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The Mechanics of Interest Rate Swaps - Eve
The Mechanics of Interest Rate Swaps - Eve
Web Site
For information on the International
Swap and Derivative Association and
size of the markets go to www.isda.org
11
Swap Terminology
Note:
Fixed-rate payer can also be called the floatingrate receiver and is often referred to as having
bought the swap or having a long position.
Floating-rate payer can also be referred to as the
fixed-rate receiver and is referred to as having
sold the swap and being short.
12
14
15
16
17
18
19
20
21
22
24
25
100
f0
The next slide shows the cash flows at the expiration dates
from closing the 10 short Eurodollar contracts at the same
assumed LIBOR used in the previous swap example, with
the Eurodollar settlement index being 100 LIBOR.
26
27
28
29
4.
30
31
32
Party A
Party B
33
34
35
Party A
Swap Bank
Fixed Rate Payer
Party B
36
38
39
40
Party B
NP $25m
Party A
NP $50m
Swap Bank
Fixed Rate Payer
Party C
NP $25m
41
42
43
44
46
Party A
Swap Bank
Party B
Swap Agreement:
1.
2.
3.
4.
5.
6.
7.
365
(Fixed Rate)
360
(LIBOR)
48
49
50
52
53
54
56
57
Pay 5.5%
Receive LIBOR
5.5%
+LIBOR
LIBOR
+5%
0.5%
(annual)
0.25%
(semiannually
58
59
V0Fix
$25,000
$94,049
t
t 1 (1 (.05 / 2))
4
60
$25,000
$92,927
t
t 1 (1 (.06 / 2))
61
Swap Valuation
At origination, most plain vanilla swaps have an economic
value of zero. This means that neither counterparty is
required to pay the other to induce that party into the
agreement.
An economic value of zero requires that the swaps
underlying bond positions trade at parpar value swap.
If this were not the case, then one of the counterparties
would need to compensate the other. In this case, the
economic value of the swap is not zero. Such a swap is
referred to as an off-market swap.
62
Swap Valuation
Whereas most plain vanilla swaps are originally par
value swaps with economic values of zero, as we
previously noted, their economic values change
over time as rates change.
That is, existing swaps become off-market swaps as
rates change.
63
Swap Valuation
In the preceding example, the fixed-payers position on the
5.5%/LIBOR swap had a value of $94,049 one year later when the
fixed-rate on new 2-year par value swaps was 5%; that is, the holder
of the fixed position would have to pay the swap bank at least
$94,049 to assume the swap.
On the other hand, the fixed-payers position on the 5.5%/LIBOR
swap had a value of $92,927 when the fixed-rate on the new 2-year
par value swap was 6%; that is, the holder of the fixed position
would have receive $92,927 from the swap bank.
64
Swap Valuation
Just the opposite values apply to the floating position.
Continuing with our illustrative example, if the fixed rate on new 2year par value swaps were at 5%, then a swap bank who assumed a
floating position on a 5.5%/LIBOR swap and then hedged it with a
fixed position on a current 2-year 5.5%/LIBOR swap would gain
$25,000 semiannually over the next two year.
As a result, the swap bank would be willing to pay $94,049 for the
floating position. Thus, the floating position on the 5.5% swap
would have a value of $94,049:
Fl
0
$25,000
$94,049
t
t 1 (1 (.05 / 2))
65
Swap Valuation
Offsetting Swap Positions
Original Swap: Floating Payers Position
Original Swap: Floating Payers Position
Pay LIBOR
Receive 5.5%
LIBOR
+5.5%
Pay 5%
Receive LIBOR
5%
+LIBOR
0.5% (annual)
V0Fl
$25,000
(1 (.05 / 2))t $94,049
t 1
66
Swap Valuation
If the fixed rate on new 2-year par value swaps were at
6%, then a swap bank assuming the floating position on a
5.5%/LIBOR swap and hedging it with a fixed position on
a current 2-year 6%/LIBOR swap would lose $25,000
semiannually over the next year.
As a result, the swap bank would charge $92,927 for
assuming the floating position.
Thus, the floating position on the 5.5% swap would have a
negative value of $92,927:
V0Fl
$25,000
(1 (.06 / 2))t $92,927
t 1
4
67
Swap Valuation
Offsetting Swap Positions
Original Swap: Floating Payers Position
Original Swap: Floating Payers Position
Pay LIBOR
Receive 5.5%
LIBOR
+5.5%
Pay 6%
Receive LIBOR
6%
+LIBOR
0.5% (annual)
V0Fl
$25,000
$92,927
t
t 1 (1 (.06 / 2))
4
68
Swap Valuation
In general, the value of an existing swap is equal to
the value of replacing the swapreplacement
swap.
