interest rate swaps and agreements chapter 28. swaps cbs and ibs are major participants dealers ...
TRANSCRIPT
Interest Rate Swaps and Agreements
Chapter 28
Swaps
CBs and IBs are major participants dealers traders users
regulatory concerns regarding credit risk exposure five generic types of swaps
interest rate swaps currency swaps credit swaps commodity swaps equity swaps
Interest Rate Swaps
OTC instruments investors can go through securities firm or commercial
bank firms can act as brokers or dealers for investor
counterparty risk can be significant Swap can be viewed as
package of forward/future contracts package from CFs from buying and selling cash market
instruments fixed rate payer has position similar to long position in floating
rate bond and short in fixed rate (borrowing by issuing fixed rate bond)
floating payer has position like purchasing fixed rate bond and financing purchase at floating rate
Interest Rate Swaps
counterparties agree to exchange periodic interest payments with dollar amount based on notional principal plain vanilla – fixed-rate payer and floating-rate
payer reset frequency reference rates
Plain Vanilla Interest Rate Swap Example
Consider money center bank that has raised $100 million by issuing 4-year notes with 10% fixed coupons. On asset side: C&I loans linked to LIBOR. Duration gap is negative.
DA - kDL < 0 Second party is savings bank with $100 million
in fixed-rate mortgages of long duration funded with CDs having duration of 1 year.
DA - kDL > 0
Interest Rate Swaps
We depict this fixed-floating rate swap transaction in the following
Interest Rate Swaps
The expected net financing costs for the FIs are shown below
Interest Rate Swaps
Assume that the realized path of LIBOR over the 4 year life of the contract would be as follows 9%, 9%, 7%, and 6% at the end of each of the 4 years. The money center bank’s variable payments to the thrift are indexed to these rates by the formula:
(LIBOR + 2%) * $100m The annual payments made by the thrift were the
same each year
10% * $100m.
Interest Rate Swaps
End of year One-Year LIBOR
LIBOR + 2%
Pmt by MCB
Pmt by thrift Net Pmt by MCB
1 9% 11% $11 $10 +$1 2 9% 11% $11 $10 +$1 3 7% 9% $9 $10 -$1 4 6% 8% $8 $10 -$2 TOTAL $39 $40 -$1
Interest Rate Swaps
example notional of $50m where X is fixed rate payer and
Y is floating rate payer – X pays 10% per year and Y pays the 6-month LIBOR – payments every 6 months for next 5 years what will payments be if 6-month LIBOR is 7%
Swaps
Swaps
trade date effective date maturity date dates can differ for counterparties in same swap terminology to describe position
Swaps
fixed rate payer is short the bond market – explain
fixed rate payer – position that is exposed to the price sensitivities of a longer-term liability and a floating-rate bond
floating rate payer – position that is exposed to the price sensitivities of a fixed-rate bond and a floating-rate liability
Swaps• dealer quotes fixed payer to pay 8.85% and receive LIBOR “flat” – bid price dealer quotes floating payer is to pay LIBOR flat and receive 8.75% - spread is 10bp• fixed rate is spread above Treasury yield curve – say 10 year Treasury yield is 8.35% - offer price dealer quoted is 10 year Treasury plus 50bp vs. receiving LIBOR flat• bid price dealer quoted for floating payer is LIBOR flat vs. 10 year Treasury plus 40bp• dealer quotes swap as 40-50 – dealer willing to enter into swap to receive LIBOR and pay fixed rate equal to 10-yr Treas. plus 40bp – willing to enter into swap to pay LIBOR and receive fixed rate equal to 10-yr. Treas. plus 50bp
Swap Rate
to determine rate, remember that no upfront CFs are made, so PV of payments must be equal swap rate for floating payer must be rate that makes PV of
payments on fixed-rate side equal to payments on floating rate side
what rate do we use to discount CFs to find PV? example
swap settlement date is January 1 at year 1 floating-rate payments made quarterly based on actual/360 reference rate is 3-month LIBOR notional amount is $100m term of swap is 3 years
Swap Example
today 3-month LIBOR is 4.05% floating payment is
fixed rate payer receives payment on March 31 of
next payment from April 1 to June 30 – 91 days 3 month Eurodollar CD futures contract for
settlement on June 30 of year 1 is 95.85 so Eurodollar futures rate is 4.15%
Swap Example
for the fixed-rate payment
suppose swap rate is 4.98% and quarter has 90 days
Swap Rate
key principle in finding swap rate is no arbitrage opportunity – PV of payments received must equal PV of payments made
rate used for discounting? forward discount factor is PV of $1 received
at period t find forward discount factor for period using forward
rates – but adjust rates for number of days in quarter
Forward Discount Factors
for period 1 for period 2 for period 3
Swap Rate no arbitrage – PV of fixed = PV of floating fixed rate pmt for period t PV of fixed rate payment for period t is
PV of fixed rate payments
no arbitrage so
Valuing a Swap
one year later, rates change so payments by floating rate side change – how does this affect value?
Asset/Liability Management
bank has portfolio of $50m of 5-year loans with fixed rate of 10% - loans are interest only with semiannual pmts and principal due at end of 5 yrs – CF is $2.5m every 6 months to fund, bank will issue 6 month CDs on which it
pays 6-month LIBOR plus 40bp at what LIBOR rate is bank in trouble? bank wants to lock in spread over cost of funds
Asset/Liability Management
life insurance firm pays 9% over next 5 years on GIC – amount is $50m firm can invest $50m in 5 year floating rate
security on which rate is 6-month LIBOR plus 160bp with coupon reset every 6 months
risk for insurance firm?
Asset/Liability Management
swap available in market has terms: every 6 months bank pays 8.45% (annual rate) every 6 months bank receives LIBOR every 6 months insurance firm pays LIBOR every 6 months insurance firm receives 8.40%
what does swap do for each party? bank locks in spread of 155bp insurance firm locks in spread of 100bp
For the bank
For the insurance firm
Asset/Liability Management
bank – alters CF of assets from fixed to floating
life insurance firm – alters CF of assets from floating to fixed
asset swap – in above example liability swap