Swaps and Interest Rate Options

Outline
Interest rate swaps
Foreign currency swaps
Circus swap
Interest rate options

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 Both swaps and interest rate options are
relatively new, but extensively used
In mid-2000, there was over $60 trillion
outstanding in interest rate swaps, foreign
currency swaps, and other interest rate options

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 Hedging with interest rate swaps
Immunizing with interest rate swaps
Exploiting comparative advantage in the
credit market

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 Popular with bankers, corporate treasurers,
and portfolio managers who need to
manage interest rate risk
A swap enables you to alter the level of risk
without disrupting the underlying
portfolio:
asset
liability

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 The most common type of interest rate swap is the
fixed for floating rate swap
One party makes a fixed interest rate payment to another
party making a floating interest rate payment
Only the net payment is made (difference check)
The firm paying the floating rate is the swap seller
The firm paying the fixed rate is the swap buyer

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 Typically, the floating interest rate is linked
to a market rate such as
LIBOR or
T-bill rates
BAs in Canada
The swap market is standardized partly by
the International Swaps and Derivatives
Association (ISDA)
ISDA provisions are master agreements
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 A plain vanilla swap refers to a standard
contract with no unusual features or bells
and whistles
The swap facilitator will find a counterparty
to a desired swap for a fee or take the other
side
A facilitator acting as an agent is a swap broker
A swap facilitator taking the other side is a swap
dealer (swap bank)

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 Plain Vanilla Swap Example

A large firm pays a fixed interest rate to its bondholders, while a

smaller firm pays a floating interest rate to its bankers
The two firms could engage in a swap transaction which results in
the larger firm paying floating interest rates to the smaller firm, and
the smaller firm paying fixed interest rates to the larger firm

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Large firm with a strong credit rating
takes advantage of it s borrowing capacity
and borrows fixed term in the bond market
interest rate outlook - declining rates
enters into a swap agreement to move to
floating rate debt but still leveraging its
strong credit rating and borrowing capacity

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Smaller firm with weaker credit rating
no/minimal access to long term bond market due to its
relatively weak credit rating
typically borrows floating rate from its bank(s)
would like to fix its borrowing rate as part of its risk
management program
can achieve its fixed rate objectives by entering into a
swap agreement

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 Plain Vanilla Swap Example (contd)

LIBOR 50 bp

Big Firm 8.05%

Smaller Firm

8.05% LIBOR +100 bp

Bondholders Bankers

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 Plain Vanilla Swap Example

A facilitator might act as an agent in the transaction and charge a

15 bp fee for the service.

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 Plain Vanilla Swap Example
LIBOR -50 bp LIBOR -50 bp

Big Firm Facilitator Smaller Firm

8.05% 8.20%

8.05% LIBOR +100 bp

Bondholders Bankers

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 Swaps can be entered into at same time the firm accesses
the bond market - e.g. 5 year fixed rate bond issue
immediately swapped into floating rate via a swap
agreement
or
A swap can be negotiated at any time over the life of an
existing borrowing e.g. 7 year bond issue two years prior -
firm now expects interest rates to decline - 5 years
remaining on the bond issue - firm enters into a 5 year
fixed to floating rate swap

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 The swap price is the fixed rate that the two
parties agree upon
The tenor is the term of the swap
The notional value determines the size of
the interest rate payments
Counterparty risk refers to the risk that one
party to the swap will not honor its part of
the agreement

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 Interest rate outlook over expected
borrowing horizon
Use swaps where the borrowing horizon is
longer term
use futures where the interest rate risk is short
term
absolute interest rate levels and or yield
curve shape
credit or swap spreads

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 Interest rate swaps can be used by
corporate treasurers to adjust their
exposure to interest rate risk
The duration gap is:

Total Liabilitie s
D gap D asset D liabilities
Total assets

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 A positive duration gap means a banks net
worth will suffer if interest rates rise
The treasurer may choose to move the duration
gap to zero
This could be accomplished by selling some of the
banks loans and holding cash equivalent securities
instead
or
using interest rate swaps to close the duration gap

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 Interest rate swaps can be used to exploit
differentials in the credit market

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 Credit Market Example
AAA Bank and BBB Bank currently face the following borrowing
possibilities:
Firm Fixed Rate Floating Rate

AAA Current 5-yr LIBOR

T-bond + 25 bp

BBB Current 5-yr LIBOR + 30 bp

T-bond + 85 bp

Quality Spread 60 bp 30 bp

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 Credit Market Example (contd)

AAA Bank has an absolute advantage over BBB in both the fixed
and the floating rate markets. AAA has a comparative advantage in
the fixed rate market.

The total gain available to be shared among the swap participants

is the differential in the fixed rate market minus the differential in
the variable rate market, or 30 bps.

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 Credit Market Example (contd)

AAA Bank wants to issue a floating rate bond, while BBB wants to
borrow at a fixed rate. Both banks will borrow at a lower cost if they
agree to an interest rate swap.

AAA Bank should issue a fixed rate bond because it has a

comparative advantage in this market. BBB should borrow at a
floating rate. The swap terms split the rate savings 50-50. The
current 5-yr T-bond rate is 4.50%.

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 Credit Market Example (contd)

Treasury + 40 bp

AAA BBB
LIBOR

Treasury + 25 bp LIBOR +30 bp

Bondholders Bondholders

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 Credit Market Example (contd)

The net borrowing rate for AAA is LIBOR 15 bps

The net borrowing rate for BBB is Treasury + 70 bps

The net rate for both parties is 15 bps less than without the
swap.

