Documente Academic
Documente Profesional
Documente Cultură
exchange of cash flows based upon a fixed and floating rate. y Often referred to a plain vanilla swap, the agreement consists of one party paying a fixed interest rate on a notional principal amount in exchange for the other party paying a floating rate on the same notional principal amount for a set period of time. y In this case the currency of the agreement is the same for both parties.
Notional Principal
y The term notional principal implies that the principal
itself is not exchanged. If it was exchanged at the end of the swap, the exact same cash flows would result.
An Example
y Company B agrees to pay A 5% per annum on a
notional principal of $100 million y Company A Agrees to pay B the 6 month LIBOR rate prevailing 6 months prior to each payment date, on $100 million. (generally the floating rate is set at the beginning of the period for which it is to be paid)
occur each six months (using a fixed rate of 5% compounded semi annually). y Company B will pay: ($100M)(.025) = $2.5 Million to Firm A each 6 months.
Swap Diagram
LIBOR Company A 5% Company B
Swap Diagram
5.2% LIBOR
Company A
LIBOR +.2% 5%
Company B
5.8%
LIBOR+.8%
The swap in effect transforms a fixed rate liability or asset to a floating rate liability or asset (and vice versa) for the firms respectively.
Role of Intermediary
y Usually a financial intermediary works to establish the
swap by bring the two parties together. y The intermediary then earns .03 to .04% per annum in exchange for arranging the swap. y The financial institution is actually entering into two offsetting swap transactions, one with each company.
Swap Diagram
LIBOR 5.2% Co A 4.985% LIBOR
FI
5.015%
Co B LIBOR+.8%
on the short term rates. y For example the first floating payment was listed as 2.10. However since it is a money market rate the six month LIBOR should be quoted on an actual /360 basis. y Assuming 184 days between payments the actual payment should be 100(0.042)(184/360) = 2.1467
payment may not actually be equal on each payment date. y The fixed rate is often based off of a longer maturity instrument and may therefore uses a different day count convention than the LIBOR. If the fixed rate is based off of a treasury note for example, the note is based on a different day convention.
contacted by parties on both side of a swap at the same time. y The intermediary must enter into the swap without the counter party. The intermediary then hedges the interest rate risk using interest rate instruments while waiting for a counter party to emerge. y This practice is referred to as warehousing swaps.
A B
Difference between fixed rates = 1.2% Difference between floating rates = 0.7% B Has an advantage in the floating rate.
Swap Diagram
LIBOR 10% Co A 9.935% LIBOR
FI
9.965%
Co B LIBOR+1%
A pays LIBOR+.065% instead of LIBOR+.3% B pays 10.965% instead of 11.2% The FI makes .03%
Spread Differentials
y Why do spread differentials exist? y Differences in business lines, credit history, asset and
liabilities, etc
either:
y A long position in one bond combined with a short
Swap Rate
y This works after you know the fixed rate. y When entering into the swap the value of the swap
should be 0. y This implies that the PV of each of the two series of cash flows is equal. Each party is then willing to exchange the cash flows since they have the same value. y The rate that makes the PV equal when used for the fixed payments is the swap rate.
Example
y Assume that you are considering a swap where the
party with the floating rate will pay the three month LIBOR on the $50 Million in principal. y The parties will swap quarterly payments each quarter for the next year. y Both the fixed and floating rates are to be paid on an actual/360 day basis.
and that there are 93 days in the first period. y The first floating payment would then be
Eurodollar futures is 96.05 implying a forward rate of 100-96.05 = 3.95 y Given that there are 91 days in the period. y The second floating payment would then be
using the same forward rates. y The first cash flow will have a PV of:
using the same forward rates. y The second cash flow will have a PV of:
499 ,236 .1111 ! 489 ,495 .4412 93 91 1 .038 1 .0395 360 360
PV of floating
y The total PV of the floating cash flows is then the sum
Swap rate
y The fixed rate is then the rate that using the same
procedure will cause the PV of the fixed cash flows to have a PV equal to the same amount. y The fixed cash flows are discounted by the same rates as the floating rates. y Note: the fixed cash flows are not the same each time due to the changes in the number of days in each period. y The resulting rate is 4.1294686
Swap Spread
y The swap spread would then be the difference between
the swap rate and the on the run treasury of the same maturity.
and corresponding interest rates have likely changed. y The actual second payment will be based upon the 3 month LIBOR at the end of the first period. y Therefore the value of the swap is recalculated.
