Honors Thesis Proposal Sensitivity Test of Interest Rate Swaps Akua Amoah Advisor: Dr.

John MacDonald April 19, 200 Abstract The !oal o" #his pro$ec# is #o under#ake a sensi#ivi#% #es# #ha# &ill e'hi(i# #he vola#ili#% o" in#eres# ra#e s&ap values usin! pro$ec#ed in#eres# ra#es. The #es# &ill essen#iall% reveal discrepancies (e#&een in#eres# ra#e s&ap values repor#ed on #he (alance shee#s o" selec#ed "irms and #he resul#in! s&ap values produced "rom a simula#ion #es# usin! pro$ec#ed in#eres# ra#es as a (asis o" valua#in! s&aps. The "irms are re)uired under accoun#in! re!ula#ions, speci"icall% *A+ ,o 1 #o use #he in#rinsic "air value me#hod o" valuin! s&aps. The main cri#eria upon &hich #he "irms chosen "or #his #es# &ill (e selec#ed include, #he availa(ili#% and accessi(ili#% o" #he "irms1 "inancial s#a#emen#s, #he si!ni"icance o" #he s&ap value amoun#s repor#ed in #heir (alance shee#s. The scope o" #he #es# &ill (e limi#ed #o a(ou# #&elve #o "i"#een 2+A (ased "irms. 3 &ill (e usin! a Mon#e 4arlo +imula#ion. 5% "eedin! in #he s&ap values repor#ed (% #he "irms, and several pro$ec#ed in#eres# ra#es, #he simula#ion &ill provide mul#iple scenarios o" ne& s&ap values "or #he "irms. The resul#s o" #his simula#ion &ill provide #he "ounda#ion "or an anal%sis o" #he discrepancies (e#&een #he ne& s&ap values and #he ori!inal s&ap values in #he "irms6 (alance shee#s. The anal%sis &ill include an e'plana#ion o" #he charac#eris#ics o" in#eres# ra#es "luc#ua#ions and a repor# o" #heir e""ec#s on #he s&ap values. M% conclusion &ill (e dra&n "rom #he resul#s and ma% se# an e'ample o" ho& in#eres# ra#e s&aps can (e 7#rul% valued8. 3 &ill (e &orkin! under #he !uidance o" Pro" John MacDonald. Introduction *ollo&in! #he 9orld4om and :nron scandals, accoun#an#s have &i#nessed an increased in#eres# in o"";(alance shee# #ransac#ions and i#ems. 4onse)uen#l%, accoun#in! re!ula#ions re!ardin! o"";(alance -and i#s amendmen#s *A+ ,os. 1 ., 1 /0

shee# i#ems have (ecome more s#rin!en#. The *inancial Accoun#in! +#andards 5oard -*A+50 implemen#ed *A+ ,o 1 <Accoun#in! "or Deriva#ives and Hed!in! Ac#ivi#ies6, &hich re)uires #ha#

in#eres# ra#e s&aps #o!e#her &i#h a !roup o" o#her "ormer o"";(alance shee# deriva#ives, (e repor#ed in #he (alance shee#s a# "air value. *A+ 1 &as enac#ed in 199/ and "ull% implemen#ed (% June 2001. 3# has

since had amendmen#s ,o 1 / and 1 .. This is $us# an indica#ion o" #he !rea# con#rovers% surroundin! *A+ 1 . Man% "irms en!a!e in in#eres# ra#e s&aps mainl% as a means o" hed!in! and "inancin!. 3n#eres# ra#e s&aps curren#l% accoun#s "or a(ou# .=> o" deriva#ive hed!in!. An in#eres# ra#e s&ap is an a!reemen# (e#&een #&o par#ies -also kno&n as coun#er par#ies0 #o e'chan!e a series o" in#eres# pa%men#s over a period o" #ime &i#hou# e'chan!in! #he underl%in! principal amoun#. These pa%men#s are #ied #o di""eren# inde'es such as ?35@A, #he #reasur% ra#e, or some o#her inde' -Malhor#a D.B, 199.0. The underl%in! principal amoun#s, &hich are ac#uall% no#ional amoun#s, are usuall% no# e'chan!ed durin! s&aps. These are #he #%pes o" in#eres# ra#e s&aps m% s#ud% &ill (e (ased on. 5elo& is a simple dia!ram #o e'plain #he "air value me#hod o" accoun#in! "or in#eres# ra#e s&aps, as speci"ied under *A+ 1 .

