Background

Definition: Interest rate swap is an agreement between two parties to exchange one set of interest rate payments for another s Usually an exchange of a stream of fixed-rate interest payments for floating-rate payments s Characteristics
s
q Over-the-counter

trading—coordinated and negotiated by financial institution q Contracts less standardized than other derivatives like futures and options
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Provisions of a Swap
The notional principal value to which the interest rates are applied to calculate the interest payments s The fixed interest rate s The floating rate s The frequency of payments, such as every six months or every year
s

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Background
Example of two financial institutions, one in the U.S and one in Europe used to illustrate swap concepts s A U.S. financial institution with liabilities more rate-sensitive than assets is affected adversely by rising interest rates s A European financial institution has access to long-term, fixed-rate funds but makes floating rate loans and has the opposite exposure as compared to U.S. institution
s
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All rights reserved.S. .Exhibit 15. Borrowers Fixed Interest Payments Floating Interest Payments Fixed-Rate Long-Trm e Deposits European Depositors Interest on Deposits European Financial Institution Floating-Rate Loans European Borrowers Floating Interest Payments on Loans Copyright© 2002 Thomson Publishing.1 An Interest Rate Swap Short-T rm e Deposits Fixed-Rate Long-T erm Loans U. Financial Institution Fixed Interest Payments on Loans U.S.S. Depositors Interest on Deposits U.

and foreign institution negotiate a swap.S.Background If interest rates increase and the U.S. the U.S. institution gets higher interest payments as rates rise to help offset the increased cost of funds s If interest rates decline then the foreign institution makes lower interest payments to the U. which helps offset the lower interest payments the European institution receives on loans s Copyright© 2002 Thomson Publishing. All rights reserved. .

pension funds and insurance companies exposed to interest rate risk use swaps to manage it s Intermediaries match up firms s q Charge fees q May provide a credit guarantee.Participation by Financial Institutions Institutions including banks. All rights reserved. for a fee s Dealer q Takes a counterparty position to serve clients q Results in risk exposure unless it has an offsetting swap with another client Copyright© 2002 Thomson Publishing. .

and European institution given in the example information s LIBOR or London Interbank Offer Rate used as the as the index s Copyright© 2002 Thomson Publishing. All rights reserved. .Types of Interest Rate Swaps Plain vanilla swap involves periodic exchange of fixed-rate payments for floating-rate payments s Basic exchange of payments for the U.S.

All rights reserved.3 Plain Vanilla Swap Level of Interest Payments Scenario of Rising Interest Rates Floating Inflow Payments Fixed Outflow Payments Level of Interest Payments Scenario of Declining Interest Rates Fixed Outflow Payments Floating Inflow Payments 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 End of Year End of Year Copyright© 2002 Thomson Publishing. .Exhibit 15.

All rights reserved.Types of Interest Rate Swaps A forward swap is an exchange of interest payments that does not begin until some future point in time s Used if an institution is currently insulated against rate risk but anticipates risk beginning at a future time s Swap period is delayed but institution locks in future terms s Locks in at the prevailing rates based on expectations about future interest rates s Copyright© 2002 Thomson Publishing. .

Exhibit 15. .5 Forward Swap Level of Interest Payments Level of Interest Payments Scenario of Rising Interest Rates Floating Inflow Payments Scenario of Declining Interest Rates Fixed Outflow Payments Fixed Outflow Payments Floating Inflow Payments Forward Swap Is Arranged at This T ime Forward Swap Is Arranged at This T ime Swapping of Payments Begins at This T ime Swapping of Payments Begins at This T ime 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8 End of Year End of Year Copyright© 2002 Thomson Publishing. All rights reserved.

Types of Interest Rate Swaps Callable swaps are a swap option that allows counterparty with fixed payments to terminate prior to maturity s U. .S. All rights reserved. institution in the example could terminate swap if rates decline and then capture the benefits s Party with the right to terminate pays a premium in the form of a higher fixed rate s May also involve a termination fee s Copyright© 2002 Thomson Publishing.