Currency Swaps
y The primary purpose of a currency swap is to
transform a loan denominated in one currency into a loan denominated in another currency. y In a currency swap, a principal must be specified in each currency and the principal amounts are exchanged at the beginning and end of the life of the swap. y The principal amounts are approximately equal given the exchange rate at the beginning of the swap.
A simple example
Assume that company A pays a fixed rate of 11% in sterling and receives a fixed interest rate of 8% in dollars. Let interest payments be made once a year and the principal amounts be $15 million and L10 Million Company A Dollar Cash Sterling Cash Flow (millions) Flow (millions) 2/1/1999-15.00 +10.00 2/1/2000 +1.20 -1.10 2/1/2001 +1.20 -1.10 2/1/2002 +1.20 -1.10 2/1/2003 +1.20 -1.10 2/1/2004 +16.20 -11.10
Intuition
y Suppose A could issue bonds in the US for 8% interest,
the swap allows it to use the 15 million to actually borrow 10million sterling at 11% (A can invest L 10M @ 11% but is afraid that $ will strength it wants US denominated investment)
comparative advantage argument presented earlier for interest rate swaps. y It is likely that the domestic firm has an advantage in borrowing in its home country.
The strategy
y Company A borrows dollars at 5% per annum y Company B borrows AUD at 13% per annum
They enter into a swap Result Since the spread between the two companies is different for each firm there is the ability of each firm to benefit from the swap. We would expect the gain to both parties to be 2 - 0.4 = 1.6% (the differences in the spreads).
Swap Diagram
AUD 11.9% 5% AUD 13%
Co A
5%
FI
6.3%
Co B AUD 13%
A pays 11.9% AUD instead of 12.6% AUD B pays 6.3% $US instead of 7% $US The FI makes .2%
can be decomposed into a position in two bonds, just like an interest rate swap. y In the example above the company is long a sterling bond and short a dollar bond. The value of the swap would then be the value of the two bonds adjusted for the spot exchange rate.
Swap valuation
y Let S = the spot exchange rate at the beginning of the
swap, BF is the present value of the foreign denominated bond and BD is the present value of the domestic bond. Then the value is given as Vswap = SBF BD
The correct discount rate would then depend upon the term structure of interest rates in each country
Other swaps
y Swaps can be constructed from a large number of underlying assets. y Instead of the above examples swaps for floating rates on both sides of the transaction. y The principal can vary through out the life of the swap. y They can also include options such as the ability to extend the swap or put (cancel the swap). y The cash flows could even extend from another asset such as exchanging the dividends and capital gains realized on an equity index for a fixed or floating rate.
over time. This decreases the fixed payment. Useful for managing mortgage portfolios and mortgage backed securities. y Accreting Swap The notional principal increases over the life of the swap. Useful in construction finances. For example is the builder draws down an amount of financing each period for a number of periods.
curve implies it should pay 8%. y The PV of the extra payments is transferred as a one time fee at the beginning of the swap (thus keeping the initial value equal to zero)
some point in time in the future y If the rates are based on the current forward rate there should not be any exchange of principal when the payments begin. Other wise it is an off market swap and some form of compensation is needed y Extension Swap an agreement to extend the current swap (a form of forward swap)
Basis Swaps
y Both parties pay floating rates based upon different
indexes. y For example one party may pay the three month LIBOR while the other pays the three month T- Bill. y The impact is that while the rates generally move together the spread actually widens and narrows, Therefore the return on the swap is based upon the spread.
many of the modifications just discussed. y Swaps may also be combined to produce desired outcomes. y CIRCUS Swap (Combined interest rate and currency swap). Combines two basic swaps
Swapation
y An option on a swap that specifies the tenor, notional
principal fixed rate and floating rate y Price is usually set a a % of notional principal y Receiver Swapation
y The holder has the right to enter into a swap as the fixed
rate receiver
y Payer Swapation y The holder has the right to enter into a particular swap as the fixed rate payer.