3n li!h# o" #he "ac# #ha# *A+ 1

is a "airl% ne& re!ula#ion and has (een descri(ed (% some

accoun#an#s and "inancial anal%s#s as one o" #he mos# con"usin! *A+5 re!ula#ions, mos# research and s#udies are s#ill in pro!ress. Ho&ever, much o" &ha# has (een done include proposals o" ne& in#eres# ra#e s&ap valua#ions -Jensen A, h##p:CC&&&.#rini#%.eduCr$ensenCacc#= D1CspeakersC1 !los".h#m 0, empirical

s#udies o" in#eres# ra#es s&aps -Min#on 5, 199D0 and varia#ions o" in#erpre#a#ions and anal%ses o" *A+ 1 and i#s amendmen#s -Jensen A, h##p:CC&&&.#rini#v.eduCr$ensenCacc#= D1CsEeakersC1 !los".h#m0. 5%

"ac#orin! in pro$ec#ed in#eres# ra#es &i#h #he !iven s&ap values derived "rom * A+ 1

"air value me#hod,

m% pro$ec# &ill essen#iall% imi#a#e real;li"e scenarios o" s&ap values i" pro$ec#ed in#eres# ra#es &ere "ac#ored in. 3# &ill also e'amine #he e""ec#s o" chan!es in #he s&ap values o" #he chosen "irms. To m% kno&led!e #his #%pe o" s#ud% is unpreceden#ed. Tasks 3 &ill per"orm prior #o runnin! #he simula#ion include #he "ollo&in!: 1. Providin! a cri#ical anal%sis o" *A+ 1 . 2. Derivin! pro$ec#ed in#eres# ra#es (ased on curren# and pas# #rends o" in#eres# ra#es mainl% "rom "or&ard ra#e a!reemen#s, euro "u#ures, ?35@A ra#es. . 4losel% moni#orin! in#eres# ra#e "luc#ua#ion in #he marke#. D. Mas#erin! #he Mon#e 4arlo simula#ion. =. Dra&in! meanin!"ul conclusions "rom resul#s and comparisons. The scope o" #his #es# &ill (e limi#ed #o a(ou# #&elve #o "i"#een 2+A (ased "irms. The cri#eria "or pickin! #he "irms &ould (e hi!hl% dependen# upon #he su(s#an#ial amoun#s o" #he s&ap values repor#ed in #he (alance shee#s, and #he availa(ili#% o" o#her in"orma#ion a(ou# #he na#ure and #he in#eres# ra#e s&aps. Objectives This research &ill uncover #he vola#ili#% o" #he value in#eres# ra#e s&aps caused (% #he varia(le ra#e used in #he s&ap valua#ions. 3# &ill also e'press #he impac# o" in#eres# ra#e "luc#ua#ions in cer#ain #%pes o" in#eres# ra#e s&aps. The !oal is #o run a sensi#ivi#% #es# usin! pro$ec#ed in#eres# ra#es and sho& #he vola#ili#% o" s&ap values. The research &ill in e""ec#, provide real;li"e scenarios o" &ha# #he s&ap values &ould (e i" pro$ec#ed in#eres# ra#es &ere "ac#ored in #he valua#ion o" in#eres# ra#e s&aps. There has (een considera(le amoun# o" research on #he empirical s#udies o" in#eres# ra#e s&aps, proposals o" di""eren# valua#ion me#hods o#her #han #he *A+ 1 "air value me#hod, and varia#ions o" in#erpre#a#ions o" *A+ 1

re!ula#ions. 3ndeed, some research #ha# deals &i#h in#eres# ra#e s&ap valua#ions propose #ha# #he *A+ 1 "air value me#hod is de"icien# in accoun#in! "or "u#ure "luc#ua#ions o" in#eres# ra#es. Ho&ever, none has

delved in#o #he area o" providin! scenarios (ased on ac#ual values o" e'is#in! "irms via simula#ions usin! #he pro$ec#ed in#eres# ra#es #ha# *A+ 1 M% con#en#ion is #ha# #he *A+ 1 me#hod lacks. me#hod does no# depic# #he #rue value o" in#eres# ra#e s&aps

