CHAPTER 9

INTEREST RATE DERIVATIVES MARKET

Learning objectivesBy the end of this chapter, you should be able to:• Understand interest rates and the risk

associated with them.• Explain the hedging methods used to reduce the

exposure to interest rate risk.• Describe interest rate swaps.• Apply the appropriate type of interest rate

swaps.• Identify the advantages and disadvantages of

interest rate swaps.

INTEREST RATE• Cost of borrowing money.• Can be seen as profit over time due to financial

instruments.• Interest may change due to economic changes.• Different types of loan offer different interest

rate.

INTEREST RATE RISK• Risk occurs when there are changes in the

market interest rate.• Borrowers are concerned with increasing

interest rate.• Lenders are concerned with decreasing interest

rate.• Lenders and borrowers can lend or borrows at

fixed or floating rate.

INTEREST RATE RISKSINTEREST RATE BORROWER LENDER

RISINGFAVOURABLE TO USE FIXED RATE

FAVOURABLE TO USE FLOATING

RATE

FALLINGFAVOURABLE TO USE FLOATING

RATE

FAVOURABLE TO USE FIXED RATE

HEDGING• Definition A hedge is a position established in one market

in an attempt to offset exposure to the change in the interest rate of an equal but opposite obligation in another market.

• Risk can be inherent to a business activities and specific to certain businesses.

• Some risks can be avoided through hedging.

HEDGING STRATEGIES• Forward rate agreement (FRA) Forward rate agreement enables a company to protect itself against

interest risk by fixing the effective rate of interest before the intended borrowing or deposit date.

• Interest rates futures (IRF) Interest rate futures (IRF) are used by companies to enter into

speculative (or hedge) positions on changes in short-term interest rates.

• Interest rate options Interest rate options are used by investors, borrowers and traders to

manage interest rate risk exposures. The product is available on payment of an upfront fee, called the premium.

HEDGING• Interest rate swaps (IRS) An interest rate swap is a derivative in which one party exchanges

a stream of interest payments for another party’s stream of cash flows based upon some notional principal amount of money, maturity, and interest rates. IRS can be used by hedgers to manage their fixed or floating assets and liabilities. As such, interest rate swaps are very popular and highly liquid instruments.

• Swaptions Swaptions are a hybrid derivative product that integrates the benefit

of swaps and options. The buyer of a swaption has the right, but not the obligation, to enter an interest rate or currency swap during a limited period of time and at a specified rate.

CHARACTERISTICS OF IRS• One of the largest components of the global

derivatives market.• Customised bilateral transactions where parties

agree to exchange cash flows at fixed periodic intervals.

• Over the counter instruments (OTC).• Each side of a swap is called a leg.• Companies involved are known as

counterparties.

Interest Rate Swaps (IRS)• 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.

Interest Rate Swaps (IRS) Fixed 10% of RM100 mil

Fixed Rate. Floating

Payer Rate Payer

6 month KLIBOR +1% RM100 mil. • 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%.

Interest Rate Swaps (IRS)• 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%.

Scenario 1: 6 month KLIBOR = 6%• The payment obligation for each party is as follows:• Fixed Rate Payer: [10% x RM100,000,000] / 2 = RM5,000,000• Floating Rate Payer: [(6%+1) x RM100,000,0000] / 2 = RM3,500,000• Since the fixed rate payer’s obligation is higher by

RM1,500,000 he pays this amount. The netted cash flow will be:

• Fixed Rate Floating Rate Payer RM1,500,000 (net difference) Payer

Scenario 1: 6 month KLIBOR = 11.2%• With changed floating interest rate, the payment obligation

would now be:• Fixed Rate Payer: [10% x RM100m] / 2 = RM5,000,000• Floating Rate Payer: [(11.2%+1) x RM100m] / 2 = RM6,100,000• Here, since the floating rate payer’s obligation is higher, he

has to pay the net amount of RM1,100,000. Now the cash flow will be:

• Fixed Rate Floating Rate Payer RM1,100,000 (net difference) Payer

Two Important Factors…• 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 the changes in the floating interest rate; that will determine the direction and quantum of payments.

Swap Terminology• Fixed rate payer : The Counterparty in swap agreement

who pays based on a fixed interest rate.

• Floating rate payer : Counterparty who pays based on a floating interest rate.

• Reset Frequency : The time interval over which the floating rate is reviewed and reset.

• Reference Rate : The market interest rate on which the Floating Rate Payer's payment will

be based ‑ typically an interbank rate like KLIBOR, LIBOR, T-bill rate etc.

• Notional Principal : The principal amount on which interest payment amounts are determined. Notional amount is never exchanged, only the interest amounts based on

it.

