LECTURE 5: INTEREST RATE SWAPS

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 LECTURE OBJECTIVES
1. To understand the concept of Swap transactions.
2. To explore the uses of Interest–Rate Swaps.
3. To identify, design and calculate payoffs from Interest–Rate Swaps.
4. To explore on the role of intermediary banks in Swap transactions.

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LECTURE OUTLINE
 Introduction to Interest-Rate Swaps.
 Designing Cash Flows of Plain Vanilla Fixed-for-Floating Interest Rate Swaps.
 Uses of Interest-Rate Swaps in speculation.
 Payoffs from Interest-Rate Swaps that benefits equally to both counterparties.
 And other uses of Swaps in banking transactions.

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 WHAT IS A SWAP?
 A swap is a bilateral contract between two counterparties that calls for
periodic mutual exchanges of cash flows on specified dates and calculated using
specified agreed terms and conditions.
 The contract specifies the dates (say, T 1, T2, ... , Tn ) on which cash
flows will be exchange between counterparties.
 The contract also specifies the rules according to which the cash flows
due from each counterparty on these dates are calculated.
 The largest chunk of the swap market, also the subject of study in this
lecture, is occupied by Interest-Rate Swaps, in which each point of the
swap is tied to a specific interest rate index mainly the Plain Vanilla Fixed-for-Floating Rate Swap.
 Other categories includes: Currency swap; Equity swap; Commodity Swap; Credit Default Swaps (CDS), etc.

 We focus our lecture on the structures of Interest – Rate Swaps.

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INTEREST-RATE SWAPS

 An interest-rate swap is a bilateral agreement between two counterparties to

exchange interest payments in a common currency calculated using
specified rules on a given notional principal.
 The principal is not exchanged in a swap (hence, “notional” principal).
 Mostly the Interest – Rate Swap should be mutually beneficial.
 And calculated based on an equal amount of principal involved on a similar
period of time.

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 THE MAIN CONCEPT OF INTEREST RATE SWAP
 Difference in view of Floating Libor rate.
 The Long Swap holder is in view that the Floating Libor rate will keep increasing
against the Flat rate Fixed interest. Therefore, the Long Swap holder feels can earn
profit by Paying Fixed rate and Receive Floating Libor rate.
 The Short Swap holder is in view that the Floating Libor rate will keep decreasing
against the Flat rate Fixed interest. Therefore, the Short Swap holder feels can earn
profit by Receiving Fixed rate and Pay Floating Libor rate.

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THE PLAIN VANILLA FIXED-FOR-FLOATING RATE SWAP

 The most common type of swap is the plain vanilla fixed-for-floating interest rate swap in which:
 One counterparty (the “long position”) makes payments computed on a fixed interest rate
specified in the contract.
 The other counterparty (the “short position”) makes the floating-rate payments (typically
linked to Libor) on the same principal in the contract.
 Importantly, the payment frequency of the two sides need not be the same:
 E.g. the floating rate payments can be quarterly whilst the fixed rate payments are made semi-
annually. This lecture assumes same frequency of time.
 If both points have the same frequency, it is often the case that only the net interest payment is
taken into account.

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 INTEREST-RATE CONVENTION
 Since swaps are fixed-income derivatives, the convention for quoting interest rates is important.
There are two types of day-count conventions:
 The first is the money-market convention, often applied to the floating-rate (Libor) payment.

 In the U.S. and Eurozone, this is Actual/360 day-count, though in the UK and some commonwealth
countries (Australia), it is Actual/365.
 The second is “30/360” convention (swap market convention), often applied to the fixed rate
payment
 We treat each month in the horizon as having 30 days, and a year as having 12 months.

 Thus, if the three-month interest rate is 5%, the interest payable quarterly per dollar of principal is:

 0.05 x 90/360 = 0.0125

 And if the six-month interest rate is 10%, the interest payable semi-annually per dollar of principal
is:
 0.10 x 180/360 = 0.05
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 SWAP PAYOFFS
 The cash flows generated by plain vanilla fixed-for-floating rate swaps are similar to that of FRAs, but
there are few minor differences.
 In an FRA, the cash flows for both legs are computed using Actual/360 (i.e. money market convention)

 In a swap, the cash flows on the floating side are typically based on Actual/360 while those on the fixed
side use Number of months x/12.
 Exam questions would specify this clearly.