(ecause i# does no# #ake in#o accoun# "u#ure "luc#ua#ions o" in#eres# ra#es. 3 &ill e'pec# discrepancies (e#&een #he s&ap values repor#ed under *A+ 1 and #he s&ap values resul#s produced "rom m%

simula#ions. 3 &ill #hen provide evalua#ions and dra& conclusions "rom #he discrepancies. M% research &ill (e an e'hi(i#ion o" in#eres# ra#e s&ap valua#ions usin! pro$ec#ed in#eres# ra#es. 3# &ill re"lec# in #he s&ap valua#ions, #he vola#ili#% o" #he in#eres# ra#es. 3# &ill also de"ine #he cause and ori!ins o" a##ainin! #he resul#in! s&ap values a"#er #he pro$ec#ed ra#es have (een "ac#ored in. 3n addi#ion, i# &ill e'plain in de#ail ho& #he ne& values &ere arrived a#. M% s#ud% &ill serve as a (asis "or anal%s#s #o derive in"orma#ion re!ardin! in"luences o" in#eres# ra#e "luc#ua#ions o" s&ap values. M% s#ud% &ill also su!!es# &a%s (% &hich pro$ec#ions o" "luc#ua#ions ma% (e accoun#ed "or in in#eres# ra#e s&aps. 3# &ill also e'plain #he na#ure o" #he rela#ionship (e#&een s&ap values and curren#, pro$ec#ed and his#orical in#eres# ra#es. Methods 3n order #o a##ain #he e'pec#ed and desired resul#s 3 &ill under#ake #his research in an orderl% manner as indica#ed (elo&. Pick #he "irms #o use "or #his research. +ome "ac#ors #ha# &ill (e considered include o o o o The !eo!raphical (oundar% &ill (e 2+A (ased "irms The availa(ili#% and accessi(ili#% o" #he "irms mos# recen# "inancial s#a#emen#s *irms usin! similar #%pes o" in#eres# ra#e s&aps The amoun# o" #he s&ap value repor#ed in (alance shee#s

Moni#or #he marke# #o de#ermine in#eres# ra#e #rends and #ransac#ions under rela#ed deriva#ives. Derive #he pro$ec#ed in#eres# ra#es. o These ra#es &ill (e (ased on an anal%sis o" curren# and his#orical #rends in #he marke#

4alcula#ions &ill use ra#es "rom "or&ard ra#e a!reemen#s, ?35@A ra#es "rom #he spo# marke#, euro "u#ures and o#hers

*or each "irm, 3 &ill conduc# a Mon#e;4arlo simula#ion o The Mon#e 4arlo simula#ion is a so"#&are pro!ram #ha# calcula#es mul#iple scenarios o" a model (% repea#edl% samplin! values "rom #he pro(a(ili#% dis#ri(u#ions "or #he uncer#ain varia(les. The Mon#e 4arlo simula#ion is in m% vie& appropria#e (ecause i# models #he real li"e si#ua#ionF i# is a(le #o !enera#e several resul#s under various condi#ions. 3# is an e""icien# me#hod as i# has #he capa(ili#% #o simpli"% #edious compu#a#ions &i#hin a "e& seconds. o o 3# &ill use #he s&ap values !iven in #he (alance shee#s The simula#ion &ill run several #housands #imes under various ra#es