The owner receives a fixed payment (like a coupon payment) and pays a floating rate (the exercise price) y Payer swapation if exercised the owner is paying a stream similar to the issue of a bond.
In-the-Money Swapations
y A receiver swapation is in the money if interest rates
fall. The owner is paying a lower fixed rate in exchange for the fixed rate specified in the contract. y Similarly a payer swapation is generally in the money if interest rates increase since the owner will receive a higher floating rate.
When to Exercise
y The owner of the receiver swapation should exercise if
the fixed rate on the swap underlying the swapation is greater than the market fixed rate on a similar swap. In this case the swap is paying a higher rate than that which is available in the market.
a call option at a given date in the future. y The firm has paid for the call option by being forced to pay a higher coupon on the bond than on a similar noncallable bond. y Assume that the firm has determined that it does not want to call the bond at its first call date at some point in the future. y The call option is worthless to the firm, but it should theoretically have value.
match the call feature of the bond. y The firm would receive for this a premium that is equal to the value of the call option.
Example
y Assume the firm has previously issued a 9% coupon
bond that makes semiannual payments and matures in 7 years with a face value of $150 Million. y The bond has a call option for one year from today.
Example continued
y The firm can sell a European Receiver Swapation with an expiration in one year. The Swapation terms are for semiannual payments at a fixed rate of 9% in exchange for floating payments at LIBOR. y The firm receives a premium for the swapation equal to a fixed percentage of the $150 Million notional value (equal to the value of the call option). y The firm can keep the premium but has a potential obligation in one year if the counter party exercises the swap.
Example Continued
y In one year the fixed rate for this swap is 11% y The option will expire worthless since the owner can
earn a fixed 11% on a similar swap. y The firm gets to keep the premium.
Example Continued
y If in one year the fixed rate of interest on a similar swap
is 7% the owner will exercise the swap since it calls for a 9% fixed rate. y The firm can call the bond since rates have decreased. It can finance the call by issuing a floating rate note at LIBOR for the term of the swap. y The floating rate side of the swap pays for the note and the firm is still paying the original 9% fixed, but it has also received the premium on the swapation
represent a firm commitment to extend the swap. An extendible swap has the option to extend the agreement. y Arranged via a plain vanilla swap an a swapation.
market. y Previously there had been restrictions on the flow of currency. y A parallel loan market developed to get around restrictions on the flow of currency from one country to another, Especially restrictions imposed by the Bank of England.
each with subsidiaries in both countries. y Assume that the free-market value of the pound is L1=$1.60 and the officially required exchange rate is L1=$1.44. y Assume the British Firm wants to undertake a project in the US requiring an outlay of $100,000,000.
100,000,0000/1.44 = L69,444,000 y The cost of the project at the free market exchange rate is 100,000,0000/1.60 = L62,500,000 y The firm is paying an extra L7,000,000
subsidiary operating in England at a floating rate based on LIBOR and The US firm lends $100,000,000 to the British firm at a fixed rate of 7% in the US the official exchange rate is avoided. y The result is a basic fixed for floating currency swap. (In this case each loan is separate default on one loan does not constitute default on the other).
transform it into a fixed rate debt via an interest rate swap. y By receiving floating and paying fixed, the firm nets just a spread on the floating transaction creating a fixed rate debt (the rate paid on the swap plus the spread)
receive fixed rate swap easily transforms the fixed rate. Again the fixed rates cancel out (or result in a spread) leaving just a floating rate.
without any call option. y It can create a call option. If it had a call option in place it would retire the debt if called. Look at this as creating a new financing need (you need to finance the retirement of the debt.) y You want the ability to call the bond but not the obligation to do so.
fixed rate, canceling out its current fixed rate obligation. y It will pay a new floating rate as part of the swap (similar to financing the call with new floating rate debt).
principal payments are denominated in one currency and coupon payments denominated in another currency. y Assume you own a bond that makes its payments in US dollars, but you would prefer the coupon payments to be in another currency with the principal repayment in dollars. y A fixed for fixed currency swap would allow this to happen
dollars swap with the bond. y The dollars received from the bond are used to pay the dollar commitment on the swap. You then just receive the German Marks.
