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Prof Mahesh Kumar Amity Business School profmaheshkumar@rediffmail.com

Introduction

The interest rate risk results from a mismatch of maturity of assets and liabilities respectively. Example: Example: 1. A bank faces interest rate risk if the sources of funds have shorter term to maturity than of its advances. 2. A multinational runs an interest rate risk arising from mismatched timing in re-pricing those assets & liabilities that are sensitive to interest rate.

Introduction

3. Risk emanating from a loan contracted at a fixed or floating rate (linked to the base lending rate) by an enterprise, a bank or an insurance company is referred to as interest rate risk. (IRR). Multinationals are subjected to interest rate risk on their lending/borrowing operations. Interest rate risk results into an increase of financial charge on borrowing or into a capital loss on bonds. Financial markets developed instruments- options, futures and swaps- on interest to cover these risks.

4.

What is interest?

Interest is the reward to the investor for parting with liquidity and undertaking certain risk towards non-payment by borrowers.

What is interest rate risk?

i) ii)

Interest rate risk refers to the likely changes in the cash flows or future value of a firm on account of changes in the interest rates in the market. The cash flows in connection with a financial asset or liability may relate to a) interest and b) principal. Based on this interest rate risk is segregated as Income risk Capital risk

**What is income risk?
**

There are two types of interest rates- fixed interest rates and floating interest rates. A fixed interest rate remains the same throughout the duration of contract. A floating interest rate is fixed with reference to a benchmark rate. The effect of floating rate is to keep the interest rate in line with the current trends. A long term investor can achieve the effect of floating rate by investing for short term and rolling over the investment on due dates at the prevailing rates of interest.

**What is income risk?
**

A borrower at floating rate runs the risk that at future revisions the rate of interest may be higher and thus expenditure turns out to be higher. A lender at floating rate runs the risk of reduction in his income if the future interest rate is lower than the current rate. For borrowing and lending at fixed rate, the risk is measured with respect to the opportunity cost. A person who has invested or lent at fixed rate loses opportunity income if the interest rate move up. This potential for losing the realized or opportunity income in the case of investments and potential for having to pay for higher interest or losing the opportunity to pay lower interest constitutes the income risk.

**What is Capital Risk?
**

Capital risk refers to the reduction in the value that a long term financial asset may suffer due to change in interest rate. Suppose a bank holds 12% government bond maturing after 5 years at the rate of Rs. 98/-. If the government issues a new bond carrying interest at 14%, the market value of 12% bond will fall. 12/98*100=12.24 12/X*100=14, X= Rs. 85.6 or Rs.86 It may be noted that the capital risk arises when long term assets are held for a short time.

**Interest Risk Manifestation
**

1. 2. There is a relationship between interest rate risk and prices of financial securities. The price of a financial security is equal to the present value of cash flows (Ft) that is generated during its life. The price of a fixed rate financial security P, refundable at the end of the borrowing period depends upon The coupon amount: Coupon (C) is equal to the amount: nominal value of the bond and the interest rate. The mode of capital refund: Normally refund R is refund: done in one lot at the end of the life of a bond, but it can also be done in installments over a period of a number of years.

**Interest Risk Manifestation
**

3. 4. Market interest rate (r); (r); Maturity Period (N) of the borrowing. borrowing.

N

P !

§

t !1

Ft C C C R ! .......... .. t 2 (1 r ) n 1 r 1 r (1 r )

Where Ft represents the cash flows generated by the fixed income security. When the market interest rate increase, the price of the fixed income security decreases and conversely when interest rate decreases, the fixed income security increases.

**Asset Liability Structure and Importance of Interest Rate Risk
**

For financial institutions like banks, there are additional dimensions to interest rate risk as both assets and liabilities are interest bearing. These are known as basis risk and gap exposure Basis risk arises when the interest on assets and liabilities are reckoned on different basis. For instance, a bank lends six months at LIBOR/PLR +1% which is funded by the bank accepting six month term deposits at fixed interest rate. The bank accepts to roll over both the loan and deposit at the end of six months. It is possible that the variation in LIBOR/PLR may not match with that for term deposits.

**Asset Liability Structure and Importance of Interest Rate Risk
**

Gap exposure arises when the assets and liabilities mature for different periods. For instance the bank may have committed for two years lending but the funding in form of fixed deposits may only be for six months. At the time of renewal of deposits, the interest rates may vary which will not be accompanied by similar changes in interest rates on advances.

**Measurement of Interest Rate Risk
**

Interest rate risk is measured by: a) Sensitivity b) Duration

Measurement of Interest Rate Risk

Sensitivity (S) in the price of a fixed income financial security indicates the percentage change in price for each 1% change in the market interest rate (r) P 1 N tFt P ! S! § P t !1 (1 r)t 1 r

The value of sensitivity depends upon several factors: a) Life of the security. b) Interest rate on the security c) Market interest rate

**Measurement of Interest Rate Risk
**

If for example, S=3, it implies that a 1% (increase from x to x+1%) change in the market interest rate would result into 3% loss of capital. Conversely, a 1% decrease in interest rate will yield capital appreciation of 3%. Several principles have been demonstrated by F.R.Macaulay in a study on interest rates. 1. Bond prices vary in opposite direction to that of interest rate variation.