69
Swap Valuation
Chapter 17
Formally, the
values of the fixed
and floating swap
positions are:
where:
SV
fix
K P KS
NP
P t
t 1 (1 K )
S
P
K
fl
SV
NP
P t
t 1 (1 K )
M
70
Swap Valuation
Note that these values are obtained by discounting
the net cash flows at the current YTM (KP).
As a result, this approach to valuing off-market
swaps is often referred to as the YTM approach.
71
Swap Valuation
The equilibrium price of a bond is obtained not by
discounting the bonds cash flows by a common discount
rate, but rather by discounting each of the bonds cash flows
by their appropriate spot ratesthe rate on a zero-coupon
bond.
Valuing bonds by using spot rates instead of a common
YTM ensures that there are no arbitrage opportunities from
buying bonds and stripping them or buying zero-coupon
bonds and bundling them.
72
Swap Valuation
The argument for pricing bonds in terms of spot rates also
applies to the valuation of off-market swaps.
Similar to bond valuation, the equilibrium value of a swap is
obtained by discounting each of the swaps cash flows by
their appropriate spot rates.
The valuation of swaps using spot rates is referred to as the
zero-coupon approach.
73
Comparative Advantage
Swaps are often used by corporations and financial
institutions to take advantage of arbitrage
opportunities resulting from capital-market
inefficiencies.
To see this consider the following case.
74
Comparative Advantage
Case:
ABC Inc. is a large conglomerate that is working on raising
$300,000,000 with a 5-year loan to finance the acquisition
of a communications company.
Based on a BBB credit rating on its debt, ABC can borrow
5-year funds at either
A 9.5% fixed the 9% rate represents a spread of 250 bp over a 5year T-note yield
Or
A floating rate set equal to LIBOR + 75
75
Comparative Advantage
Suppose:
The treasurer of ABC contacts his investment banker for suggestions on
how to obtain a lower rate.
The investment banker knows the XYZ Development Company is
looking for 5-year funding to finance its $300,000,000 shopping mall
development.
Given its AA credit rating, XYZ could borrow for 5 years at either
A fixed rate of 8.5% (150 bp over T-note)
Or
A floating rate set equal to the LIBOR + 25 bp
76
Comparative Advantage
Fixed Rate
ABC
9.5%
XYZ
8.5%
Credit Spread
100 bp
Floating Rate
LIBOR 75 bp
LIBOR 25 bp
50 bp
preference
Fixed
Floating
77
Comparative Advantage
The Investment banker realizes there is a
comparative advantage.
XYZ has an absolute advantage in both the fixed and
floating market because of its lower quality rating, but it
has a relative advantage in the fixed market where it
gets 100 bp less than ABC.
ABC has a relative advantage (or relatively less
disadvantage) in the floating-rate market where it only
pays 50 bp more than XYZ.
78
Comparative Advantage
Thus, it appears that investors/lenders in the fixed-rate market
assess the difference between the two creditors to be worth
100 bp, whereas investors/lenders in the floating-rate market
assess the difference to be 50 bp.
Arbitrage opportunities exist whenever comparative advantage
exist.
In this case, each firm can borrow in the market where it has a
comparative advantage and then swap loans or have the
investment banker set up a swap.
79
Comparative Advantage
Note:
The swap wont work if the two companies pass their
respective costs. That is:
ABC swaps floating rate at LIBOR + 75bp for 9.5%
fixed
XYZ swaps 8.5% fixed for floating at LIBOR + 25bp
Typically, the companies divide the differences in credit
risk, with the most creditworthy company taking the most
savings.
80
Comparative Advantage
Given total savings of 50 bp (100 bp on fixed 50bp
float), suppose the investment banker arranges an
8.5%/LIBOR swap with a NP of $300,000,000 in which
ABC takes the fixed-rate position and XYZ takes the
floating-rate payer position.
ABC
Swap Bank
XYZ
81
Comparative Advantage
ABC would issue a $300,000,000 FRN paying LIBOR +
75bpthe FRN combined with the fixed-rate swap would
give ABC a synthetic fixed-rate loan paying 9.25%:
ABC' s Synthetic Fixed Rate Loan
FRN
Pay LIBOR 75%
LIBOR .75%
Swap
Pay 8.5% Fixed
8 .5 %
Swap
Re ceive LIBOR
LIBOR
Pay 8.5% .75%
9.25%
Direct Loan Rate 9.5%
82
Comparative Advantage
XYZ would issue a $300,000,000, 8.5% fixed-rate bond
this fixed-rate loan combined with the floating-rate
swap would give XYZ a synthetic floating-rate loan
paying LIBOR.
