Interest Rate Swaps

1. Chapter 16 Interest Rate Swaps

2. Interest Rate Swaps: Origin • The Student Loan Marketing Association (Sallie Mae) was established in 1970 to develop a secondary market for student loans. • Sallie Mae issued securities and used the proceeds to buy students loans created by banks and other institutions. • The loans bought by Sallie Mae had intermediate terms and floating rates tied to the T-bill rate • The securities sold by Sallie Mae to finance the loan purchases tended to be short term with rates highly correlated with T-bill rates.

3. Interest Rate Swaps: Origin • As a Federal Agency, Sallie Mae had access to intermediate fixed-rate funds at favorable rates, but preferred the floating-rate funds given the nature of its loan assets. • At the same time, there were a number of corporations that had access to favorable floating rates, but preferred fixed-rate funds to finance their assets.

4. Interest Rate Swaps: Origin • In 1982, Sallie Mae issued its first fixed-rate intermediate bond through a private placement and swapped it for a floating-rate note tied to the 91-day T-bill rate that was issued by ITT, thus creating the first interest rate swap.

5. Interest Rate Swaps: Origin • The swap provided ITT with fixed-rate funds that were 17 BP below the rate it could obtain on a direct fixed-rate loan. • The swap provided Sallie Mae with cheaper intermediate-term, floating-rate funds. • Both parties therefore benefited from the swap.

6. Interest Rate Swaps: Origin • Today there exist an interest rate swap market where over $5 trillion dollars (in notional principal) of swaps of fixed-rate loans for floating-rate loans occur each year

7. Interest Rate Swaps: Origin • The market primarily consist of financial institutions and corporations who use the swap market to hedge more efficiently their liabilities and assets. • Many institutions create synthetic fixed or floating- rate assets or liabilities with better rates than the rates obtained on direct liabilities and assets.

8. Interest Rate Swaps: Definition Definition: • A swap is an exchange of cash flows, CFs: It is a legal arrangement between two parties to exchange specific payments.

9. Interest Rate Swaps: Types • There are three types of swap: • Interest Rate Swaps: Exchange of fixed-rate payments for floating-rate payments • Currency Swaps: Exchange of liabilities in different currencies • Cross-Currency Swaps: Combination of Interest rate and Currency swap

10. Plain Vanilla Interest Rate Swaps Definition • Plain Vanilla or Generic Interest Rate Swap involves the exchange of fixed-rate payments for floating-rate payments.

11. Plain Vanilla Interest Rate Swaps: Terms • Parties to a swap are called counterparties. There are two parties: • Fixed-Rate Payer • Floating-Rate Payer • Rates: • Fixed rate is usually a T-note rate plus BP • Floating rate is a benchmark rate: LIBOR.

12. Plain Vanilla Interest Rate Swaps: Terms • Reset Frequency: Semiannual • Principal: No exchange of principal • Notional Principal (NP): Interest is applied to a notional principal; the NP is used for calculating the swap payments.

13. Plain Vanilla Interest Rate Swaps: Terms 6. Maturity ranges between 3 and 10 years. 7. Dates: Payments are made in arrears on a semiannual basis: • Effective Date is the date interest begins to accrue • Payment Date is the date interest payments are made.

14. Plain Vanilla Interest Rate Swaps: Terms 8. Net Settlement Basis: The counterparty owing the greater amount pays the difference between what is owed and what is received – only the interest differential is paid. 9. Documentation: Most swaps use document forms suggested by the International Swap Dealer Association (ISDA) or the British Banker’s Association. The ISDA publishes a book of definitions and terms to help standardize swap contracts.

15. Swap Terminology Note: • Fixed-rate payer can also be called the floating-rate receiver and is often referred to as having bought the swap or having a long position. • Floating-rate payer can also be referred to as the fixed-rate receiver and is referred to as having sold the swap and being short.

16. Plain Vanilla Interest Rate Swap: Example Example: • Fixed-rate payer pays 5.5% every six months • Floating-rate payer pays LIBOR every six months • Notional Principal = $10M • Effective Dates are 3/1 and 9/1 for the next three years

17. Plain Vanilla Interest Rate Swap: Example

18. Interest Rate Swap: Point Points: • If LIBOR > 5.5%, then fixed payer receives the interest differential. • If LIBOR < 5.5%, then floating payer receives the interest differential.

