Swaps Pricing and Strategies

I. Defining A Swap A “plain vanilla” interest rate swap is

a contract that involves two parties exchanging their interest payments obligations (no principal is exchanged) of two different kinds of debt instruments - one bearing a fixed interest rate (fixed-rate payer) and the other a floating rate (floating-rate payer) on a periodic basis over the fixed time period.

I. Defining A Swap EX: A 3-year 11% fixed for six-

month LIBOR floating $10 million swap settled every six months requires a fixed-rate payer to pay 11% fixed-rate interest on a notional principal of $10 million to a floating-rate payer in exchange for a variable-rate interest that depends on a pre-specific six-month LIBOR rate on $10 million principal.

I. Defining A Swap Cash flows for the fixed-rate payer:

Every 6 months

$10m*11%*1/2

$10m*LIBOR*1/2

Cash inflows

Cash outflows

3 yrs

I. Defining A Swap Cash flows for the floating-rate

payer:

Every 6 months

$10m*11%*1/2

$10m*LIBOR*1/2

Cash inflows

Cash outflows

3 yrs

I. Defining A Swap If the suitable LIBOR rate was 10%,

the swap requires the fixed-rate-payer to pay $550,000 (= $10m * 11% * 0.5) to floating-rate-payer in exchange for receiving $500,000 (= $10m * 10% * 0.5) from floating-rate- payer.

I. Defining A Swap In real practice, only the difference is

transacted, that is, the swap requires fixed-rate-payer to pay $50,000 net to floating rate payer. This exchange will take place every six months until the maturity.

I. Defining A Swap The six-month LIBOR rate that is actually

used on a payment date is the rate prevailing six months earlier. This reflects the way in which interest is paid on LIBOR-based loans. The first exchange of cash flows is know with certainty when the contract is negotiated.

II. Gains From Swaps Typical transactions involve one party

that is an established, highly  rated issues that prefers floating rate  obligations  but can  sell  fixed-rate debt at a relatively low  rate,  while  the other party is usually a lower-rated issuer preferring fixed-rate obligation.  This  arrangement allows each party to borrow  with the  preferred  type  of interest obligation usually at  a  lower overall cost of financing than each party could obtain on its own (to exploit "comparative advantage").

II. Gains From Swaps This exploitation is possible because the

existence of different relative costs in different maturity markets which is connected to differences in the credit ratings of swap partners. Investors  require  lower-rated  borrowers  to pay relatively high risk premiums when borrowing at a long-term fixed rate rather than at a short-term floating rate.

II. Gains From Swaps Example: The  Sallie Mae:  A highly-rated institution

prefers floating  rate debt to match short-term loan in  its students  loan portfolio but can sell fixed-rate debt at relatively low rate.

A MSB: A relatively low-rated institution prefers to match its long-term, fixed-rate mortgage portfolio with fixed-rate funds.

II. Gains From Swaps _______________________________________ Cost: Fixed Rate Floating-Rate Borrowing Cost Borrowing Cost _______________________________________ MSB 13% LIBOR+1.5% SALLIE MAE 11 LIBOR Quality Spread 2% 1.5%

Quality Spread Difference or Arbitrage Opportunity 0.5% _______________________________________

II. Gains From Swaps All-in-cost computation: ____________________________________________________

MSB Sallie Mae ____________________________________________________ Funding Cost: MSB issues floating L+1.5% Sallie Mae issues Fixed 11%  Swap Payments: MSB pays fixed to Sallie Mae 11.3% L Sallie Mae pays floating to MSB -L -11.3% ____________________________________________________ All-in-cost 12.8% L - 0.3% Comparable Cost 13.0% L Cost Saving 0.2% 0.3% ____________________________________________________

II. Gains From Swaps MSB Bank Sallie Mae _________________________________________________________ Funding Cost: MSB issues floating L+1.5% Sallie issues Fixed 11% Swap Payments: MSB pays fixed to Bank 11.3% -11.3% Bank pays floating to MSB - L L Bank pays fixed to Sallie Mae 11.2% -11.2% Sallie Mae pays floating to Bank -L L _________________________________________________________ All-in-cost 12.8% -0.1% L -0.2% Comparable Cost 13.0% 0% L Cost Saving 0.2% 0.1% 0.2% ________________________________________________________

III. Why Swap? Alternative Explanations

1. Underpriced Credit Risk or Risk Shifting: It has been argued that credit risk is

underpriced in floating-rate loans, which gives rise to the arbitrage opportunities.

