1. Interest Rate Derivative Market15

2. Chapter Objectives Describe the types of interest rate swaps available
Describe the risks of swaps
Identify other commonly used interest rate derivative instruments
Describe the globalization of swap markets

3. Background
Definition: Interest rate swap is an agreement between two parties to exchange one set of interest rate payments for another
Usually an exchange of a stream of fixed-rate interest payments for floating-rate payments
Characteristics
Over-the-counter trading—coordinated and negotiated by financial institution
Contracts less standardized than other derivatives like futures and options

4. Provisions of a Swap
The notional principal value to which the interest rates are applied to calculate the interest payments
The fixed interest rate
The formula and type of index used to determine the floating rate
The frequency of payments, such as every six months or every year
The lifetime of the swap

5. Background
Payments equal the differential multiplied by the notational amount used to calculate payments
No payment of notional principal
Payments made based on net amounts
Swaps used to manage risk or to speculate
Market imperfections help explain the existence of swaps
If used for speculation, can involve losses

6. Background
Example of two financial institutions, one in the U.S and one in Europe used to illustrate swap concepts
A U.S. financial institution with liabilities more rate-sensitive than assets is affected adversely by rising interest rates
A European financial institution has access to long-term, fixed-rate funds but makes floating rate loans and has the opposite exposure as compared to U.S. institution

7. Exhibit 15.1 An Interest Rate Swap
Short-T
erm
Deposits
Long-T
Fixed-Rate
erm Loans
U.S.
Depositors
Borrowers
European
Financial
Institution
U.S. Financial
Interest
on Deposits
Fixed Interest
Payments on Loans
Fixed
Interest
Payments
Floating
Interest
Payments
Fixed-Rate
Long-T
erm
Deposits
Floating-Rate
Loans
Interest
on Deposits
Floating Interest
Payments on Loans

8. Background
If interest rates increase and the U.S. and foreign institution negotiate a swap, the U.S. institution gets higher interest payments as rates rise to help offset the increased cost of funds
If interest rates decline then the foreign institution makes lower interest payments to the U.S. which helps offset the lower interest payments the European institution receives on loans

9. Background
Both institutions limit the potential benefits they might receive if rates moved in their favor—a hedge
U.S. bank forgoes potential benefits from rate declines
European bank forgoes any potential benefits from rate increases
Different kinds of swaps are possible which vary in the degree to which they cover the interest exposure and allow institutions to capture benefits if rates move in their favor

10. 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

11. Types of Interest Rate Swaps
Plain vanilla swap involves periodic exchange of fixed-rate payments for floating-rate payments
Basic exchange of payments for the U.S. and European institution given in the example information
LIBOR or London Interbank Offer Rate used as the as the index

12. Exhibit 15.3 Plain Vanilla Swap
Scenario of Declining
Interest Rates
Scenario of Rising
Interest Rates
Floating Inflow Payments
Level of Interest Payments
Fixed Outflow Payments
Level of Interest Payments
Fixed Outflow Payments
Floating Inflow Payments 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Y
ear
End of Y
ear

13. Types of Interest Rate Swaps
A forward swap is an exchange of interest payments that does not begin until some future point in time
Used if an institution is currently insulated against rate risk but anticipates risk beginning at a future time
Swap period is delayed but institution locks in future terms
Locks in at the prevailing rates based on expectations about future interest rates

14. Exhibit 15.5 Forward Swap a a End of Y ear End of Y ear
Scenario of Rising
Scenario of Declining
Interest Rates
Floating Inflow Payments
Interest Rates
Fixed Outflow Payments
Fixed Outflow Payments
Level of Interest Payments
Level of Interest Payments
Floating Inflow Payments at
This T
Forward
Swap Is
Arranged
ime
Forward
Swap Is
Arranged at
This T
ime T
Swapping of Payments
Begins at
This
ime
Swapping of Payments
Begins at
This T
ime 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Y
ear
End of Y
ear

15. Types of Interest Rate Swaps
Callable swaps are a swap option that allows counterparty with fixed payments to terminate prior to maturity
U.S. institution in the example could terminate swap if rates decline and then capture the benefits
Party with the right to terminate pays a premium in the form of a higher fixed rate
May also involve a termination fee

