Chapter 9 Swaps and Interest Rate Derivatives Interest

Chapter 9 Swaps and Interest Rate Derivatives

Interest Rate and Currency Swaps v Interest Rate Swaps Ø v an agreement between 2 parties to exchange interest payments for a specific maturity on an agreed notional amount. The purpose of swap usage is to reduce potential risk and costs. How the Classic Swap Works v Ø Ø Notional principal: a reference amount used only to calculate interest expense but never repaid. Maturities: less than 1 to over 15 years v Types Ø Ø Coupon swap: fixed vs. flexible interest rate Basis swap: flexible interest rates based on different reference rates (LIBOR or Treasury Bond)

The Classic Swap v LIBOR (London Interbank Offered Rate): the most important reference rate in a swap Ø Ø Ø The average interest rate at which a selection of banks in London are prepared to lend to one another (ex. USD LIBOR 6 = 6 month interest rate in terms of US dollar) The reference interest rate in London for Eurocurrency such as Eurodollar, Euroyen, and so on. Eurocurrency is a time deposit of money in an international bank located in a country that is different from the country that issued the currency. ü ü Eurodollar is a dollar denominated time deposit of money in a bank out of US. Euroyen is yen denominated time deposit of money in a bank out of Japan.

The Swap Bank v A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. v The swap bank can serve as either a broker or a dealer. Ø As a broker, the swap bank matches counterparties but does not assume any risk of the swap. Ø As a dealer, the swap bank stands ready to accept either side of a swap, and then later lay off their risk, or match it with a counterparty.

An Example of an Interest Rate Swap v Consider this example of a “plain vanilla” interest rate swap. v Bank A is a AAA-rated international bank located in the U. K. and wishes to raise $10, 000 to finance floating-rate Eurodollar loans to its clients. Ø Bank A can issue 5 -year fixed-rate Eurodollar bonds at 10 percent. Ø Alternatively, the bank can issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans. Ø It would make more sense for the bank to issue floatingrate notes at LIBOR to finance floating-rate Eurodollar loans.

An Example of an Interest Rate Swap v Firm B is a BBB-rated U. S. company. It needs $10, 000 to finance an investment with a fiveyear economic life. Ø Firm B is considering issuing 5 -year fixed-rate Eurodollar bonds at 11. 75 percent. Ø Alternatively, firm B can raise the money by issuing 5 year floating-rate notes at LIBOR + ½ percent. Ø Firm B would prefer to borrow at a fixed rate.

An Example of an Interest Rate Swap v The borrowing opportunities of the two firms: Company B Bank A Differential s Fixed Rate 11. 75% 10. 00% 1. 75% Floating Rate LIBOR+. 5% LIBOR . 50% QSD=1. 25 v Company A (B) has comparative advantage for issuing fixed (floating) rated debt. v. However, company A wants to pay floating rate interest rate, while company B does fixed interests.

The QSD v The Quality Spread Differential is the difference between the default-risk premium differential on the fixed-rate debt and the default risk premium differential on the floating-rate debt. v QSD represents the potential gains from the swap that can be shared between the counterparties and the swap bank. v There is no reason to presume that the gains will be shared equally. v In the above example, company B is less credit-worthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.

An Example of an Interest Rate Swap 10 3/8% Bank LIBOR – 1/8% Bank A The swap bank makes this offer to Bank A: Bank A pay LIBOR – 1/8 % per year on $10 million for 5 years and The swap bank will pay you 10 3/8% on $10 million for 5 years.

An Example of an Interest Rate Swap ½% of $10, 000 = $50, 000. That’s quite a cost savings per year 10 3/8% for 5 years. Swap Bank LIBOR – 1/8% Bank 10% A Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net cash outflows of -10 3/8 +10 + (LIBOR – 1/8) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap.

An Example of an Interest Rate Swap The swap bank makes this offer to company B: You pay us 10½% per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years. Swap Bank 10 ½% LIBOR – ¼% Company B

An Example of an Interest Rate Swap Here’s what’s in it for B: They can borrow externally at LIBOR + ½ % and have a net ½ % of $10, 000 = $50, 000 that’s quite a cost savings per year for 5 years. Swap Bank 10 ½% LIBOR – ¼% cash outflow position of 10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11. 25% which is 0. 5% better than they can borrow fixed. Company B LIBOR + ½%

An Example of an Interest Rate Swap The swap bank makes money too. 10 3/8% Swap Bank ¼% of $10 million = $25, 000 per year for 5 years. 10 ½% LIBOR – 1/8% LIBOR – ¼% Bank Company A B Cash Inflow of Swap Bank: LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8 ¼

