Chapter

1. 12 Chapter Interest Rates Swaps, FRAs and Credit Derivatives

2. This chapter is designed to provide an overview of Swaps, Forward Rate Agreements and Credit Derivatives. The chapter examines Interest Rate and Currency Swaps. Following a description, the mechanics and application of these contracts are examined. The use of credit rate derivatives in managing credit risk is outlined with emphasis on the structure of the contracts. At the end of the chapter, readers should have a good understanding of the basic design and the application of these derivatives to managing risk. Chapter Objective

3. Swaps are customized bilateral transactions in which the parties agree to exchange cash flows at fixed periodic intervals, based on an underlying asset. Being customized, swaps are over-the-counter or OTC instruments. Depending on the kind of underlying asset, there are different kinds of swaps. An Interest Rate Swap (IRS) is a transaction in which the parties exchange cash flows based on two different interest rates. Interest Rate Swaps (IRS)

4. In a fixed-for-floating swap, one party pays an amount based on a fixed interest rate whereas the other party pays in exchange, an amount based on a floating interest rate. The size of the payment is determined by multiplying the interest rate with the “notional principal”. The notional principal is the principal amount on which interest payments are calculated. The notional principal remains unchanged over the maturity of the swap. In an IRS cash flows are swapped at fixed predetermined intervals over the tenor of the agreement. The fixed intervals, known as reset periods may be six monthly, quarterly, etc, whereas the tenor or maturity of the swap may be 5 or 10 years.

5. The figure outlines the cash flows involved in a fixed-for-floating IRS of 5 year maturity and RM100 million notional principal. If the reset frequency is 6 months, then a total of 10 cash flow swaps will occur over the 5 years. The fixed rate payer, will pay an annualized 10% fixed rate while the floating rate payer, will pay 6 month KLIBOR +1%. Fixed 10% of RM100 mil. Floating Rate Payer Fixed Rate Payer 6 month KLIBOR +1% RM10 mil.

6. The cash flow payment based on the interest rates will occur once every 6 months. Since the payments are to be made simultaneously, often the cash-flows are netted such that only a single payment occurs. As to who pays whom, would obviously depend on which rate is higher. If the floating rate; 6 month KLIBOR + 1% is higher than the fixed rate of 10% the floating rate payer pays the difference. If the floating rate is lower than 10%, then the fixed payer pays the difference. To see how this works, we examine two scenarios; first if the 6 month KLIBOR is at 6% at reset period and a second scenario where the 6 month KLIBOR is at 11.2%.

7. The payment obligation for each party is as follows: Fixed Rate Payer: Floating Rate Payer: Since the fixed rate payer’s obligation is higher by RM1,500,000 he pays this amount. The netted cash flow will be: Scenario 1: 6 month KLIBOR = 6% Fixed Rate Payer Floating Rate Payer RM1,500,000 (net difference)

8. With changed floating interest rate, the payment obligation would now be: Fixed Rate Payer: Floating Rate Payer: Here, since the floating rate payer’s obligation is higher, he has to pay the fixed rate pay the net amount of RM1,100,000. Now the cash flow will be: Scenario 1:6 month KLIBOR = 11.2% Fixed Rate Payer Floating Rate Payer RM 1,100,000 (net difference)

9. First, the notional principal is never exchanged. Second, only the net difference is paid. Thus, at any reset period, there will be a cash flow if the two rates are unequal. Since the fixed rate payer’s obligation is known up front, it is changes in the floating interest rate; that will determine the direction and quantum of payments. Two Important Factors…

10. Swap Terminology

11. ISDA had streamlined and standardized much of the paperwork for IRS, making the process much more simplified and thereby incurring lower costs. A Basis Swapis one where both rates are floating and parties try to lock-in or profit from differences in swap spreads. A Forward-Starting Swap enables parties to lock-in current favourable yields for financing issues that will be carried out at a future date. An Amortizing Swap is one where the notional principal reduces over time while a swap with an Inverse floater is one where the floating rate is negatively correlated with a benchmark reference interest rate. Finally, there are also swaps with embedded options. Being customized products, any structural form or variant is possible as long as it is mutually agreed by the two parties. Though an intermediary is not necessary, it is very common. Intermediaries play one of two roles; either as a broker or market maker. As broker, an intermediary designs the swap and collects a fee. As market maker, the intermediary becomes the counterparty. Why Use IRS?