**Measurement of Interest Rate Risk
**

2. When bonds differ only in terms of market interest rates one having the lower coupon will vary more for the same variation of market interest rate. When bonds differ only in terms of their maturity, the one having longer maturity will vary more for the same variation of the market interest rate. For every bond, a given increase in the interest rate results into a smaller variation of price than identical decrease in the interest rate. For a given percentage increase or decrease of interest rate (coupon rate), and everything else being same, the price variation is higher for the security with the lower coupon.

3.

4.

5.

**Measurement of Interest Rate Risk
**

Duration: Duration: It is an index of time during which an investor recovers his funds initially invested. It is expressed in terms of years It enables to compare bonds issued with different conditions. Duration is calculated as:

1 S ! P

N

§

t !1

t *

Ft (1 r ) t

Duration is also equal to the product of sensitivity and the factor (1+r)

**Measurement of Interest Rate Risk
**

The securities with longer duration have greater volatility than those with shorter duration. Thus the higher duration implies greater risk. If the duration of the asset is higher than that of liability, the financial firm is holding a long position and then the risk comes from increase in interest rates as the decrease in the value of assets held will be higher than the advantage accruing from a decrease in sum payable. On the other hand, if the establishment holds a short position i.e. the duration of the asset is smaller than that of liability, the risk emanates from a decrease in rates.

**Managing Interest Rate Risk
**

The derivatives that are based on interest rate fall under two categories. a) Derivatives that reduce the cost of borrowing e.g. swaps b) Derivatives meant to ensure that cost of borrowing does not exceed the predetermined level or the income on investment does not go below the expected level. Forward rate agreements and interest rate options fall under this category.

Interest Rate Futures

An interest rate futures contract is a commitment to deliver (for the seller of the contract) or to take delivery of (for the buyer of the contract) financial securities of a specific amount, on a predetermined future date.

**Interest Rate Futures Market
**

1. 2. 3.

4. 5. 6. 7. 8.

Important interest rate future markets are: Chicago Board of Trade (CBOT) at Chicago Chicago Mercantile Exchange (CME) at Chicago London International Financial Future Exchange LIFFE at London Marche a Terme International de France (MATIF) at France Deutsche TerminBorse (DTB) at Frankfurt Sydney Futures Exchange (SFE) at Sydney Tokyo Financial Future Exchange (TIFFE) at Tokyo Singapore International Monetary Exchange (SIMEX) at Singapore

**Different Interest Rate Futures
**

1. 2. There exists two types of future contracts: Short term contracts which permit the enterprises to cover themselves against short term interest rate risks. Long term contracts permitting the enterprises to cover themselves against long term interest rate risks. In short term interest rate futures the underlying financial instruments are generally short term treasury bonds or 3 months deposits. In long term interest rate future contracts financial instruments are generally long term treasury bonds. Most of the interest rate future contracts do not result into delivery.

Quotation of Short Term Interest Rate Futures

The quotation of short term futures is made in the form of an index I corresponding to I=(100-i) where i represents implicit rate at the date of maturity. Index I is expressed with two decimal. If the implicit interest rate is 9.20%, the quotation for the contract will be 1009.20=90.80. If the implicit rate increases to 12.10% then the quotation will be 10012.10=87.90

Quotation of Short Term Interest Rate Futures

The minimum fluctuation also known as tick of a contract is fixed. For example, for a 3 months Euro dollar contract of USD 1000000, it is equal to 0.01 percent of the contract i.e. it is equal to 1000000* 0.01/100* 3/12 = USD 25. Thus, a change of 1 percent will bring a profit or loss of USD 2500 (=25*100) on above future contract. Opening price of a session, settlement price or closing rate, highest rate, lowest rate, volume traded is published for each future exchange

**Basic Characteristics of Rate Futures
**

Basis: The basis, in the context of the futures Basis: market, represents the difference between the forward rate and spot rate (i.e. spot rate on settlement date). The basis may be positive or negative during the contract period but however on the maturity date, there is a convergence of the basis because the forward rate on that date becomes same as the spot rate. If the duration of a deposit or a loan is not equal to the duration of the futures contract, the enterprise or the bank exposes itself to a basis risk.

**Basic Characteristics of Rate Futures
**

Maturity Date: These are four in number: Date: March, June, September and December. Guarantee Deposits: These are made to Deposits: clearing exchanges so as to ensure the solvability of operators and these margins vary from 2 to 4 percent. Gains and losses are calculated on daily basis. This is also known as Marking to Market. If the Market rates moves unfavorably for the operators he is called upon to make supplementary payments (called margins). Conversely, he receives payments if the rates have moved in his favor.

**Covering Risk in the Interest Rate Futures
**

Market

of

When a futures contract is bought or sold, the price is fixed but payment is made at a future date. When interest rate rise, the price of an interest rate future comes down. The risk of rise in interest rate is covered by selling futures contracts. The enterprise that wants to cover itself against rise of interest rates sells contracts of amount and duration equivalent to the position that it wants to cover. If a rise does takes place, the gain that the enterprise would have by repurchasing at a lower price the contracts it had sold compensates the loss resulting from the rise in the rate.

Covering Risk in the Interest Rate Futures

Market

of

When the interest rate falls, the price of an interest rate future increases. The risk of fall in interest rates is covered by buying future contracts. The enterprise that wants to cover itself against fall of interest rates buys contracts for an amount and a duration equivalent to the position that it wants to cover. If the fall does take place, the gain that the enterprise would have by reselling at a higher price the contracts that it had bought earlier compensates the loss resulting from the fall of the rate.

