1. Swaps Copyright 2014 Diane Scott Docking 1

2. Learning Objectives Describe an interest rate swap Understand swap terminology Be able to set up a simple plain vanilla swap Copyright 2014 Diane Scott Docking 2

3. Definition – Swap A swap is a financial contract whereby two _______________ agree to exchange periodic payments The dollar amount of the payments exchanged is based on a pre-determined _________________amount In a swap both parties are exposed to ________________________ 3

4. Copyright 2014 Diane Scott Docking 3 Common Types of Swaps Used by Banks ____________swap occurs when the counterparties swap payments in the same currency based on an base interest rate _________ swap is used to hedge against exchange rate risk from mismatched currencies on assets and liabilities _____________ swap, counterparties can buy or sell protection against particular types of events that can adversely affect the credit quality of a debt obligation The two parties are called __________________and ___________________ The specific credit-related events are identified in the contract is called the credit event 4

5. Copyright 2014 Diane Scott Docking Provisions of an Interest Rate Swap The notional principal - value to which the interest rates are applied to calculate the interest payments Payments equal the differential in rates multiplied by the notational This is called ___________________. Payments made based on net amounts Reduces the potential damage if one party defaults on its obligation No payment of notional principal The formula and type of index used to determine the floating rate The ______________ of payments, such as every six months or every year The _______________ of the swap 5

6. Copyright 2014 Diane Scott Docking Provisions of an Interest Rate Swap (cont.) By definition/convention: Swap ________ agrees to pay fixed-rate If Buy a swap – entering into a SHORT hedge. Why? You are E(i) to increase (want to be paying the FR); therefore, Prices to decrease. Swap ______agrees to pay floating-rate. If Sell a swap – entering into a LONG hedge. Why? You are E(i) to decrease (want to be paying the VR); therefore, Prices to increase. 6

7. Copyright 2014 Diane Scott Docking Why are Swaps Used by Financial Institutions? Allows FIs : To save money and hedge against interest-rate risk. To better match the duration of assets and liabilities. Better match “funding” of assets. (Correct mismatch of assets and liabilities) To hedge against FX rate risk 7

8. 8Copyright 2014 Diane Scott Docking Swap Markets Swaps are not standardized contracts Swap dealers (usually financial institutions) keep markets liquid by matching counterparties or by taking positions themselves The International Swaps and Derivatives Association (ISDA) is a 815 member association among 56 countries that sets codes of standards for swap documentation Swaps are not standardized contracts Swap dealers (usually financial institutions) keep markets liquid by matching counterparties or by taking positions themselves The International Swaps and Derivatives Association (ISDA) is a 815 member association among 56 countries that sets codes of standards for swap documentation

9. Copyright 2014 Diane Scott Docking 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 9

10. Copyright 2014 Diane Scott Docking Plain Vanilla Interest Rate Swap 10

11. Copyright 2014 Diane Scott Docking Plain Vanilla Swap: Interest Rate Debt or Revenue Swap Involves periodic exchange of fixed-rate payments for floating-rate payments No actual transfer of principal, only interest payments on debt or investment/loan contracts. Useful in managing interest rate gap problems in FIs BEFORE SWAP Firm 1 Fixed rate assets Variable rate liabilities Firm 2 Variable rate assets Fixed rate liabilities AFTER SWAP Firm 1 Fixed rate assets Fixed rate liabilities Firm 2 Variable rate assets Variable rate liabilities 11 Concerned if interest rates decrease Concerned if interest rates increase

12. Copyright 2014 Diane Scott Docking Risk of Interest Rate Swaps Substantial Brokerage Fees Basis risk the chance that the index (reference rate) does not move in perfect tandem with the floating-rate instruments Credit or Counterparty risk exists because one of the firms may not meet its payment obligations but this is minimized If Counterparty 1 defaults and does not make a required payment; then Counterparty 2 would stop all subsequent payments Disputes between counterparties: International Swap Dealers Association (ISDA) offers an advisory service to members. 12

13. Copyright 2014 Diane Scott Docking Risk of Interest Rate Swaps (cont.) Price risk the risk that interest rate changes can cause the gap position of a bank or firm to change. Thus, the swap’s effectiveness can change. Market valuation risk In 1999 the Financial Accounting Standards Board (FASB) required all derivatives, including swaps, to be stated at fair market value. Thus, they can affect a bank’s or firm’s financial condition. 13

14. Copyright 2014 Diane Scott Docking Advantages of Interest Rate Swaps Avoids refinancing costs Avoids rigidity of maturity dates on futures Can be negotiated to cover any length of period Can do a reverse swap. If don’t like or regret what you did. 14

