Risk Management Hedging with Swaps 1 Copyright 2014 Diane Scott Docking

Terminology, Conventions and Market Quotes Fixed-Rate payer Pays fixed rate in the swap Receives floating rate in the swap Is considered the buyer of a swap Is long a swap; but Has entered into a short hedge Why? You are E(i) to increase (want to be paying the FR); therefore, Prices to decrease. Has constructed a position with the price sensitivities of a longer-term liability and a floating- rate asset (ST Asset funded by a LT liability) 2

Copyright 2014 Diane Scott Docking Terminology, Conventions and Market Quotes Floating-Rate payer Pays floating rate in the swap Receives fixed rate in the swap Is considered the seller of a swap Is short a swap; but Has entered into a long hedge Why? You are E(i) to decrease (want to be paying the VR); therefore, Prices to increase. Has constructed a position with the price sensitivities of a longer-term asset and a floating- rate liability (LT Asset funded by a ST liability) 3

Copyright 2014 Diane Scott Docking 4 Plain Vanilla Interest Rate Swap

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 5 Concerned if interest rates decrease Concerned if interest rates increase

Example: Analyzing & Constructing an Interest Rate Debt Swap Town Bank and Country Bank have the following opportunities for borrowing in the short-term (floating rate) and long-term (fixed rate) markets: Town BankCountry Bank Floating RateT-bill + 1.0%T-bill + 2.0% Fixed Rate 8% 10.5% Town Bank has a positive gap and Country Bank has a negative gap. 1. Show how both banks can benefit from a swap in the sense of lowering their interest rate risk and their cost of funds. Assume any potential savings is split ⅔ to Town and ⅓ to Country. 2. Based upon your swap construction in #1, what is the net payover amount (in $) for the next 4 years given the following information: Notional amount = $1,000,000 T-bill rates: Year 1 = 6%; Year 2 = 8%; Year 3 = 3%; Year 4 = 10% Copyright 2014 Diane Scott Docking 6

Solution to Example: Analyzing & Constructing an Interest Rate Debt Swap 1.a) Need the opposite regarding desired payments 1.b) Need savings potential Copyright 2014 Diane Scott Docking 7

Solution to Example: Analyzing & Constructing an Interest Rate Debt Swap 1.c) LT premium > ST premium (usually is the required case) So, YES a swap is possible between the two parties! 2.a) Allocate potential savings between the two parties. Assume any potential savings is split ⅔ to Town and ⅓ to Country. Savings to Town: ⅔ x 1.50%=1.00% Savings to Country: ⅓ x 1.50%=0.50% Copyright 2014 Diane Scott Docking 8 >

Solution to Example: Analyzing & Constructing an Interest Rate Debt Swap 2.b) Construct the Swap Copyright 2014 Diane Scott Docking 9

Solution to Example: Analyzing & Constructing an Interest Rate Debt Swap 2.c) Determine Payover rate, and who pays whom and when. Payover rate = FR – VR under terms of the swap. Payover rate = 8.00% - T% If T ____ 8%; a wash If T ____ 8%; Town pays Country: (T% - 8%) x Notional Amount If T ____ 8%; Country pays Town: (8% - T%) x Notional Amount Copyright 2014 Diane Scott Docking 10

Solution to Example: Analyzing & Constructing an Interest Rate Debt Swap What is the net payover amount (in $) for the next 4 years given the following information: Notional amount = $1,000,000 T-bill rates: Year 1 = 6%; Year 2 = 8%; Year 3 = 3%; Year 4 = 10% Copyright 2014 Diane Scott Docking 11

Copyright 2014 Diane Scott Docking12 a Variable-Rate Payments at LIBOR + ½% Fixed-Rate Payments at 9½% Investors in Fixed-Rate Bonds Issued by Quality Co. Risky Co.Quality Co. Fixed-Rate Payments at 9% Investors in Variable-Rate Bonds Issued by Risky Co. Variable-Rate Payments at LIBOR + 1% Borrower with lower credit rating pays fixed payments of borrower with higher credit rating, while Borrower with higher credit rating pays short-term floating rate of borrower with lower credit rating Plain Vanilla Swap #2 Quality Interest Rate Swap

Copyright 2014 Diane Scott Docking 13 Example: Analyzing & Constructing a Quality Interest Rate Swap Risky Bank can borrow short-term at Prime % and long- term at 11.50%.Safe Bank can borrow short-term at Prime and long-term at 9%. Risky Bank wants to borrow long-term, but feels their long- term rate is too expensive. Safe Bank wants to borrow short- term and is always looking for a way to lower its short-term borrowing rate. 1. Could a swap be constructed between Risky and Safe Bank that would be advantageous to both? If so, how? What would be the potential savings? 2. Construct a swap. Assume any potential savings is split 2/3 to Risky Bank and 1/3 to Safe Bank. 3. What is the net payover rate and who will pay whom?

Copyright 2014 Diane Scott Docking 14 Solution to Example: Analyzing & Constructing a Quality Interest Rate Swap

Copyright 2014 Diane Scott Docking 15 Solution to Example: Analyzing & Constructing a Quality Interest Rate Swap (cont.)

Copyright 2014 Diane Scott Docking 16 Solution to Example: Analyzing & Constructing a Quality Interest Rate Swap (cont.)

Copyright 2014 Diane Scott Docking 17 Solution to Example: Analyzing & Constructing a Quality Interest Rate Swap (cont.)

Regulation The Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have implemented uniform guidelines that require banks to: establish internal guidelines regarding hedging activity establish trading limits disclose large contract positions that materially affect the risk to shareholders and outside investors As of 2000 the FASB requires all firms to reflect the marked-to-market value of their derivatives positions in their financial statements Prior to the Dodd-Frank Act, swap markets were governed by relatively little regulation—except indirectly at FIs through bank regulatory agencies The Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have implemented uniform guidelines that require banks to: establish internal guidelines regarding hedging activity establish trading limits disclose large contract positions that materially affect the risk to shareholders and outside investors As of 2000 the FASB requires all firms to reflect the marked-to-market value of their derivatives positions in their financial statements Prior to the Dodd-Frank Act, swap markets were governed by relatively little regulation—except indirectly at FIs through bank regulatory agencies 18 Copyright 2014 Diane Scott Docking

Regulation The Dodd-Frank Act of 2010 requires most OTC derivatives to be exchange-traded to ensure performance by all parties The act also requires OTC derivatives be regulated by the SEC and/or the CFTC The Dodd-Frank Act of 2010 requires most OTC derivatives to be exchange-traded to ensure performance by all parties The act also requires OTC derivatives be regulated by the SEC and/or the CFTC 19 Copyright 2014 Diane Scott Docking