SWAPS and the Eurodollar Market: Introducing a

Third Perspective on Interest Rate Risk Management

A. The Notion of a SWAP 
1. Forward Contracts allow borrowers to remove interest rate risk over a
specific future time period, say i periods ahead for n periods.
  As a result, we must continually sign such contracts if we wish to
remove long term risk on a regular basis. A convenient way to do this is
via a SWAP.
  a. This is important because Eurodollar loans are floating rate
loans.

b. Standard forward contracts in this market are “3 x 3” or “3 x 6”

meaning that the forward contract locks in a rate for in 3
months from the 3 months following or in 3 months for the 6
months following.
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2. Definition: An interest rate SWAP is an enforceable agreement
between two parties to exchange cash flows period by period.
  - One party pays a fixed rate payment and receives a
variable floating rate payment. This party is the insured.
- The counterparty pays the floating rate and receives the
fixed rate payment. This party bears the risk.
  These rates are applied to an agreed-upon fixed “notional”
amount. The resulting payments are what is exchanged.

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B. Uses of SWAPS

1. The uses of such instruments are threefold:

(i) they give access to fixed or floating rate capital markets;

(ii) it allows participants to manage their asset/liability structure more

effectively;

(iii) it provides a tool for hedging interest rate risk.

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Example: Managing Assets and Liabilities
  Consider a Bank with a very simple balance sheet:
Assets Liabilities
$100 MM $100 MM
10 year loan at 8% 6 mo. CDs at 5%
Every 6 months the Bank has to refinance the CDs, whose rates are typically tied to
LIBOR.
Suppose, for simplicity, the CD rate is the LIBOR rate. Consider a SWAP whereby the
Bank exchanges their variable liability for a fixed rate liability at 7%.

DEPOSITORS

LOANS BANK SWAP DEALER

8% pays 7%

receives 6 mo. LIBOR

Now the bank only has to worry about the “credit risk” of the borrower and the 4
SWAP dealer.
2. “Who wants floating?
“Who wants fixed?”
“Wants to receive variable and
pay a fixed payment”
a. Speculators who believe
Eurodollar rates will rise
b. Banks which have fixed rate
loans (mortgages) but variable
rate obligations (CDs)
c. Firms with variable rate loans,
yet steady cash flow streams
(e.g., drug firms; industrial
firms)
SWAPS can be thought of as insurance against rate changes.
“Wants to receive fixed and
pay variable”
Speculators who believe
rates will fall
Banks which have variable
rate assets (mortgages)
and want to reduce risk in
this part of their portfolio
Firms with variable
streams of income but who
have fixed obligations and
want to reduce risk
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C. The Mechanism of a SWAP
 
1. What actually is swapped? It is only the fixed and floating rate payments
themselves (“coupons”) – on a given notional principal – that are exchanged.
 
2. Time Horizon: specified by the SWAP contract: In principal it can be for
any time period: 1 year, 5 years, 10 years, etc.
 
3. Example of a SWAP contract:
 
X pays Y: 10% fixed rate per year on a notional $50 M
Y pays X: 6 month LIBOR rate adjusted every 6 months.
 
Payments are thus exchanged every 6 months:

X pays Y: $50 M  10  = $2.5 million (fixed rate).

 
 2
Y pays X: 50 M x 6 month LIBOR rate (which varies ≡ floating rate)

The fixed rate is known as the SWAP rate.

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D. How Is the SWAP Rate Determined?
 
1. It is that rate which equates the PV of the two payment streams. It
is computed as the result of a three step procedure:
  Step 1: Compute the floating rate payments using the forward LIBOR
rates. These are the no-arbitrage rates in the Eurodollar market.
  Step 2: Discount the floating rate payments using the LIBOR “term
structure” to obtain the present value of the expected floating rate
payments.
  Step 3: Adjust the Fixed Rate to bring about equality in the two present
values.
  This is an NPV = 0 procedure within the universe of LIBOR securities.
It thus costs “nothing,” aside from transactions fees, to enter into such
contracts.
  The Key Ingredient: the Forward LIBOR Term Structure
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E. An Example: Computing the SWAP Rate
 1. Consider a 1.5 year SWAP with three payments exchanged. Notional Amount
$100 M.
  Although LIBOR rates are available only up to one year, forward LIBOR rates
are available from Bloomberg or Reuters since LIBOR forward contracts are
traded.
LIBOR
We need r LIBOR
.5 , f
.5 .5 , f LIBOR
1 .5 ,
1.85% 2.2% 2.72% (annualized)
float
C float
.5
C1float C1.5
 r.5LIBOR 
Thus, Cfloat
= $100 M    $.925 MM
 2 
.5

