CHAPTER 9: INTEREST RATE DERIVATIVES MARKET

Cost of borrowing money

Can be seen as profit over time due to financial instruments
Interest may change due to economic changes
Different types of loan offer different interest rate

INTEREST RATE RISK

Risk occurs when there are changes in the market interest rate
Borrowers are concern with increasing interest rate
Lenders are concern with decreasing interest rate
Lenders and borrowers can lend or borrows at fixed or floating rate
INTEREST RATE

BORROWER

LENDER

Rising

Favourable to use fixed rate

Favourable to use floating rate

Falling

Favourable to use floating rate

Favourable to use fixed rate

HEDGING
A hedge is a position established in one market in an attempt to offset exposure to the
change in the interest rate of an equal but opposite obligation in another market.
Risk can be inherent to a business activities and specific to certain businesses
HEDGING STRATEGIES
1. Forward rate agreement (FRA)
Forward rate agreement enables a company to protect itself against interest risk by
fixing the effective rate of interest before the intended borrowing or deposit date.
2. Interest rates futures (IRF)

Interest rate futures (IRF) are used by companies to enter into speculative (or
hedge) positions on changes in short-term interest rates.
3. Interest rate options
Used by investors, borrowers and traders to manage interest rate risk exposures
The product is available on payment of an upfront fee, called the premium
4. Interest rate swaps (IRS)
A derivative in which one party exchanges a stream of interest payments for another
partys stream of cash flows
Can be used by hedgers to manage their fixed or floating assets and liabilities
Can be used by speculators to replicate unfunded bond exposures to profit from
changes in interest rates. As such, interest rate swaps are very popular and highly
liquid instruments.
5. Swaptions
A hybrid derivative product that integrates the benefit of swaps and options.
The buyer of a swaption has the right, but not the obligation, to enter an interest
rate or currency swap during a limited period of time and at a specified rate.
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FACTORS AFFECTING HEDGING STRATEGY

Appropriate hedging strategy depending on current situation
Maturity of borrowing or investments
Size of transaction involved
Amount of option premium required to be paid
Creditworthiness of company
Cost of hedging as compared to possible opportunity loss
Impact of various hedging techniques
INTEREST RATE SWAPS
One of the largest components of the global derivatives market
Customized bilateral transactions where parties agree to exchange cash flows at fixed
periodic intervals
Over the counter instruments (OTC)
Each side of a swap is called a leg
Companies involved are known as counterparties
PURPOSE OF SWAPS
Reduce their exposure to changes in the interest rates on a particular transaction.
Lower their net expected costs of borrowing with respect to bonds.
Manage their exposure to the changing market conditions in advance of anticipated issuance
of bonds.
Achieve more flexibility in meeting the overall financial objectives that cannot be achieved in
conventional markets.
Obtain customized cash flows to match the required payment obligations or revenue
projections.
TYPE OF SWAPS
1. Fixed-to-floating rate swap
To convert a fixed rate asset (lending) or liability (borrowing) to a floating rate asset or
liability
Company makes fixed rate payment and receive a floating rate payment
Known as plain vanilla swap.
2. Floating-to-fixed rate swap
To convert a floating rate asset or liability to fixed rate asset or liability
Company makes a floating rate payment and receive a fixed rate payment
3. Floating-to-floating rate swap
To hedge against the spread between two indexes widening or narrowing
To customize exposure to specific points on the yield curve
Parties try to profit from the differences in the swap spreads
Known as basis swap.

APPLICATION OF INTEREST RATE SWAPS

1. Arbitraging
Companies arbitrage to avoid mispricing due to differences in opinions regarding the
creditworthiness of their companies
2. Hedging
Borrowers will hedge against a hike in interest rate to avoid paying high financing
cost
Lenders will try to hedge against a falling interest rate to avoid low yield from its
investment
Interest rate swaps enable the counterparties to hedge against the increase and
decrease in interest rates.
3. Speculating
Used to estimate the future movements of interest rates.
By speculating, it is hoped that companies would gain when the interest rate
actually changes.
PRICING OF INTEREST RATE SWAPS
When valuing interest rate swaps, managers may have to forecast and make estimation on
certain variables they consider as factors affecting the price of a swap.
This involves using extrapolation and other techniques to derive the estimates. As such,
different managers may value a swap differently.
RISKS ASSOCIATED WITH INTEREST RATE SWAPS
1. Interest rate risks
It originates from changes in the floating rate. In a plain vanilla fixed-to-floating rate
swap, the party which pays the floating rate benefits when rates fall.
2. Credit risk
Contracts that represent agreements between two parties, such as swaps, always
involve credit risks.
Counterparties must make payments periodically.
There are possibilities that one party may not be able to fulfill its obligation exposing
the other party to risk.
3. Market risk
Arises from the possible movements on a variable associated with the swap
instrument, such as interest rates and exchange rates
It makes the value of the swap negative for one of the parties involved in it.
4. Sovereign risk
The risk associated with the country in whose currency a swap is being considered.
Covers political stability or the possibility of exchange controls being introduced.
Lead to credit risk in a currency swap.

GLOBALISATION
With globalization the process of swapping will not only apply to interest rates but will also include
the currencies of countries involved in a transaction.
1. Interest Rate Swaps in Different Currencies
The two types of currency-interest swaps are as follows:
(i)
Fixed-to-floating rate swap, different currencies
(ii)
Fixed-to-floating rate swap, different currencies
2. Currency Swaps
A currency swap is a contract in which two counterparties exchange a specific
amount of two different currencies, exchange interest payments in two currencies
over the term of the swap and re-exchange the principal at maturity
Three processes involved:
(i)
Companies exchange the amount of principal
(ii)
Periodically exchange the interest payments throughout the life of the swap
(iii)
Principal amount is re-exchanged at the end of the swap
ADVANTAGES OF CURRENCY SWAPS
Able to reduce cost of finance
Able to restructure their capital without having to pay back their debt
Companies can access the international market
DISADVANTAGES OF CURRENCY SWAPS
Company may not be able to reduce risk when there is an adverse movement in exchange
rates
There is possibility that counterparties may default and lead to credit risk