Covering Risk in the Interest Rate Futures

Market

of

The number (N) of contracts to be bought or sold is determined by

MC DC N! v v CorrelationCoefficient Mc Dc

where MC=Amount to be covered Mc=Amount of the contract DC=Duration of the position Dc=Duration of the contract

Covering Risk in the Interest Rate Futures

Market

of

If the duration of contract and the position of the contract are identical and the correlation between the rate to be covered and rate of the future is perfect i.e.1, then the number of contracts is equal to

MC N! Mc

In practice, N is not always a whole number. In that case, the number is rounded to the nearest whole number because one can buy or sell contracts only in whole numbers.

**Risk from the Rise in Interest Rate
**

This is the risk to which are exposed: 1. The enterprises which have taken a loan on a renewable rate or on a roll over basis. 2. The enterprises that have to borrow in future.

Example 1

In December of the current year, the treasury manager of a company envisages that he would have to borrow USD 1000000 on 15th March next year. In December, Euro Dollar futures for March is quoted at 89.50, implying thereby an interest rate of 10.50% The treasury manager knows that his bank will charge an interest rate of 1% over and above that of LIBOR. He wishes to cover himself against any rise in interest rate between December and March. He sells in December one futures contract (of USD 1000000 million) of March to cover himself against a borrowing rate of 11.50% (10.5% LIBOR+1%)

Example 1

Possible Scenario : A couple of days before 15th March, LIBOR=11.20%. The treasury manager is to pay the bank: 1000000*(11.20+1)*3/12=USD 30500 He repurchases his futures contract at a price of 88.90 (the price quoted on the day the deal is closed), which he had sold for 89.50 in December. The gain for him is (89.50-88.90)*100*25=USD 1500 Thus the net interest paid by the treasury manager is 30500-1500=USD 29500 So the effective interest rate is 29000/1000000 *12/3 = 11.6%

Example 1

This difference emanates from the difference between the LIBOR (11.20%) and the implied rate by the contract at the time of liquidation (11.10 percent i.e. 100-88.90) This risk is referred to as the risk of basis. It can be favorable or unfavorable to the treasurer. It is minimum when the date of borrowing is close to the date of maturity of the contract.

Example 2

On 1 March of the current year, an enterprise knows that it will have to borrow on 15 June a sum of USD 10 million for 3 months. On 1 March, the 90 days interest rate on Euro dollar market is 8.5%. But the enterprise anticipates a rise in interest before June. To cover itself against this eventuality, the enterprise sells 10 future contract (=10 million/1 million) maturing in June. The contract price is 91.50

Example 2

Possible Scenario : On 15 June, when the enterprise borrows, the interest rate on 90 days borrowing is 13%. It pays an interest: 10000000*13*90/360= USD 325000 But at the same time, the enterprise buys back the futures contracts that it has sold in March. The price on 15 June is 87. In doing so, it makes a gain, 10*(91.50-87)*100*25= USD 112500 Thus the net payment made by the enterprise is 325000-112500= USD 212500 This means that the enterprise has paid a net interest rate of 212500/10000000 *12/3=8.5%

Example 3

A company is to borrow DM 2.5 million in December for 3 months. At the moment (September), the December DM future is quoted at 92.5. The market rate of Euro DM is 7.5%, which is likely to go up in months to come. What should the company do ? Assume that on 15 December, the DM future has fallen to 91.5 and the Euro DM rate is 8.6%

Example 3

Since the DM borrowing rate is likely to go up between September and December, the company will do well to sell DM future contracts to cover against interest rate risk. The value of one Euro DM contract is DM 1 million while the sum to be hedged is 2.5 million. So the company has to sell either 2 contracts or 3 contracts. Let us say it sells 3 contracts.

Example 3

On December 15, the company borrows at 8.6%. The sum it would receive for the face value of DM 2.5 million is found by the price yield formula

Bond Pr ice ! FaceValue [1

Yield v N ] 360

where N is the borrowing period in days. So the sum realized is 2.5[1-0.086*90/360]=DM 2.44625 million But the sum that would have been realized at the yield rate of 7.5% is 2.5[1-0.075*90/360]= DM 2.453125 million So shortfall = DM 2.453125-DM 2.44625= DM 6875 Now the company buys back the future contracts. The gain is equal to 100 ticks (=92.5-91.5). So the gain is 3*100*25= DM 7500. Thus the shortfall is made up through hedging.

Example 4

A company plans to borrow USD 20 million by issuing a 90 days commercial paper in August. The yield rate of the CP is 10.5% at the moment, i.e. in the month of March. Interest rates are anticipated to rise. Since no future contracts are available in CP, the company can resort to T-bill futures. September T-bill futures are quoted at 90.20. Assume that on August 15, the CP yield has risen to 11 percent and T bill future contract is quoting at 89.60. What is the company expected to do?

Solution: Example 4

In March, at the yield rate of 10.5%, the CP issue will result into a realization of 20[1-(0.105*90/360)=USD 19.475 million But in August the sum realized is going to be 20[1(0.11*90/360)]= USD 19.45 million The shortfall is equal to USD 0.025 million = USD 25000 To hedge against the interest rate risk the company sell 20 T-bill September future contracts and repurchases them on August 15. The gain on the future contract is 90.2-89.60 or 60 ticks. This is equal to 20*25*60=USD 30000 Thus the shortfall is more than compensated by hedging.