15. Swap Example 1: ABC Co. and XYZ Co. have entered into the following swap agreement: Term = 8 years, paid annually Notional amount = $200 million Swap legs: ABC Co. pays XYZ Co. LIBOR + 0.50% XYZ Co. pays ABC Co. 6% Questions?: 1) What type of swap is this? 2) Who is the buyer of this swap? 3) What is the net payover rate? Who pays whom when and how much? 4) Suppose at the end of year 1 the LIBOR = 4%. Show the swap transactions. Copyright 2014 Diane Scott Docking 15

16. Solution to Swap Example 1: 1) What type of swap is this? 2) Who is the buyer of this swap? Copyright 2014 Diane Scott Docking 16

17. Solution to Swap Example 1: 3) What is the net payover rate? Who pays whom when and how much? Payover Rate = FR – VR = 6% – (L+0.5%) = 6% – L – 0.5% = ______________ If L _____________a wash If L _____________; ABC pays XYZ: (_______________) x Notional Amount If L _____________; XYZ pays ABC: (_______________) x Notional Amount Copyright 2014 Diane Scott Docking 17 XYZABC Pay FRReceive FR Receive VRPay VR Net Profit

18. Solution to Swap Example 1: (cont.) 4) Suppose, at the end of year 1, LIBOR = 4%. Show the swap transactions. Since L < 5.5%; XYZ pays ABC: (5.5% - L) x Notional Amount (5.5% - 4%) x $200 mill. = 1.5% x $200 mill. = $3,000,000 Copyright 2014 Diane Scott Docking 18 Notional Amount = $200,000,000 XYZABC Pay FR- $12,000,000+ $12,000,000Receive FR 6% x $200 million Receive VR+$ 9,000,000- $ 9,000,000Pay VR (L+0.5%) x $200 million 4.5% x $200 million Net Profit- $ 3,000,000+ $ 3.000,000

19. Swap Example 2: TOP Bank has made a $200 million, 5 year, 6% fixed-rate loan (simple interest) to NBT Co. TOP Bank has funded this loan by borrowing $200 million for 5 years at a variable rate of LIBOR + 1%, adjusted annually. LIBOR is currently at 2%. TOP Bank has also entered into a swap agreement with GMAC with the following terms: Term = 5 years, paid annually Notional amount = $200 million Swap legs: TOP Bank pays GMAC 3% annually GMAC pays TOP Bank LIBOR + 0.50% annually Questions?: 1) What is TOP Bank’s risk if it does not enter into the swap with GMAC? 2) What type of swap is this? 3) Who is the buyer of this swap? 4) What is the net payover rate? Who pays whom when and how much? 5) Suppose at the end of year 1 the LIBOR = 6%. Show the swap transactions. 6) What did TOP Bank accomplish by entering into this swap? Copyright 2014 Diane Scott Docking 19

20. Solution to Swap Example 2: 1) What is TOP Bank’s risk if it does not enter into the swap with GMAC? Loan revenue = 6%6% Funding costs = L+1% currently Libor = 2%, so3% Net spread = 5% - L currently3% Risk is that Libor will _________ to 5% or _________ and the loan becomes unprofitable. 2) What type of swap is this? 3) Who is the buyer of this swap? Copyright 2014 Diane Scott Docking 20

21. Solution to Swap Example 2: (cont.) 4) What is the net payover rate? Who pays whom when and how much? Payover Rate = FR – VR = 3% – (L+0.5%) = 3% – L – 0.5% = _______________ If L = 2.5%; a wash If L ____ 2.5%; GMAC pays TOP Bank: (L - 2.5%) x Notional Amount If L ____ 2.5%; Top Bank pays GMAC: (2.5% - L) x Notional Amount Copyright 2014 Diane Scott Docking 21 TOP BankGMAC Pay FRReceive FR Receive VRPay VR Net Profit

22. Solution to Swap Example 2: (cont.) 5) Suppose, at the end of year 1, LIBOR = 6%. Show the swap transactions. Since L > 2.5%; GMAC pays TOP Bank: (L – 2.5%) x Notional Amount (6% - 2.5%) x $200 mill. = 3.5% x $200 mill. = $7,000,000 Copyright 2014 Diane Scott Docking 22 Notional Amount = $200,000,000 Top BankGMAC Pay FR- $ 6,000,000+ $ 6,000,000Receive FR 3% x $200 million Receive VR+$ 13,000,000- $ 13,000,000Pay VR (L+0.5%) x $200 million 6.5% x $200 million Net Profit+ $ 7,000,000- $ 7.000,000

23. Solution to Swap Example 2: (cont.) 6) What did TOP Bank accomplish by entering into this swap? Top Bank has changed the VR debt to FR debt and locked in a net spread of $5 million per year for the next 5 years. Copyright 2014 Diane Scott Docking 23 Top BankFor 5 years on $200 million Loan revenue+ 6% Funding cost- (L+1%) Net spread 5% - L Swap payment- 3% Swap receipt+(L+0.5%) Net spread w/ swap 2.5%x $200 mill. = $5,000,000