12. One of the first uses of IRS was as an instrument to take advantage of comparative advantage that companies may have across different credit markets. Despite integrated financial markets, credit assessment of companies, either due to informational asymmetries or coverage by analysts, may be different. Thus, differences may occur between the market for fixed versus floating loans or between short versus long term credit markets. These differences would translate into different funding costs for the same firm in the different credit markets. What is happening is, different markets are pricing credit differently based on its own assessment. It is thismispricing that can be arbitraged. Arbitrage using IRS

13. Illustration: Arbitraging Notice the difference in spreads for the two firms in the different markets. In the fixed rate market there is a one percent difference in yields whereas in the floating rate market the spread is half percent. Obviously, one of the two markets is not pricing the credit risk differential correctly. The 0.5% difference in spreads between the two markets can be thought of as mispricing. It is this mispricing of 0.5% that is arbitrageable with an IRS.

14. With a commercial bank (Citibank as intermediary) the IRS could be structured as follows: 9.0 % 9. 875 % Citibank, (intermediary) Alfa (prefers floating) Beta (prefers fixed) Borrow fixed @ 9% p.a. Borrows floating (@ LIBOR + 0.75%)

15. ________________________Alfa Beta_____ Cost if borrowed directly LIBOR + 1/4% 10.00 % Cost of borrowing with IRS LIBOR 9.875%___ Cost saving from IRS + 0.25% + 0.125% Gain to Citibank Receive from Beta 9.875% Pay to Alfa (9.00%) Receive from Alfa LIBOR Pay to Beta (LIBOR + .75%)______ Gain + 0.125% Notice that the sum total of the gain to each party equals 0.50% (0.25% + 0.125% + 0.125%). The 0.50% total is essentially the percentage ‘mispricing’. In this case Alfa, which had absolute advantage in both markets gets the bigger portion. The proportion by which the mispricing differential is divided among the parties is obviously negotiated.

16. There are three common ways by which IRS is used to manage rate risk: (i) to hedge against rising rates (borrowers) (ii) to hedge against falling rates (lenders) and (iii) to manage asset – liability duration gaps. Hedging Interest Rate Risk with IRS

17. Suppose a borrower, Sykt. ABC, has a 5 year, RM10 million loan from Maybank. Maybank charges an interest based on 6 month KLIBOR +2% payable semi annually. Sykt. ABC obviously has interest rate exposure. The firm’s funding costs will increase as 6 month KLIBOR rises. Given these circumstances, the logical way for Sykt. ABC to manage the rate risk would be through a IRS. Sykt. ABC should enter the swap as the fixed rate payer and floating rate receiver. If the notional principal and reset frequency are structured to match the underlying position that it has with Maybank, then Sykt. ABC would have perfectly hedged it’s interest rate risk. Hedging Rising Interest Rates

18. In the IRS, Syarikat ABC pays an annualized fixed rate of 8% every 6 months on RM10 million notional. In exchange it receives a cash flow equivalent to the prevailing spot 6 month KLIBOR rate on RM10 million notional. Hedging against Rising Rates with IRS Fixed 8% Syarikat ABC IRS Counterparty 6 month KLIBOR Floating 6 month KLIBOR + 2% Maybank

19. Sykt. ABC protects itself from rising interest rates because it’s increased payments to Maybank will be offset by the increased payments it receives from the counterparty as interest rates rising. Since both the receivable from the counterparty and the payable to Maybank are referenced on 6 month KLIBOR, Sykt. ABC’s inflows from the swap offset the outflow to Maybank. With the IRS, Sykt. ABC has effectively turned its floating rate payable into a fixed rate one. Effectively a 10% annualized fixed rate loan. (8% to swap counterparty and 2% spread over KLIBOR to Maybank). Given the above example; it should be easy to see what needs to be done to hedge against falling interest rates. One should do the opposite of what Sykt. ABC did in the above IRS. That is, enter into an IRS as the floating rate payer. The following example illustrates the logic.

20. KL Money Brokers, (KLMB) manages a money-market fund for corporate clients. The size of the fund is RM50 million, invested mostly in 3 month MGS (Malaysian Government Securities) and commercial papers. The returns approximate the 3 month KLIBOR. Based on its in-house research, KLMB expects short term rates to fall over the next few years. The firm is worried that falling short term rates will mean lower yields from its investments and reduced returns to its clients. To avoid the resulting withdrawals, KLMB wants to try and maintain current returns over the next 3 years. What can KLMB do to maintain steady returns in the face of falling short-term rates? Answer: Enter a 3 year IRS of RM50 million notional principal as the floating rate payer. Fig 12.4 shows the structure of the proposed IRS. Hedging against Falling Interest Rates

