Currency Interest Swaps by Nitant T

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Swaps and Interest

Rate Options


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Outline

Introduction

Interest rate swaps

Foreign currency swaps Circus swap

Interest rate options


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Introduction

Both swaps and interest rateoptions are relatively new, butvery large

In mid-2000, there was over $60trillion outstanding in interest rateswaps, foreign currency swaps, and

other interest rate options


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Interest Rate Swaps

Introduction

Immunizing with interest rateswaps

Exploiting comparativeadvantage in the credit market


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Introduction

Popular with bankers, corporatetreasurers, and portfoliomanagers who need to manage

interest rate risk

A swap enables you to alter thelevel of risk without disruptingthe underlying portfolio


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Introduction (contd)

The most common type ofinterest rateswap is the fixed for floating rate swap

One party makes a fixed interest rate

payment to another party making a floatinginterest rate payment

Only the net payment is made (differencecheck)

The firm paying the floating rate is theswap seller

The firm paying the fixed rate is theswapbuyer


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Typically, the floating interestrate is linked to a market ratesuch as LIBOR or T-bill rates

The swap market is standardizedpartly by theInternational

Swaps and DerivativesAssociation (ISDA)

ISDA provisions are master

agreements


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Aplain vanilla swap refers to astandard contract with nounusual features or bells andwhistles

Theswap facilitatorwill find acounterparty to a desired swapfor a fee or take the other side

A facilitator acting as an agent is aswap broker

A swap facilitator taking the otherside is aswap 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 bondholders.

The two firms could engage in a swap transactionwhich results in the larger firm paying floatinginterest rates to the smaller firm, and the smaller

firm paying fixed interest rates to the larger firm.


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Plain Vanilla Swap Example (contd)

Big Firm SmallerFirm

Bondholders

Bondholders

LIBOR 50 bp

8.05%

8.05% LIBOR +100 bp


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A facilitator might act as an agent in the

transaction and charge a 15 bp fee for the service.


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Big Firm SmallerFirm

Bondholders

Bondholders

8.05% LIBOR +100 bp

Facilitator

LIBOR -50 bp

8.05% 8.20%

LIBOR -50 bp

facilitator


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Theswap price is the fixed rate thatthe two parties agree upon

The tenoris the term of the swap

The notional value determines thesize of the interest rate payments

Counterparty riskrefers to the riskthat one party to the swap will not

honor its part of the agreement


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Immunizing With Interest Rate

Swaps

Interest rate swaps can be usedby corporate treasurers to adjusttheir exposure to interest rate

risk

The duration gap is:

sliabilitieassetgap DassetsTotal

sLiabilitieTotalDD


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Swaps (contd)

A positive duration gap means abanks net worth will suffer ifinterest rates rise

The treasurer may choose to movethe duration gap to zero

This could be accomplished by selling

some of the banks loans and holdingcash equivalent securities instead


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Swaps (contd)

Using the banks balance sheet,we can algebraically solve for theproportion of the firms assets to

be held in cash so that theduration gap is zero:

0D

assetsTotal

sLiabilitieTotal-durationassetloanaveragex100.0xD

sliabilitie

cashcashgap


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Exploiting Comparative Advantage

in the Credit Market

Interest rate swaps can be usedto exploit differentials in thecredit 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

T-bond + 25 bp

LIBOR

BBB Current 5-yrT-bond + 85 bp

LIBOR + 30 bp

Quality Spread 60 bp 30 bp


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in the Credit MarketCredit Market Example (contd)

AAA Bank has an absolute advantage over BBB in

both the fixed and the floating rate markets. AAAhas a comparative advantage in the fixed ratemarket.

The total gain available to be shared among theswap participants is the differential in the fixed ratemarket minus the differential in the variable ratemarket, or 30 bps.


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in the Credit MarketCredit Market Example (contd)

AAA Bank wants to issue a floating rate bond,

while BBB wants to borrow at a fixed rate. Bothbanks will borrow at a lower cost if they agree toan interest rate swap.

AAA Bank should issue a fixed rate bond because ithas a comparative advantage in this market. BBBshould borrow at a floating rate. The swap termssplit the rate savings 50-50. The current 5-yr T-bond rate is 4.50%.


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Credit Market Example (contd)

AAA BBB

Bondholders

Bondholders

LIBOR

Treasury + 40 bp

Treasury + 25 bp LIBOR +30 bp


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Credit Market Example (contd)

The net borrowing rate for AAA is LIBOR 15bps

The net borrowing rate for BBB is Treasury +70 bps

The net rate for both parties is 15 bps less thanwithout the swap.


