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Interest Rate Swaps: Pre-2008 Crisis

Interest Rate Swaps: Pre-2008 Crisis

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Published by Jasvinder Josen
Immediately after the crisis, Interest Rate Swaps (IRS) underwent a significant change in the market where motivation of trading them were concerned. Primary motive was hedging and not speculation. This is the first of a two-part series that explains more about the IRS as a derivative instruement
Immediately after the crisis, Interest Rate Swaps (IRS) underwent a significant change in the market where motivation of trading them were concerned. Primary motive was hedging and not speculation. This is the first of a two-part series that explains more about the IRS as a derivative instruement

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Published by: Jasvinder Josen on Feb 24, 2011
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06/29/2015

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THEEDGE mal aysia   |  january 17, 2011

interest Rate swaps: Pre-2008 crisis
the IRS to Company B would be: [- Libor + 6% • Arbitrage opportunities - 8% = - Libor – 2%] So, synthetically the comThe IRS market is closely linked to the inpany has managed to pay on its bond, Libor + terest rate futures and forwards markets.Arbiby 2%, and can now benefit from further falls in trageurs continuously trade between forwards, Jasvin Josen the interest rate. The rate may still seem high futures and swaps resulting in the rates for the compared with newly issued bonds, but con- different derivatives within the same tenor to time deposits and receives three-month Libor sidering the issuing cost of bonds, the swap stay in close proximity. (London Interbank Offer Rate), for example, + transaction does seem worthwhile. 0.2% on its mortgages. Say the Libor at the first Some important features of three-month interval is 5%. The bank makes a Speculation interest rate swaps margin of 0.2% from its lending business. Say Interest rate swaps are also very often used by Before we go further, it would be useful to unafter three months,Libor falls to 4.8%.The bank’s market participants who want to take profit derstand some important features of the IRS, margins are now being squeezed. from the movement in interest rates.The main such as: Bank A would be interested in entering into speculators in the swap market are the propri- • Reset dates a fixed-for-floating IRS (see Chart 1) where it etary trading desks of investment banks and These are pre-set dates when the floating What is an interest rate swap could swap the fixed interest paid on its time hedge funds. rate in the IRS will be reset to An interest rate swap (IRS) is an agreement be- deposits with a three-month Libor. In this way, Traditionally, an investor the current rate. For examtween two parties to swap interest payments Bank A is not exposed to the changes in Libor who expects interest rates The swap market ple, an IRS that has one floaton an agreed notional sum of the same cur- as the interest rate risk is hedged with the IRS. to fall would purchase cash has undergone ing leg paying three-month rency. In the case of a plain-vanilla IRS, par- The IRS will slightly reduce the bank’s overall bonds,whose price increases an evolution Libor (say 5%) will be re-set ties exchange fixed interest rates with floating margin, but eliminates the bigger downside as interest rates fall. Today, — a change in every three months at pre-deinterest rates. when Libor moves the other way. investors with a similar view termined dates.At these dates, The interest rate swap is an important tool could enter a floating-for- the motivation the three-month Libor (which in hedging for banks and corporations. They Hedging with interest rate swaps — cor- fixed interest rate swap; as of trading, which was 5%) will be changed to the can also be attractive speculation instruments porations interest rates fall, investors has brought about current rate (say 4.8%). • Fixed rate or swap rate as we will see later. Say Company B issued a 10-year fixed bond pay a lower floating rate in new risk that at 8% and it is into its fifth year now. Interest exchange for the same fixed was considered In a previous article, “FinanHedging with interest rate swaps rates have fallen, and the company wishes it rate. cial Wizardry in Swaps — the negligible before — commercial banks had issued a floating rate bond instead. It is not A speculator can also take the crisis Greek case” ( March 8, 2010), Commercial banks that are funded on time too late. It can enter into an IRS as in Chart 2. a view of the shape of the the swap rate for a cross curdeposits (paying fixed rates) and issue float- Company B pays the floating Libor and receives interest rate curve, an exrency swap was discussed. In ing rate mortgages are exposed to interest rate a fixed rate of 6% from the swap counter-party. ample of which can be seen any fixed-for-floating swap, risk. For instance, say Bank A pays 5% on its The net effect of the cash flows of the bond and in Chart 3.The speculator may believe that the the fixed rate to be paid by the fixed rate difference between the six-month Libor rates payer will be such that it makes the swap will fall further relative to the three-year swap “fair”. In other words, at the inception of rate. The Libor only has maturities of up to 12 the swap, the price of the swap should months. He enters into a constant maturity ideally be zero. Now, the price of the swap Chart 1 – Hedging with interest rate swaps   swap paying the six-month Libor rate and reis simply the present value of its floating (commercial banks) ceiving the three-year swap rate (which is peand fixed cash flows. To make the price riodically set to the market swap rate). zero, the fixed rate is adjusted to make the present value zero. This fixed rate is also The interest rate swap market known as the swap rate or the at-market The interest rate swap market flourishes not swap rate. only for the reasons of hedging and speculaSpeculation tion, but also because of two more important New developments features: Interest rate swaps are also very often used by Now that we have a reasonable level of undermarket participants who want to take a view • Quality spread differential between standing of the plain-vanilla interest rate swap, andfirms from the movement in interest rates. The main speculators in the swap market profit in the next article, we will study how the swap areDue to the varying levels of counter-party market changed after the 2008 crisis, bringproprietary trading desk of investment banks and hedge funds. risk of companies, there is often a “quality ing about “basis risk” which was considered Traditionally, an investor whoallows both par- insignificantwould purchase cash bonds, be spread differential”, which expected interest rates to fall before but cannot afford to whose to benefit from an interest rate swap.Say fall. Today,now. ties price will increase as the interest rates sidelined investors with a similar view could Hedging with the IRS – The example of the corporation Bank A (rated AAA) is interest rate swap; enter a floating-for-fixedable to borrow fundsas interest rates fall, investors would pay a at Bank B (rated BBB) will Jasvin Josen is a specialist in developing Say Company B issued a 10 year fixed bond at 8% and it is into its 5th year now. Interest Libor + 2% whileexchange for the same fixed rate. lower floating rate in have to borrow at Libor + 3%.They could enter methodologies for valuation of various he interest rate derivatives market is the largest derivatives market in the world, and among the oldest. Interestingly, the credit crisis of 2008 has turned out to be one of the watershed moments for this highly established market. The swap market has undergone an evolution — a change in the motivation of trading, which has brought about new risk that was considered negligible before the crisis. This article will first brief the reader on the plainvanilla interest rate swap and its prime trading motivations before the crisis.