**Risk from Fall in Interest Rate
**

Two types of enterprises are exposed to such risk: 1. The enterprise that have borrowed on a fixed rate 2. The enterprise that envisages to place their funds in the future.

Example

A treasury manager is to receive in three months i.e. in December of the current year, a sum of GBP 5 million that he would like to place at 3 month LIBOR rate till April next year. He fears a fall in the rate of pound sterling. 3 months LIBOR in September is 10 percent; Price of 3 months sterling futures in September is 90 To cover himself against the risk of fall in the interest rate, he buys 10 (=5/0.5) future contracts in September.

Example

Possible Scenario : On maturity in December, the rate falls to 8 percent. The treasury manager suffers a loss of opportunity of 5000000*(0.10-0.08)*3/12=GBP 25000 At the same time, in future market, he sells his contracts that he had earlier bought whose price is now 92. So he makes a gain 10*(92-90)*100*12.5 = GBP 25000 Thus his loss of opportunity is compensated by the gain on futures market.

**Advantages of Interest Rate Futures
**

Interest rate future are an efficient means of reducing the risks of rates and are used widely for: 1. Reduce the impact of rate fluctuations on anticipated positions; this in turn ensures the business unit a more certain borrowing rate or rate of return on its fixed income securities. 2. Arbitrage between the future market and spot market.

**Limitations of Interest Rate Futures
**

Basis risk occurs when the maturity date of borrowing or lending does not coincide with the maturity date of a futures contract, Risk of correlation is incurred when the rate covered is not perfectly correlated with the rate of a futures contract Risk of indivisibility is incurred when the number of contracts bought or sold does not perfectly correspond to the amount to be covered.

Covering Interest Options Market

Rate

Risk

in

Options on interest rate may be used: 1. For covering against interest rate variations; in effect purchase of option enables the buyer to ensure that he would not have to pay more than a certain rate of interest on his borrowing; or would not receive less than a certain minimum rate on his lending 2. For speculation 3. For arbitrage operations

**Organized Markets of Interest Rate Options
**

Interest rate options were first of all negotiated on the Stock Exchange of Amsterdam. In 1982, an option market developed in Chicago (CBOT). Thereafter, the markets of Sydney, London, Singapore, Paris, Copenhagen, Montreal etc were developed. Assets traded on interest rate options market are either fixed rate financial securities or an interest rate guarantee; 3 month LIBOR, 3 months Euro Dollar, 3 months Euro DM etc.

**Mechanism of Interest Rate Options
**

Purchase of a call option gives a right to the holder to buy a financial asset at a fixed price and purchase of put option gives him a right to sell a financial asset at a fixed price, called exercise price, on payment of premium to the seller of the option.

**Mechanism of Interest Rate Options
**

Interest rate options have certain characteristics: 1. Contracts are standardized from the viewpoints of amount, maturity and period (March, June, September, December) 2. Exercise price are given at intervals of 0.25 dollar for Euro dollar contracts for example 92.25, 92.50, 92.75 etc. 3. Quotations, for example, for Euro Dollar contracts are made in index points and 1 index point corresponds to 25 dollars. Thus, if an option on Euro dollar is quoted at 0.30, this means that the option has a price of 0.30*100*25= 750 dollars. Minimum fluctuation is 25 dollars. 4. Contracts are easily negotiable 5. The clearing house ensures the regularity of operations.

**Mechanism of Interest Rate Options
**

1.

2.

Purchase of put option: option: A put option is also called borrowing option. It is used to cover against rise in interest rate. This option is used by enterprise that has to borrow by issuing bonds or a portfolio manager who has to shortly liquidate his bonds.

**Mechanism of Interest Rate Options
**

Let us say the treasury manager estimates in January that he would need to borrow in March. The current interest rate on bonds is 6%, but it is likely to go up in March. So he buys put option by paying a price. If in March, the rate goes up he exercises his put option and sells his bonds at 6%. And if the rate remains 6% or goes down he abandons his put option. Similarly, a portfolio manager knows that he would liquidate his bonds in 3 months. The bond rate is currently at, say, 93. But if the interest rate goes up, the bond rate may come down to say 90 in March. So in order to cover this risk he buys put options. If the interest rate goes up, he will exercise his option and liquidate his bonds at the price of Rs.93. On the other hand, if the rate does go down (or in other words, the bond price go up to 96), he would abandon his option and liquidate his bonds at the price of 96.

**Mechanism of Interest Rate Options
**

Purchase of call option: option: A call option is used when one fears a fall in interest rates. For example, a treasury manager has to place in example a months¶ time dollars for 3 months. He fears that the interest rate may come down from current 6 to 5 percent. So he buys a call option. He will buy this option if the interest goes down so as to ensure a return of 6 percent or more on his placement. On a contrary, he will abandon his option and place his dollars at the prevailing market rate, say 7.5%, if interest rates rise.

**Instruments on Over The Counter Market
**

Fixed Rate Instruments on OTC Forward Forward Operation: This is an operation Operation: that enables an operator to fix immediately interest rates of a debt or a loan which will be contracted at a later date. For example, an enterprise wants to ascertain today the interest rate on debt which it will borrow after 3 months for 6 months. This can be achieved by: 1. Borrowing for 9 months today 2. Lending for 3 months today.