21. In the swap, KLMB essentially passes thru its earnings from 3 month paper to the counterparty as the 3 month KLIBOR. It receives in exchange a fixed rate of X %. As a result, KLMB can be assured of providing its clients with a return approximating X% eventhough short term rates are falling. If the reset frequency is set to match the interval period(s) over which KLMB pays its clients, the company is well protected from falling rates. KLMB Counterparty Fixed Rate of X% 3 month KLIBOR 3 month tenor papers

22. Duration is a measure of interest rate sensitivity and that asset-liability mismatches in duration result in duration gaps. A financial institution with a positive gap (larger duration of assets relative to liabilities) will be susceptible to rising interest whereas one with a negative gap to falling rates. To reduce a positive duration gap, a bank should enter an IRS as the floating rate receiver. It can increase the positive gap or lengthen the duration of its assets by being the floating rate payer/fixed rate receiver in a long dated IRS. Hedging Duration Gaps

23. With this IRS, the new duration of the bank’s assets will be; 9 years for existing assets of RM100 million, and 6 months for the newly created asset of RM100 mil. (notional principal). The new weighted average duration of assets is now: 9.0 years x (0.5) + 0.5 years x (0.5) = 4.5 years + 0.25 years New duration of assets is therefore 4.75 years. Even if we hold the duration of liabilities to be unchanged at the original 1.8 years; the new duration gap is: 4.75 years – 1.8 years = 2.95 years The IRS therefore reduced the positive gap of the bank from 9.0 years previously to 2.95 years. Interest rate exposure as measured by the positive gap has been reduced to a third of what it was prior to the IRS. Pay fixed interest Bank Counter Party Receive floating (every 6 months)

24. IRS could be used to speculate on expected interest rate movements. However, unlike interest rate futures contracts which, being exchange traded instruments could easily be reversed, swaps being customized, would require the consent of the counterparty in order to reverse. Still, IRS are used to speculate on rate movements over extended periods. Where plain-vanilla, fixed-for-floating swaps are concerned, it is easy to see what the appropriate strategy should be to speculate on rate movements. Being a floating rate receiver would be the logical strategy if one expects interest rates to rise while the opposite will be true if rates are expected to fall. Speculating with IRS

25. Mr. Lee a bond trader has just completed his assessment of interest rate outlook. He is convinced that rates are likely to rise steadily over the next 2 years. To take advantage of this likely rise, Mr. Lee intends to enter an IRS. What should his position be to benefit from rising rates? Answer : He should enter the swap as the fixed rate payer and floating rate receiver. Illustration: Speculating on Expected Increase in Interest Rates

26. The logic in taking the above position is that, while Mr. Lee will pay a fixed amount, the amount he receives will increase as interest rates rise. If his expectation of a steady increase comes true, Mr. Lee will be receiving steadily higher net cash flow at each future reset period. However, should his expectation not bear out and interest rates fall instead, Mr. Lee stands to lose in the IRS. The size of the potential profit or loss of the position will depend on the notional principal and the tenor of the swap. To speculate on expected falling interest rates, the speculator should establish the opposite of Mr. Lee’s position above. To profit from an IRS from falling rates, one should enter as the floating rate payer and fixed rate receiver. If interest rates indeed fall, the speculator would have to pay progressively lower amounts but would receive the same fixed amount. Fixed Rate Mr. Lee Counter-party Floating

27. Financial Institutions often try to make a call on interest rate movements. For example if a bank’s assessment leads it to believe that interest rates are likely to fall, the bank might want to increase the positive duration gap between its assets – liabilities. A quick and easy way to achieve this would be by entering a long dated IRS as the floating rate payer and fixed rate receiver. While asset-liability mismatches are inevitable for banks, managing the gaps become easy with IRS. Duration Gaps and Interest Rate Expectation

28. A fixed-for-floating swap is priced such that the present value (PV) of the fixed payments equalthe PV of the expectedcash flows of the floating rate. First, to compute PVs, the appropriate discount rate has to be estimated. This is done by estimating the swap-spread. The swap spread is essentially the premium above the treasury yield applicable for the swap. Since the spread is a premium over treasury bills, a “swap curve” is often estimated based on the treasury yield curve. For long tenor swaps, the yield curve may have to be derived through extrapolation. Pricing Interest Rate Swaps

29. The next task is to estimate the potential cash flows from the floating rate payer. In highly liquid and deep markets this is done by looking at the forward yield curve. The forward yield curve is typically derived from pricing of forward based interest rate derivatives such as interest rate futures contracts. Often the trading in distant futures contrast is not sufficiently active to get reliable prices. This is where the bootstrapping technique is used and estimates are then used as indicators of what future yields of the reference rate is likely to be. Once the expected future floating rate is estimated, the cash flow is determined by multiplying the estimated yield with the notional principal. This estimated cash flow is then discounted and set equal to the discounted cash flow arising from the fixed rate payment. The above valuation method, sets the value of an IRS to be net zero NPV at initiation.