An Example of an Interest Rate Swap The swap bank makes ¼% Swap 10 3/8% Bank LIBOR – 1/8% 10 ½% LIBOR – ¼% Bank Company A B A saves ½% B saves ½%

Application of Interest Swap on page 332 v IBM issued a two-year, floating-rate bond in the amount of $100 million on which it pays LIBOR 60. 5% semiannually with the first payment due on June 30, 2009. Ø IBM would prefer fixed rate payments. v IBM entered into swap with Citibank under the following contract. Ø IBM agreed to pay Citibank an annual rate of 8% and receive LIBOR 6. v How much net interest payment did IBM make semiannually? Ø Cash inflows of interests = LIBOR 6 Ø Cash outflows of interest = 8% + LIBOR 6 - 0. 5% Ø Net payment (Cash outflows) = 8% + LIBOR 6 - 0. 5% LIBOR 6 = 7. 5%

The Currency Swap v Currency Swaps Ø Two parties exchange one currency- denominated debt for the other currency denominated debt at periodic intervals. Ø Swap one currency denominated interest payment with other currency denominated interest payments v Purpose Ø Avoid exchange rate risk. Ø Reduce costs of borrowing. v Two parties may exchange principal amounts at maturity at a predetermined exchange rate. v However, the right of offset is possible. Ø Each party can offset any non-payment of principal or interest with a comparable nonpayment. v In case of default by one party, the counter party does not make its contractually obligated

An Example of a Currency Swap v Suppose a US MNC wants to finance a £ 10, 000 expansion of a British plant. v They could borrow dollars at a cheaper interest rate in the US since they are well known. v The US MNC could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad. Ø Home bias effect v The US MNC has an incentive to borrow dollars and exchange dollars for pounds. Ø This will give them the exchange rate risk: financing a sterling project with dollars. Ø A sterling project generates the pound cash flows but US MNC has to pay dollar interests.

An Example of a Currency Swap v If they can find a British MNC with a mirror-image financing need, they may both benefit from a swap. v If the spot exchange rate is S 0($/£) = $1. 60/£, the U. S. firm needs to find a British firm which wants to finance dollar borrowing in the amount of $16, 000.

An Example of a Currency Swap v Firm A is a U. S. –based multinational and firm B is a U. K. –based multinational. v Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below. $ ₤ Differentials Company A 8. 0% 11. 6% 3. 6% Company B 10. 0% 12. 0% 2% QSD=1. 6%

Comparative Advantage as the Basis for Swaps v A is the more credit-worthy of the two firms. Ø A pays 2% less to borrow in dollars than B. Ø A pays. 4% less to borrow in pounds than B: Ø Ø A has a comparative advantage in borrowing dollars. B has a comparative advantage in borrowing pounds.

An Example of a Currency Swap Bank $8% £ 11% $8% $9. 4% £ 12% Firm A B £ 12%

An Example of a Currency Swap A’s net position is to borrow at £ 11% Bank $8% £ 11% $8% $9. 4% £ 12% Firm A B A saves £. 6% £ 12%

An Example of a Currency Swap B’s net position is to borrow at $9. 4% Swap Bank $8% £ 11% $8% $9. 4% £ 12% Firm A B £ 12% B saves $. 6%

An Example of a Currency Swap The swap bank makes money too: Swap Bank $8% £ 11% $8% Firm A 1. 4% of $16 million financed with 1% of £ 10 million per year for 5 years. $9. 4% £ 12% Firm £ 12% At S 0($/£) = $1. 60/£, that is a gain of $64, 000 per year for B 5 years. The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap).

Comparative Advantage for Swap v A has a comparative advantage in borrowing dollars. v B has a comparative advantage in borrowing pounds. v If they borrow according to their comparative advantage and then swap, there will be gains for both parties. v Total benefits for two parties and swap bank will be QSD.

Swap Market Quotations v Swap banks will tailor the terms of interest rate and currency swaps to customers’ needs. v They also make a market in standardized swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread. v For example, “ 6. 60 — 6. 85 for SF against LIBOR 6”, quoted by US swap bank, means the swap bank will pay fixed-rate SF denominated payments at 6. 60% against receiving dollar LIBOR or it will receive fixed -rate SF denominated payments at 6. 85% against paying dollar LIBOR. Ø As a dealer, the swap bank pay less interest at the bid price and receive higher interest rate.