19. Interest Rate Swaps’ Fundamental Use • Synthetic Fixed-Loans and Investments • Synthetic Floating-Rate Loans and Investments

20. Conventional Floating-Rate Loan Swap: Fixed-Rate Payer Position Swap: Fixed-Rate Payer Position  Synthetic Fixed Rate Pay Floating Rate Pay Fixed Rate Receive Floating Rate Pay Fixed Rate A synthetic fixed-rate loan is formed by combining a floating-rate loan with a fixed-rate payer’s position.

21. Synthetic Fixed-Rate Loan • Example: A three-year, $10M floating-rate loan with rates set equal to the LIBOR on 3/1 and 9/1 combined with a fixed-rate payer’s position on the swap just analyzed.

22. Synthetic Fixed-Rate Loan

23. Conventional Fixed-Rate Loan Swap: Floating-Rate Payer Position Swap: Floating-Rate Payer Position Synthetic Floating Rate Pay Fixed Rate Pay Floating Rate Receive Fixed Rate Pay Fixed Rate A synthetic floating-rate loan is formed by combining a fixed-rate loan with a floating-rate payer’s position.

24. Synthetic Floating-Rate Loans • Example: A three-year, $10M, 5% fixed-rate loan combined with the floating-rate payer’s position on the swap just analyzed.

25. Synthetic Floating-Rate Loans

26. Swaps as Bond Positions • Swaps can be viewed as a combination of a fixed-rate bond and flexible-rate note (FRN). • A fixed-rate payer position is equivalent to buying a FRN paying the LIBOR and shorting a fixed-rate bond at the swap’s fixed rate. • From the previous example, the sale at par of a three-year bond, paying 5.5% interest and principal of $10M (semi-annual payments) and the purchase of a three-year, $10M FRN (or variable-rate loan) with the rate reset every six months at the LIBOR would yield the same CFs as the fixed-rate payer’s swap.

27. Swaps as Bond Positions • A floating-rate payer position is equivalent to shorting a FRN at the LIBOR and buying a fixed-rate bond at the swap fixed rate. • From the previous example, the sale of a three-year, $10M FRN paying the LIBOR and the purchase of a three-year, $10M, 5.5% fixed-rate bond at par would yield the same CFs as the floating-rate payer’s swap.

28. Swaps as Bond Positions • Question: Since the CFs on swaps can be duplicated, what is the economic justifications for swaps? • Answer: Swaps provide a given set of CFs more efficiently and at less risk than the aforementioned bond portfolio.

29. Swaps as Bond Positions • Efficiency: With swaps there is no underwriting and they are an off-balance sheet item. • Credit Risk: Swaps fall under contract law and not security law. Consider a party holding portfolio of a short FRN and a long fixed-rate bond. • If the issuer of the fixed-rate defaults, the party still has to meet its obligations on the FRN. • On a swap, if the other party defaults, the party in question no longer has to meet her obligation. Thus, swaps have less credit risk than combinations of equivalent bond positions.

30. Swaps as Eurodollar Futures Positions • A swap can also be viewed as a series of Eurodollar futures contracts. • Consider a short position in a Eurodollar strip in which the short holder agrees to sell 10 Eurodollar deposits, each with face values of $1M and maturities of six months, at the IMM‑index price of 94.5 (or discount yield of RD = 5.5%), with the expirations on the strip being March 1st and September 1st for a period of two and half years.

31. Swaps as Eurodollar Futures Positions • With the index at 94.5, the contract price on one Eurodollar futures contract is $972,500: • The exhibit shows the cash flows at the expiration dates from closing the 10 short Eurodollar contracts at the same assumed LIBOR used in the above swap example, with the Eurodollar settlement index being 100‑LIBOR.

32. Swaps as Eurodollar Futures Positions

33. Swaps as Eurodollar Futures Positions • Comparing the fixed‑rate payer's net receipts shown in Column 5 of the first exhibit with the cash flows from the short positions on the Eurodollar strip shown in the preceding exhibit, one can see that the two positions yield the same numbers.

