M ECHANICS OF AN I NTEREST R ATE S WAP Ahmad Sharif Pour Date: June 1, 2011

A GENDA Overview of Interest Rate Swap Valuing Interest Rate Swap Risks Associated with Interest Rate Swap Reasons for the Rapid Growth of Interest Rate Swap Market.

I NTEREST R ATE S WAP Interest rate swap transactions began in 1981 Eurobond as principal security The largest component of the OTC interests rate derivatives market As of December 2010, national amount outstanding ($364 trillion) Gross market value ($13 trillion)

A N O VERVIEW OF I NTEREST R ATE S WAPS An agreement between two counterparties Exchange periodic interest payments based on predetermined principal value Time frame Notional principal amount Fixed interest rate (Fixed-rate payer) Floating interest rate (Floating-rate payer) Treasury bills, LIBOR (London Interbank Offered Rate), commercial paper, bankers acceptance, certificates of deposit, federal funds rate, and prime rate Payment dates

Firm A (Payer)Firm B (Receiver) Floating Rate Fixed Rate Time Frame: 5 years Notional principal amount: $50 Million Fixed rate: 10% Floating rate: six-month LIBOR Payment dates: Every six months

H OW I NTEREST R ATE S WAPS ARE USED Applications of Interest Rate Swaps Alter Cash flow of asset to provide a better match between assets and liabilities Asset Swap Alter cash flow of assets from fixed to floating or from floating to fixed without affecting the underlying assets. Liability Swap Alter cash flow of liabilities from fixed to floating or from floating to fixed without affecting the underlying assets

A SSET S WAP Firm A Financial Intermediary LIBOR + 40 bps 10% Firm B LIBOR bps Bond 9.5% 10% LIBOR + 60 bps Net = [(LIBOR bps + 10%) - LIBOR + 60bps] = 10.9% Net = [(10%+ LIBOR + 40bps) – 9.5%] = LIBOR + 90bps Financial Intermediary Net:.7%

I NTEREST R ATE S WAP V ALUATION Summing the present value of cash flow 1 st step: calculate the present value of floating rate payments 2 nd step: calculate the present value of the notional principal. Then, multiply it by the days in the period LIBOR futures rate as discount rate 3 rd step: calculate the swap rate Divide the results from step 1 by results from step 2 Result is the fixed rate that the party is willing to pay in return for receiving the 6-month LIBOR

I NTEREST R ATE S WAP R ISKS Interest rates increase Interest rates decrease Fixed-rate payerGainLoss Floating-rate payerLossGain Interest Risk

I NTEREST R ATE S WAP R ISKS -C ONT. Credit risk Occurs when counterparties default on the swap agreement Only one party at a time will be subject to credit risk Example Suppose company A pays 8% and company B pays 6-month LIBOR Now, if market rate on swaps falls below 8%, company B benefits and company A may default. Company B suffers a credit loss if company A goes bankrupt What happens if the interest rate increase to 9%?

R EASONS FOR THE R APID G ROWTH OF I NTEREST R ATE S WAP M ARKET Ability of institutional investors and corporate borrowers to changes the nature of their assets and liabilities Credit arbitrage opportunities Comparative advantage Increased volatility of interest rates Caused borrowers and lenders to hedge or manage their risk exposure Interest rate swap is more liquid than forward rate contract

T AKE - AWAY Interest rate swap is an agreement between two counterparties to exchange periodic interest payment Notional principal amount is not exchanged. Rather the interest rate times notional principal amount is exchanged. Alter cash flow of assets from fixed to floating or from floating to fixed without affecting the underlying assets. Interest rate valuation methods: Summing present value of cash flows YTM and zero coupon method Interest rate swaps risks Interest risk Credit risk

Q UESTIONS

R EFERENCES 5/24/2011, Amounts outstanding of over-the-counter (OTC) derivatives, Fabozzi, Frank. Modigliani, Franco. and Jones, Frank. 2010, Foundations of Financial Markets and Institutions (Pearson Prentice Hall) 5/24/2011, Understanding Interest Rate Swap Math and Pricing, Beidleman, Carl R. I991, Interest Rate Swaps (Richard D. Irwin, INC.)