Variations of Basic Currency and Interest Rate Swaps v Currency Swaps Ø fixed for fixed, fixed for floating , floating for floating v Interest Rate Swaps Ø fixed for floating, zero-for floating, floating for floating (basis swap) v For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit. v A credit default swap (CDS): is a swap contract in which a buyer makes a series of payments to a seller and, in exchange, receives the right to a payoff if a buyer’s credit instrument goes into default or on the occurrence of a specified credit event, for example bankruptcy or restructuring: Insurance

Risks of Swap Bank v Interest Rate Risk Ø Interest rates might move against the swap bank before it finds the counter party. v Basis Risk Ø If the floating rates of the two counterparties are not pegged to the same index. v Exchange rate Risk Ø In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

Risks of Interest Rate and Currency Swaps (continued) v Credit Risk Ø This is the major risk faced by a swap dealer—the risk that a counter party will default. v Mismatch Risk (As a broker) Ø It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time. v Sovereign (country) Risk Ø The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.

Roles of Swap Market v Existence of QSD indicates market imperfection. v Swaps offer market completeness that has accounted for their existence and growth. v Swaps provide more customized financing types desired by particular borrowers. Ø Both counterparties can benefit (as well as the swap dealer) through financing in terms of cost savings, risk management and tailored financing.

Swap Market v The growth of the swap market has been astounding. v Swaps have become an important source of revenue and risk for banks v Swaps are off-the-books transactions. Ø Swap transaction does not appear as assets or liabilities on the balance sheet.

Interest Rate Forwards and Futures v Swaps provide a tool of reducing interest rate risk as well as interest costs. Companies can use forward and futures contracts to manage their interest rate expenses and risk. Forward and futures contracts: v v Ø Ø Ø Forward forwards Forward rate agreements Eurodollar futures t 0 variable interest rate between t 1 and t 2 t 1 t 2 v Variable interest rate between t 1 and t 2 is only determined when time reaches t 1. Ø However, a company can fix the interest rate between t 1 and t 2 at t 0 through three ways.

Interest Rate and Forwards and Futures v Forward forwards Ø a contract that fixes an interest rate today on a future loan (debt) or deposit. Contract conditions: Ø ü ü ü specific interest rate principal amount of future loan starting and ending dates of future interest rate period

Example of Forwards v Telecom Argentina needs to borrow $10 million in six months for a three month period. Ø It could wait six months and borrow the money at then-current interest rate, being exposed to interest rate risk. Ø Instead, it can make contract a forwards that fixes interest rate at 8. 4% per annum. Ø This contract guarantees six months from today.

Interest Rate, Forwards, and Futures v Forward rate agreements (FRAs) are more popular than forwards. Ø Two parties agree an fixed interest rate applied to a specified future interest period on a notional amount. v If the flexible interest rate moves against the position of one party (A), the other party (B) agrees to compensate the former. v FRA contract that involves two parties, a buyer and a seller. Ø The buyer agrees to pay the seller the increased interest cost on a notational amount if interest rates fall below an agreed rate. Ø The seller agrees to pay the buyer the increased interest cost if interest rates increase above the agreed rate. ü The buyer will receive compensation from increases in interest rate.

Forward Rate Agreements v Who is buyer? Ø Has an obligation of flexible interest payments for a specific future period. Ø If interest rate increases, he may have to pay more interest payments. Ø Fix an interest rate applied to a specified future interest period on a notional amount. v Income of buyer with RA (“ 6 x 3”FRA at 6. 5%) = a contract starting in 6 months for a 3 -month period. notional principle x (LIBOR 6 - forward rate) (days/360) 1 + LIBOR 6 x (days/360) = Present value of increase interest payments v Suppose that the notional amount is $ 1 million and LIBOR 6 is 7. 5% six-month later. Ø Buyer’s income = 1, 000 (0. 075 -0. 065) (90/360) / [1+0. 075 x 90/360]

Eurodollar Futures v v Eurodollar Futures are more popular than FRA because Eurodollar futures market provides high liquidity. Eurodollar: Time deposit of dollar in an international bank in a non-US. country. Ø Ø Ø v Suppose that LIBOR 3 is 3. 5% (per annum) today. Actual 3 -month interest rate = 0. 035 (1/4) = 0. 00875 for 3 months $ 100, 000 of Eurodollar with 3 month maturity is valued at $99, 125 (=100, 000*(1 -0. 00875)) or $99, 125 will grow to $100, 000 for 3 months. Eurodollar futures is a cash-settled futures contract on a three-month $ 1 million Eurodollar Ø Contracts traded on: ü ü ü Ø Chicago Mercantile Exchange London International Financial Futures Exchange Singapore International Monetary Exchange Notional principal of one contract is $ 1 million.

