1. Interest Rate Swaps Blackwell, et al, chapter 13 and other materials

2. Swaps A swap is an agreement to exchange cash flows at specified future times according to specified rules. The most common swap is a single-currency interest rate swap that exchanges a fixed coupon stream for a variable coupon stream. This is referred to as a plain vanilla swap. 2

3. Selected Types of Swaps Plain vanilla: floating for fixed payment Basis swap: floating for floating rate Yield curve swap: short-term interest for long-term interest Amortizing swap: the notional principal is reduced as termination date approaches Accretion swap: notional principal increases Index amortizing swap: amortization depends on whether floating rate is above or below a given level Extendable swap: one party has the right to extend the swap Formula swaps: these swaps use complex formulas to establish the payments; these swaps are leveraged in that multiples are used which makes them dangerous; it was formula swaps that hit Proctor and Gamble (P&G) and Gibson Greeting Cards 3

4. Other types of swaps Substitution swap: swap identical bonds with different prices to take advantage of temporary mispricing. Intermarket spread swap: swap different bonds to take advantage of unusual spreads in one market. Rate anticipation swap: change portfolio duration by swapping to take advantage of anticipated changes in interest rates. Pure yield pickup swap: swap bonds of different risk to pick up the extra yield on the riskier bond.

5. Understanding Swaps In general, swaps are used to hedge or speculate on interest rates. A agreement between two parties to exchange periodic interest payments Effect: to alter the cash flow characteristics of an asset or liability Example: a variable rate loan can be swapped into a fixed rate loan and vice versa Uses To alter the interest rate exposure of a given asset or liability To alter asset/liability gap of a financial institution To develop tailored products for customers To speculate on the direction of interest rate moves 5

6. The Interest Exchange The dollar amount of the interest payment is based on a stated amount. This stated amount is known as the notional amount. The dollar amount payable by each party to the agreement is equal to that party’s interest rate times the notional amount of the agreement This is not a loan. The notional amount is not at risk; its sole role is to determine the payments that are to be exchanged 6

7. The Plain Vanilla Swap Party A agrees to pay party B a fixed interest payment of R f every three months for five years. Party B agrees to pay Party A variable rate equal to the three-moth Eurodollar rate for five years The notional amount is multiplied times each notional amount to determine the dollars exchanged. The dollars are exchanged on a net basis Why might part A want the SWAP Party A has a variable rate loan with a contract rate equal to the Eurodollar rate plus 150 basis points. BUT, party A wants a fixed rate loan. The swap enables party A to fix the rate paid on the loan to RFD plus 150 basis points How: the Eurodollar based payment that A receives from B is paid to the lender, along with the 150 bp spread. The borrower no longer has a variable obligation. 7

8. Direction of the SWAP Payments To fix the rate on a floating rate liability: Borrower pays a fixed rate to the counterparty and receives a variable rate from the counterparty To float the rate on a fixed rate liability: The borrower pays a floating rate to the counterparty and receives a fixed rate from the counterparty To float a fixed rate asset: Asset holder pays a fixed rate to the counterparty and receives a variable rate from the counterparty To fix a floating rate asset Asset holder pays a floating rate to the counterparty and receives a fixed rate from the counterparty 8

9. 9 Understanding Swaps Example of a Plain Vanilla Swap Blue Chip, Inc: is rated AAA and can borrow for 5 years either at a fixed 7% or LIBOR + 25 basis points. Brown Chip, Inc: is rated BBB and can borrow for 5 years at a fixed 10% or LIBOR + 125 basis points. The two companies agree to a swap as follows.

10. 10 Understanding Swaps Blue Chip Brown Chip Libor + 25bp 7% + 1% 7%Libor + 125bp Blue Chip is not altruistic, so Brown Chip must provide some extra for Blue Chip in the swap

11. 11 Understanding Swaps Now the cash flows from the swap are For Brown Chip, the company will: pay a fixed rate on the swap of-8% pay a floating rate to its funding source of- (Libor +125bp) receive a floating rate from the swap of+ Libor + 25bp Hence, the overall rate to Brown Chip will be: -9% Now, let’s take a look at Blue Chip, the company will: pay a fixed rate to its funding source of-7% pay a floating rate on the swap of - (Libor +25bp) receive a fixed rate from the swap of+8% Hence, the overall rate to Blue Chip will be: - (Libor -75bp)

12. 12 Understanding Swaps The outcome of the swap is that both companies pay a lower rate. Blue Chip moves from LIBOR + 25 bp to LIBOR – 75 bp and Brown Chip moves from 10% fixed to 9% fixed.

13. 13 Understanding Swaps Both parties in this swap pay a lower rate in the swap than they could get individually. However, we need to be aware that there is risk in a swap. A swap is a contract between two parties so we have counterparty risk related to failure to make the agreed upon payments. However, by not exchanging principal amounts a swap minimizes the credit risk in the agreement.

14. Understanding Swaps The Steps in a Plain Vanilla Swap 1.You have to analyze the business situation and determine the current cash flows. Then you need to determine what you want the cash flows to be. 2.The second step is to work out the details of the swap. This comprises several issues. First, you have to identify when the swap will start and when it will end. Remember, a swap contract is a legal document so you have to be quite specific in identifying who is responsible for what actions. This includes identifying the counterparty with whom you are dealing. 3. Next, is the identification of the notional principal. Participants to an interest rate swap do not actually exchange the principal amounts, but have to identify the principal for interest calculation purposes. 4. Now, we have to identify the details associated with each leg of the swap. 14

15. 15 Understanding Swaps Landfill example You are the CFO for a landfill and you have a loan from YUR bank for trucks and earth movers. The loan is a fixed-rate loan set at the 10-year Treasury bond rate + 200 bp, which equaled 8% at the time of the loan.