All in Cost
y The IRR for a given financing alternative, it includes all
costs including administration, flotation , and actual cash flows. y The cost is simply the rate that makes the PV of the cash flows equal to the current value of the borrowing.
of $40 million priced at par y A loan of $40 million for 10 years at a floating rate of LIBOR + 30 Bps reset every six months with the current LIBOR rate of 6.5%. Plus a swap transforming the loan to a fixed rate commitment. The swap will require the firm to pay 6.5% fixed and receive floating.
All in cost
y The bond has a all in cost equal to its yield to maturity,
7% y Assuming the firm must pay $400,000 to enter into the swap so it only nest $39,600,000. Today. The net interest rate it pays is 6.8% implying semiannual payments of (.068/2)(40,000,000) = $1,360,000 plus a final payment of 40,000,000. This implies a rate of .034703 every six months or .069406 every year.
funds, but its credit rating had been downgraded to BBB-. The firm needed $50,000,000 to fund continuing operations. y They wanted long term debt in the range of 8 to 10 years and a fixed rate. Treasury rates were at 10.1 % and BF Goodrich anticipated paying approximately 12 to 12.5%
* taken from Kolb - Futures Options and Swaps
Rabobank
y Rabobank was a large Dutch banking organization
consisting of more than 1,000 small agricultural banks. The bank was interested in securing floating rate financing on approximately $50,000,000 in the Eurobond market. y With a AAA rating Rabobank could issue fixed rate in the Eurobond market for approximately 11% and for a floating rate of LIBOR plus .25%
The Intermediary
y Salomon Brothers suggested a swap agreement to each
party. y This would require BF Goodrich to issue the first public debt tied to LIBOR in the United States. Salomon Brothers felt that there would be a market for the debt because of the increase in deposits paying a floating rate due to deregulation.
Problems
y Rabobank was interested in the deal,but fearful of
credit risk. A direct swap would expose it to credit risk. Without an active swap market it was common for swaps to be arranged between the two counter parties. y The two finally reached an agreement to use Morgan Guaranty as an intermediary.
The agreement
y BF Goodrich issued a noncallable 8 year floating rate
note with a principal value of $50,000,000 paying the 3 month LIBOR rate plus .5% semiannually. The bond was underwritten by Salomon. y Rabobank issued a $50,000,000 non callable 8 year Eurobond with annual payments of 11% y Both entered into a swap with Morgan Guaranty
The swaps
y BF Goodrich promised to pay Morgan Guaranty
5,500,000 each year for eight years (matching the coupon on the Rabobanks debt). Morgan agreed to pay BF Goodrich a semi annual rate tied to the 3 month LIBOR equal to: .5(50,000,000)(3 mo LIBORx) x represents an undisclosed discount y Rabobank received $5,500,000 each year for 8 years and paid semi annul payments of LIBOR-x
other eliminating the credit risk concerns of Rabobank. y Morgan received a one time fee of $125,000 paid by BF Goodrich plus an annual fee of 8 to 37 Bp ($40,000 to $185,000) also paid by BF Goodrich.
BF Goodrich
y Assuming that the discount from LIBOR was 50 Bp
and that the service fee was 22.5 BP (the midpoint of the range). BF Goodrich paid an all in cost of 11.9488 % annually compared to 12 to 12.5% if they had issued the debt on their own.
Rabobank s Position
y At the time of financing it would have paid LIBOR plus
25 to 50 Bp. Given that it paid no fees and the fixed rate canceled out it ended up paying LIBOR - x.