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 In a currency swap, two parties

Exchange currencies at the prevailing exchange

rate
Then make periodic interest payments to each
other based on a predetermined pair of interest
rates, and
Re-exchange the original currencies at the
conclusion of the swap

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 Cash flows at origination:

Euro Principal

C$ Principal
Cdn. Co. Swap Dealer

Fixed
Rate C$
Interest

Bondholders
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 Cash flows at each settlement:

Euro Fixed Rate

Cdn. Co. Swap Dealer

C$ - Fixed Rate

C$
Fixed Rate
Interest

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 Cash flows at maturity:

Euro Principal

Cdn. Co. Swap Dealer

C $ Principal

Retire C$
Issue

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 Combining both interest rate and currency
swaps

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 A circus swap combines an interest rate and
a currency swap

Involves a plain vanilla interest rate swap and

an ordinary currency swap
Both swaps might be with the same
counterparty or with different counterparties

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 Interest associated with original currency
swap

Euro - Fixed

Cdn. Co. Swap Dealer

C$ - Fixed

Fixed C$
Interest

Bondholders
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 Interest rate swap to move from fixed
euros to floating rate euros
Euro Fixed

Cdn. Co. Swap Dealer

Euro Floating

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 Circus swap with two counterparties = net
position of:
Floating Rate Euros

Cdn. Co. Swap Dealer

Fixed Rate C$

Fixed C$
Interest

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 Deferred swap
Floating for floating swap
Amortizing swap
Accreting swap

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 In a deferred swap (forward start swap), the
cash flows do not begin until sometime
after the initiation of the swap agreement
Motivation - desire to manage future
interest rate risk but reflecting todays
interest rate conditions

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 ABC corporation has a required borrowing 2
years from now
interest rate outlook is for rates trending
upward
deferred swap could lock in todays fixed
rates for a premium
a deferred or forward swap is in effect 2
swaps

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 Pay 2 year Pay 7 year
Fixed Fixed
Swap ABC Co. Swap
Dealer Dealer

Pay Receive
BAs BAs

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 ...in two years time

Pay 7 year (5 years remaining)

Fixed

ABC Co. Swap

Dealer
Receive
Borrow BAs
Floating
Rate BAs

Bankers

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 Dealer factors in the cost of carry in
offering the deferred 5 year rate (one swap)
Considerations
interest rate outlook
time frame
cost of carry - the cost of the hedge
steep yield curve - higher cost of carry
flat yield curve - minimal cost of carry

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 In a floating for floating swap, both parties
pay a floating rate, but with difference
benchmark indices

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 In an amortizing swap, the notional value
declines over time according to some
schedule

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 In an accreting swap, the notional value
increases through time according to some
schedule

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 Interest rate cap
Interest rate floor
Calculating cap and floor payoffs
Interest rate collar
Swaption

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 Most of the trading done off the exchange
floors

The interest rate options market is

Very large
Highly efficient
Highly liquid
Easy to use

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 Growth in Interest Rate Options
Notional Value
15
(Trillions)

10

0
1992 1993 1994 1995 1996 1997 1998 1999 2000
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 An interest rate cap

Is like a portfolio of European call options

(caplets) on an interest rate
On each interest payment date over the life of the
cap, one option in the portfolio expires
Is useful to firms with floating rate liabilities
Caps the periodic interest payments at the
caplets exercise price

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 Long interest rate cap (exercise price 7%)

$ Payoff

Option expires worthless Payoff

Floating Rate
7%

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 Short interest rate cap (exercise price 7%)

$ Payoff

Option expires worthless

Floating Rate
7% Payout

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 An interest rate floor
Is related to a cap in the same way that a put is
related to a call
like a portfolio of European put options
(floorlets) on an interest rate
On each interest payment date over the life of the
cap, one option in the portfolio expires
Is useful to firms with floating rate assets
Puts a lower limit on the periodic interest
payments at the floorlets exercise price

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 Long interest rate floor (exercise price 6.5%)

$ Payoff

Payoff Option expires worthless

Floating Rate
6.5%

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 Short interest rate floor (exercise price 6.5%)

$ Payoff

Option expires worthless

Floating Rate
Payout 6.5%

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 There are no universally acceptable terms
to caps and floors

However, frequently the terms provide for

the cash payment on an in-the-money
caplet or floorlet to be based on a 360-day
year

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 Cap payout formula:
days in payment period
cap payout (notional value)
360
(benchmark rate - striking price)

If the benchmark rate is less than the

exercise price, the payout is zero

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 Floor payout formula:
days in payment period
floor payout (notional value)
360
(striking price - benchmark rate)

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 An interest rate collar is simultaneously
long an interest rate cap and short an
interest rate floor

Sacrifices some upside potential in

exchange for a lower position cost
Premium from writing the floorlets reduces
position costs

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 Long cap
$ Payoff

No payout Inflow
Floating Rate
Outflow k1 k2

Short floor

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 A swaption is an option on a swap
Can be either American or European style
A payer swaption (put swaption) gives its
owner the right to pay the fixed interest
rate on a swap
A receiver swaption (call swaption) gives its
owner the right to receive the fixed rate
and pay the floating rate

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