16. 16 Understanding Swaps Landfill example You believe the economy is about to improve and interest rates will decline, so you want a way to reduce your loan rate. You can (1) switch banks, (2) refinance at your current bank, or (3) enter into a swap contract. Switching banks and refinancing are costly, so you decide to do a swap. You enter into the following swap with NU bank.

17. 17 Understanding Swaps Landfill example Fixed Rate: Treasuries + 200bp LandfillNU Bank Variable Rate YUR Bank Fixed Rate: Treasuries + 200bp

18. 18 Understanding Swaps Landfill example Start Date: 01/01/x1End Date: 01/01/x4 Counter-party: NU Bank Pay SideReceive Side TypeFloatingFixed Payment Frequency Semi-AnnualAnnual Price/BasisLibor8.00% Day CountActual/36030/360 Landfill plain vanilla swap agreement

19. 19 Understanding Swaps (cont.) Landfill example This swap is not without risk. You have taken a position in the swap based on your analysis that interest rate will decline. If interest rate increase instead, you will pay a higher rate on your loan because now you effectively have a variable-rate loan.

20. 20 Understanding Swaps Landfill example In an interest rate swap, the bank typically quotes only the fixed rate side. For example, at the time of our swap NU bank has the following swap quotes. NU-Bank Swap Quotations against 6-Month Libor 2-year7.92 / 94 3-year8.00 / 04 4-year8.22 / 27 Day Count 30/360

21. 21 Understanding Swaps (cont.) Landfill example Here is how you read the quotes. If you receive a fixed rate from the bank for two years, then you will receive 7.92%. If you want to pay the bank a fixed rate for two years, then you will agree to pay 7.94%.

22. Another Illustration of a Plain Vanilla Swap Suppose that the floating rate party has agreed to Pay the Eurodollar deposit rate The rate is set at the start of each period and is typically based on the average prevailing offer rate at 5 major banks It is paid at the end of the period Suppose that funds are swaps on April 15 based on a notional amount of 1,000,000. Floating rate would have been established on January 15th Suppose that the average of 5 banks was 5.375% and the fixed rate party pays 6% On April 15th, the floating rate party has an obligation of 1,000,000 x.0134375 = 13,437.50 On April 15th the fixed rate party has an obligation of 1,000,000 x.015 = 15,000 Funds are exchanged on a net basis, so the fixed rate party pays the floating rate party 1,562.50 22

23. Pricing a SWAP The fixed rate portion must be established To do so, the swap writer needs some notion of the likely floating rate payments This is obtained from the Eurodollar futures market The fixed rate is the rate that sets the PV of the floating rate payments to the PV of the fixed rate payments when the discount factor is the zero coupon yield curve associated with the floating rate 23

24. Eurodollar Zero-Coupon Yield Curve First Quarter of 40 quarter zero coupon yield curve Second quarter of 40 quarter zero coupon yield curve Third Quarter of 40 quarter zero coupon yield curve Third Quarter of 40 quarter zero coupon yield curve Where E0 = current Eurodollar rate F1 = current 3-mo E$ contract to expire in 4 months F2 = = current 3-mo E$ contract to expire in 8 months F40 = current 3-mo E$ contract to expire in 40 months

25. The Value of a Swap Rise in Rates As interest rates change, the value of the swap changes Suppose that interest rates rise The future rates shift upward, increasing the expected cash flow stemming from the floating rate portion If the futures market shifts upward, the associated zero coupon yield curve shifts upward The rise in the zero coupon yield curve decreases the PV of the fixed payment and offsets the effect of the increase in the cash flow expected from the floating rate The difference between the PV of the floating and the fixed payments is now positive Consequences Counterparty that pays floating and receives fixed now has a liability since the PV of what it pays is greater than the PV of what it receives Counterpaty that pays fixed and receives floating has an asset, since the PV of what it receives is greater than the PV of what it pays 25

26. The Value of a Swap Rise in Rates As interest rates change, the value of the swap changes Suppose that interest rates rise The future rates shift upward, increasing the expected cash flow stemming from the floating rate portion If the futures market shifts upward, the associated zero coupon yield curve shifts upward The rise in the zero coupon yield curve decreases the PV of the fixed payment and offsets the effect of the increase in the cash flow expected from the floating rate The difference between the PV of the floating and the fixed payments is now positive Consequences Counterparty that pays floating and receives fixed now has a liability since the PV of what it pays is greater than the PV of what it receives Counterpaty that pays fixed and receives floating has an asset, since the PV of what it receives is greater than the PV of what it pays 26

27. Credit Derivatives Credit derivatives permit the transfer of credit risk between parties in isolation from other forms of risk Institution can either Acquire credit risk Hedge risk Types Credit default swaps Total rate of return swaps Credit-linked notes Benefits Allow lenders to reduce concentration risk Allow lenders to increase the total return on a portfolio, given the risk, by structuring the portfolio to diversify credit exposures Problem: Products are new and untested Depends on thorough understanding of portfolios existing risk profile 27