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Interest Rate Swaps

Interest Rate Swaps. Berk Ahishalioglu 06.04.2013. Presentation Overview . Required Terminology Interest Swap Market Mechanics of Interest Rate Swaps Risks in Interest Rate Swaps Q&A Session. Interest Rate Swap.

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Interest Rate Swaps

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  1. Interest Rate Swaps Berk Ahishalioglu 06.04.2013

  2. Presentation Overview • Required Terminology • Interest Swap Market • Mechanics of Interest Rate Swaps • Risks in Interest Rate Swaps • Q&A Session

  3. Interest Rate Swap • Swap: Aderivative instrument in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. NOT DEBT INSTRUMENT! • Interest Rate Swaps • Currency Swaps • Credit Swaps • Commodity Swaps • Equity Swaps • Interest Rate Swap: Atransaction between two so-called counterparties in which fixed and floating interest-rate payments on a notional amount of principal are exchanged over a specified term.THE NOTIONAL AMOUNT ITSELF IS NEVER EXCHANGED!

  4. Facts about Swap Market • The majority of the swaps are traded over-the-counter (OTC). • 70% of the global OTC derivatives markets is swaps. • The outstanding amount of the interest rate swap is above 77% of all theinternational OTC derivative market • Interest rate swap marketis one of the largest and most liquid global financial markets.

  5. Bank for International Settlements

  6. Financial Intermediary • Inpractice, the swap counterparties do not interact directly. A financialinstitutionintervenes. • Financial intermediary holds two separate swap contracts with each counterparty. • It has two basic functions. • Itmaintains the swap stock. • Financial intermediary undertakes the interest rate risk for both counterparties.

  7. Mechanics of Interest Rate Swaps Company A and Company B have been offered the following rates per annum on a $20M 5-year loan. Calculate the relative gains (quality spread) between fixed and floating markets for A and B. Δfix= 13.4%-12%=1.4% (140b.p.) Δfloating=(LIBOR+0.6%)-(LIBOR+0.1%)=0.5 (50b.p.)

  8. Mechanics of Interest Rate Swaps • Comparative Advantage Theory • One entity may have an advantage in fixed-rate markets. • One entity may have an advantage in floating-rate markets. • Comparative Advantage Theory is one of the main reasons for the rapid growth of the interest rate swaps. • Which company has a comparative advantage in fixed-rate markets ? A or B ? • 2) Calculate the comparative advantage gain. • Comparative advantage gain= Δfix-Δfloating • Comparative advantage gain=1.4%-0.5%=0.9% (90 b.p.)

  9. Mechanics of Interest Rate Swaps Before Swap Agreement Company A borrowed $20 M at 12% fixed rate. Company B borrowed $20 M at LIBOR+0.6% floating rate. After Swap Agreement The terms offered to Company A by financial intermediary are as follows: • Every six months, Company A will pay LIBOR to the intermediary. • Every six months, the intermediary will pay 12% (annual rate) to Company A. The terms offered to Company B by financial intermediary are as follows: • Every six months, Company B will pay 12.1% (annual rate) to the intermediary. • Every six months, the intermediary will pay LIBOR to the Company B.

  10. Mechanics of Interest Rate Swaps From Company A’s Perspective Annual Interest Rate Paid: 12%+LIBOR Annual Interest Rate Received: 12% Net Cost: 12%+LIBOR-12%=LIBOR Gain: Original Floating-Rate-Net Cost of Swap Agreement for Company A Gain: LIBOR+0.1%-LIBOR=0.1% (10 b.s.) From Company B’s Perspective Annual Interest Rate Paid: 12.1%+LIBOR+0.6% Annual Interest Rate Received: LIBOR Net Cost: 12.1%+LIBOR+0.6%-LIBOR=12.7% Gain: Original Fixed-Rate-Net Cost of Swap Agreement for Company B Gain: 13.4%-12.7%=0.7% (70 b.s.)

  11. Mechanics of Interest Rate Swaps From Financial Intermediary’s Perspective Annual Interest Rate Paid: 12%+LIBOR Annual Interest Rate Received: 12.1%+LIBOR Gain: Annual Interest Rate Received-Annual Interest Rate Paid Gain: (12.1%+LIBOR)-(12%+LIBOR)=0.1%(10b.s.) Comparative advantage gain= 0.9% (90b.s.) Gain for Company A: 0.1% (10b.s.) Gain for Company B: 0.7% (70b.s.) Gain for Financial Intermediary: 0.1% (10b.s.) The difference in spreads provides an opportunity for both counterparties to reduce the cost of raising funds.

  12. Potential Benefits of Interest Rate Swaps • Reducing Borrowing Costs • Matching Assets and Liabilities • An asset swap permits the two financial institutions to alter the cash flow characteristics of its assets: from fixed to floating or from floating to fixed. • A liability swap permits two institutions to change the cash flow nature of their liabilities • Manage Interest Rate Risks

  13. Risk/Return Profile of Counterparties to an Interest Rate Swap The value of an interest rate swap fluctuates with market interest rates.

  14. Risks of Interest Rate Swaps • Price Risk Warehousing Swaps: Arranging a swap contract with one counterparty without having arranged an offsetting swap with another counterparty. • Credit Risk Exposure to the risk of failure of a counterparty.

  15. Quiz

  16. Questions • ?

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