Chapter 13

1. Chapter 13 Swaps and Interest Rate Options

2. Outline • Interest rate swaps • Foreign currency swaps • Circus swap • Interest rate options

3. Introduction • Both swaps and interest rate options are relatively new, but extensively used • In mid-2000, there was over $60 trillion outstanding in interest rate swaps, foreign currency swaps, and other interest rate options

4. Interest Rate Swaps • Hedging with interest rate swaps • Immunizing with interest rate swaps • Exploiting comparative advantage in the credit market

5. Interest Rate Swaps • 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: • asset • liability

6. Interest Rate Swaps • 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

7. Interest Rate Swaps • Typically, the floating interest rate is linked to a market rate such as • LIBOR or • T-bill rates • BA’s in Canada • The swap market is standardized partly by the International Swaps and Derivatives Association (ISDA) • ISDA provisions are master agreements

8. ‘Plain Vanilla’ Swap – Hedging Interest Rate Risk • 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)

9. Plain Vanilla Swap • 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

10. Plain Vanilla Swap 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 bankers • 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

11. Plain Vanilla Swap - Motivations Large firm with a strong credit rating • takes advantage of it s borrowing capacity and borrows fixed term in the bond market • interest rate outlook - declining rates • enters into a swap agreement to move to floating rate debt but still leveraging its strong credit rating and borrowing capacity

12. Plain Vanilla Swap - Motivations Smaller firm with weaker credit rating • no/minimal access to long term bond market due to its relatively weak credit rating • typically borrows floating rate from its bank(s) • would like to fix its borrowing rate as part of its risk management program • can achieve its fixed rate objectives by entering into a swap agreement

13. Plain Vanilla Swap Plain Vanilla Swap Example (cont’d) LIBOR – 50 bp Big Firm Smaller Firm 8.05% 8.05% LIBOR +100 bp Bondholders Bankers

14. Plain Vanilla Swap Plain Vanilla Swap Example A facilitator might act as an agent in the transaction and charge a 15 bp fee for the service.

15. Plain Vanilla Swap Plain Vanilla Swap Example LIBOR -50 bp LIBOR -50 bp Big Firm Facilitator Smaller Firm 8.05% 8.20% 8.05% LIBOR +100 bp Bondholders Bankers

16. Plain Vanilla Swaps - Timing • Swaps can be entered into at same time the firm accesses the bond market - e.g. 5 year fixed rate bond issue immediately swapped into floating rate via a swap agreement or • A swap can be negotiated at any time over the life of an existing borrowing e.g. 7 year bond issue two years prior - firm now expects interest rates to decline - 5 years remaining on the bond issue - firm enters into a 5 year fixed to floating rate swap

17. Interest Rate Risk Management -Considerations • Interest rate outlook over expected borrowing horizon • Use swaps where the borrowing horizon is longer term • use futures where the interest rate risk is short term • absolute interest rate levels and or yield curve shape • credit or ‘swap’ spreads

18. Interest Rate Risk Management Considerations • Interest Rate Outlook • Floating rate alternative if outlook is lower • Fixed rate if outlook is higher • Absolute Levels and Yield Curve • Borrow fixed rate – premium but no risk • Borrow floating rate – at lower rates at shorter end of the yield curve – but with interest rate risk

19. Interest Rate Risk Management Considerations • Fixed to Floating interest rate swap • Outlook for rates lower • Steeper yield curve – lower rates at short end • Absolute borrowing levels • Credit/swap spreads • Floating to Fixed interest rate swap • Outlook for rates higher • Flatter yield curve • Absolute borrowing levels • Credit/swap spreads

20. Swap Timing – Anticipating Interest Rate Changes • Interest rate changes need to be anticipatedand swaps need to be negotiated ahead of the actual interest rate movement for the buyer to achieve the desired result

21. 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:

22. 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 or • using interest rate swaps to close the duration gap …how would this be done?

23. Exploiting Comparative Advantage in the Credit Market • Interest rate swaps can be used to exploit differentials in the credit market

24. Exploiting Comparative Advantage in the Credit Market Credit Market Example AAA Bank and BBB Bank currently face the following borrowing possibilities:

25. Exploiting Comparative Advantage in the Credit Market Credit Market Example (cont’d) AAA Bank has an absolute advantage over BBB in both the fixed and the floating rate markets. AAA has a comparative advantage in the fixed rate market. The total gain available to be shared among the swap participants is the differential in the fixed rate market minus the differential in the variable rate market, or 30 bps.

26. Exploiting Comparative Advantage in the Credit Market Credit Market Example (cont’d) AAA Bank wants to issue a floating rate bond, while BBB wants to borrow at a fixed rate. Both banks will borrow at a lower cost if they agree to an interest rate swap. AAA Bank should issue a fixed rate bond because it has a comparative advantage in this market. BBB should borrow at a floating rate. The swap terms split the rate savings 50-50. The current 5-yr T-bond rate is 4.50%.

