Cap and Floor Payoffs
There are no universally acceptable terms to caps and floors – OTC instruments customized to meet needs of both parties However, frequently the terms provide for the cash payment on an in-the-money caplet or floorlet to be based on a 360-day year
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Calculating Cap and Floor Payoffs (cont’d)
Cap payout formula: If the benchmark rate is less than the exercise price, the payout is zero …..all in borrowing cost will be hedged at the strike price plus the option premium
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Calculating Cap and Floor Payoffs (cont’d)
Floor payout formula:
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Interest Rate Collar An interest rate collar is simultaneously long an interest rate cap and short an interest rate floor Sacrifices some upside potential in exchange for a lower position cost Premium from writing the floorlets reduces position costs
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Interest Rate Collar (cont’d)
Long cap $ Payoff Inflow No payout Floating Rate k2 Outflow k1 Short floor
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Swaption A swaption is an option on a swap
Can be either American or European style A payer swaption (put swaption) gives its owner the right to pay the fixed interest rate on a swap A receiver swaption (call swaption) gives its owner the right to receive the fixed rate and pay the floating rate
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