However, the arbitrage opportunities should  disappear  as  the expansion of the swap market has effectively increased the demand for  floating-rate debt by lower-rated companies and  the  demand for fixed-rate debt by higher-rated companies.

III. Why Swap? Alternative Explanations

Jan Loeys suggests that the quality spread is the  result  of risk  being shifted from the lenders to the shareholders. To  the extent  that lenders have the right to refuse to roll over  debt, more default risk is shifted from the lenders to the shareholders as the maturity of the debt decrease. With this explanation, the "gains"  from a swap would instead be transfers from  the  shareholders of the lower-rated firm to the shareholders of the  higher-rated firm.

III. Why Swap? Alternative Explanations

2. Information Asymmetries Arak, Estrella,  Goodman, and Silver argue

 that  the  "issue short term - swap to fixed" combination would be preferred if the firm: has information that would lead it to expect its

own  credit spread  to be lower in the future than the market  expectation changes in its credit spread than  is the market;

expects higher risk-free interest rates than does the market;

is more risk-averse to changes in the risk-free rate than is the market.

III. Why Swap? Alternative Explanations

3. Differential Prepayment Options Borrowing  fixed directly has a put option

on  interest  rates (prepayment),  while the "borrow floating - swap to  fixed"  does not.  Thus the lower-rated firm can borrow at a fixed  rate  more cheaply by swapping from floating because the firm in effect  has sold an interest rate option. At least a portion of the  funding cost  "savings"  obtained by the lower-rated firm come  from  the premium on this option.

III. Why Swap? Alternative Explanations

4. Tax and Regulatory Arbitrage In  the less-regulated Eurodollar market,

the costs  of  issue could  be  considerably less than in the U.S. However,  not  all firms have direct  access to the Eurodollar market. The  swap contract  provides  firms with access and permits more  firms  to take advantage of this regulatory arbitrage.

IV. VALUATION OF INTEREST RATE SWAPS

1.  Indication Pricing Schedule: __________________________________________________ Bank Pays Bank Receives Current Maturity Fixed Rate Fixed Rate TN Rate __________________________________________________ 2 yrs 2 yr TN + 30 bps 2 yr TN +38 bps 7.52% 3 3 yr TN + 35 bps 3 yr TN + 44 bps 7.71 4 4 yr TN + 38 bps 4 yr TN + 48 bps 7.83 5 5 yr TN + 44 bps 5 yr TN + 54 bps 7.90 6 6 yr TN + 48 bps 6 yr TN + 60 bps 7.94 7 7 yr TN + 50 bps 7 yr TN + 63 bps 7.97 10 10 yr TN + 60 bps 10 yr TN + 75 bps 7.99 __________________________________________________

V. Returns and Risks of Swaps to End Users

On the positive side 1.  Interest rate swaps primarily allow institutions

to manage interest  rate  risk  by swapping for preferred  interest payment obligations.

2.  Swaps  also provide institutions with vehicles to  obtain cheaper  financing by exploiting arbitrage  opportunities across financial markets.

3.  Swaps  allow institutions to gain access to debt  markets that otherwise would be unattainable or too costly.

4.  Relative  to other alternative risk management, swaps are more flexible and costless.

V. Returns and Risks of Swaps to End Users

On the negative side: 1.Swaps are not standardized contracts,

which leads to several problems: a. Negotiating a mutually agreeable swap

contract involved time, energy, and resources. b. A secondary market is not available, at a

result, it is difficult  and costly to "back out" of a swap agreement if the need arises.

