IRS Introduction

8/6/2019 IRS Introduction

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Confidential eClerx An ISO / IEC 27001:2005 Certified Company

eClerx An ISO / IEC 27001:2005 Certified Company

eClerx Training Collateral

Interest Rate Swaps


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Confidential April 2008Confidential-For Internal Use only Internal Confidential

Interest Rate Swaps

An interest rate swap is an agreement entered into between two counterpartiesunder which cash flows of a fixed rate leg are exchanged for those of a floatingrate leg without actual exchange of the notional.

A fixed rate leg is one where the interest rate is known in advance. e.g. 8% on anotional of 100,000 USD

A floating rate leg is one whose value is obtained by resetting against an agreed

reference rate. E.g. LIBOR

The principal amount is notional because there is no need to exchange actualamounts of principal

The most popular version is the `plain vanilla swap', also known as a `generic

swap


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Interest Rate Swaps

Lets motivate this discussion with a relatively simple example: XYZ corporate has $200 million of floating rate debt at LIBOR. This means that they at the beginning of the year they reset the interest rate

on the loan to LIBOR, and pay that rate for the rest of the year. They would prefer to have a fixed rate.

Here is what the current situation is:

XYZ

Corp

Pays LIBOR

How could XYZ switch to a fixed rate loan?

T

hey could retire t

he current loan and issue a fixed-rate loan.

They could enter into an interest rate swap.


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Interest Rate Swaps

What they could do would be to enter into a swap agreement in which they

agreed to pay a fixed rate of interest (say 6.9548%) on a notional amount, andthen to receive the LIBOR rate on that amount as well.

This can be illustrated as:

The net effect is, of course, that XYZ corporation is now paying a fixed rate of6.9548% on $200 million.

XYZ

Corp

Pays LIBORSwap

Dealer

Receives LIBOR

Pays 6.9548%

We can see that XYZ corporation has an incentive to enter into this contract,

they are able to convert a floating rate commitment into a fixed rate one, butwhy would the dealer enter into this arrangement?

One potential reason is that the dealer has a fixed rate commitment thatthey would like to convert into a floating rate instrument.

More likely, however, they are doing this simply to earn a fee.

They can enter into a nearly-offsetting agreement with a second

counterparty.


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Interest Rate Swaps

Let us assume that there is now a second corporation, ABC Corp, that is currently

paying 7.00% on a fixed rate bond, and they

wis

hto convert t

hat into a floatingrate instrument.

XYZCorp

Pays LIBORSwapDealer

Receives LIBOR

Pays 6.9548%ABCCorp

Pays 7.00%

If the swap dealer agreed to a second swap withABC, one where ABC paid LIBORto the dealer and received 6.85% fixed, the net effect is that the dealer earns0.1048% on the notional.

XYZ

Corp

Pays LIBORSwap

Dealer

Receives LIBOR

Pays 6.9548%

ABC

Corp

Pays 7.00%Pays LIBOR

Gets 6.85%


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Comparative Advantage

Lets say that there are two companies, AAA and BBB, who can borrow in eitherthe fixed or floating rate markets at the following rates:

Company Fixed Floating

AAA 10.0% 6-Month LIBOR + 0.3%

BBB 11.2% 6-Month LIBOR + 1.0%

Clearly AAA has an absolute advantage in both markets, but since BBB pays

only 0.7% more in the floating markets (as opposed to the 1.2% more theypay in the fixed markets), they have a comparative advantage in thefloating market.

In this case we can structure a swap transaction that will be beneficial to bothAAA and BBB (and the dealer!).

First, both AAA and BBB issue debt in the markets in which they both havecomparative advantages (say $100m).

AAA

Corp

10.0%SwapDealer

BBBCorp

LIBOR+1.0%


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Comparative Advantage

In this case we can structure a swap transaction that will be beneficial to both

AAA and BBB (and the dealer!). Then BBB enters into a swap where they receive LIBOR and pay a fixed

rate of 10%. Their net is to pay fixed 11%, which is better than the 11.2%they could get by issuing debt in the fixed market.

AAA

Corp

10.0%

SwapDealer

9.90%

LIBORBBBCorp

LIBOR+1.0%

LIBOR

10%

AAA Net:Pays LIBOR+0.10%Net Gain: .20%

ABC Net:Pays 11%Net gain: 0.2%


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Other Types of Swaps

basis swap is a swap between two different kinds of floating rate debt in the

same currency e.g., betw

een 6 month

LIBOR and 3 month

LIBOR or betw

een 6month LIBOR and US prime rate.

zero coupon swap is a swap between floating rate and single payment of fixedinterest at maturity. (A zero coupon bond pays no interest but gives the holderan increase in value at maturity; with a zero coupon swap, the single payment offixed interest represents this increase in value).

amortizing swap is one where the notional principal decreases over its life.These swaps designed for use with loans where the principal increases ordecreases in the same way.