 .5 f.5LIBOR 
  $1.1 MM
float
C 1 = $100 M 
 2 
float  1 f.5LIBOR 
C 1.5 = $100 M    $1.36 MM
 2 
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These are the expected – no arbitrage -- floating rate payments.
2. Next we discount these at the corresponding “spot” LIBOR rates. Problem:
LIBOR spot rates are available only up to one year.
 
However, knowledge of the forward rates allows us, in a world of no (LIBOR)
arbitrage, to construct the consistent set of corresponding spot rates.
 
This is another sense of “Bootstrapping” except that it uses forward rates to
construct spot rates (rather than the reverse as earlier).
LIBOR
f
.5 .5 f LIBOR
1 .5
2 2

t = 0 .5 1 1.5
LIBOR
LIBOR r1LIBOR r
1.5
r
.5
2 2
2

 r.5LIBOR   .0185 
1    1    1.00925
 2   2 
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 2
 r LIBOR
  r.5LIBOR  .5 f.5LIBOR 
1    1  1 
1

 2   2  2 

 .022 
=  1.00925 1    1.02035  r1Libor  .022049
 2 

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 r1.5
LIBOR
  r.5LIBOR  .5 f.5LIBOR  1 f.5LIBOR 
1    1  1   1  
 2   2  2  2 

 .022  .0272 
= (1.00925)  1   1  
 2  2 
3
 r1.5LIBOR

 1    1.03423  r Libor
1.5  .02256
 2 

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Thus, the value of the floating payments is:
3
 r1.5Libor

 1  
 2 
.925 MM 1.1MM 1.36 MM
PV FLOAT   
(1.00925) (1.02035) (1.03423)

= 3.298702 MM
2
 r1Libor 
1  
 2 

Calculations of the Swap Rate for the Lecture on Interest Rate Swaps.

t Given ratesImplied Term

CF float
Structure
PV S Fixed Rate
0.5 0.0185 0.925 3.298703 2.929478 1.126038 0.022521

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3. Lastly, we compute the SWAP rate, where we discount the fixed payments at
the same term structure of LIBOR rates: Let S denote the swap cash payment

 
 
 S S S 
  3
3
  r.5LIBOR   r1LIBOR 
2
 r1.5  

LIBOR
PVFIXED =  1   1   1  
t 1
  2   2   2  
        
1.00925 1.02035 1.03423

3.2987 MM = 2.9295 S
 
=> S = 1.126 MM.

This is a “6 month” cash flow.

On an annual basis:
S = 2(1.126) = 2.2521 MM 2.2521
On an annualized rate basis, this is equivalent to  2.2521%
  100
This is the swap rate. It is a no arbitrage rate within the scope of the LIBOR
family of rates. 12
F. Duration of a SWAP
1. Consider an N-year SWAP
2. Duration of Fixed side
- Same duration as an N-year bond with coupon rate “S”
3. Duration of Floating side
- Always have a PV of $100. Intuition: when interest increases, you
receive more interest, but also discount more. The effect offsets each
other. Duration of floating side: 0.
4. Receive fixed/pay floating SWAP has a positive duration.
5. Receive floating/pay fixed SWAP has a negative duration.
6. SWAP can hedge interest rate risk via duration adjustment, just
like an N-year bond.

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G. Conclusion
We have illustrated the notion of a SWAP contract as another device
for managing interest rate risk. Next we will see how the writing of
such contracts can allow us to hedge bond portfolio price risk. A
current issue in the SWAP market: the financial integrity of the banks
participating in the Eurodollar market.
1. SWAPS allow borrowers to insure against increases in the general
level of LIBOR rates, but not against increases in the spread they
must pay.
2. By signing a SWAP to pay or receive the fixed rate, investors
essentially lock in a complex average of the forward rates.
3. How does an investor exit the SWAP market if he has a large
outstanding position?

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