ILLUSTRATION• A Ltd borrows US$50 million at a floating interest

rate of LIBOR plus a credit spread of 0.5% payable in 5 years.

• At the same time, B Ltd borrows US$50 million at a fixed interest rate of 9% payable also in 5 years.

• A Ltd and B Ltd may agree to swap their liabilities whereby A will pay B a fixed interest at 9% and B may pay A a floating rate of LIBOR plus 0.5%.

Interest Rate Swaps (IRS)• Generally, banks and financial institutions

will act as the intermediaries to these counterparties. (and make large amount of profits from these transactions).

ILLUSTRATION 8%

Syarikat Super Syarikat Duper

Floating rate Fixed Rate KLIBOR + 0.5%

Originally Borrow Originally BorrowKLIBOR +0.5% Fixed Rate 8%

PURPOSE OF SWAPS Generally swaps are used for financing and

managing of assets and liabilities. It also has other benefits like:

• Reduce their exposure to changes in the interest rates on a particular transaction.

• Lower their net expected costs of borrowing with respect to bonds.

• Manage their exposure to the changing market conditions in advance of anticipated issuance of bonds.

• Achieve more flexibility in meeting the overall financial objectives that cannot be achieved in conventional markets.

• Obtain customized cash flows to match the required payment obligations or revenue projections.

TYPES OF SWAPS• Fixed-to-floating rate swap

The fixed-to-floating rate swaps in the same currency are used to convert a fixed rate asset (lending) or liability (borrowing) to a floating rate asset or liability and vice versa. This type of swap is better known as plain vanilla swap.

• Floating-to-fixed The floating-to-fixed rate swaps are used to convert a floating rate

asset or liability to a fixed rate asset or liability.

• Floating-to-floating rate swap The floating-to-floating rate swaps in the same currency are used to

hedge against the spread between two indexes widening or narrowing. Here, parties try to profit from the differences in the swap spreads. This type of swap is better known as basis swap.

APPLICATION OF IRS• Arbitraging Differences in opinions regarding the creditworthiness of

companies can to a certain extent, affect the cost and will lead to mispricing. And, it is this mispricing that companies are trying to arbitrage.

• Hedging Borrowers will hedge against a hike in interest rate to

avoid paying high financing cost, and the lenders will try to hedge against a falling interest rate to avoid low yield from its investments. Interest rate swaps enable the counterparties to hedge against the increase and decrease in interest rates.

APPLICATION OF IRS

• Speculating Interest rate swaps can be used to estimate the

future movements of interest rates. By speculating, it is hoped that companies would gain when the interest rate actually changes.

Arbitraging - Illustration• Harta Ltd and Property Ltd are presently borrowing at the following

interest rate:

• Notice that there are differences in spreads between the fixed rate market and floating rate market for both firms. Neither of the market has priced the credit risk differential correctly. This has led to mispricing. It is these differences that we are going to arbitrage.

• Harta Ltd intends to borrow at a floating rate and Property wants to borrow at a fixed rate. It is safe to assume that Harta Ltd has a higher credit rating since it can borrow at cheaper costs.

• A bank is planning to arrange a swap and wishes to keep a spread of 25 basis points.

Fixed Floating

Harta 6% LIBOR + 0.5%Property 7% LIBOR + 0.75%

Arbitraging - Illustration

• Best for Harta; fixed rate since the company get 1% lower than Property compare to floating rate ( 0.25% lower)

• Best for Property; Floating rate coz it manage to get 0.25% higher than Harta compare to fixed rate (1% higher)

• HOWEVER; – Harta Ltd intends to borrow at a floating rate and Property wants to borrow at a

fixed rate. It is safe to assume that Harta Ltd has a higher credit rating since it can borrow at cheaper costs.

Fixed FloatingHarta 6% LIBOR + 0.5%Property 7% LIBOR + 0.75%

Difference 1% 0.25%

• Harta will borrow directly from bank at LIBOR + 0.5% and Property borrow directly from bank at 7%.

• A bank is planning to arrange a swap and wishes to keep a spread of 25 basis points.

• IRS– Harta pay Property floating rate and Property

pay Harta Fixed rate.