30. However, as market interest rates change, the value of the IRS would change. For example, if rates rise and the futures yield curve steepens, the fixed rate payer benefits as the floating rate payment will have to increase. Thus, the value of the IRS increases to the fixed rate payer (and decreases for the floating rate payer). For the fixed rate payer, the value of the IRS is now not zero but positive NPV. The ringgit value of the positive NPV would simply be net NPV of the increase in payments he receives from the floating rate payer. If subsequent to initiating an IRS interest rates fall instead, the opposite happens.

31. Except the earlier mentioned advantages, there are two additional advantages, first, an IRS being a non funding transaction carries much lower credit risk. Since the notional principal never changes hands and cash flows at reset periods are exchanged simultaneously (or netted out), counterparty risk is minimized. Thus, parties could mutually choose to ‘walk-away’ from the deal. This does mean however that there is no counterparty risk – there can still be implied losses. Issues in IRS Markets

32. A Currency Swap is a transaction in which two parties agree to exchange a fixed amount of one currency for another. The main difference between an interest rate swap (IRS) and a Currency swap is that in an IRS notional principal is never exchanged. In a currency swap however the notional principal in two different currencies is exchanged. A first exchange of the two currencies occurs at the initiation of the swap contract. Typically, this first exchange is often based on prevailing spot exchange rates at the time. This initial exchange is then reversed at the end of the swap contract period. Since the amounts exchanged in both periods are exactly the same, exchange rate risk is eliminated. Currency Swaps

33. Suppose a Malaysian company, MISC, with operations in Japan wishes to expand its warehousing facilities in Yokohama. The cost of the expansion will be 100 million ¥en. Its banker in Japan, The Bank of Tokyo is willing to provide the financing on the following terms: Principal Amount = ¥en 100 million Loan Tenor = 5 years Interest = fixed 5%; (¥en 5 million) payable annually on 31st Dec. Principal to be repaid in one lump sum at end of 5th year Now suppose, Matsushita, a Japanese firm with operations in Malaysia wants to expand its facilities in Malaysia. The estimated cost of the expansion is RM10 million. Matsushita’s banker in Malaysia, Maybank is willing to provide a RM10 million loan on the following terms: Principal Amount = RM10 million Loan Tenor = 5 years Interest = fixed 8%; (RM800,000) payable annually on 31st Dec. Principal to be repaid in one lump sum at end of 5th year If each firm takes the loan being offered without doing anything more, they face exchange rate risk on both the principal amount and the annual interest payments. If the currency they borrow in, appreciates against their home currency, their effective cost increases. Additionally, since each firm’s revenues are mostly in their respective home currency, having a large foreign currency denominated obligation causes a currency mismatch. Illustration: A Currency Swap

34. To avoid these problems both MISC and Matsushita could take the foreign currency loans they are being offered and then enter into a currency swap in order to overcome the exchange rate risk. To see how the swap can be structured; assume that the spot exchange rate between the ¥en and the Ringgit is 10 ¥en per Ringgit. To lock-in the prevailing exchange and avoid currency risk on both the principal and interest payments over the next 5 years, they can undertake the swap as follows. MISC takes the loan principal of 100 million ¥en from Bank of Tokyo and forwards it to Matsushita, which in turn gives MISC the RM10 million it received from Maybank. These principal amounts are reversed at the end of the 5th year. In addition, at the end of each year, MISC gives RM800,000 being 8% interest on RM10 million to Matsushita which in turn gives ¥en 5 million as (5%) interest on the ¥en loan. Each company simply passes on the payments received to their respective banks as fulfillment of their obligation.