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 End of Year End of Year Copyright© 2002 Thomson Publishing. because interest rate trend is downward.6 Callable Swap Scenario of Rising Interest Rates Floating Inflow Payments Fixed Outflow Payments* Scenario of Declining Interest Rates Level of Interest Payments Level of Interest Payments Fixed Outflow Payments* Floating Inflow Payments Option is exercised to terminate the swap at this time. . All rights reserved.Exhibit 15.

.Types of Interest Rate Swaps Putable swaps allow the counterparty with floating-rate payments to terminate prior to maturity s European institution in the example could terminate swap if rates increase and then capture the benefits s Party with the right to terminate pays a premium in the form of a higher fixed rate s May also involve a termination fee s Copyright© 2002 Thomson Publishing. All rights reserved.

All rights reserved.7 Putable Swap Scenario of Rising Interest Rates Scenario of Declining Interest Rates Level of Interest Payments Floating Inflow Payments * Fixed Outflow Payments Level of Interest Payments Fixed Outflow Payments* Floating Inflow Payments Option is exercised by recipient of fixed outflow payments to terminate the swap at this time. 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 End of Year End of Year Copyright© 2002 Thomson Publishing. because interest rate trend is upward.Exhibit 15. .

.Types of Interest Rate Swaps Extendable swaps allow the fixed-for-floating party to extend the swap period s Benefits from the ability to extend a current swap rather than negotiate a new swap at the prevailing market rates in existence when the initial swap matures s This feature involves a higher price s May have to pay fees if swap is extended s Copyright© 2002 Thomson Publishing. All rights reserved.

Exhibit 15.8 Extendable Swap Scenario of Rising Interest Rates Floating Inflow Payments Scenario of Declining Interest Rates Level of Interest Payments Level of Interest Payments Fixed Outflow Payments Fixed Outflow Payments Floating Inflow Payments At this time. . At this time. All rights reserved. 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 End of Y ear End of Year Copyright© 2002 Thomson Publishing. the institution would likely extend the swap period. the institution would likely decide not to extend the swap period.

. All rights reserved.Types of Interest Rate Swaps Zero-coupon-for-floating swaps involve a fixed-rate payer that makes a single payment at the maturity of the swap s Floating-rate payer makes periodic payments s An example is a U. institution with shortterm deposits funding zero coupon bonds s The risk is that an interest rate increase causes the bond prices to fall and increases the cost of funds on the liability side of the balance sheet s Copyright© 2002 Thomson Publishing.S.

9 Zero-Coupon-For-Floating Swap Scenario of Rising Interest Rates • A Single Lump-Sum Fixed Outflow Payment Floating Inflow Payments Scenario of Declining Interest Rates •A Single Lump-Sum Fixed Outflow Payment Level of Interest Payments Level of Interest Payments Floating Inflow Payments 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 End of Year End of Year Copyright© 2002 Thomson Publishing. All rights reserved. .Exhibit 15.

firm may believe rates will not go above cap and if they do.Types of Interest Rate Swaps Rate-capped swaps exchange fixed-rate payments for floating-rate payments that are capped and involve up-front fees s Example of U.S. swap’s effectiveness is limited Copyright© 2002 Thomson Publishing. All rights reserved.S. . and European firm s q European firm may want to limit its possible payments with the cap and know what its maximum payments will be q U.

10 Rate-Capped Swap Scenario of Rising Interest Rates Cap Level Purple Line Reflects Floating Inflow Payments If a Cap Did Not Exist Floating Inflow Payments Based on Cap Fixed Outflow Payments Cap Level Scenario of Declining Interest Rates Fixed Outflow Payments Floating Inflow Payments Payer of Fixed Outflow Payments Receives Premium atThis T ime for Agreeing to Cap 1 2 3 4 5 6 7 8 1 Payer of Fixed Outflow Payments Receives Premium atThis T ime for Agreeing to Cap 2 3 4 5 6 7 8 End ofY ear End ofY ear Copyright© 2002 Thomson Publishing. All rights reserved. .Exhibit 15.