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rates have fallen and the company wished it issued a floating rate bond instead. It is not too IRS where Bank a view Libor +shape of the interest rate curve, an example of into an A speculator can also take B pays of the 2.5% derivative products. She has over 10 and fixed rate from Bank A. This years’ experience in investment banking late. It can enter into an IRS as in Chart 2. Company B pays the floating LIBOR and receivesreceives aThe speculator may believe that the difference between the six-month which is a Chart for is beneficial3. Bank B as it is cheaper than and the financial industry in Europe and fixed rate of 6% from the swap counterparty. The net effect of the cash flows of theLIBOR rates will fallthe market. As for Bankthree-year swap rate. The LIBOR only has bond financing from further relative to the A, Asia. Comments: jasvin@gmail.com. the fixed maturities rate to 12 months. He also better constant maturity swap paying the sixand the IRS to Company B would be: [- LIBOR +6% - 8% = - LIBOR – 2%] So, synthetically the of up negotiated is oftenenters into aReaders may also follow her at http:// than borrowing on the market. derivativetimes.blogspot.com. month company has managed to pay on its bond, LIBOR + 2% and can now benefit from further LIBOR rate and receiving the three-year swap rate (which is periodically set to the Cusatis, thomas: hedging instruments and risk management market falls in the interest rate. The rate may still seem high compared to newly issued bonds, butswap rate). Hedging with the IRS – The example of the corporation considering the issuing cost of bonds, the swap transaction does seem worthwhile. Chart 3 – An example of an Interest Rate (Yield) Curve

Say Company B issued a 10 year fixed bond atexampleit is into its 5th year now. Interest Chart 2 – Interest Rate Swap (Hedging 8% and 2) rates have fallen and the company wished it issued a floating rate bond instead. It is not too late. It can enter into an IRS as in Chart 2. Company B pays the floating LIBOR and receives a fixed rate of 6% from the swap counterparty. The net effect of the cash flows of the bond and the IRS to Company B would be: [- LIBOR +6% - 8% = - LIBOR – 2%] So, synthetically the company has managed to pay on its bond, LIBOR + 2% and can now benefit from further falls in the interest rate. The rate may still seem high compared to newly issued bonds, but considering the issuing cost of bonds, the swap transaction does seem worthwhile.

Chart 2 – Hedging with interest rate swaps (corporations)

Chart 3 – an example of an interest rate (yield) curve

Chart 2 – Interest Rate Swap (Hedging example 2)

Source: Cusatis, Thomas: Hedging Instruments and Risk Management

The IRS market

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