Aecord #he "indin!s or resul#s "or each "irm. The resul#s o(#ained "rom #he simula#ion &ill (e evalua#ed, anal%Ged and compared #o #he s&ap values "rom #he "irm1s (alance shee#s. Dra& conclusions (ased on each "irm. +ummariGe #he "indin!s "or all "irms and dra& a conclusion "rom a (roader perspec#ive. Management plan This research &ill (e #aken under #he !uidance o" m% advisor ; Pro". John MacDonald. 9i#h his e'per#ise in "inance, he &ill (e a !rea# &eal#h o" in"orma#ion and assis#ance "or me. 3 &ill need his assis#ance especiall% &hen derivin! pro$ec#ed in#eres# ra#es. The (ulk o" m% &ork &ill s#em "rom #he incremen# o" m% #heore#ical kno&led!e on deriva#ives and hed!in!, and "rom #he use o" anal%#ical skills #o de#ec# per#inen# poin#s. 3 have !ained su(s#an#ial accoun#in! skills "rom upper level accoun#in! courses like 3n#ermedia#e Accoun#in!. 3 am presen#l% #akin! a "inance course #ha# has "acili#a#ed m% comprehension o" in#eres# ra#es and deriva#es. 5% sprin! 200D, 3 &ill (e e)uipped &i#h a su""icien# "inancial (ack!round and 3 &ould have

enhanced m% accoun#in! skills, as 3 &ill (e #akin! o#her upper level "inance and accoun#in! courses like Advanced Accoun#in!, Audi#in! and Mone% and 5ankin!.

The na#ure o" m% research is such #ha# i# does no# limi# me #o s#a% in a par#icular loca#ion. This !ives me #he li(er#% #o &ork an%&here provided #ha# 3 have access #o #he 3n#erne# and #o #he li#era#ure #ha# 3 &ill need #o enhance m% comprehension on #he su($ec#. 9hile a&a% durin! #he summer, 3 &ill (e correspondin! &i#h m% advisor and upda#in! him on m% pro!ress. 3 am keepin! $ournals #o record #he summar% o" each readin! #ha# 3 do. This &ill (e especiall% (ene"icial #o me &hen 3 need #o make evalua#ions and dra& conclusions. M% advisor and 3 are in #he process o" desi!nin! a mu#uall% a!reea(le #ime line. Ho&ever #he #a(le (elo& ou#lines #he #en#a#ive schedule "or no&. Tentative Research Time Outline

3 &ill main#ain a $ournal in &hich 3 &ill keep accoun# o" m% pro!ressF i# &ill par#icularl% (e use"ul "or anal%sis o" m% "indin!s. 9hile a&a%, 3 &ill correspond &i#h m% advice via email and #elephone. 3 &ill

also con#inue #o mee# &i#h m% advisor on a &eekl% (asis &hile in school and desi!na#e a &eekl% #ime slo# #o "or m% individual &ork on #his research. Literature search The li#era#ure search 3 have conduc#ed #o da#e includes #he "ollo&in!: Books: Bapner A. Benne#h, Marshall *. John, 199 , The Swap Market, 2nd :di#ion, Bol( Pu(lishin! 4ompan%, *?, 199 . Journals: Malhor#a D.B., sprin! 199., An Empirical Examination of the Interest Rate Swap Market, Euar#erl% Journal o" 5usiness economics v H, n2, Min#on 5., Jul% 199., An Empirical examination of basic aluation mo!els for plain anilla "#S# interest rate swaps, Journal o" *inancial :conomics, vDD 2=1;2.. +aman# A., 199H, An Empirical Stu!$ of Interest Rate Swap "sa%e b$ &onfinancial 'orporate Business, Journal o" *inancial +ervices Aesearch 10:D ;=. (ebsites: h##p:CC&&&.#rini#%.eduCr$ersenCacc#s DlCspeakersC1 s&apvalue.h#mIin#roduc#ion

h##p:CC&&&.decisioneerin!.comCmon#e;carlo;simula#ion h##p:CC&&&."as(.or! h##p:CC&&&Csmar#mone%.comCone(ondCinde'.c"mJs#or%K%ieldcurve