 Another difference is the FRA’s payoffs are in the discounted form and paid at the beginning of the
reference period whereas the swap payoffs are in undiscounted form and paid at the end of the period,
which means no economic difference.
 As indicated earlier, if both legs have the same frequency, it is often the case that only the net interest
payment is made.
 The best way to understand swap payoffs is via an example.
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 SWAP PAYOFFS: A COMPLETE EXAMPLE
 Consider a three-year fixed-for-floating rate swap with the following parameters:

Notional Principal Amount $ 100,000,000

Spot Date 15 June, Year 1.
Term 3 Years
Interest Rate Index 6–month Libor
Reset Intervals Every 6 months
Swap rate (k): 6%
Initial Libor rate 6.5%
Payment frequency (Fixed) 6 months
Payment Frequency (Floating) 6 months

 We compute the cash flows to the holder of the Long swap (pays fixed and receive floating rate). For Short
Swap holder will the opposite.
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 SWAP PAYOFFS: PAYMENT DATES
 Note that there are six payment dates in all:

 December 15, Year 1 (first payment)

 June 15, Year 2 ( 2nd payment)

 December 15, Year 2 ( 3rd payment)

 June 15, Year 3 ( 4th payment)

 December 15, Year 3 (5th payment)

 June 15, Year 4. (6th payment)

 The floating rate payment on the first payment date is based on the Libor rate observed on the spot
date. Assume this rate is 6.50%.
 The floating-rate payments below are computed using the money-market (Actual/360) convention.

 The fixed-rate payments are computed using the swap-market (30/360) convention.

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 EXAMPLE: THE FIRST PAYMENT DATE
 The floating rate received on December 15, Year 1, is computed using the Libor on the spot
date: (assuming there were 183 days in between)
(100,000,000) x ( 0.065 x 183/360) = $3,304,167
 The fixed payment on December 15, Year 1, is computed using the rate k:

(100,000,000) x ( 0.06 x 180/360) = $3,000,000

 The long position pays Fixed rate and receives Floating rate:
 Therefore, net receipts of long position on December 15, Year 1:

3,304,167 — 3,000,000 = $304,167

 This first payment is known at the time of entering into the swap. The Floating rate interest will
be reset at every new payment date for the next payment point.

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 EXAMPLE: THE SECOND PAYMENT DATE
 Now, suppose the Libor rate on the first reset date is 7.00%
 Floating payment on June 15, Year 2:
 (100,000,000) x ( 0.07 x 182/360) = $3,538,889
 Fixed payment on June 15, Year 2:
 (100,000,000) x ( 0.06 x 180/360) = $ 3,000,000
 Therefore, net receipts of long position on June 15, Year 2:
 3,538,889 – 3,000,000 = $538,889

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 SWAPS PAYOFFS: COMPLETING THE EXAMPLE
 Proceeding similarly, the table below completes swap payments assuming hypothetical Libor
rates on the remaining swap reset dates in the Long Swap position holder.
  Days from LIBOR at Swap Fixed Floating  
Time last reset last reset Rate K Payments Receipts Net $

15 Dec Year 1 183 6.50% 6.00% (3,000,000) 3,304,167 304,167

15 June Year 2 182 7.00% 6.00% (3,000,000) 3,538,889 538,889
15 Dec Year 2 183 6.50% 6.00% (3,000,000) 3,304,167 304,167
15 June Year 3 182 6.25% 6.00% (3,000,000) 3,159,722 159,722
15 Dec Year 3 183 5.75% 6.00% (3,000,000) 2,922,917 (77,083)
15 June Year 4 182 5.25% 6.00% (3,000,000) 2,668,750 (331,250)

 The Fixed rate payments are constant at $3,000,000 while the Floating rates receipts are
variable at the reset dates (rates refer to Libor that can either go up or go down)

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 USES OF INTEREST-RATE SWAPS
 Interest-rate swaps link floating and fixed-rate markets. This gives rise to many uses:
 The background: Back-to-back and parallel loans in the 1970s.
 Financial benefits from exploiting the comparative advantage.
 Comparison of funding costs and lowering cost of funds.
 Hedging and risk-management: Converting a liability (or an asset) from fixed to
floating, or from floating to fixed.
 Speculation and other uses.
 Transactions costs: ISDA master swap agreement, while providing for
customization, provides for a number of common features for many swaps.