16. Exhibit 15.6 Callable Swap a a a End of Y ear End of Y ear
Scenario of Rising
Floating Inflow
Payments
Scenario of Declining
Interest Rates
Interest Rates
Fixed Outflow
Payments*
Fixed Outflow Payments*
Floating Inflow Payments
Level of Interest Payments
Level of Interest Payments
Option is exercised to
terminate the swap at
this time, because interest
rate trend is downward. 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Y
ear
End of Y
ear

17. Types of Interest Rate Swaps
Putable swaps allow the counterparty with floating-rate payments to terminate prior to maturity
European institution in the example could terminate swap if rates increase and then capture the benefits
Party with the right to terminate pays a premium in the form of a higher fixed rate
May also involve a termination fee

18. Exhibit 15.7 Putable Swap a a End of Y ear End of Y ear
Scenario of Rising
Scenario of Declining
Interest Rates
Interest Rates
Floating Inflow Payments
Fixed Outflow Payments *
Fixed Outflow
Payments *
Floating Inflow
Payments
Level of Interest Payments
Level of Interest Payments
Option is exercised by
recipient of fixed outflow
payments to terminate
the swap at this time, because
interest rate trend is upward. 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Y
ear
End of Y
ear

19. Types of Interest Rate Swaps
Extendable swaps allow the fixed-for-floating party to extend the swap period
Benefits from the ability to extend a current swap rather than negotiate a new swap at the prevailing market rates in existence when the initial swap matures
This feature involves a higher price
May have to pay fees if swap is extended

20. Exhibit 15.8 Extendable Swap
Scenario of Rising
Floating Inflow
Payments
Scenario of Declining
Interest Rates
Interest Rates
Fixed Outflow
Payments
Fixed Outflow
Payments
Floating Inflow
Payments
Level of Interest Payments
Level of Interest Payments
At this time, the institution
would likely extend
the swap period.
At this time, the institution
would likely decide not to
extend the swap period. 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Y
ear
End of Y
ear

21. Types of Interest Rate Swaps
Zero-coupon-for-floating swaps involve a fixed-rate payer that makes a single payment at the maturity of the swap
Floating-rate payer makes periodic payments
An example is a U.S. institution with short-term deposits funding zero coupon bonds
The risk is that an interest rate increase causes the bond prices to fall and increases the cost of funds on the liability side of the balance sheet

22. Exhibit 15.9 Zero-Coupon-For-Floating Swap
Single Lump-Sum
Fixed Outflow Payment
Scenario of Rising
Scenario of Declining
Interest Rates
Interest Rates
• A
Single Lump-Sum
Fixed Outflow Payment
Floating Inflow Payments
Floating Inflow
Payments
Level of Interest Payments
Level of Interest Payments 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Y
ear
End of Y
ear

23. Types of Interest Rate Swaps
Rate-capped swaps exchange fixed-rate payments for floating-rate payments that are capped and involve up-front fees
Example of U.S. and European firm
European firm may want to limit its possible payments with the cap and know what its maximum payments will be
U.S. firm may believe rates will not go above cap and if they do, swap’s effectiveness is limited

24. Exhibit 15.10 Rate-Capped Swap
Scenario of Rising
Purple Line Reflects
Floating Inflow Payments
If a Cap Did Not Exist
Scenario of Declining
Interest Rates
Interest Rates
Cap
Floating Inflow Payments
Based on Cap
Cap
Level
Level
Fixed
Outflow
Payments
Fixed Outflow Payments
Floating
Inflow
Payments
Payer of Fixed Outflow Payments
Receives Premium at
This T
ime
for
Agreeing to Cap
Agreeing to Cap
Payer of Fixed Outflow Payments
Receives Premium at
for
This T
ime 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Y
ear
End of Y
ear

25. Types of Interest Rate Swaps
Equity swaps involve the exchange of interest payments for payments linked to the degree of change in a stock index
Example
Company with a fixed 7% interest rate
Swaps a fixed rate for rate of appreciation in an index over a period of time
If index appreciates by 9% a year, differential is 2%
For use by portfolio managers

