Interest Rate Derivative Market

1. Interest Rate Derivative Market 15

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

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. Floating Inflow Payments Fixed Outflow Payments Fixed Outflow Payments Floating Inflow Payments Exhibit 15.3 Plain Vanilla Swap Scenario of Declining Interest Rates Scenario of Rising Interest Rates 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 a a

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. Floating Inflow Payments Fixed Outflow Payments Fixed Outflow Payments Floating Inflow Payments Forward Forward Swap Is Swap Is Arranged Swapping of Payments Arranged Swapping of Payments at This T ime Begins at This T ime at This T ime Begins at This T ime Exhibit 15.5 Forward Swap Scenario of Declining Scenario of Rising Interest Rates Interest Rates Level of Interest Payments Level of Interest Payments 1 2 3 4 5 6 7 8 0 0 1 2 3 4 5 6 7 8 End of Y ear End of Y ear a a

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. Floating Inflow Payments Fixed Outflow Fixed Outflow Payments* Payments* Floating Inflow Payments Option is exercised to terminate the swap at this time, because interest rate trend is downward. Exhibit 15.6 Callable Swap Scenario of Rising Scenario of Declining Interest Rates Interest Rates 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 a a a

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. Floating Inflow Payments Fixed Outflow * Fixed Outflow Payments * Payments Floating Inflow Payments Option is exercised by recipient of fixed outflow payments to terminate the swap at this time, because interest rate trend is upward. Exhibit 15.7 Putable Swap Scenario of Rising Scenario of Declining Interest Rates Interest Rates 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 a a

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. Floating Inflow Payments Fixed Outflow Fixed Outflow Payments Payments Floating Inflow At this time, the institution Payments would likely extend the swap period. At this time, the institution would likely decide not to extend the swap period. Exhibit 15.8 Extendable Swap Scenario of Rising Scenario of Declining Interest Rates Interest Rates 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 a a a

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. • A Single Lump-Sum Fixed Outflow Payment • A Single Lump-Sum Fixed Outflow Payment Floating Inflow Payments Floating Inflow Payments Exhibit 15.9 Zero-Coupon-For-Floating Swap Scenario of Rising Scenario of Declining Interest Rates Interest Rates 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 a a

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. Purple Line Reflects Floating Inflow Payments If a Cap Did Not Exist Floating Inflow Payments Based on Cap Fixed Outflow Fixed Outflow Payments Payments Floating Inflow Payments Payer of Fixed Outflow Payments Payer of Fixed Outflow Payments Receives Premium at This T ime Receives Premium at for Agreeing to Cap for Agreeing to Cap Exhibit 15.10 Rate-Capped Swap Scenario of Rising Scenario of Declining Interest Rates Interest Rates Cap Cap Level Level 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 a a

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

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