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Lecture #28

Swaps and Interest Rate Options

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Outline

Introduction Interest rate swaps Foreign currency swaps Circus swap Interest rate options

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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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Source:

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© 2004 South-Western Publishing