Securing financing
y BF Goodrich was able to secure financing via its use of
the swaps market, this is a common use of the market. y The example provides a good illustration of the idea of the comparative advantage arguments we discussed earlier.
the debt market y Mexcobre (Mexicana de Corbre) is the copper exporting subsidiary of Grupo Mexico. In the late 1980 s it would have had a difficult time borrowing in international credit markets due to concerns or default risk y However it was able to borrow $210 million for 38 months from a group of banks led by Paribas
* from Managing Financial Risk by Smithson, Smith and Wilford
11.48%. The debt replaced borrowing from the Mexican government which had cost the firm 23%. y A Belgian company Sogem agreed to buy 4,000 tons of copper per month at the prevailing spot rate from Mexcobre making payments into an escrow account in New York that was used to service the debt with any extra funds returned to Mexcobre.
Quarterly payments of 11.48% interest plus principal Banks Escrow $210 million loan Excess cash if it builds up 4,000 tons of copper per month
Mexcobre
SOGEM
Swaps
y Swaps were added between Paribas and the escrow
account to hedge the price risk of copper and between Paribas and the banks to change the banks position to a floating rate
Paribas
Fixed Floating $2,000 per ton Spot Price per ton
Quarterly payments of 11.48% interest plus principal Banks Escrow $210 million loan Excess cash if it builds up 4,000 tons of copper per month
Mexcobre
SOGEM
bonds, therefore the duration of the swap should equal the duration of the bond portfolio. y The duration can be either positive or negative depending on the side of the swap
Duration of Swaps
y Duration of Receive Fixed Swap = y Duration of Underlying coupon bond - Duration of underlying floating Rate Bond >0 y Duration of Pay Fixed Swap = y Duration of underlying floating Rate Bond - Duration of Underlying coupon bond <0
Example
y Consider a swap with a semiannual fixed rate of 7%
and a floating rate that resets each six months. y The duration of the fixed rate side (assuming a 100 notional principal) is 5.65139 years Duration of Receive Fixed Swap =5.65139-0.5=5.15369 Duration of Pay Fixed Swap =0.5-5.65139=-5.15369
Calculating Duration
y Duration of floating rate security is equal to the time
between resetting of the rate. y Therefore the duration of the swap actually depends upon the duration of the fixed rate side. y Receive Fixed rate swaps will then usually lengthen the duration of an existing position while pay fixed swaps will shorten the duration of an existing position.
impacting the duration of the assets and liabilities on the balance sheet. y Going to look at a fictional financial services firm FSF
Liabilities
$75,000,000
Floating Rate Notes $40,000,000 (5 yr mat7.3% yld semi) Coupon Bond $24,111,725 (10 yr semi 6.5% coup $25,000,000 par, 7% YTM
Total Assets
$1555,467,133
$16,355,408 $155,467,133
Basic Duration
N $ Weighted Duration ! DA ! w i Da i of Asset Portfolio i !1
where w j !
Asset j
Duration
Assets
Cash Marketable Sec Amortizing loans Duration 0.00 0.500 4.604562
Liabilities
6mo money mkt Floating Rate Notes Coupon Bond Duration 0.5000 0.5000 7.453369
of the portfolio. y The idea is to construct a portfolio with a duration of zero. y Let MVi be the market value and Di be the Duration of the assets (A), liabilities (L) or hedge vehicle (H) then MVA(DA)+MVH(DH) = 0 and MVL(DL)+MVH(DH) = 0
possible to solve for a notional value (or market value) of the swap that would make the portfolio duration zero. y Previously we found the duration of a swap: Duration of Receive Fixed Swap =5.65139-0.5=5.15369 Duration of Pay Fixed Swap =0.5-5.65139=-5.15369
Asset Hedge
y The asset can then be hedged by solving for the
notional value (MVH) of the pay fixed swap MVA(DA)+MVH(DH) = 0 155,467,133(3.922)+(-5.15369)(MVH) =0 MVH=$118,365,451
Liability Hedge
y The liabilities can then be hedged by solving for the
notional value (MVH) of the receive fixed swap MVL(DL)+MVH(DH) = 0 (-139,111,725)(1.705202)+(5.15369)(MVH) =0 MVH=$46,048,651
GAP Analysis
y Static GAP-- Goal is to manage interest rate income in
calculating GAP over a broad range of time intervals provides a better measure of long term interest rate risk.