Example 1

Company ABC wants to obtain USD 5 million in 3 months for 6 months. It fears a rise in interest rates and therefore, would like to fix the rate from now itself. The bank rates at the moment are as follows:

Duration 3 Month 9-Month Borrowing Rates 3.5 3.75 Lending rates 3.6 4

The manager wants to ensure the rate that he would have to pay on his borrowings. What should he do and what is the rate he can lock in.

Solution: Example 1

The ABC Company borrows for 9 months at a rate of 4% and immediately lends for 3 months at a rate of 3.5% Thus after 3 months for 1 dollar the company will have (1+0.035*3/12) But the bank should receive after 9 months (1+0.04*9/12) So the effective rate, say i, to be paid by the company is worked out by equality (1+0.035*3/12)(1+i/100*6/12)= (1+0.04*9/12) i=4.213% This is the forward rate for the company for borrowing after 3 months for a period of 6 months.

Example 2

A treasury manager after 5 months will need to borrow Rs.300000 for 3 month. The current rates are as follows

Duration 3 Month 5 Month 8 Month 9-Month Borrowing Rates 9.5 9.8 10.0 10.2 Lending rates 10.0 10.2 10.5 10.8

The manager wants to ensure the rate that would have to pay on his borrowings. What should he do and what is the rate he can lock in.

Solution: Example 2

Since he has to borrow after 5 months for a period of 3 months, the rates that concern him are those corresponding to 5 months and 8 months. He should borrow at 10.5% and lend this sum immediately for 5 months at 9.8% Let us say the effective rate is i. Then, [1+(0.098*5/12)] [1+(i/100*3/12)] = [1+0.105*8/12)] i=11.2% Thus the treasury manager has been able to lock in an effective rate of 11.2%. The interest on borrowing would amount to: 300000*0.112*3/12 =Rs.8400

**Instruments on Over The Counter Market
**

Fixed Rate Instruments on OTC Forward Rate Agreement (FRA): It is a tailor (FRA): made futures contract. Unlike normal future contracts which are standardized, a forward rate agreement is for pre-decided maturity date, for a pre-decided amount and at a pre-decided rate, as may be agreed between the borrower and the lender.

**Instruments on Over The Counter Market
**

Example, an enterprise knows that after 6 months, its need is for a 3 month loan. The enterprise can lock in the interest rate on this loan by buying a FRA from a bank. The bank may offer to sell 6 month forward rate agreement on a 3 months LIBOR at 6%. If at the end of 6 months, the 3 months LIBOR rate is greater than 6%, the bank will pay the difference to the enterprise. But if the 3 months LIBOR rate is less than 6%, the enterprise would pay the difference to the bank. Settlements of FRAs are done on the notional value.

**Instruments on Over The Counter Market
**

Example, a company buys a 5/11 (borrowed for 6 months after 5 months from today) FRA at 6% for a notional principal of 1 million. If after 5 months, LIBOR stands at 6.40%, the counterparty will pay the company the difference- 40 points or $2000 (=1000000* 0.40/100*6/12) If LIBOR goes down, say to 5.5%, the company will pay the difference ($2500).

**Instruments on Over The Counter Market
**

The FRA may, prima facie, sound more attractive than futures. However, banks usually charge a higher rate if an enterprise wants to borrow odd amounts for odd periods. If the manager of the enterprise changes his mind and wants to sell his forward contract, he must negotiate afresh with the bank.

Example 1

A company will need to buy after 4 months a forward rate agreement (FRA) from a bank to borrow for 3 months. The 4/7 FRA is quotes at 6.5. What will the company do if after 4 months, the rate a) Rises to 7% b) Falls to 6% c) Remains at 6.5%

Example 1

a) Since the rate has risen, the bank has to pay the difference to the company. Say, the borrowing is planned for $ 1 million. Then the bank has to pay (0.07-0.065)* 1000000* 3/12= $ 1250. b) Since the rate has fallen to 6%, the company will have to pay the bank, an amount (0.0650.06)*100000*3/12= $1250 c) Since there has been no change in the rate, neither the bank nor the company pays or receives.

**Swap Introduction- Definition and Uses
**

A swap is an arrangement between two companies to exchange cash flows at one or more future dates. Swaps are used: To reduce the cost of capital Manage risk (interest rate, exchange rate, commodity price movement) Exploit economies of scale Enter new markets Create synthetic instruments

1. 2. 3. 4. 5.

Financial Swaps

Financial swaps have three variants: a) Currency Swap b) Interest Rate Swap c) Combined Interest Rate and Currency Swap (CIRCUS)

**Introduction-Swap Variants
**

µVanilla Swaps¶ can be used in three different settings: 1. An interest rate swap to convert a fixed rate obligation to a floating rate obligation 2. A currency swap to convert an obligation in one currency to an obligation in another currency 3. A commodity swap to convert a floating price to fixed price

Introduction

A forward contract can be viewed as simple example of swap. A forward contract leads to the exchange of cash flows on just one future date, swaps typically lead to cash flow exchanges taking place on several future dates. Interest rate and currency swaps are often discussed together and are collectively called rate swaps.

Introduction-LIBOR

The floating side has most often been tied to the London Inter bank Offer Rate abbreviated as LIBOR. LIBOR is the rate of interest offered by the banks on deposits of other banks in Eurocurrency markets. One month LIBOR is the rate offered on one month deposit, three month LIBOR is the rate offered on three month deposit and so on. LIBOR rates are determined by trading between banks and change frequently so that the supply of funds in inter bank market equals the demand for funds in that market.