35. Mechanics of A Currency Swap

36. An FRA is a forward contract in which two parties agree to cash settle the difference between a fixed rate and a floating reference interest rate based on a notional principal. Where, is the notional principal and tenor is the length of underlying borrowing / lending period Forward Rate Agreement (FRA)

37. Suppose you are the CFO of XYZ Corporation. Your company has to make a RM10 million payment to a supplier. The payment is due in 3 months. Since you do not have the funds available, you have arranged with your banker to get a 6‑month loan of RM10 million in 90 days. Your banker, Maybank has agreed to provide the loan at 6‑month KLIBOR + 1 %. Having made the arrangement, you now worry that any increase in KLIBOR over the next 90 days would increase your cost of funds. The 6‑month KLIBOR is now quoted at 8 %. In order to "lock‑in" your cost of funds you might enter into an FRA with another bank (Citibank) on the following terms: Notional Principal RM 10 million. Terms: if 6‑month KLIBOR exceeds 8%, bank pays CF equivalent of difference. if 6‑month KLIBOR is less than 8 % your company pays CF equivalent of difference. Maturity: 90 days based on 6 month borrowing/lending. Illustration : Hedging borrowing cost with an FRA

39. Interest Paid to Maybank = on RM 10 mil. loan [(.09 + .01) = .10] Less Reimbursement from Citibank = RM 47,847 Net Interest Payment = RM 452,153 ========= Effective Interest = RM 452,153 / RM 10 mil.= 0.0452 for 6 months Annualized = 0.0452 x 2 = 0.090 = 9% Notice that the effective annualized interest rate of 9% is the rate you wanted to "lock in" initially. (6‑month KLIBOR was 8 % + 1 % = 9 %). To take advantage of expected rising rates, one enters the FRA as floating rate receiver. If rates are expected to fall instead, one enters as floating rate payer. Effective Cost of Funds with FRA

40. Credit Derivatives are customized financial derivatives used in the management of credit risk. Defined broadly, credit risk is essentially, the probability that a borrower will default. This inability could be due to firm-specific factors such as mismanagement, fraud etc., or systematic / economy wide factors such as recessions. A firm’s credit rating is a qualitative measure of its credit worthiness or credit risk. Markets in pricing credit risk translate credit rating; a qualitative measure into a quantitative one the credit risk premium. The Credit risk premium is essentially the premium or extra return required for investing in a firm’s debt instrument, relative to the risk-free rate. Credit Derivatives

41. Credit derivatives are customized contracts designed to manage credit risk. There are three factors to note. First, credit risk occurs even if there is no technical bankruptcy. Second, market risk (i.e. change in market price of assets) and credit risk are interrelated. Third, market risk, i.e. the change in the market price of a debt instrument could also be due to macro-factors. Until the recent advent of credit derivatives, banks managed credit risk by techniques such as loan underwriting, loan syndication, and asset securitization. Currently, the three most common Credit Derivatives are Default Swaps, Loan Portfolio and Total Return Swaps.

42. Three common types of Credit Swaps: (i) A Default Swap (ii) A Loan Portfolio Swap and (iii) A Total Return Swap. Credit Swaps

43. A Default Swap is typically a bilateral arrangement between two parties wherein one party agrees to take on the credit risk in exchange for a periodic fee. The ‘buyer’ in the arrangement pays the periodic fee to the seller who will reimburse the buyer if a pre-specified ‘credit event’ occurs. A Default Swap Commercial Bank Insurance Firm Periodic Payments Payment if triggering credit event occurs

44. A Loan Portfolio Swap is a means by which banks can reduce the concentration risk of their loan portfolio by diversifying. Loan portfolio concentration can be either geographical or sectoral. That is, a regional bank may have all its loans given out within a certain region of the country – thus geographic concentration. Alternatively, a bank might have a huge portion of its loans extended to a particular industry or economic sector. A Loan Portfolio Swap

45. A total return swap (TRS) is a little more complicated than the loan portfolio swap. In a loan portfolio swap, the parties only exchange the respective payments they receive on the portion of loan identified to be swapped, in a TRS both the interest payments received and the capital gains or losses are adjusted for in the swap cash flows. A Total – Return Swap

46. Credit options are essentially calls and puts with either an interest-rate or debt instrument as the underlying asset. Just as options can be used to manage risk, credit options can be used to hedge credit risk. The underlying logic of using Call options to seek protection from risk arising from upside movement and puts against falling prices/values applies. For example, if one would be hurt by rising interest rates, than going long Call options on interest rates would be appropriate. On the other hand, if falling values would hurt than going long put options would be sensible. Credit Options

47. Credit linked notes are debt instruments with embedded options exercisable by the issuer. A Credit linked note therefore would consist of a straight bond and an option. The difference between callable bond and credit linked notes is whereas the issuer of a callable bond has an option to reduce the maturity of the bond by ‘calling’ it for redemption earlier, the issuer of the credit linked note has the option to reduce the coupon interest of the bond. Just as the yield on a callable bond would be higher than that of a straight bond of the same risk class, the yield of a credit linked note would be higher too. Credit Linked Notes

48. Key Terms