XYZ' s Synthetic Floating Rate Loan
Loan
Pay 8.5% fixed
Swap
Swap
8.5%
Pay LIBOR
LIBOR
Re ceive 8.5% Fixed Rate 8.5%
Pay LIBOR
LIBOR
Comparative Advantage
Points:
1.
2.
3.
4.
84
Hidden Option
85
Hidden Option
86
Hidden Option
Scholars argue that the credit spreads that exit are due to
the nature of contracts available to firms in fixed and
floating markets.
87
Hidden Option
88
Hidden Option
Swap Applications
In general, swaps can be used in three
ways:
1. Arbitrage
2. Hedging
3. Speculation
90
Arbitrage
In the above case, the differences in credit
spreads among markets made it possible for the
corporations to obtain better rates with
synthetic positions than with direct.
This example represents an arbitrage use of
swaps.
91
Arbitrage
In general, the presence of comparative
advantage makes it possible to create not only
synthetic loans with lower rates than direct, but
also synthetic investments with rates exceeding
those from direct investments.
To illustrate this, four cases showing how
swaps can be used to create synthetic fixed-rate
and floating-rate loans and investments are
presented below.
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Pay LIBOR 1%
LIBOR 1%
Swap
Pay 9% Fixed
9%
Swap
Re ceive LIBOR
LIBOR
Pay 9% 1%
10%
94
Pay LIBOR 1%
LIBOR 1%
Swap
Pay 8% Fixed
8%
Swap
Re ceive LIBOR
LIBOR
Pay 8% 1%
9%
Arbitrage Example:
Synthetic Floating-Rate Loan
Bank with an AA rating has made a 5-year, $20,000,000 loan
that is reset every six months at the LIBOR plus bp. The
bank could finance this by
Selling CDs every 6 months at the LIBOR
Or
Create a synthetic floating-rate loan by selling a 5year fixed note and taking a floating-rate payers
position on a swap.
96
Arbitrage Example:
Synthetic Floating-Rate Loan
The synthetic floating-rate loan will be equivalent to the
direct floating-rate loan paying LIBOR if the swap has a
fixed rate that is equal to the 9% fixed rate on the note:
Synthetic Floating Rate Loan
Loan
Pay 9% fixed
9%
Swap
Pay LIBOR
LIBOR
Swap
Re ceive 9% Fixed Rate 9%
Pay LIBOR
LIBOR
Rate on Direct Floating Loan LIBOR
97
Arbitrage Example:
Synthetic Floating-Rate Loan
Given the bank can borrow at a 9% fixed rate for 5 years, the synthetic
floating-rate loan will be cheaper than the direct floating-rate loan at
LIBOR if the swap has a fixed rate that is greater than 9%.
Example: A synthetic floating-rate loan formed with a 9.5%/LIBOR
swap is 50 bp less than the direct floating rate:
Synthetic Floating Rate Loan
Loan
Pay 9% fixed
Swap
Pay LIBOR
Swap
Re ceive 9.5% Fixed Rate
Pay LIBOR .5%
9%
LIBOR
9.5%
(LIBOR .5%)
Arbitrage Example:
Synthetic Fixed-Rate Investment
Swaps can also be used to augment investment return.
Example:
A trust fund that is looking to invest $20,000,000 for 5 years in a
high quality fixed-income security.
Alternatives:
Invest in a high quality, 5-year 6% fixed coupon bond selling at
par
Or
Buy a 5-year FRN paying the LIBOR + bp and take a floatingrate payer position on a swap.
99
Arbitrage Example:
Synthetic Fixed-Rate Investment
If the fixed rate on the swap is greater than the rate on
the direct investment (6%) minus the bp on the FRN,
then the synthetic fixed-rate loan will yield a higher
return than the T-note.
100
Arbitrage Example:
Synthetic Fixed-Rate Investment
Example: A synthetic fixed rate investment formed with an
investment in a 5-year FRN paying LIBOR plus 100 bp and a
6%/LIBOR swap yields a 7% rate compared to a 6% rate from the
direct investment.
Re ceive LIBOR 1%
Pay LIBOR
Re ceive 6% Fixed Rate
Re ceive 7% Fixed Rate
LIBOR 1%
LIBOR
6%
7%
101
Arbitrage Example:
Synthetic Floating-Rate Investment
Example:
Investment Fund is looking to invest $20,000,000 for 5
years in a FRN.
Alternatives:
Invest in a high quality, five-year FRN paying LIBOR plus 50
bp
Or
Invest in a 5-year fixed-rate bond and take a fixed-rate payer
position
102
Arbitrage Example:
Synthetic Floating-Rate Investment
If the fixed rate on the swap plus the bp on the direct FRN investment
is less than the rate on fixed-rate bond, then the synthetic floating-rate
investment will yield a higher return than the FRN.