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Uses ofIRS

To obtain lower cost funding To hedge interest rate exposure To take speculative positions in relation to future movements in interest rates. Swapping allows issuers to revise their debt profile to take advantage of current

or expected future market conditions.


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What is a Swaption

The option to enter into an interest rate swap. In exchange for an optionpremium, the buyer gains the right, but not the obligation, to enter into aspecified swap agreement with the issuer on a specified future date.

The agreement will specify whether the buyer of the swaption will be a fixed-ratereceiver.

Types OfSwaptions:

European Swaption: It gives t

he Buyer t

he rig

ht to exercise only on t

hematurity date of option.

American Swaption: It gives the Buyer the right to exercise at any time duringthe option period.

Bermudan Swaption: It gives the buyer the right to exercise on specific datesduring the option period.


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What is a Swaption Straddle?

Swaption Straddle is just a variation ofSwaption. But the difference being is thathere the Fixed / Floating rate payers are not fixed.

The holder of the option can determine whether he wants to be a Fixed or aFloating rate payer.

Depending on the profitability of position & general outlook of interest rates, theholder takes his bets. Holder has the right but not the obligation to exercise the

option.


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What are Cancelables?

Cancelables are options which enable a party to terminate a swap before itsactual termination date.

Cancelables are of 2 types: Callable swap & Putable swap.

A. An Interest rate swap where the fixed rate payer has the right but not theobligation to terminate the swap at one or more pre-determined timesduring the life of the swap is called an Callable swap

B. A Swap where the Floating rate payer has the right to terminate is known

as Putable swap.


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Cancelables v/s Swaptions

Swaptions are the optional right to enter into an swap but cancelablesare the optional right to exit out of an Swap.

Swaptions can have cash settlement / physical but Cancelables do nothave Cash Settlement.

In Swaptions the Party having the right ofSwaption have to pay to the seller ofthe Swaption a Premium but in Cancelable the Party having the right to exit have

to pay to another Party an Additional Amt.


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CAP

An interest rate cap is a way of placing a maximum value on a customers floatingrate index (e.g. Prime, LIBOR, C.P., PSA).

For an up-front fee (premium), the customer selects the term of the cap, and themaximum value of the index.

The maximum value of the index is called the strike rate .

How it Works:

The buyer and seller of the cap agree on the term (tenor), the strike rate,notional amount (size), amortization , starting date and frequency of settlement.

If the applicable index resets above the strike rate, then the National City paysthe customer the difference between the index and the strike rate times the daysbasis of the reset period times the optional amount outstanding.


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Floor

An interest rate floor is used to set a minimum value on a customers floatingrate index (e.g. Prime, LIBOR, C.P., PSA).

For an up-front fee (premium), the buyer of the floor selects the term of thefloor, and the minimum value of the index. The minimum index value is called the

strike rate .

How it Works:

The buyer and seller agree upon the term (tenor), the strike rate, the notionalamount (size), the amortization of the floor (bullet , mortgage, straight line,etc.), the start date, and the frequency of settlement.

If the applicable index resets beneath the strike rate, then National City pays thecustomer the difference between the strike rate and the index times the notionalamount outstanding times the days basis for the settlement period.


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COLLAR

Combining a cap and a floor into one product creates a Collar .

In this strategy Cap is bought is at higher rate and a Floor is sold at lower rate toreduce the premium for the Cap.

Hence your floating rate obligations are taken care of once the cap rate isbreached and you pay the difference of floor and current rate if floor rate isbreached.

Similar to Caps and Floors the customer selects the index (Prime, LIBOR, C.P.,PSA), the length of time, and strike rates for both the cap and the floor.

The buyer and the seller agree upon the term (tenor), the cap and floor strikerates, the notional amount, the start date, and the settlement frequency.

If at any time during the tenor of the collar, the index moves above the cap strikerate or below the floor strike rate, one party will owe the other a payment.


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Product Portfolio

13%

14%

6%64%

2%

1%

European Trades Cap/Floors American Trades

Bermudan Trades Swaption Straddle Vanilla Swaps


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