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 EXPLOITING COMPARATIVE ADVANTAGE
“Comparative” versus “Absolute” advantage.
 The relevance of comparative advantage in determining equal gains in a Swap.
 Comparative advantage in the context of financial markets:
 Difference between borrowing rates of “high rated and low rated” borrower is often greater in the fixed-rate
market than in the floating rate market.
 E.g. Company ABC is a AAA rated can borrow at Fixed rate of 6% and Floating rate of Libor + 0.5%; while
Company XYZ is A rated could borrow a Fixed rate of 8% and at Floating rate of Libor + 1.0%
Fixed Floating Differential
Company XYZ 8.00% Libor + 1.0%
Company ABC 6.00% Libor + 0.5%
Credit Spread 2.00% 0.5% 1.5%

 There is a positive 1.5% differential that both counterparties can equally share to reduce their borrowing
costs when they Swap.
 This makes a Pareto-improving (“everyone benefits”) swap feasible.
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 EXPLOITING COMPARATIVE ADVANTAGE

 “Comparative” versus “Absolute” advantage.

 The relevance of comparative advantage in determining equal gains in a Swap.
 Comparative advantage in the context of financial markets:
 When 2 institutions has a similar requirement either to borrow or invest a some Notional Principle for a
similar period of time, then the both could customize a Swap strategy that can reduce their borrowing
cost or increase investment returns over the horizon of time.
 Normally, among the 2 firms, one could have higher credit rating than the other. The one with higher
credit rating could borrow at lower fixed interest cost than the other. This difference in interest cost
becomes a comparative advantage of the higher credit rated firm, while if the higher credit rated firm may
also have lower floating (Libor) interest rate for borrowing. This becomes an absolute advantage for the
higher credit rated firm.
 By comparing mainly on the fixed interest rate market, the lower credit rated firm can Swap its similar
borrowing with the higher credit rated firm.
 The most important thing is that both firms (the higher and lower credit rated) should benefit in lowering
their cost of borrowing either equally or at a agreed ratio.
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 EXPLOITING COMPARATIVE ADVANTAGE: THE CONCEPT

Company ABC is a AAA credit rated which can borrow at Fixed rate of 6% p.a. and Company
XYZ is AA rated can borrow a Fixed rate of 8% p.a.

Company ABC can borrow in the floating rate market at Libor + 0.5%;
Company XYZ can borrow at Libor + 1.0% in the floating rate market.
Fixed Floating Differential
Company XYZ 8.00% Libor + 1.0%
Company ABC 6.00% Libor + 0.5%
Credit Spread 2.00% 0.5% 1.5%

 There is a positive 1.5% comparative advantage that both counterparties can equally share to reduce
their funding costs by 1.5 / 2 = 0.75% each if they swap their borrowing need.
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 This makes a Pareto-improving (“everyone benefits”) swap feasible.
EXPLOITING COMPARATIVE ADVANTAGE: THE CONCEPT

 Assuming that,
 Company ABC intending to borrow in Floating Libor market for 5 years. And
 Company XYZ intending to borrow in Fixed rate market for 5 years.
 If Company ABC borrow in Floating = Libor + 0.5 interest rate per annum.
 If Company XYZ borrow in Fixed = 8.00% per annum.
 By exchanging in a Swap: (Both companies will borrow in opposite markets)
 Company ABC would borrow in Fixed rate market at 6.00%
 Company XYZ would borrow in Floating rate market at Libor + 1.00%.