Example: A synthetic floating-rate investment formed with an
investment in a 5-year, 7% fixed-rate bond and a fixed-rate payers
position on a 6%/LIBOR swap 50 bp more than the direct investment.
Synthetic FRN
Fixed Rate Bond
Swap
Swap
Re ceive 7%
Re ceive LIBOR
Pay 6% Fixed Rate
Re ceive LIBOR 1%
7%
LIBOR
6%
LIBOR 1%
104
Swap ApplicationsHedging
Hedging Example 1:
One alternative would be to refund the floating-rate debt
with fixed-rate debt. This, though, would require the cost
of issuing new debt (underwriting, registration, etc.), as
well as calling the current FRN or buying the FRN in the
market.
Problem: Very costly.
106
Swap ApplicationsHedging
Hedging Example 1:
Another alternative would be to hedge the floating-rate
debt with short Eurodollar futures contracts (strip), put
options on Eurodollar futures, or an interest rate call.
Problem: Standardization of futures and options creates
hedging risk.
107
Swap ApplicationsHedging
Hedging Example 1:
Third alternative would be to combine the floating-rate
debt with a fixed-rate payers position on a swap to
create a synthetic fixed -rate debt.
Advantage: Less expensive and more efficient than
issuing new debt and can be structured to create a better
hedge than exchange options and futures.
108
Swap ApplicationsHedging
Hedging Example 2:
Suppose a companys current long-term debt consist
primarily of fixed-rate bonds, paying relatively high
rates.
Suppose interest rates have started to decrease.
109
Swap ApplicationsHedging
Hedging Example 2:
One alternative would be to refund the fixed-rate debt with
floating-rate debt. This, though, would require the cost of
issuing FRN (underwriting, registration, etc.), as well as
calling the current fixed rate bonds or buying them in the
market if they are not callable
Problem: Very costly.
110
Swap ApplicationsHedging
Hedging Example 2:
Another alternative would be to hedge the fixed-rate
debt with long Eurodollar futures contracts (strip), put
options on Eurodollar futures, or an interest rate call.
Problem: Standardization of futures and options creates
hedging risk.
111
Swap ApplicationsHedging
Hedging Example 2:
Third alternative would be to combine the fixed-rate debt
with a floating-rate payers position on a swap to create
synthetic floating-rate debt.
Advantage: Less expensive and more efficient than
issuing new debt and can be structured to create a better
hedge than exchange options and futures.
112
Swap ApplicationsSpeculation
Swaps can be used to speculate on short-term
interest rate.
Speculators who want to profit on short-term rates
increasing can take a fixed-rate payers position
alternative to a short Eurodollar futures strip.
Speculators who want to profit on short-term rates
decreasing can take a floating-rate payers position
alternative to a long Eurodollar futures strip.
113
Swap ApplicationsChanging a
Fixed-Income Funds Interest Rate Exposure
For financial and non-financial corporations, speculative
positions often take the form of the company changing the
exposure of its balance sheet to interest rate changes.
For example, suppose a fixed income bond fund with a
portfolio measured against a bond index wanted to increase the
duration of its portfolio relative to the indexs duration based on
an expectation of lower interest rate across all maturities.
The fund could do this by selling its short-term Treasuries and
buying longer-tern ones or by taking long positions in Treasury
futures.
With swaps, the fund could also change in portfolios duration
by taking a floating-rate payers position on a swap.
114
Swap ApplicationsChanging a
Fixed-Income Funds Interest Rate Exposure
If they take a floating-rate position and rates were to
decrease as expected, then not only would the value of
the companys bond portfolio increase but the company
would also profit from the swap.
On the other hand, if rates were to increase, then the
company would see decreases in the value of its bond
portfolio, as well as losses from its swap positions.
By adding swaps, though, the fund has effectively
increased its interest rate exposure by increasing its
duration.
115
Swap ApplicationsChanging a
Fixed-Income Funds Interest Rate Exposure
Instead of increasing its portfolios duration, the fund
may want to reduce or minimized the bond portfolios
interest rate exposure based on an expectation of higher
interest rate.
In this case, the fund could effectively shorten the
duration of its bond fund by taking a fixed-rate payers
position on a swap.
If rates were to later increase, then the decline in the
value of the companys bond portfolio would be offset by
the cash inflows realized from the fixed-payers position
on the swap.
116
Credit Risk
Credit Risk
118
Credit Risk
119
Credit Risk
120
Credit Risk
Credit Risk
The example illustrates that two events are
necessary for default loss on a swap:
Actual default on the agreement
Adverse change in rates
Credit risk on a swap is therefore a function of
the joint likelihood of financial distress and
adverse interest rate movements.
122
Credit Risk
123