© 2004 south-western publishing 1 chapter 13 swaps and interest rate options
TRANSCRIPT
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Introduction
Both swaps and interest rate options are relatively new, but very large– In mid-2000, there was over $60 trillion
outstanding in interest rate swaps, foreign currency swaps, and other interest rate options
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Interest Rate Swaps
Introduction Immunizing with interest rate swapsExploiting comparative advantage in
the credit market
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Introduction
Popular with bankers, corporate treasurers, and portfolio managers who need to manage interest rate risk
A swap enables you to alter the level of risk without disrupting the underlying portfolio
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Introduction (cont’d)
The most common type of interest rate swap is the fixed for floating rate swap– One party makes a fixed interest rate payment to
another party making a floating interest rate payment
– Only the net payment is made (difference check)– The firm paying the floating rate is the swap seller– The firm paying the fixed rate is the swap buyer
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Introduction (cont’d)
Typically, the floating interest rate is linked to a market rate such as LIBOR or T-bill rates
The swap market is standardized partly by the International Swaps and Derivatives Association (ISDA)– ISDA provisions are master agreements
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Introduction (cont’d)
A plain vanilla swap refers to a standard contract with no unusual features or bells and whistles
The swap facilitator will find a counterparty to a desired swap for a fee or take the other side– A facilitator acting as an agent is a swap broker– A swap facilitator taking the other side is a swap
dealer (swap bank)
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Introduction (cont’d)
Plain Vanilla Swap Example
A large firm pays a fixed interest rate to its bondholders, while a smaller firm pays a floating interest rate to its bondholders.
The two firms could engage in a swap transaction which results in the larger firm paying floating interest rates to the smaller firm, and the smaller firm paying fixed interest rates to the larger firm.
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Introduction (cont’d)
Plain Vanilla Swap Example (cont’d)
Big Firm Smaller Firm
Bondholders Bondholders
LIBOR – 50 bp
8.05%
8.05% LIBOR +100 bp
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Introduction (cont’d)
Plain Vanilla Swap Example (cont’d)
A facilitator might act as an agent in the transaction and
charge a 15 bp fee for the service.
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Introduction (cont’d)
Plain Vanilla Swap Example (cont’d)
Big Firm Smaller Firm
Bondholders Bondholders
8.05% LIBOR +100 bp
Facilitator
LIBOR -50 bp
8.05% 8.20%
LIBOR -50 bp
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Introduction (cont’d)
The swap price is the fixed rate that the two parties agree upon
The tenor is the term of the swap The notional value determines the size of
the interest rate payments Counterparty risk refers to the risk that one
party to the swap will not honor its part of the agreement
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Immunizing With Interest Rate Swaps
Interest rate swaps can be used by corporate treasurers to adjust their exposure to interest rate risk
The duration gap is:
sliabilitieassetgap Dassets Total
sLiabilitie TotalDD
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Immunizing With Interest Rate Swaps (cont’d)
A positive duration gap means a bank’s net worth will suffer if interest rates rise– The treasurer may choose to move the duration
gap to zero This could be accomplished by selling some of the
bank’s loans and holding cash equivalent securities instead
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Immunizing With Interest Rate Swaps (cont’d)
Using the bank’s balance sheet, we can algebraically solve for the proportion of the firm’s assets to be held in cash so that the duration gap is zero:
0Dassets Total
sLiabilitie Total
-durationasset loan averagex100.0xD
sliabilitie
cashcashgap
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Exploiting Comparative Advantage in the Credit Market
Interest rate swaps can be used to exploit differentials in the credit market
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Exploiting Comparative Advantage in the Credit Market
Credit Market Example
AAA Bank and BBB Bank currently face the following borrowing possibilities:
Firm Fixed Rate Floating Rate
AAA Current 5-yr
T-bond + 25 bp
LIBOR
BBB Current 5-yr
T-bond + 85 bp
LIBOR + 30 bp
Quality Spread 60 bp 30 bp
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Exploiting Comparative Advantage in the Credit Market
Credit Market Example (cont’d)
AAA Bank has an absolute advantage over BBB in both the fixed and the floating rate markets. AAA has a comparative advantage in the fixed rate market.
The total gain available to be shared among the swap participants is the differential in the fixed rate market minus the differential in the variable rate market, or 30 bps.
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Exploiting Comparative Advantage in the Credit Market
Credit Market Example (cont’d)
AAA Bank wants to issue a floating rate bond, while BBB wants to borrow at a fixed rate. Both banks will borrow at a lower cost if they agree to an interest rate swap.
AAA Bank should issue a fixed rate bond because it has a comparative advantage in this market. BBB should borrow at a floating rate. The swap terms split the rate savings 50-50. The current 5-yr T-bond rate is 4.50%.
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Exploiting Comparative Advantage in the Credit Market
Credit Market Example (cont’d)
AAA BBB
Bondholders Bondholders
LIBOR
Treasury + 40 bp
Treasury + 25 bp LIBOR +30 bp
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Exploiting Comparative Advantage in the Credit Market
Credit Market Example (cont’d)
The net borrowing rate for AAA is LIBOR – 15 bps
The net borrowing rate for BBB is Treasury + 70 bps
The net rate for both parties is 15 bps less than without the swap.