Example
Over next 6 Months: Rate Sensitive Liabilities = $120 million Rate Sensitive Assets = $100 Million GAP = 100M 120M = - 20 Million If rate are expected to decline by 1% Change in net interest income = (-20M)(-.01)= $200,000
GAP Analysis
y Asset sensitive GAP (Positive GAP) y RSA RSL > 0 y If interest rates K NII will K y If interest rates L NII will L y Liability sensitive GAP (Negative GAP) y RSA RSL < 0 y If interest rates K NII will L y If interest rates L NII will K y Would you expect a commercial bank to be asset or
only the income statement is impacted, the book value on the balance sheet remains the same.
calculated.
y It assumes that all rates move together.
Select time Interval Develop Interest Rate Forecast Group Assets and Liabilities by the time interval (according to first repricing) Forecast the change in net interest income.
Rate Sensitive Assets Rate Sensitive Liabilitie s 1 Liability Sensitive " 1 Asset Sensitive
frame y Any principal payment on a loan is rate sensitive if it is to be recorded during the time period y Assets or liabilities linked to an index y Interest rates applied to outstanding principal changes during the interval
interest rates will be the same for both assets and liabilities. y If it isn t you need to calculate GAP using the respective change. y Spread effect The spread between assets and liabilities may change as rates rise or decrease
Strengths of GAP
y Easy to understand and calculate y Allows you to identify specific balance sheet items that
Weaknesses of GAP
y Off Balance Sheet Activities y Basic GAP ignores changes in off balance sheet activities that may also be sensitive to changes in the level of interest rates. y Ignores changes in the level of demand deposits
Basic DGAP !
$ Weighted Duration
$ Weighted Duration
of Libaility Portfolio
Basic DGAP
y If the Basic DGAP is + y If Rates K L in the value of assets > L in value of liab Owners equity will decrease y If Rate L K in the value of assets > K in value of liab Owners equity will increase
Basic DGAP
y If the Basic DGAP is (-) y If Rates K L in the value of assets < L in value of liab Owners equity will increase y If Rate L K in the value of assets < K in value of liab Owners equity will decrease
Basic DGAP
y Does that imply that if DA = DL the financial
DGAP
y Let MVL = market value of liabilities and MVA =
market value of assets y Then to immunize the balance sheet we can use the following identity:
DGAP calculation
MVL DGAP ! DA DL MVA 139,111,725 DGAP ! 3.922013 1.705202 155,467,133 ! 2.396201
have the same properties as a long position in a bond with a duration of 2.396201. y We can hedge using our equation from before and the duration of the interest rate swap.
the duration of the hedge to be negative. This requires the pay fixed swap from before with a notional value equal to MVH below. MVi(Di)+MVH(DH) = 0 $155,467,725(2.396201)+(-5.151369)MVH=0 MVH=$72,316,800
DGAP Analysis
y If DGAP is (+) y An K in rates will cause MVE to L y An L in rates will cause MVE to K y If DGAP is (-) y An K in rates will cause MVE to K y An L in rates will cause MVE to L y The closer DGAP is to zero the smaller the potential
Weaknesses of DGAP
y It is difficult to calculate duration accurately
(especially accounting for options) y Each CF needs to be discounted at a distinct rate can use the forward rates from treasury spot curve y Must continually monitor and adjust duration y It is difficult to measure duration for non interest earning assets.
yield
y Offer a range of products, customers may not prefer the
ones that help GAP or DGAP Need to offer more attractive yields to entice this decreases profitability.
Changing Duration
y You can also manipulate the duration of your cash
flows. This allows you to lower your interest rate sensitivity instead of eliminating it. y Let DG* be the desired duration gap, DG be the current duration gap, DS be the duration of the Swap, and MVH* be the notional value of required for the swap.
MV D ! D G DS Total Assets
* G * H
The negative sign just indicate that we need a pay fixed swap (the duration would then be negative making the MV positive)