27. Exploiting Comparative Advantage in the Credit Market Credit Market Example (cont’d) Treasury + 40 bp AAA BBB LIBOR Treasury + 25 bp LIBOR +30 bp Bondholders Bondholders

28. Exploiting Comparative Advantage in the Credit Market Credit Market Example (cont’d) • The net borrowing rate for AAA is LIBOR – 15 bps • The net borrowing rate for BBB is Treasury + 70 bps • The net rate for both parties is 15 bps less than without the swap.

29. Foreign Currency Risk • 1971 – the Breton Woods Agreement was suspended by global monetary leaders • Currencies previously tied to the price of gold and to the $US now floated freely • The result- currency volatility and currency risk • 1972 – CME began trading currency futures • 1981 – Salomon Bros brokered the first currency swap between the World Bank and IBM (German marks Swiss francs)

30. Foreign Currency Risk Today • ‘Euro’ volatility • Weakening US dollar • Strengthening Canadian dollar (other ‘resource currencies) • Impacted Canadian firms and individual investors • E.g. oil & gas producers selling commodities denominated in $US and Canadian investors investing in US securities

31. Foreign Currency Swaps • In a currency swap, two parties • Exchange currencies at the prevailing exchange rate • Then make periodic interest payments to each other based on a predetermined pair of interest rates, and • Re-exchange the original currencies at the conclusion of the swap

32. Foreign Currency Swaps (cont’d) • Cash flows at origination: Euro Principal C$ Principal Cdn. Co. Swap Dealer C$ Fixed Rate Interest Bondholders

33. Foreign Currency Swaps (cont’d) • Cash flows at each settlement: Euro Fixed Rate C$ - Fixed Rate Cdn. Co. Swap Dealer C$ Fixed Rate Interest

34. Foreign Currency Swaps (cont’d) • Cash flows at maturity: Euro Principal C $ Principal Cdn. Co. Swap Dealer Retire C$ Issue

35. Circus Swap • Combining both interest rate and currency swaps

36. Circus Swap • A circus swap combines an interest rate and a currency swap • Involves a plain vanilla interest rate swap and an ordinary currency swap • Both swaps might be with the same counterparty or with different counterparties

37. Circus Swap • Interest associated with original currency swap Euro - Fixed C$ - Fixed Cdn. Co. Swap Dealer Fixed C$ Interest Bondholders

38. Circus Swap • Interest rate swap to move from fixed euros to floating rate euros Euro Fixed Euro Floating Cdn. Co. Swap Dealer

39. Circus Swap • Circus swap with two counterparties = net position of: Floating Rate Euros Fixed Rate C$ Cdn. Co. Swap Dealer Fixed C$ Interest

40. Swap Variations • Deferred or ‘forward’ swap • Floating for floating swap • Amortizing swap • Accreting swap

41. Deferred Swap • In a deferred swap (forward start swap), the cash flows do not begin until sometime after the initiation of the swap agreement • Motivation - desire to manage future interest rate risk but reflecting today’s interest rate conditions

42. Deferred Swap - Example • ABC corporation has a required borrowing 2 years from now • interest rate outlook is for rates trending upward • deferred swap could lock in today’s fixed rates for a premium • a deferred or forward swap is in effect 2 swaps

43. Deferred Swap - Example Pay 7 year Fixed Pay 2 year Fixed Swap Dealer ABC Co. Swap Dealer Pay BA’s Receive BA’s

44. Deferred Swap - Example ...in two years time Pay 7 year (5 years remaining) Fixed ABC Co. Swap Dealer Receive BA’s Borrow Floating Rate BA’s Bankers

45. Deferred Swap - • Rate is established today and ‘deferred’ for a period of time • Dealer factors in the ‘cost of carry’ in offering the deferred 5 year rate (one swap) • Considerations • interest rate outlook • time frame • cost of carry - the cost of the ‘hedge’ • steep yield curve - higher cost of carry • flat yield curve - minimal cost of carry

46. Floating for Floating Swap • In a floating for floating swap, both parties pay a floating rate, but with difference benchmark indices

47. Amortizing Swap • In an amortizing swap, the notional value declines over time according to some schedule

48. Accreting Swap • In an accreting swap, the notional value increases through time according to some schedule

49. Interest Rate Options • Interest rate cap • Interest rate floor • Calculating cap and floor payoffs • Interest rate collar • Swaption ………similar instruments available on commodities such as oil and gas

50. Interest Rate Options • Most of the trading done off the exchange floors • The interest rate options market is • Very large • Highly efficient • Highly liquid • Easy to use