INTEREST RATE SWAPS Berk Ahishalioglu 06 04 2013

INTEREST RATE SWAPS Berk Ahishalioglu 06. 04. 2013

Presentation Overview • Required Terminology • Interest Swap Market • Mechanics of Interest Rate Swaps • Risks in Interest Rate Swaps • Q&A Session

Interest Rate Swap • Swap: A derivative instrument in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. NOT DEBT INSTRUMENT! ü Interest Rate Swaps ü Currency Swaps ü Credit Swaps ü Commodity Swaps ü Equity Swaps • Interest Rate Swap: A transaction between two so-called counterparties in which fixed and floating interest-rate payments on a notional amount of principal are exchanged over a specified term. THE NOTIONAL AMOUNT ITSELF IS NEVER EXCHANGED!

Facts about Swap Market • The majority of the swaps are traded over-the-counter (OTC). • 70% of the global OTC derivatives markets is swaps. • The outstanding amount of the interest rate swap is above 77% of all the international OTC derivative market • Interest rate swap market is one of the largest and most liquid global financial markets.

Bank for International Settlements

Financial Intermediary • In practice, the swap counterparties do not interact directly. A financial institution intervenes. • Financial intermediary holds two separate swap contracts with each counterparty. • It has two basic functions. üIt maintains the swap stock. üFinancial intermediary undertakes the interest rate risk for both counterparties.

Mechanics of Interest Rate Swaps Fixed-Rate Floating-Rate Company A 12% LIBOR+0. 1% Company B 13. 4% LIBOR+0. 6% Company A and Company B have been offered the following rates per annum on a $20 M 5 -year loan. 1) Calculate the relative gains (quality spread) between fixed and floating markets for A and B. Δfix= 13. 4%-12%=1. 4% (140 b. p. ) Δfloating=(LIBOR+0. 6%)-(LIBOR+0. 1%)=0. 5 (50 b. p. )

Mechanics of Interest Rate Swaps Comparative Advantage Theory • One entity may have an advantage in fixed-rate markets. • One entity may have an advantage in floating-rate markets. • Comparative Advantage Theory is one of the main reasons for the rapid growth of the interest rate swaps. Which company has a comparative advantage in fixed-rate markets ? A or B ? 2) Calculate the comparative advantage gain. Comparative advantage gain= Δfix-Δfloating Comparative advantage gain=1. 4%-0. 5%=0. 9% (90 b. p. )

Mechanics of Interest Rate Swaps Before Swap Agreement Company A borrowed $20 M at 12% fixed rate. Company B borrowed $20 M at LIBOR+0. 6% floating rate. After Swap Agreement The terms offered to Company A by financial intermediary are as follows: 1)Every six months, Company A will pay LIBOR to the intermediary. 2)Every six months, the intermediary will pay 12% (annual rate) to Company A. The terms offered to Company B by financial intermediary are as follows: 1)Every six months, Company B will pay 12. 1% (annual rate) to the intermediary. 2)Every six months, the intermediary will pay LIBOR to the Company B.

Mechanics of Interest Rate Swaps From Company A’s Perspective Annual Interest Rate Paid: 12%+LIBOR Annual Interest Rate Received: 12% Net Cost: 12%+LIBOR-12%=LIBOR Gain: Original Floating-Rate-Net Cost of Swap Agreement for Company A Gain: LIBOR+0. 1%-LIBOR=0. 1% (10 b. s. ) From Company B’s Perspective Annual Interest Rate Paid: 12. 1%+LIBOR+0. 6% Annual Interest Rate Received: LIBOR Net Cost: 12. 1%+LIBOR+0. 6%-LIBOR=12. 7% Gain: Original Fixed-Rate-Net Cost of Swap Agreement for Company B Gain: 13. 4%-12. 7%=0. 7% (70 b. s. )

Mechanics of Interest Rate Swaps From Financial Intermediary’s Perspective Annual Interest Rate Paid: 12%+LIBOR Annual Interest Rate Received: 12. 1%+LIBOR Gain: Annual Interest Rate Received-Annual Interest Rate Paid Gain: (12. 1%+LIBOR)-(12%+LIBOR)=0. 1% (10 b. s. ) Comparative advantage gain= 0. 9% (90 b. s. ) Gain for Company A: 0. 1% (10 b. s. ) Gain for Company B: 0. 7% (70 b. s. ) Gain for Financial Intermediary: 0. 1% (10 b. s. ) The difference in spreads provides an opportunity for both counterparties to reduce the cost of raising funds.

Potential Benefits of Interest Rate Swaps • Reducing Borrowing Costs • Matching Assets and Liabilities üAn asset swap permits the two financial institutions to alter the cash flow characteristics of its assets: from fixed to floating or from floating to fixed. üA liability swap permits two institutions to change the cash flow nature of their liabilities • Manage Interest Rate Risks

Risk/Return Profile of Counterparties to an Interest Rate Swap Interest Rates Decrease Interest Rates Increase Floating-Rate Payer Gain Loss Fixed-Rate Payer Loss Gain The value of an interest rate swap fluctuates with market interest rates.

Risks of Interest Rate Swaps • Price Risk Warehousing Swaps: Arranging a swap contract with one counterparty without having arranged an offsetting swap with another counterparty. • Credit Risk Exposure to the risk of failure of a counterparty.

Quiz

Questions • ?