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 DESIGNING A SWAP STRATEGY
 The target is that both forms should save 0.75% interest costs per annum.

Party ABC XYZ

Pay Lenders - (6.00) - (L + 1.00)
XYZ pay ABC + (6.00) - (6.00)
ABC pay XYZ - (L – 0.25) + (L – 0.25)
Net Cost Payable - (L – 0.25) - (7.25)

Company ABC 6 Company XYZ

+ 6.00% - 6.00 = 0 % + (L – 0.25) – (L + 1.00) = - 1.25
PAY L – 0.25 TO XYZ PAY 6.00% TO ABC = 6 + 1.25 = 7.25
(L – 0.25)


6.00% L + 1.00%

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 EXPLOITING COMPARATIVE ADVANTAGE: CONCEPT CHECK

Party Fixed Floating

Company A 5.00% L – 0.50%
 Company A, the higher-rated entity, wants to borrow at floating rate for 5 years.
Company B
 Company B, the lower-rated entity, 7.00% L + 0.50%
wants to borrow at fixed rate for 5 years.
 Relevant borrowing rates: Absolute Difference 2.00% 1.00%

 The difference between Fixed and Floating market is 2.00% – 1.00% = 1.00% which is the clear advantage in
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a Swap (when shared equally will reduce both party’s cost by 0.5% or 50 basis points)
 Company A can borrow cheaper in both markets (Fixed and Floating), but has a clear comparative
 THE SWAP STRUCTURE DESIGN
 The target is to design a swap structure that can reduce the cost of borrowing for both parties equally by 0.5% or
50 basis points.
 There is no one single formula for swap structure.
Comp A Comp B
Pay Lenders - 5.00% - (L + 0.5%)
A pays B (Libor) -L +L
B pays A (6.00%) + 6.00% - 6.00%
Net cost payable - (L – 1.00%) - 6.50%
Savings 50 basis points 50 basis points

 Originally Company A suppose to borrow in Floating rate at L – 0.5%, after Swap deal Comp. A’s cost of borrowing is L
– 1.00%, which is 50 bps lower than before.
 Originally Company B suppose to borrow in Fixed rate at 7.00%, after Swap deal Comp. B’s cost of borrowing is just
6.50%, which is 50 bps. Lower than before swap deal.
 50 bps on $500 mil borrowing can be $2.5 million saving.
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 SWAP STRUCTURE DIAGRAM
Based on the same example:

6%
5% L + 0.5%
Comp A Comp B
Libor

 Net borrowing cost to A: (5% + L) - 6% = L – 1.00%: 50bps better *

 Net borrowing cost to B: (L+ 0.5% + 6%) – L = 6.5%: 50bps better **
 * Comp. A pays lenders 5.00% and also pays Comp. B Libor; while it receives 6.00% from Comp. B
 Financing cost wise: Libor ( 5.00 – 6.00%) = L – 1.00%; As originally should be L – 0.5%
 ** Comp. B pays lenders L + 0.5% and also pays Comp. A 6.00%; while it receives L from Comp. A
 Financing cost wise: L – L = 0; 6.00% + 0.5% = 6.50%; as originally should be 7.00%
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 SWAP THROUGH A SWAP BANK (F.I.)
Normally a swap between two parties are arranged by a Financial Institution (F.I.) or also called as a Swap Bank who become
another party in a Swap deal. The FI would earn a commission or a fee for arranging the swap successfully.
Therefore, during designing a swap transaction, we should take into account for the commission to the swap bank as a part of the
interest exchange between swap parties.
Let us analyze another Example based on a swap through a swap bank.
Companies A and B have been offered the following rates per annum on a $20 million five-year loan:
 
Fixed Rate Floating Rate

Company A 5.0% LIBOR + 0.1%

Company B 6.4% LIBOR + 0.6%

Assuming that, Company A requires a floating-rate loan; and Company B requires a fixed-rate loan.
Design a swap that will net a swap bank, acting as intermediary, 0.1% per annum and that will appear equally attractive to both
companies.
 SWAP THROUGH A SWAP BANK (F.I.)
 Lets design the Swap between Company A and B including the Swap Bank’s commission.
 First check if the swap has positive spread differential?
  Fixed Rate Floating Rate

