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### Chapter 13

Swaps and Interest Rate Options

Outline

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

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

Interest Rate Swaps

- Hedging with interest rate swaps
- Immunizing with interest rate swaps
- Exploiting comparative advantage in the credit market

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

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

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

‘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)

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

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

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

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

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.

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

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

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

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

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
or

- using interest rate swaps to close the duration gap

- This could be accomplished by selling some of the bank’s loans and holding cash equivalent securities instead

- The treasurer may choose to move the duration gap to 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)

Treasury + 40 bp

AAA

BBB

LIBOR

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:
Euro Principal

C$ Principal

Cdn. Co.

Swap Dealer

C$

Fixed

Rate

Interest

Bondholders

Foreign Currency Swaps (cont’d)

- Cash flows at each settlement:
Euro Fixed Rate

C$ - Fixed Rate

Cdn. Co.

Swap Dealer

C$

Fixed Rate

Interest

Foreign Currency Swaps (cont’d)

- Cash flows at maturity:
Euro Principal

C $ Principal

Cdn. Co.

Swap Dealer

Retire C$

Issue

Circus Swap

- Combining both interest rate and currency swaps

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

Circus Swap

- Interest associated with original currency swap
Euro - Fixed

C$ - Fixed

Cdn. Co.

Swap Dealer

Fixed C$

Interest

Bondholders

Circus Swap

- Interest rate swap to move from fixed euros to floating rate euros
Euro Fixed

Euro Floating

Cdn. Co.

Swap Dealer

Circus Swap

- Circus swap with two counterparties = net position of:
Floating Rate Euros

Fixed Rate C$

Cdn. Co.

Swap Dealer

Fixed C$

Interest

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
- Motivation - desire to manage future interest rate risk but reflecting today’s interest rate conditions

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

Deferred Swap - Example

Pay 7 year

Fixed

Pay 2 year

Fixed

Swap

Dealer

ABC Co.

Swap

Dealer

Pay

BA’s

Receive

BA’s

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

Deferred Swap -

- 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

Floating for Floating Swap

- In a floating for floating swap, both parties pay a floating rate, but with difference 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

- Interest rate cap
- Interest rate floor
- Calculating cap and floor payoffs
- Interest rate collar
- Swaption

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

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

- Is like a portfolio of European call options (caplets) on an interest rate

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

Interest Rate Floor (cont’d)

- Long interest rate floor (exercise price 6.5%)

$ Payoff

Payoff

Option expires worthless

Floating Rate

6.5%

Interest Rate Floor (cont’d)

- Short interest rate floor (exercise price 6.5%)

$ Payoff

Option expires worthless

Floating Rate

6.5%

Payout

Calculating Cap and Floor Payoffs

- There are no universally acceptable terms to caps and floors
- However, frequently the terms provide for the cash payment on an in-the-money caplet or floorlet to be based on a 360-day year

Calculating Cap and Floor Payoffs (cont’d)

- Cap payout formula:
- If the benchmark rate is less than the exercise price, the payout is zero

Calculating Cap and Floor Payoffs (cont’d)

- Floor payout formula:

Interest Rate Collar

- An interest rate collar is simultaneously long an interest rate cap and short an interest rate floor
- Sacrifices some upside potential in exchange for a lower position cost
- Premium from writing the floorlets reduces position costs

Interest Rate Collar (cont’d)

Long cap

$ Payoff

Inflow

No payout

Floating Rate

k2

Outflow

k1

Short floor

Swaption

- A swaption is an option on a swap
- Can be either American or European style
- A payer swaption (put swaption) gives its owner the right to pay the fixed interest rate on a swap
- A receiver swaption (call swaption) gives its owner the right to receive the fixed rate and pay the floating rate

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