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Foreign Currency Swaps

In a currency swap, two parties

Exchange currencies at theprevailing exchange rate

Then make periodic interestpayments to each other based on apredetermined pair of interest

rates, and Re-exchange the original currencies

at the conclusion of the swap


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Foreign Currency Swaps (contd)

Foreign Currency Swap Example

A multinational US corporation has a subsidiary inGermany. It just signed a 3-year contract with aGerman firm. The German firm will provide rawmaterials, with the US firm paying 1 million Eurosevery 6 months for the 3-year period. The currentexchange rate is $0.90/Euro.

The contract is fixed in Euro terms, but if the dollar

depreciates against the Euro, dollar accountspayable would increase.


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Foreign Currency Swap Example (contd)

A currency swap is possible with the following

terms:

Tenor = 3 years

Notional value = 25 million Euros ($22.5 million)

Floating rate = $ LIBOR

Fixed rate = 8.00% on Euros


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The swap will result in the following payments

every six months:

Fixed rate payment = 25,000,000 Euros x 8.00% x0.5 = 1,000,000 Euros

Floating rate payment = $22.5 million x 0.5 x

LIBOR


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Cash Flows at Origination

25 million euros

$22.5 million

Party 1 Party 2


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Cash Flows at Each Settlement

$ LIBOR

1 million euros

Party 1 Party 2


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Cash Flows at Maturity

$22.5 million

25 million euros

Party 1 Party 2


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Circus Swap

Introduction

Swap variations


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Introduction

A circus swap combines aninterest rate and a currencyswap

Involves a plain vanilla interest rateswap and an ordinary currencyswap

Both swaps might be with the samecounterparty or with differentcounterparties


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Circus swap with twocounterparties:

8% on Euros

$ LIBOR

Party 1 Party 2


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Circus swap with twocounterparties (contd):

$ LIBOR

6.50% USParty 1 Party 3


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8% on Euros

6.50% USParty 1 Net


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Party 1 is effectively paying 8% on

Euros and receiving 6.5% in U.S.dollars


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Swap Variations

Deferred swap

Floating for floating swap

Amortizing swap Accreting swap


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Deferred Swap

In a deferred swap (forwardstart swap), the cash flows donot begin until sometime after

the initiation of the swapagreement

If the swap begins now, the

deferred swap is called aspot startswap


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Floating for Floating Swap

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

indices


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Amortizing Swap

In an amortizing swap, thenotional value declines over timeaccording to some schedule


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Accreting Swap

In an accreting swap, thenotional value increases throughtime according to some schedule


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Interest Rate Options

Introduction

Interest rate cap

Interest rate floor Calculating cap and floor payoffs

Interest rate collar

Swaption


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Introduction

Most of the trading done off theexchange floors

The interest rate options marketis

Very large

Highly efficient

Highly liquid

Easy to use


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Growth in Interest Rate Options

Notional Value

0

5

10

15

1992 1993 1994 1995 1996 1997 1998 1999 2000

(Trillions)


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Interest Rate Cap

An interest rate cap

Is like a portfolio of European calloptions (caplets) on an interest rate

On each interest payment date over thelife of the cap, one option in theportfolio expires

Is useful to firms with floating rate

liabilities

Caps the periodic interest paymentsat the caplets exercise price


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Interest Rate Cap (contd)

Long interest rate cap (exerciseprice 7%)

$ Payoff

Option expires worthless

7% Floating Rate

Payoff


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Interest Rate Cap (contd)

Short interest rate cap (exerciseprice 7%)

$ Payoff


7% Floating RatePayout


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Interest Rate Floor

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 interestpayments at the floorlets exercise price


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Interest Rate Floor (contd)

Long interest rate floor (exercise price6.5%)

$ Payoff


6.5% Floating Rate

Payoff


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Interest Rate Floor (contd)

Short interest rate floor (exercise price6.5%)

$ Payoff


6.5% Floating RatePayout


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Calculating Cap and Floor Payoffs

There are no universally acceptableterms to caps and floors

However, frequently the termsprovide for the cash payment on anin-the-money caplet or floorlet to bebased on a 360-day year

C l l ti C d Fl P ff


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(contd)

Cap payout formula:

If the benchmark rate is less

than the exercise price, thepayout is zero

price)striking-rate(benchmark

360

periodpaymentinDaysvalue)(notionalpayoutCap

C l l ti C d Fl P ff


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(contd)

Floor payout formula:

rate)benchmark-price(striking

360

periodpaymentinDaysvalue)(notionalpayoutFloor


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Interest Rate Collar

An interest rate collar issimultaneously long an interest ratecap and short an interest rate floor

Sacrifices some upside potential inexchange for a lower position cost

Premium from writing the floorlets

reduces position costs


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Swaption

Aswaption is an option on a swap Can be either American or European style

Apayer swaption (put swaption) gives itsowner 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 andpay the floating rate

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Currency Interest Swaps by Nitant T

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