Types of Interest Rate Swaps Equity swaps involve the exchange of interest payments for payments linked to the degree of change in a stock index s Example s q Company with a fixed 7% interest rate q Swaps a fixed rate for rate of appreciation in an index over a period of time q If index appreciates by 9% a year. . All rights reserved. differential is 2% q For use by portfolio managers Copyright© 2002 Thomson Publishing.

Other Types of Interest Rate Swaps s Rate swaps to accommodate financing needs q Corporations with varied debt ratings swap fixed for floating interest payments q Swap parties benefit from considerable differential in capital market rates for parties Tax swaps q Firm with expiring loss carryforwards swaps with q Firm expects future losses but has large gains from operations this year Copyright© 2002 Thomson Publishing. All rights reserved. .

All rights reserved. Fixed-Rate Payments at 9½% Fixed-Rate Payments at 9% Risky Co. V ariable-Rate Payments at LIBOR + 1% Investors in Fixed-Rate Bonds Issued by Quality Co.Exhibit 15. .11 Interest Rate Swap Variable-Rate Payments at LIBOR + ½% Quality Co. Investors in V ariable-Rate Bonds Issued by Risky Co. Copyright© 2002 Thomson Publishing.

. All rights reserved.Risk of Interest Rate Swaps Basis risk is the chance that the index does not move in perfect tandem with the floating-rate instruments s Credit risk exists because one of the firms may not meet its payment obligations but this is minimized s q If counterparty 1 defaults it does not make a required payment q Counterparty 2 would stop all subsequent payments Copyright© 2002 Thomson Publishing.

Risk of Interest Rate Swaps s Credit risk concerns exist for those that guarantee swaps q Regulators are considering how to respond q Large growth in swaps market so this concern will receive continued attention s Sovereign risk is the potential adverse effect from a country’s political conditions that could prevent one party from fulfilling its obligations Copyright© 2002 Thomson Publishing. . All rights reserved.

Pricing Interest Rate Swaps Prevailing market interest rates determine swap rates s Availability of counterparties influences pricing s q If there are numerous potential counterparties it increases the chance of negotiating favorable terms q This will change as economic conditions change s Credit and sovereign risk also influence prices Copyright© 2002 Thomson Publishing. . All rights reserved.

All rights reserved.S.Factors Affecting the Performance of Interest Rate Swaps Swap performance is affected by several underlying forces s Indicators monitored by participants in the swaps markets include any that would affect interest rates s q U. . economic conditions q International economic conditions q Monetary and fiscal policy Copyright© 2002 Thomson Publishing.

. where interest rate changes may vary s Manufacturing corporations from various countries also engage in swaps s Interest rate swaps are denominated in many currencies s Lack of information and credit risk concerns reduced if intermediaries back payments s Copyright© 2002 Thomson Publishing. All rights reserved.Globalization of Swap Markets Counter-parties for interest rate swaps extends beyond United States.

.Globalization of Swap Markets Currency swap is an arrangement in which currencies are exchanged at specified foreign exchange rates and at specified intervals s Used by firms to hedge their risks from foreign currency exposure caused by inflows and outflows denominated in different currencies s Currency swaps available in several variations and may involve intermediaries s Copyright© 2002 Thomson Publishing. All rights reserved.

Globalization of Swap Markets s s s s Hedging bond payments with currency swaps involves Firm 1 issuing a bond denominated in euros to fund its euro operations Firm 1 receives euros in the course of business that would be used to repay the bonds Investors in the euro market do not know Firm 1 very well Firm 1 swaps with Firm 2. a company that wants to issue dollar debt but is not well known by investors who buy dollar-denominated debt Copyright© 2002 Thomson Publishing. . All rights reserved.

Globalization of Swap Markets s Risks of currency swaps involve the same risks as other interest rate swaps q Basis risk q Credit risk q Sovereign risk Copyright© 2002 Thomson Publishing. . All rights reserved.