Introduction-LIBOR

A five year loan with a rate of interest specified as 6 month LIBOR plus 0.5% p.a. In this life of loan is divided into ten periods each six months in length. For each period the rate of interest is set at 0.5% p.a. above the six month LIBOR rate at the beginning of the period. Interest is paid at the end of the period. LIBOR rates are quoted on annual basis and by convention is stated as though year has 360 days, but the interest is actually paid everyday. This results in increase in effective rate of interest.

Structure of Swap

All swaps have basically the same structure. Two parties, called counterparties, agree to one or more exchanges of specified quantities of underlying assets. These underlying assets are known as notional. A swap may involve one exchange of notional, two exchange of notional, a series of exchange of notional or no exchange of notional. The notional exchanged in the swap may be same or different.

**Interest Rate Swap
**

In interest swap the loan liability is not exchanged; only periodical payment of interest is exchanged. The loan amount becomes the notional value on which the interest is calculated. An interest rate swap is also known as the coupon swap where the liabilities exchanged are of fixed and floating interest rates. In a basis swap, the interest rate involved are both floating, but on different basis for instance one may be pegged to LIBOR and other to treasury bill rate.

**Interest Rate Swap
**

A zero coupon swap is a special type of swap where one counterparty makes lump sum payment of interest instead of periodical payments. The lump sum payment can occur at any time, up-front, at maturity or during the life of the swap.

Structure of Swap

Between the exchange of notional counter party make payments to each other for using the underlying assets. The first counterparty makes periodic payment at a fixed price for using second counterparty¶s assets. The fixed price is the swap coupon. At the same time, the second counter party makes periodic payment at a floating rate for using the first counterparty¶s assets. Usually we have an intermediary that serves as a counterparty to both end user and is called swap dealer or market maker or swap bank. The swap dealer profits from bid-ask spread it imposes on the swap coupon.

**Interest Rate Swap
**

A standardized fixed-to-floating interest rate swap, known in the market jargon as plain vanilla coupon swap (also referred to as µexchange of borrowings¶) is an agreement between two parties in which each contracts to make payment to the other on a particular dates in the future till a specified termination date. The party which makes fixed payments and which are fixed at outset are known as fixed rate payer. The party which makes payments the size of which depends upon the future evolution of a specified interest rate index e.g. LIBOR is known as floating rate payer.

**Interest Rate Swap
**

Interest rate swaps are used to reduce the cost of financing. In these cases, one party has access to comparatively cheap fixed rate funding but desires floating rate of interest while another party has access to comparatively cheap floating rate funding but desires fixed rate of funding.

**Interest Rate Swap-Example
**

Consider a three year swap initiated on March 15,2005, between Infosys and Wipro. We assume Infosys agrees to pay to Wipro an interest rate of 5% p.a. on a notional principal of 100 crores and in return Wipro agrees to pay Infosys six month LIBOR rate on the same notional principal. We assume that agreement specifies that payments are exchanged every six months, and the 5% rate is quoted with semi annual compounding. The swap can be diagrammatically depicted as: 5%

Wipro Infosys

LIBOR

**Interest Rate Swap-Example
**

Cash flows to Infosys in a Rs100 cr three year interest rate swap when a fixed rate is paid and LIBOR is received

Date 6 mth LIBOR rate (%) Floating cash flow rcvd Fixed cash flow paid Net cash flow

Mar 15,¶05 4.20 Sep 15,¶05 4.80 Mar 15,¶06 5.30 Sep 15,¶06 5.50 Mar 15,¶07 5.60 Sep 15,¶07 5.90 Mar 15,¶08 6.40 +2.10 +2.40 +2.65 +2.75 +2.80 +2.95 -2.50 -2.50 -2.50 -2.50 -2.50 -2.50 -0.40 -0.10 +0.15 +0.25 +0.30 +0.45

**Interest Rate Swap-Example
**

From above table we can enunciate the cash flows in the third column of the table are the cash flows from a long position in a floating rate bond. The cash flows in the fourth column of the table are the cash flows from the short position in a fixed rate bond. The exchange can be regarded as the exchange of fixed rate bond for a floating rate bond. Infosys whose position is described in the table is long a floating rate bond and short a fixed rate bond. Wipro is similarly long a fixed rate bond and short a floating rate bond.

**Using the Swap to Transform a Liability
**

The swap could be used to transform a floating rate loan into a fixed rate loan. Suppose that Infosys arranged to borrow Rs.100 cr at LIBOR plus 10 basis points and Wipro has a three year Rs.100 cr loan outstanding on which it pay 5.2%. The swap between two companies can be shown as 5.2% 5%

Wipro Infosys

LIBOR

LIBOR+0.1%

**Using the Swap to Transform a Liability
**

After Infosys has entered into the swap it has three cash flows: It pays LIBOR plus 0.10 to its outside lenders. It receives LIBOR under the terms of the swap. It pays 5% under the term of the swap. These three sets of cash flows net out to an interest rate payment of 5.1%. Thus for Infosys the swap could have the effect of transforming borrowings at a floating rate of LIBOR plus 10 basis point into a borrowings at a fixed rate of 5.1%

1. 2. 3.

**Using the Swap to Transform a Liability
**

For WIPRO the swap has following three set of cash flows: It pays 5.2% to its outside lenders It pays LIBOR under the terms of the swap. It receives 5% under the terms of the swap. These three cash flows net out to an interest payment of LIBOR plus 0.2% . Thus for WIPRO the swap has the effect of transforming borrowings at a fixed rate of 5.2% into a borrowings at a floating rate of LIBOR plus 20 basis points.