Arbitraging - Illustration• _________________ Harta Ltd Property

Ltd• Cost if borrowed directly LIBOR + 0.50% 7 %• Cost of borrowing with IRS LIBOR + 0.75% 6%___• Gain/(Loss) (0.25%) 1%• Transfer of Loss 0.25% (0.25%)• Net - 0.75%• Less: Payables to bank (0.25%)• Net gain 0.50%• Sharing of gain 0.25% 0.25%• The counterparties will end up paying:

Harta Limited LIBOR + 0.5 - 0.25 = LIBOR + 0.25

Property Limited 7% - 0.25 = 6.75%

Arbitraging - Illustration• Alternatively, the sharing of gains can be calculated as

follows:

• Gains to be shared between companies:• = 1% - 0.25% = 0.75%• Less: Payables to bank 0.25%• Net gain 0.50%• Sharing of gain = 0.50%/2 = 0.25% each

Fixed Floating

Harta 6% LIBOR + 0.5%

Property 7% LIBOR + 0.75%

Difference 1% 0.25%

Arbitraging - Illustration• Harta Ltd and Property Ltd are presently borrowing at the following

interest rate:

• Best rate for– Hatch – fixed– Latch – Floating

• But, Hatch prefer floating and Latch prefer fixed

Fixed FloatingHatch 5% KLIBOR + 0.15%Latch 6.5% LIBOR + 0.775%

Arbitraging - Illustration• _________________ Hatch Ltd Latch Ltd• Cost if borrowed directly KLIBOR + 0.15% 6.5 %• Cost of borrowing with IRS LIBOR + 0.775% 5%___• Gain/(Loss) (0.625%) 1.5%• Transfer of Loss (0.625%)• Net - 0.875%• Less: Payables to bank -• Net gain 0.8750%• Sharing of gain 0.4375% 0.4375%• The counterparties will end up paying:

Hatch Limited KLIBOR – 0.2875

Latch Limited 6.5% - 0.4375 = 6.0625%

Problem 4

• Alternatively, the sharing of gains can be calculated as follows:

• Gains for each company:– 0.1625 % (assuming principal = 1M)– RM162500 – RM75000 = RM87500

• Effective Cost– Ozzy – KLI + (0.375 – (0.1625-0.075)– Wolly – 7.125 – (0.1625-0.075)

Fixed Floating

Ozzy 6.5 KLI + 0.375

Wolly 7.125 KLI + 0.675

Difference 0.625 0.3

Hedging Interest Rate Risk with IRS

• 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 Rising Interest Rates• 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 against Rising Rates with IRSFixed Rate 8%

• Syarikat ABC IRS Counterparty

6 month KLIBOR

Floating 6 month KLIBOR + 2%

Maybank

• In the IRS, Syarikat ABC pays an annualized fixed rate of 8% every 6 months on RM10 million notional. [(0.08 x RM10m)/2]

• In exchange it receives a cash flow equivalent to the prevailing spot 6 month KLIBOR rate on RM10 million notional. [(6 month KLIBOR x RM10m)/2]

Hedging against Rising Rates with IRS• 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.

• Effectively a 10% annualized fixed rate loan. (8% to swap counterparty and 2% spread over KLIBOR to Maybank).

Hedging against Falling Interest Rates

• 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, and a fixed rate receiver.

PRICING OF INTEREST RATE SWAPS

• When valuing interest rate swaps, managers may have to forecast and make estimation on certain variables they consider as factors affecting the price of a swap. Most of the time, this will involve using extrapolation and other techniques to derive the estimates. As such, different managers may value a swap differently.

RISKS ASSOCIATED WITH INTEREST RATE SWAPS

• Interest rate risks This type of risk originates from changes in the floating

rate. In a plain vanilla fixed-to-floating rate swap, the party which pays the floating rate benefits when rates fall.

• Credit risk Contracts that represent agreements between two

parties, such as swaps, always involve credit risks. Counterparties must make payments periodically. There are possibilities that one party may not be able to fulfill its obligation exposing the other party to risk.

RISKS ASSOCIATED WITH INTEREST RATE SWAPS

• Market risk Market risk arises from the possible movements on a

variable associated with the swap instrument, such as interest rates and exchange rates, that makes the value of the swap negative for one of the parties involved in it.

• Sovereign risk Sovereign risk is the risk associated with the country in

whose currency a swap is being considered. Sovereign risk covers political stability or the possibility of exchange controls being introduced. Sovereign risk can lead to credit risk in a currency swap.

GLOBALISATION With globalization the process of swapping will not only

apply to interest rates but will also include the currencies of countries involved in a transaction.

• Interest Rate Swaps in Different Currencies The types of currency-interest swaps are as follows: (i) Fixed-to-floating rate swap, different currencies (ii) Fixed-to-fixed rate swap, different currencies

(iii) Floating-to-floating rate swap, different currencies• Currency Swaps A currency swap is a contract in which two

counterparties exchange a specific amount of two different currencies, exchange interest payments in two currencies over the term of the swap and re-exchange the principal at maturity.