Swaps and Interest Rate Options Chapter 13 Swaps and Interest Rate Options © 2004 South-Western Publishing

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

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

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

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

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

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

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)

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.

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

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.

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

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

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:

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

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:

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

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

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.

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 50-50. The current 5-yr T-bond rate is 4.50%.

Exploiting Comparative Advantage in the Credit Market Credit Market Example (cont’d) LIBOR AAA BBB Treasury + 40 bp Treasury + 25 bp LIBOR +30 bp Bondholders Bondholders

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.

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

Foreign Currency Swaps (cont’d) Cash flows at origination: FX Principal US $ Principal Party 1 Party 2

Foreign Currency Swaps (cont’d) Cash flows at each settlement: $ LIBOR FX Fixed Rate Party 1 Party 2

Foreign Currency Swaps (cont’d) Cash flows at maturity: US $ Principal FX Principal Party 1 Party 2

Foreign Currency Swaps (cont’d) Foreign Currency Swap Example A multinational US corporation has a subsidiary in Germany. It just signed a 3-year contract with a German firm. The German firm will provide raw materials, with the US firm paying 1 million Euros every 6 months for the 3-year period. The current exchange rate is $0.90/Euro. The contract is fixed in Euro terms, but if the dollar depreciates against the Euro, dollar accounts payable would increase.

Foreign Currency Swaps (cont’d) Foreign Currency Swap Example (cont’d) A currency swap is possible with the following terms: Tenor = 3 years Notional value = 25 million Euros ($22.5 million) Floating rate = $ LIBOR Fixed rate = 8.00% on Euros

Foreign Currency Swaps (cont’d) Foreign Currency Swap Example (cont’d) The swap will result in the following payments every six months: Fixed rate payment = 25,000,000 Euros x 8.00% x 0.5 = 1,000,000 Euros Floating rate payment = $22.5 million x 0.5 x LIBOR

Foreign Currency Swaps (cont’d) Foreign Currency Swap Example (cont’d) Cash Flows at Origination 25 million euros $22.5 million Party 1 Party 2

Foreign Currency Swaps (cont’d) Foreign Currency Swap Example (cont’d) Cash Flows at Each Settlement $ LIBOR 1 million euros Party 1 Party 2

Foreign Currency Swaps (cont’d) Foreign Currency Swap Example (cont’d) Cash Flows at Maturity $22.5 million 25 million euros Party 1 Party 2

Circus Swap Introduction Swap variations

Introduction 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

Introduction (cont’d) Circus swap with two counterparties: 8% on Euros $ LIBOR Party 1 Party 2

Introduction (cont’d) Circus swap with two counterparties (cont’d): $ LIBOR 6.50% US Party 1 Party 3

Introduction (cont’d) Circus swap with two counterparties (cont’d): 8% on Euros 6.50% US Party 1 Net

Introduction (cont’d) Circus swap with two counterparties (cont’d): Party 1 is effectively paying 8% on Euros and receiving 6.5% in U.S. dollars

Swap Variations Deferred swap Floating for floating swap Amortizing swap Accreting swap

Deferred Swap In a deferred swap (forward start swap), the cash flows do not begin until sometime after the initiation of the swap agreement If the swap begins now, the deferred swap is called a spot start swap

Floating for Floating Swap In a floating for floating swap, both parties pay a floating rate, but with different benchmark indices

Amortizing Swap In an amortizing swap, the notional value declines over time according to some schedule

Accreting Swap In an accreting swap, the notional value increases through time according to some schedule

Interest Rate Options Introduction Interest rate cap Interest rate floor Calculating cap and floor payoffs Interest rate collar Swaption

Introduction Most of the trading done off the exchange floors The interest rate options market is Very large Highly efficient Highly liquid Easy to use

Introduction (cont’d)

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

Interest Rate Cap (cont’d) Long interest rate cap (exercise price 7%) $ Payoff Payoff Option expires worthless Floating Rate 7%

Interest Rate Cap (cont’d) Short interest rate cap (exercise price 7%) $ Payoff Option expires worthless Floating Rate 7% Payout

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

Interest Rate Floor (cont’d) Long interest rate floor (exercise price 6.5%) $ Payoff Payoff Option expires worthless Floating Rate 6.5%

Interest Rate Floor (cont’d) Short interest rate floor (exercise price 6.5%) $ Payoff Option expires worthless Floating Rate 6.5% Payout

Calculating Cap and Floor Payoffs There are no universally acceptable terms to caps and floors 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

Calculating Cap and Floor Payoffs (cont’d) Cap payout formula: If the benchmark rate is less than the exercise price, the payout is zero

Calculating Cap and Floor Payoffs (cont’d) Floor payout formula:

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

Interest Rate Collar (cont’d) Long cap $ Payoff Inflow No payout Floating Rate K2 Outflow K1 Short floor

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