1. 2. 3.

**Using the Swap to Transform an Asset
**

Swaps can be used to transform the nature of an asset. Suppose that Infosys owns Rs.100cr in bonds which provide an interest of 4.7% over next three year and Wipro has an investment of similar amount that yields LIBOR minus 25 basis points. The swap between two companies can be shown as LIBOR-0.25% 5%

Wipro Infosys

LIBOR

4.7%

**Using the Swap to Transform an Asset
**

After Infosys has entered into the swap it has three cash flows: It receives 4.7% on the bonds. It receives LIBOR under the terms of the swap. It pays 5% under the terms of the swap. These three sets of cash flows net out to an interest rate inflow of LIBOR minus 30 basis points. Thus Infosys has transformed an asset earning 4.7% into an asset earning LIBOR minus 30 basis points.

1. 2. 3.

**Using the Swap to Transform an Asset
**

After Wipro has entered into the swap it has three set of cash flows: It receives LIBOR minus 25 basis points on investment. It pays LIBOR under the terms of the swap. It receives 5% under the terms of the swap. These three cash flows net out to an interest rate inflow of 4.75%. Thus Wipro has transformed an asset earning LIBOR minus 25 basis points into an asset earning 4.75%

1. 2. 3.

**Role of a Swap Dealer
**

Usually two non-financial companies such as Infosys and Wipro do not get in touch directly to arrange a swap. They each deal with a financial intermediary such as bank or other financial institutions. µPlain vanilla¶ fixed for floating swaps are usually structures so that financial institution earns 3-4 basis points on the pair of offsetting transactions.

**Role of a Swap Dealer
**

5.2%

Wipro

4.985%

Swap Dealer

5.015%

Infosys

LIBOR

LIBOR

LIBOR+0.1%

**Role of a Swap Dealer
**

4.985%

Wipro Swap Dealer

5.015%

Infosys

4.7%

LIBOR -0.25%

LIBOR

LIBOR

**Role of a Swap Dealer
**

Swaps as financial instruments have gained popularity with transformation of swap brokers into swap dealers. The swap dealer stands ready to enter a swap as a counterparty and with equal willingness to play the role of fixed rate payer or fixed rate receiver. Unlike direct swap between two end users, the swap dealer does not need to match all the terms of the first swap with Counterparty A to the second swap with Counterparty B. The swap dealer does not need to have an immediately available counterparty B into order to enter a swap with counterparty A.

**Role of a Swap Dealer
**

Swap dealers warehouse swaps and run a swap book. They seek to match their swap book in order to remove the risk associated with unmatched swaps. Thus swap dealer strives to have balanced book and any unbalances which exist are hedged by the swap dealer. 4.985% Wipro Swap Dealer 6m LIBOR 4.985% 5-yr T-note (long position) Wipro Swap Dealer G Sec Market 6 m LIBOR 6 m T-bill (short position)

**The Comparative Advantage Argument
**

The popularity of swaps concerns comparative advantages. Some companies have comparative advantage when borrowing in fixed rates whereas others have a comparative advantage in floating rate markets. To obtain a new loan, it makes sense for a company to go to the market it has a comparative advantage.

The Comparative Advantage Argument

AAACorp wants to borrow floating BBBCorp wants to borrow fixed

Fixed AAACorp BBBCorp 4.00% 5.20%

Floating 6-month LIBOR + 0.30% 6-month LIBOR + 1.00%

**The Comparative Advantage Argument
**

A key feature of the rates offered by AAACorp and BBBCorp is that difference between the two fixed rates is greater than the difference between the two floating rates. BBBCorp pay 1.2% more than AAACorp in fixed rate and 0.7% more than AAACorp in floating rate markets. Thus BBBCorp appears to have a comparative advantage in floating rate markets whereas AAACorp has comparative advantage in fixed rates markets. It is this anomaly that can lead to a swap being negotiated.

The Swap

3.95% 4%

AAA

BBB

LIBOR+1% LIBOR

**The Comparative Advantage Argument
**

The swap arrangement appears to improve the position of AAACorp and BBBCorp by 0.25% each. The total gain from deal is 0.5%. The total apparent gain from this type of interest rate arrangement is always a-b, where a is the difference between the interest rates facing the two companies in fixed rate market, b is the difference between the interest rates facing the two companies in floating rate markets. In this case a=1.2% and b=0.70%

The Swap when a Financial Institution is Involved

3.93% 4%

3.97%

AAA

LIBOR

F.I.

LIBOR

BBB

LIBOR+1%

**The Comparative Advantage Argument
**

Why are spreads between the rates offered to AAACorp and BBBCorp be different in fixed and floating market? We expect these differences to be arbitraged away. The reason for spread differentials is due to the nature of contracts available to companies in fixed and floating markets. The 4% and 5.2% rates available to AAACorp and BBBCorp in fixed rate markets are five year rates (the rates at which companies can issue five year fixed rate bonds). The LIBOR+0.3% and LIBOR+1% rates available to AAACorp and BBBCorp in floating rate markets are six month rates.

