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Chapter 13. Swaps and Interest Rate Options. Outline. Introduction Interest rate swaps Foreign currency swaps Circus swap Interest rate options. Introduction. Both swaps and interest rate options are relatively new, but very large

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## Chapter 13

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**Chapter 13**Swaps and Interest Rate Options**Outline**• Introduction • Interest rate swaps • Foreign currency swaps • Circus swap • Interest rate options**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**Interest Rate Swaps**• Introduction • Immunizing with interest rate swaps • Exploiting comparative advantage in the credit market**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**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**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**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)**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.**Introduction (cont’d)**Plain Vanilla Swap Example (cont’d) LIBOR – 50 bp Big Firm Smaller Firm 8.05% 8.05% LIBOR +100 bp Bondholders Bondholders**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.**Introduction (cont’d)**Plain Vanilla Swap Example (cont’d) LIBOR -50 bp LIBOR -50 bp Big Firm Facilitator Smaller Firm 8.05% 8.20% 8.05% LIBOR +100 bp Bondholders Bondholders**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**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:**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**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:**Exploiting Comparative Advantage in the Credit Market**• Interest rate swaps can be used to exploit differentials in the credit market**Exploiting Comparative Advantage in the Credit Market**Credit Market Example AAA Bank and BBB Bank currently face the following borrowing possibilities:**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.**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%.**Exploiting Comparative Advantage in the Credit Market**Credit Market Example (cont’d) LIBOR AAA BBB Treasury + 40 bp Treasury + 25 bp LIBOR +30 bp Bondholders Bondholders**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.**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**Foreign Currency Swaps (cont’d)**• Cash flows at origination: FX Principal US $ Principal Party 1 Party 2**Foreign Currency Swaps (cont’d)**• Cash flows at each settlement: $ LIBOR FX Fixed Rate Party 1 Party 2**Foreign Currency Swaps (cont’d)**• Cash flows at maturity: US $ Principal FX Principal Party 1 Party 2**Foreign Currency Swaps (cont’d)**Foreign Currency Swap Example A multinational US corporation has a subsidiary in Germany. It just signed a 3-year contract with a German firm. The German firm will provide raw materials, with the US firm paying 1 million Euros every 6 months for the 3-year period. The current exchange rate is $0.90/Euro. The contract is fixed in Euro terms, but if the dollar depreciates against the Euro, dollar accounts payable would increase.**Foreign Currency Swaps (cont’d)**Foreign Currency Swap Example (cont’d) A currency swap is possible with the following terms: • Tenor = 3 years • Notional value = 25 million Euros ($22.5 million) • Floating rate = $ LIBOR • Fixed rate = 8.00% on Euros**Foreign Currency Swaps (cont’d)**Foreign Currency Swap Example (cont’d) The swap will result in the following payments every six months: • Fixed rate payment = 25,000,000 Euros x 8.00% x 0.5 = 1,000,000 Euros • Floating rate payment = $22.5 million x 0.5 x LIBOR**Foreign Currency Swaps (cont’d)**Foreign Currency Swap Example (cont’d) Cash Flows at Origination 25 million euros $22.5 million Party 1 Party 2**Foreign Currency Swaps (cont’d)**Foreign Currency Swap Example (cont’d) Cash Flows at Each Settlement $ LIBOR 1 million euros Party 1 Party 2**Foreign Currency Swaps (cont’d)**Foreign Currency Swap Example (cont’d) Cash Flows at Maturity $22.5 million 25 million euros Party 1 Party 2**Circus Swap**• Introduction • Swap variations**Introduction**• 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**Introduction (cont’d)**• Circus swap with two counterparties: 8% on Euros $ LIBOR Party 1 Party 2**Introduction (cont’d)**• Circus swap with two counterparties (cont’d): $ LIBOR 6.50% US Party 1 Party 3**Introduction (cont’d)**• Circus swap with two counterparties (cont’d): 8% on Euros 6.50% US Party 1 Net**Introduction (cont’d)**• Circus swap with two counterparties (cont’d): • Party 1 is effectively paying 8% on Euros and receiving 6.5% in U.S. dollars**Swap Variations**• Deferred swap • Floating for floating swap • Amortizing swap • Accreting swap**Deferred Swap**• In a deferred swap (forward start swap), the cash flows do not begin until sometime after the initiation of the swap agreement • If the swap begins now, the deferred swap is called a spot start swap**Floating for Floating Swap**• In a floating for floating swap, both parties pay a floating rate, but with different benchmark indices**Amortizing Swap**• In an amortizing swap, the notional value declines over time according to some schedule**Accreting Swap**• In an accreting swap, the notional value increases through time according to some schedule**Interest Rate Options**• Introduction • Interest rate cap • Interest rate floor • Calculating cap and floor payoffs • Interest rate collar • Swaption**Introduction**• Most of the trading done off the exchange floors • The interest rate options market is • Very large • Highly efficient • Highly liquid • Easy to use**Interest Rate Cap**• An interest rate cap • Is like a portfolio of European call options (caplets) on an interest rate • On each interest payment date over the life of the cap, one option in the portfolio expires • Is useful to firms with floating rate liabilities • Caps the periodic interest payments at the caplet’s exercise price**Interest Rate Cap (cont’d)**• Long interest rate cap (exercise price 7%) $ Payoff Payoff Option expires worthless Floating Rate 7%**Interest Rate Cap (cont’d)**• Short interest rate cap (exercise price 7%) $ Payoff Option expires worthless Floating Rate 7% Payout**Interest Rate Floor**• An interest rate floor • Is related to a cap in the same way that a put is related to a call • Like a portfolio of European put options (floorlets) on an interest rate • On each interest payment date over the life of the cap, one option in the portfolio expires • Is useful to firms with floating rate assets • Puts a lower limit on the periodic interest payments at the floorlet’s exercise price

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