Exotic InvestmentsLesson 2

Interest Rate andCredit Default Swaps

BONUS

Aim: How can swaps be used to help

businesses succeed?

Do Now: Identify the risk a bank or investor has

when loaning money to a company.

Swaps

Do Now answer: That the company borrowing the money might not be able to pay it back.

Swaps

Interest Rate SwapsIn an interest rate swap, two market participants, known as counterparties, agree to exchange interest payments for a set period of time, typically from 1-5 years.

One counterparty makes a payment based on a fixed rate of interest, while the other counterparty makes a payment based on a floating rate of interest.

Interest Rate SwapsExample: Company A is borrowing money at a fixed rate of 6%.

Company B is borrowing the same amount of money at a variable rate of: 3.5% plus LIBOR (the London InterBank Offered Rate), a benchmark for many loans that moves up and down.

Let’s say that LIBOR is currently .5%, meaning that Company B’s variable rate is currently 3.5% + .5% = 4.0%.

Interest Rate SwapsExample (cont.): Company A, seeing that the variable rate loan rate is lower (and believing that interest rates will not rise for a long time), could make an offer to Company B that would swap A’s fixed rate for B’s variable rate.

It could offer to pay Company B interest of 4% + LIBOR and in return receive payment from company B of 5.5%.

Interest Rate SwapsExample (cont.): At this point, Company A would owe 6% to its original lenders and 4% (plus whatever the LIBOR rate is) to Company B. This results in its obligations being 10% + LIBOR. It will receive back from Company B 5.5%. This results in its final obligations being 10% - 5.5% = 4.5% plus LIBOR (which is currently .5%).

It just lowered its current interest rate from 6% to 5% (4.5% + .5%), but it has taken on the risk that interest rates may rise!

Interest Rate SwapsExample (cont.): Company B originally owed 3.5% + LIBOR interest on its loan. It has further promised in the swap to pay Company A 5.5%. Its total responsibility for interest payments is 9% + LIBOR.

However, Company A has agree to pay it whatever LIBOR is, plus 4%. Company A’s promise to cover LIBOR cancels out the variability of the rate. Company B is left with a fixed rate loan of 9% - 4% = 5%. It is paying 1% more than earlier, but it has removed the risk that interest rates may rise!

Credit Default Swaps (CDS)A swap that transfers the credit exposure of fixed income products (ie: loans) between parties

Buyer of the swap receives credit protection and the seller of the swap guarantees the credit worthiness of the fixed income security

The risk of the default is transferred from the holder of the fixed income security to the seller of the swap

BuyerSeller

Credit Protection

Risk of default Swap

Credit Default Swaps (CDS)Example: I.N. Vestor buys a $1,000,000 Frizzle,Inc. bond. He wants protection against loss of principal in the event

Frizzle, Inc. defaults on payment. He buys a credit default swap contract from a third party. I.N. Vestor makes periodic payments to the third party so

that it continues to keep the credit default swap in force. If Frizzle, Inc. defaults during the time period that I.N.

Vestor has paid for coverage, then the third party reimburses I.N. Vestor the face value of the Frizzle, Inc. bond ($1,000,000).

Note: If this sounds like insurance, it basically is!

Credit Default Swaps (CDS)

Uses for SwapsHedging: Hedging activities reduce risk. A borrower may enter into an

interest rate swap to remove the risk that a benchmark such as LIBOR goes higher, which would require it to pay more.

A purchaser of a credit default swap is buying insurance, which is the primary method for reducing risk.

Speculation: An investor may take on the risk of paying a variable rate of

interest (in return for a fixed rate) if it believes (ie: speculates) that rates will stay low and it will make a profit from the decision.

A buyer of a credit default swap (who does not own a bond and has no risk) is betting that a company will fail!

Lesson Summary1. In an interest rate swap, what are the two

parties exchanging?

2. What are the two parties formally known as?

3. What is a purchaser of a credit default swap acquiring?

4. What is this protection commonly called?

5. What are the two general uses for swaps?

6. How can swaps be used to help businesses succeed?

Web Challenge #1Challenge: LIBOR is an interest rate on which the interest rate of trillions of dollars are based.

1. Research how LIBOR was set up through 2013.

2. Identify what happened in 2012 that shocked the financial world. (Hint: Search using “rate fixing”).

3. Identify how LIBOR is currently arrived at.

Web Challenge #2Challenge: The rampant and unregulated use of Credit Default Swaps (CDSs) were a major contributor to the stock market crash of 2008 and the Great Recession. Research which firm sold the most CDSs and which consequently was not able to pay off the insurance it had sold when firms like Lehman Brothers failed. (Hint: It required a bailout from the U.S. Government in the neighborhood of $180 billion to make good on its insurance promises!)

Web Challenge #3Challenge: One of the goals of any market is to be transparent. Transparency means that its activities can be seen and understood by the participants. After the crash of 2008, regulators realized that the multi-trillion dollar credit default swap market had to come out of the shadows and be subject to scrutiny. Research and identify how the reforms in the Dodd Frank Wall Street Reform Act have brought transparency to the CDS market.