Company A 5.0% LIBOR + 0.1%

Company B 6.4% LIBOR + 0.6%

Rate Spread 1.4% 0.5%

 The inter-market differential is 1.4% - 0.5% = 0.9%. And if the swap bank takes 0.1% there is a balance of
0.8% divided equally as 0.40% each to be better off in their borrowing cost.
 The design;
 A has an apparent comparative advantage in fixed-rate markets but wants to borrow floating.
 B has an apparent comparative advantage in floating-rate markets but wants to borrow fixed.
 This provides a strong reason to swap between the two companies. Therefore, A will borrow in fixed-rate
and B will borrow in floating-rate.

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 THE SWAP DESIGN TABLE
 Based on the interest rates given, the swap between Comp A and B:

Company A F.I. Company B

Pay Lenders - (5.00%) - ( L + 0.6%)
A pays B -L +L
B pays F.I. + 5.40% - 5.40%
F.I. pays A + 5.30% - 5.30%
+ 0.01%
Net Interest payable - (L – 0.3%) + 0.01% - 6.00%

 Comp. A pays lenders 5.00% and L to B; while receiving 5.30%(Net) from B = L – 0.3% (40 bps saved)
 Comp. B pays lenders L + 0.6% and 5.40% to FI; while receiving L from A = 6.00% (40 bps saved)
 40 basis points on $20 million = 0.004 x 20,000,000 = $80,000 savings per annum.
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 THE SWAP DIAGRAM
 Based on the same example:

5.30% 5.40%
5.00% Libor + 0.6%
Comp A F.I. Comp B
 Libor Libor

 Company A pays lenders 5.00% and Libor to B; while receives 5.3% from FI.; 5.00 – 5.30 = - 0.30% and – Libor = L
– 0.30%
 Thus saving 40 basis points in borrowing cost
 Company B pays lenders Libor + 0.6% and 5.40% to F.I.; while receive Libor from A; Libor – Libor = 0; 5.40 + 0.60% =
6.00%
 Thus saving 40 basis points in borrowing cost
 F.I. Receives 5.40% from B and pays A 5.30% and earns 0.1% commission.
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 ANALYZING FUNDING COSTS
 Swaps are useful devices in comparing funding costs across markets.
 For example, suppose a firm has the following choices:
 10-year loan at a fixed rate of 8.00%. Or
 1-year Floating-rate note at (Libor + 0.75%). (Current Libor = 5.25%, say) = 5.25 + 0.75 = 6.00%
 Current Libor is lower, but this could change over 10 years.
 Suppose an active swap market exists and if the Libor rate increases over the years, the
company can swap 1-year Libor into fixed at 8%. Then, the choices become comparable:
 Borrow fixed: Cost = 8%.
 Borrow floating, swap into fixed rate. Cost = 7.75%.
 In short, swaps enable companies to issue debt in markets where rates are most favorable and
then to convert the liability structure into one of the company's choice.
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 SPECULATION AND OTHER USES

Swaps can also be used to speculate without any prior underlying exposure.
 Pay fixed, receive floating if view is that Floating rates will increase.
 Pay floating, receive fixed if view is that Floating rates will decrease.
 Swaps offer financial flexibility.
 For example, a company raising money currently that has the view that the Floating
interest rates may go down, can raise floating now and swap into fixed when floating
rates increase.
 Swaps also useful to reduce foreign exchange rate risks by exchanging fixed-for-fixed
rate loans between two different currencies. This is where parallel loans and back-to-
back loans can be practiced.

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 SUMMARY

The swaps market is the biggest component of the world derivatives market with a
notional outstanding amount of around $400 trillion.
 The great bulk of the swaps market is composed of interest-rate swaps, and the
workhorse of the interest-rate swap market is the plain vanilla fixed-for-floating
rate interest-rate swap, which was the focus of the lecturer
 Swaps enable exchanging the risk in one market for the risk in another, so are of
particular use in financing.

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