Eurodollar Futures (1) v Like other futures, traders can lock in the amount of interest payments or the amount of interest revenues by Eurodollar Futures. Ø A US company who has obligation to pay 62, 500 pounds in 6 months will have a long position on pound futures at the specific exchange rate. Ø Through this pound futures contract, it can fix $ denominated payment. v When you want to fix future interest payment, you may have a short position on Eurodollar futures. Ø When you want to lock in future interest revenues, you may have a long position on Eurodollar futures. Ø On the settlement date, LIBOR 3 determines the price of Eurodollar futures. Ø Notional principal is not delivered.

Eurodollar Futures (2) v Eurodollar futures are quoted as 100 (1 -r) where r is a forward rate of Eurodollar futures per annum v Suppose that Eurodollar futures between t+6 and t+9 are traded at 94. 65 at t Ø This means forward interest rate is 5. 35% per annum. v If you sell Eurodollar futures at the forward rate of 5. 35% at t, you fix the interest rate payment between t+6 and t+9 as 5. 35% (per annum). Ø Annualized interest rate is 5. 35%.

Eurodollar Futures (3) v 3 -month forward rate for Eurodollar futures = 5. 35 (1/4) = 1. 3375% Ø The actual price of $1 million Eurodollar futures is $ 986, 625 at time t. ü ü 1, 000 (1 -0. 013375) = 986, 625 at t. Let’s assume that LIBOR 3 becomes 6% at t+6 which is the settlement month. v The settlement price of Eurodollar futures at t+6 = 1, 000 (1 -0. 06 (1/4)) =985, 000 at t+6. Ø If you sell 1 contract of Eurodollar futures at t, your net income = 986, 625 – 985, 000 =$ 1, 625 at t+6. Ø So, your net income from short position on Eurodollar futures will reduce your interest payments when LIBOR 3

Ex 1: Eurodollar Futures v v Current date is June 30. Suppose that company A requires a $10 million bank loan on Sept 16 for 3 months. Ø Ø Ø v The contractual loan rate is LIBOR 3+1%. LIBOR 3 is currently at 5. 63%. But LIBOR 3 on Sept 16 is not certain today. Company A is exposed to future interest rate risk because LIBOR 3 for $10 million loan will be determined on Sept 16. If LIBOR 3 increases between today and Sept 16, company A has to pay higher interests. Company A can fix its future interest payment with a short position of Eurodollar Futures. Ø Ø Profits from Eurodollar futures can offset losses from high interest payments caused by increase in LIBOR 3. On the other hand, lower LIBOR 3 on Sep 16 will result in losses from short position on Eurodollar futures which will be offset by less interest payment for $10 bank loans.

Ex 1: Eurodollar Futures v September Eurodollar futures are currently trading at 94. 18. Ø v If company A sells 10 Eurodollar futures contracts, it lock in annualized interest rate of 6. 82% for $10 million bank loan. Ø Ø v 100 -94. 18 = a forward Eurodollar rate of 5. 82% per annum Forward rate of 5. 82%+1% =6. 82% Income from selling 10 contracts = 10, 000 (1 -0. 582 (90/360)) = 9, 854, 500. Suppose that LIBOR 3 rate is 6% in Sep. Ø Ø The settlement value of 10 futures contracts = 10, 000 (1 - 0. 06 (90/360)) = 9, 850, 000. The Company A’s gain = 4, 500= (9, 854, 500 -9, 850, 000) v In Sep. Company A will borrow $10 million for 3 month at v LIBOR 3+1% (=7%). Actual interest costs = 10, 000 (0. 07(90/360)) – 4, 500 = 170, 500.

Eurodollar Futures for hedge of interest rate risk v When the company expect to borrow money at the floating rate such as LIBOR in the future, it will sell Eurodollar futures contracts. Ø When it sells Eurodollar futures, it can make profits from an increase in interest rate which will compensate the company from losses of borrowing money at higher interest rate. Ø Eurodollar futures actually lock in interest payments with the forward rate of Eurodollar futures. v When the company expects to lend money at floating rate such as LIBOR in the future, it will buy Eurodollar futures contracts with the same notional principal. Ø Long position on Eurodollar contract will make the company lock in the interest revenues with the forward rate of Eurodollar futures.