26. Other Types of Interest Rate Swaps
Rate swaps to accommodate financing needs
Corporations with varied debt ratings swap fixed for floating interest payments
Swap parties benefit from considerable differential in capital market rates for parties
Brokered by financial institutions who may bear credit or default risk
Tax swaps
Firm with expiring loss carryforwards swaps with
Firm expects future losses but has large gains from operations this year

27. Exhibit 15.11 Interest Rate Swap
Risky Co.
Quality Co.
Variable-Rate Payments at LIBOR + ½%
Fixed-Rate Payments at 9½%
Fixed-Rate
Payments
at 9% V
ariable-Rate
Payments
at LIBOR + 1%
Investors in
Fixed-Rate
Bonds Issued
by Quality Co.
Investors in V
ariable-Rate
Bonds Issued
by Risky Co.

28. Risk of Interest Rate Swaps
Basis risk is the chance that the index does not move in perfect tandem with the floating-rate instruments
Credit risk exists because one of the firms may not meet its payment obligations but this is minimized
If counterparty 1 defaults it does not make a required payment
Counterparty 2 would stop all subsequent payments

29. Risk of Interest Rate Swaps
Credit risk concerns exist for those that guarantee swaps
Regulators are considering how to respond
Large growth in swaps market so this concern will receive continued attention
Sovereign risk is the potential adverse effect from a country’s political conditions that could prevent one party from fulfilling its obligations

30. Pricing Interest Rate Swaps
Prevailing market interest rates determine swap rates
Availability of counterparties influences pricing
If there are numerous potential counterparties it increases the chance of negotiating favorable terms
This will change as economic conditions change
Credit and sovereign risk also influence prices

31. Factors Affecting the Performance of Interest Rate Swaps
Swap performance is affected by several underlying forces
Indicators monitored by participants in the swaps markets include any that would affect interest rates
U.S. economic conditions
International economic conditions
Monetary and fiscal policy

32. Interest Rate Caps, Floors, and Collars
Interest rate caps offer payments in periods when a specified interest rate index exceeds a specified ceiling interest rate
Payments based on the amount by which the interest rate exceeds the cap times the notational principal
Fee paid up front
Purchaser is an institution adversely affected by rate increases while seller expects stable or declining future rates

33. Interest Rate Caps, Floors, and Collars
Interest rate floors offer payments in periods when a specified interest rate index falls below a specified floor rate.
Used to hedge against lower interest rates
Seller gets the up-front fee but has an ongoing obligation to make payments if the rate falls below the floor

34. Interest Rate Caps, Floors, and Collars
Collar involves the simultaneous purchase of an interest rate cap and sale of an interest rate floor
Cap generates payments if interest rates rise
Use fee from selling floor to buy the cap
If rates drop, the institution has the ongoing obligation created by the sale of the interest rate floor

35. Globalization of Swap Markets
Counter-parties for interest rate swaps extends beyond United States, where interest rate changes may vary
Manufacturing corporations from various countries also engage in swaps
Interest rate swaps are denominated in many currencies
Lack of information and credit risk concerns reduced if intermediaries back payments

36. Globalization of Swap Markets
Currency swap is an arrangement in which currencies are exchanged at specified foreign exchange rates and at specified intervals
Used by firms to hedge their risks from foreign currency exposure caused by inflows and outflows denominated in different currencies
Currency swaps available in several variations and may involve intermediaries

37. Globalization of Swap Markets
Hedging bond payments with currency swaps involves Firm 1 issuing a bond denominated in euros to fund its euro operations
Firm 1 receives euros in the course of business that would be used to repay the bonds
Investors in the euro market do not know Firm 1 very well
Firm 1 swaps with Firm 2, a company that wants to issue dollar debt but is not well known by investors who buy dollar-denominated debt

38. Globalization of Swap Markets
Risks of currency swaps involve the same risks as other interest rate swaps
Basis risk occurs if using a related currency or if price movements are not perfectly correlated
Credit risk
Sovereign risk