34. Swaps as Eurodollar Futures Positions Note there are some differences between the Eurodollar strip and the swap. • First, a six‑month differential occurs between the swap payment and the futures payments. This time differential is a result of the interest payments on the swap being determined by the LIBOR at the beginning of the period, while the futures position's profit is based on the LIBOR at the end of its period. 2. Second, we've assumed the futures contract is on a Eurodollar deposit with a maturity of six months instead of the standard three months.

35. Swaps as Eurodollar Futures Positions Comparison: 1. Credit Risk: On a futures contract, the parties transfer credit risk to the exchange. The exchange then manages the risk by requiring margin accounts. Swaps, on the other hand, are exposed to credit risk. 2. Marketability: Swaps are not traded on an exchange like futures and therefore are not as liquid as futures.

36. Swaps as Eurodollar Futures Positions Comparison: 3. Standardization: Swaps are more flexible in design than futures that are standardized. 4. Cash Flow Timing: CFs on swaps are based on the LIBOR six months earlier; CFs on futures are based on the current LIBOR.

37. Swap Market Structure • Swap Banks: The market for swaps is organized through a group of brokers and dealers collectively referred to as swap banks. • As brokers, swap banks try to match counterparties. • As dealers, swap banks take temporary positions as fixed or floating players; often hedging their positions with positions in Eurodollar futures contracts or spot fixed-rate and floating-rate bond positions.

38. Swap Market Structure • Brokered Swaps: • The first interest rate swaps were very customized deals between counterparties with the parties often negotiating and transacting directly between themselves.

39. Swap Market Structure • Brokered Swaps: • The financial institutions role in a brokered swap was to bring the parties together and to provide information; they had little continuing role in the swap after it was established; they received a fee for facilitating the swap. • Note: The financial institution does not assume any credit risk with a brokered swap; the counterparties assume the credit risk and must make their own assessment of default potential.

40. Swap Market Structure Dealers Swaps: • One of the problems with brokered swaps is that it requires each party to have knowledge of the other party’s risk profile. • This problem led to more financial institutions taking positions as dealers in a swap – acting as market makers.

41. Swap Market Structure • Dealers Swaps: • With dealer swaps, the swap bank - swap dealer - often makes commitments to enter a swap as a counterparty before the other end party has been located. In this market, the end parties contract separately with the swap bank, who acts as a counterparty to each.

42. Swap Market Structure • Dealers Swaps: Features • Acting as swap dealers, financial institutions serve an intermediary function. • The end parties assume the credit risk of the financial institution instead of that of the other end party. • Small or no swap fee. • The swap dealer’s compensation comes from a markup or bid-ask spread extended to the end parties. The spread is reflected on the fixed rate side.

43. Swap Market Structure • Dealers Swaps: Features • Since the financial institution is exposed to default risk, the bid-ask spread should reflect that risk. • Since the swap dealer often makes commitments to one party before locating the other, it is exposed to interest rate movements.

44. Swap Market Structure • Dealers Swaps: Features • Warehousing: To minimize its exposure to market risk, the swap dealer can hedge its swap position by taking a position in a Eurodollar futures, T-bond, FRN, or spot Eurodollar contract. This practice is referred to as warehousing.

45. Swap Market Structure • Dealers Swaps: Features • Size Problem: Swap dealers often match a swap agreement with multiple end parties. • For example, a fixed for floating swap between swap dealer and party A with a notional principal of $50M might be matched with two floating for fixed swaps with notional principals of $25M each.

47. Swap Market Structure • Dealers Swaps: Features • Running a Dynamic Book: Any swap commitment can be effectively hedged through a portfolio of alternative positions – other swaps, spot positions in T-notes and FRNs, and futures positions. • This approach to swap market management is referred to as running a dynamic book.

48. Swap Market Price Quotes • By convention, the floating rate is quoted flat without basis point adjustments; e.g..LIBOR flat. • The fixed rate is quoted in terms of the on-the-run T-note on T-bond YTM and swap spread.

49. Swap Market Price Quotes • Swap spread: Swap dealers usually quote two different swap spreads – one for deals in which they pay the fixed rate and one in which they receive: • 80/86 dealer buys at 80BP over T-note yield and sells at 86 over T-note yield. • That is, the dealer will take the fixed payer’s position at a fixed rate equal to 80 BP over the T-note yield and will take the floating payer’s position, receiving 86 BP above the T-note yield.

50. Swap Market Price Quotes Swap Rate = (Bid Rate + Ask Rate)/2