**The Comparative Advantage Argument
**

In floating rate market , the lender usually has the opportunity to receive floating rates every six months (in extreme cases can even refuse rollover of the loan), while the fixed rate financing do not have the option to change the terms of the loan. The spreads between the rates offered to AAACorp are the reflection of the extent to which BBBCorp is more likely to default than AAACorp. During the next six months there is a little chance that either AAACorp or BBBCorp will default. As we look further ahead, default stastics show that the probability of default by a company with low credit rating (such as BBBCorp) increases faster then the probability of default by company with relatively higher credit rating (such as AAACorp). This is why spread in five year loan is greater than the spread of the six month rate.

**Quotes By a Swap Market Maker
**

Maturity 2 years 3 years 4 years 5 years 7 years 10 years Bid (%) 6.03 6.21 6.35 6.47 6.65 6.83 Offer (%) 6.06 6.24 6.39 6.51 6.68 6.87 Swap Rate (%) 6.045 6.225 6.370 6.490 6.665 6.850

**Quotes By a Swap Market Maker
**

Financial institutions are merchant makers and they give quotes for a number of different maturities and number of different currencies. The bid is the fixed price in a contract where market maker will pay the fixed and receive floating; the offer is the fixed rate in a swap where the market maker will receive fixed and pay floating. The average bid and offer fixed rates is known as the swap rate.

Currency Swap

In simplest form currency swap involves exchanging principal and interest payment in one currency for principal and interest payments in another currency. A currency swap agreement requires the principal to be specified in each of the two currencies and they are exchanged at the beginning and at the end of the life of the swap. The principal amounts are chosen to be approximately equivalent using the exchange rate at the swap¶s initiation.

**Currency Swap- Example
**

Consider a hypothetical five year currency swap between IBM (a US based Co) and British Petroleum (a UK based Co) into on Feb 1, 2002. Suppose IBM pays a fixed rate of interest of 11% in sterling and receives a fixed rate of interest of 8% in dollars from British Petroleum. Interest payments are made once a year and principal amounts are $15 million and GBP 10 million. The swap for this deal can be depicted as : 11% IBM British Petroleum 8%

**Currency Swap- Example
**

This type of swap is known as fixed currency swap because interest rates in both the currencies are fixed. Initially the principal amounts flow in opposite direction to the arrows. Thus at the outset IBM receives GBP 10 million and pays $15 million. Each year during the life of the swap contract , IBM receives $ 1.20 million (8% of $15million) and pays GBP 1.10 million ( 11% of GBP 10 million) At the end of the life of the swap, it pays a principal of GBP 10 million and receives a principal of $15 million.

**The Cash Flows
**

Dollars Pounds £ $ ------millions-----±15.00 +10.00 +1.20 -1.10 +1.20 ±1.10 +1.20 ±1.10 +16.20 ±11.10

Year 2001 2002 2003 2004 2005

Currency Swap

A currency swap can transform borrowings in one currency to borrowings in another currency. The swap can also be used to transform the nature of asset. Suppose that IBM can invest GBP10 million in UK to yield 11% pa for the next five years, but feels that US dollar will strengthen against sterling and prefers US denominated investment. The swap has the effect of transforming the UK investment into a $15 million investment in the US yielding 8%.

Comparative Advantage

Currency swap can be motivated by comparative advantage. Suppose the five year fixed rate borrowing cost to General Motors and Jet Airways in USD and INR is given below: USD INR General Motors 5.0% 12.6% Jet Airways 7.0% 13% 1. INR rates are higher than US interest rates. 2. General motors is more creditworthy than Jet Airways because it is offered a more favorable rate of interest in both the currencies. 3. Since spreads are different in different currencies, swaps can be negotiated.

Comparative Advantage

Here a=2, b=0.4. This may be on account of comparative tax advantage of two companies. General Motors position might be such that USD borrowing lead to lower taxes on its worldwide income than INR borrowings and may be vice versa for Jet Airways. We now suppose that General Motors wants to borrow in INR and Jet Airways in USD. Total gain to all parties on account of this swap deal is 2-0.4=1.6% pa The deal can be depicted as;

Comparative Advantage

USD 5.0% GM USD 5.0% INR 11.9% Swap Dealer INR 13% USD 6.3% Jet Airways INR 13%

USD 5.0%

USD 5.2% Quantas Air INR 13%

GM Swap Dealer USD 5.0% INR 11.9% INR 11.9% Jet Airways some foreign risk USD 6.1% GM Swap Dealer USD 5.0% INR 13% GM bears some foreign risk USD 6.3% INR 13%

Quantas Air INR 13%

**Cross Currency Interest Rate Swap
**

This is a combination of currency swap and interest rate swap. For instance a US firm which can borrow cheap dollar funds at floating rate may exchange the liability with UK firm which borrows sterling at cheaper rates with fixed interest. This type of swap is known as CIRCUS acronym standing for Combined Interest Rate and Currency Swap.

**Credit Risk in Swaps
**

Since swaps are tailor made private arrangement between two parties, therefore they entail credit risk. If neither party defaults, the financial institution remains fully hedged. A financial institution has credit exposure from a swap only when the value of swap to the financial institution is positive and there will be no effect on the financial institution¶s position if the value of swap is negative. Potential losses from default on a swap are much less than the potential losses from default on loan with the same principal. This is because the value of the swap is usually only a small fraction of the value of the loan. Potential losses from defaults on a currency swap are greater than on an interest rate swap. The reason being principal amount in two different currencies are exchanged at the end of the life of a currency swap, a currency swap has greater value than an interest rate swap.

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