Swap Contracts, Convertible Securities, and Other Embedded Derivatives Innovative Financial Instruments Dr. A. DeMaskey Chapter 25

OTC Interest Rate Agreements u Forward-Based Interest Rate Contracts – Forward Rate Agreements – Interest Rate Swaps u Option-Based Interest Rate Contracts – Caps and Floors – Collar – Swap Options

Forward-Based Interest Rate Contracts u Forward Rate Agreement (FRA) – two parties agree today to a future exchange of cash flows based on two different interest rates – one of the cash flows is tied to a fixed rate – the other is determined at a later date (floating rate) – LIBOR is frequently used as the floating rate index – Single settlement date

Forward-Based Interest Rate Contracts u Interest Rate Swaps – multiple exposure dates could be hedged using a series of FRAs – swap contract is a prepackaged series of forward contracts to buy or sell LIBOR at the same fixed rate – priced off the LIBOR forward yield curve, but quoted off the Treasury bond yield curve fixed rate side is – the yield of a Treasury bond with a comparable maturity, and – a risk premium term known as the swap spread

Forward-Based Interest Rate Contracts u Interest Rate Swaps – fixed and floating rate payments Where fixed rate is typically the current yield on the U.S. Treasury note (T-note yield + x bps). Where floating rate used is typically the London Interbank Borrowing Rate (LIBOR + x bps).

Swap Example u Consider a 3-year swap in which every 6 months: – Firm B pays Firm A a 5% annual fixed rate – Firm A pays Firm B the prevailing 6-month LIBOR – Notional amount is $100,000,000

Solution Swap is entered into at time 0.

How Are Swaps Used? u To transform a liability – convert floating-rate loan to fixed-rate loan (or vice versa) u To transform an asset – convert fixed rate paying asset to one paying floating rate (or vice versa)

Transforming a Liability u A firm has 3 years left on its $100 million loan at LIBOR u The firm wants to convert this floating rate loan to a fixed rate loan u To accomplish this, the firm enters into the following swap: – It pays 5% fixed and receives LIBOR – Net cost = LIBOR LIBOR = 5.8%

Transforming an Asset u Suppose a firm owns a portfolio of bonds that pays a fixed rate of 4.70% u The firm whishes to convert this to a floating rate u So, it enters into the following swap: – Pays 5% fixed and receives LIBOR – Net return = LIBOR = LIBOR

Option-Based Interest Rate Contracts u Cap agreement – a series of cash settlement interest rate options, typically based on LIBOR u Floor agreement – makes settlement payments only when LIBOR is below the floor rate

Option-Based Interest Rate Contracts u Collars – combination of a cap and a floor – long in one and short in the other – cap-floor-swap parity occurs when the combination are at the same rates and have a net zero initial cost – can be viewed as a pair of option positions

Option-Based Interest Rate Contracts u Swap Options (“Swaptions”) – the right but not obligation to enter into an interest rate swap having a predetermined fixed rate at some later date – Types: Receiver swaption Payer swaption

Swap Contracting Extensions u Currency swaps – denominated in different currencies u Equity index-linked swaps – based on a variable debt rate and an equity index u Commodity swaps – fixes the price of a commodity over a certain period – hedge exposures to commodity prices

Warrants and Convertible Securities u Warrants – equity option issued by the company whose stock serves as the underlying asset – if exercised, the company will create new shares of stock to give to the warrant holder

Warrants and Convertible Securities u Convertible securities – owner has right but not obligation to convert the existing investment into another – Convertible preferred stock convertible into common stock conversion value – Convertible bonds viewed as a regular bond plus an option to exchange the bond for a number of shares of common stock

Other Embedded Derivatives u Structured notes u Dual currency bonds u Equity index-linked notes u Commodity-linked bull and bear bonds u Swap-linked notes

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