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Foreign Currency Swaps
In a currency swap, two parties– Exchange currencies at the prevailing exchange
rate – Then make periodic interest payments to each
other based on a predetermined pair of interest rates, and
– Re-exchange the original currencies at the conclusion of the swap
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Foreign Currency Swaps (cont’d)
Cash flows at origination:
FX Principal
US $ PrincipalParty 1 Party 2
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Foreign Currency Swaps (cont’d)
Cash flows at each settlement:
$ LIBOR
FX Fixed RateParty 1 Party 2
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Foreign Currency Swaps (cont’d)
Cash flows at maturity:
US $ Principal
FX PrincipalParty 1 Party 2
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Foreign Currency Swaps (cont’d)
Foreign Currency Swap Example
A multinational US corporation has a subsidiary in Germany. It just signed a 3-year contract with a German firm. The German firm will provide raw materials, with the US firm paying 1 million Euros every 6 months for the 3-year period. The current exchange rate is $0.90/Euro.
The contract is fixed in Euro terms, but if the dollar depreciates against the Euro, dollar accounts payable would increase.
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Foreign Currency Swaps (cont’d)
Foreign Currency Swap Example (cont’d)
A currency swap is possible with the following terms:
Tenor = 3 years Notional value = 25 million Euros ($22.5 million) Floating rate = $ LIBOR Fixed rate = 8.00% on Euros
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Foreign Currency Swaps (cont’d)
Foreign Currency Swap Example (cont’d)
The swap will result in the following payments every six months:
Fixed rate payment = 25,000,000 Euros x 8.00% x 0.5 = 1,000,000 Euros
Floating rate payment = $22.5 million x 0.5 x LIBOR
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Foreign Currency Swaps (cont’d)
Foreign Currency Swap Example (cont’d)
Cash Flows at Origination
25 million euros
$22.5 million
Party 1 Party 2
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Foreign Currency Swaps (cont’d)
Foreign Currency Swap Example (cont’d)
Cash Flows at Each Settlement
$ LIBOR
1 million euros
Party 1 Party 2
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Foreign Currency Swaps (cont’d)
Foreign Currency Swap Example (cont’d)
Cash Flows at Maturity
$22.5 million
25 million euros
Party 1 Party 2
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Introduction
A circus swap combines an interest rate and a currency swap– Involves a plain vanilla interest rate swap and an
ordinary currency swap– Both swaps might be with the same
counterparty or with different counterparties
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Introduction (cont’d)
Circus swap with two counterparties (cont’d):
$ LIBOR
6.50% US
Party 1 Party 3
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Introduction (cont’d)
Circus swap with two counterparties (cont’d):
8% on Euros
6.50% US
Party 1 Net
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Introduction (cont’d)
Circus swap with two counterparties (cont’d):– Party 1 is effectively paying 8% on Euros and
receiving 6.5% in U.S. dollars
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Deferred Swap
In a deferred swap (forward start swap), the cash flows do not begin until sometime after the initiation of the swap agreement– If the swap begins now, the deferred swap is
called a spot start swap
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Floating for Floating Swap
In a floating for floating swap, both parties pay a floating rate, but with different benchmark indices
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Amortizing Swap
In an amortizing swap, the notional value declines over time according to some schedule
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Accreting Swap
In an accreting swap, the notional value increases through time according to some schedule
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Interest Rate Options
Introduction Interest rate cap Interest rate floor Calculating cap and floor payoffs Interest rate collar Swaption
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Introduction
Most of the trading done off the exchange floors
The interest rate options market is– Very large– Highly efficient– Highly liquid– Easy to use
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Introduction (cont’d)
Growth in Interest Rate OptionsNotional Value
0
5
10
15
1992 1993 1994 1995 1996 1997 1998 1999 2000
(Tril
lions
)
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Interest Rate Cap
An interest rate cap– Is like a portfolio of European call options
(caplets) on an interest rate On each interest payment date over the life of the cap,
one option in the portfolio expires
– Is useful to firms with floating rate liabilities– Caps the periodic interest payments at the
caplet’s exercise price
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Interest Rate Cap (cont’d)
Long interest rate cap (exercise price 7%)
$ Payoff
Option expires worthless
7%Floating Rate
Payoff
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Interest Rate Cap (cont’d)
Short interest rate cap (exercise price 7%)
$ Payoff
Option expires worthless
7%Floating Rate
Payout
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Interest Rate Floor
An interest rate floor– Is related to a cap in the same way that a put is
related to a call– Like a portfolio of European put options
(floorlets) on an interest rate On each interest payment date over the life of the cap,
one option in the portfolio expires
– Is useful to firms with floating rate assets– Puts a lower limit on the periodic interest
payments at the floorlet’s exercise price
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Interest Rate Floor (cont’d)
Long interest rate floor (exercise price 6.5%)
$ Payoff
Option expires worthless
6.5%Floating Rate
Payoff
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Interest Rate Floor (cont’d)
Short interest rate floor (exercise price 6.5%)
$ Payoff
Option expires worthless
6.5%Floating Rate
Payout
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Calculating Cap and Floor Payoffs
There are no universally acceptable terms to caps and floors
However, frequently the terms provide for the cash payment on an in-the-money caplet or floorlet to be based on a 360-day year
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Calculating Cap and Floor Payoffs (cont’d)
Cap payout formula:
If the benchmark rate is less than the exercise price, the payout is zero
price) striking-rate (benchmark360
periodpayment in Days value)(notionalpayout Cap
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Calculating Cap and Floor Payoffs (cont’d)
Floor payout formula:
rate)benchmark - price (striking360
periodpayment in Days value)(notionalpayoutFloor
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Interest Rate Collar
An interest rate collar is simultaneously long an interest rate cap and short an interest rate floor
Sacrifices some upside potential in exchange for a lower position cost– Premium from writing the floorlets reduces
position costs
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Interest Rate Collar (cont’d)
$ Payoff
K2
Floating RateInflow
Outflow K1
No payout
Long cap
Short floor