2.  Swaps holders are exposed to default risk.  A default  on one  party  exposes the other party to interest rate  risk and possible lose of funds.

VI. Risks For Banks In Intermediating Swaps

1. As a Broker: in the early stages, commercial banks and investment  banking  firms found in their client bases  those  entities that needed swaps to accomplish funding or investing  objectives, and they matched the two entities.

2. As a Guarantor: To reduce the risk of default, many early swap transactions required that the lower credit-rated entity obtain a guarantee from a highly rated commercial bank.

3.  As a Dealer: Advanced in quantitative techniques and  futures products  for  hedging complex positions such as swaps  made  the protection of large inventory positions feasible.

VI. Risks For Banks In Intermediating Swaps

Regulators Concern: a.  Pricing Risk:

Pricing risk occurs from banks "warehousing - swaps  - from arranging a swap contract with one end-user without  having arranged at offsetting swap  with  another end-user.  Until an offsetting swap is arranged,  the  bank has an open swap position and is vulnerable to an  adverse change is swap prices.

VI. Risks For Banks In Intermediating Swaps

Regulators Concern:  b. Credit Risk:

A bank with perfectly matched swaps does not expose to price risk. If interest rates change, the value of  one swap will fall while the value of the other  rises an equal amount.  But if one of the end-user defaults, the  bank  loses the hedging value of the offsetting  swap and may suffer a capital loss.

VI. Risks For Banks In Intermediating Swaps

c. As a way to exploit deposit insurance subsidies:

The swaps market may offer banks some opportunities for exploitation of the deposit insurance system. Specifically, banks can leave their swaps unhedged and thereby speculate on interest rate movements, or they can engage in swaps with unusually risky counterparties.

VI. Risks For Banks In Intermediating Swaps

c. As a way to exploit deposit insurance subsidies:

Regulators have recognized the risk inherent in swaps and have taken it into account in the new risk-based capital requirements for banks. They reduce incentives for risk-taking through swaps by including swaps in the calculation of risk-adjusted assets. The requirements state that half of the sum of (1) 0.5 percent of the notional principal of a swap with a life of more than one year and (2) the market value of the swap, if it is positive, is to be included in risk-adjusted assets. Thus, investment in a swap requires some commitment of capital, and this reduces the risk of bank failures because capital acts as a cushion against losses.

VI. Risks For Banks In Intermediating Swaps

d. Systematic Risk to the Financial System:

The capital requirement also reduces the possibility of a destabilizing disruption to the financial markets as a result of “systemic risk” from swaps because swaps dealers tend to have numerous swaps deals with each of the other dealers, a problem at one bank could be transmitted to other banks and ultimately cause multiple failures.

VII. SWAP APPLICATIONS 1. Minimizing Financing Costs: A  U.S. Co. - wants to borrow an  amount of US

$100 million for seven years. Having issued bonds  heavily in  the recent past, US Co. would have to borrow at a  relatively unattractive  rate in the U.S.market. On the other hand, it could  obtain  favorable terms on a private  placement  issue  in Dutch marks where, for a variety of reasons, there is a  strong demand  for US Co.'s paper. In this environment, US Co. will  be wise to issue DM-denominated seven-year bonds and arrange a currency swap with a financial intermediary to exchange DM and U.S. dollar cash flows.

VII. SWAP APPLICATIONS DM 190m US$100 million Private Placement Investor Issuer U.S. Company swap

Counterparty DM 190 million   Each year DM 6.5% DM 6.5% Investor U.S. Company Swap Counterparty US$9.5%   At Maturity DM 190 m DM 190 million Investor U.S. Company Swap Counterparty US$ 100 million

VII. SWAP APPLICATIONS 2. Synthetic Asset Creation: Synthetic assets are created through a

combination of a bond  and a swap. A common structure is a bond denominated in a non-dollar currency  and a currency swap. For example, a U.S.  dollar-based investor  wants an attractive spread over six-month LIBOR,  which is  the rate at which it can fund its investments. For this,  it can  purchase a dollar denominated floating-rate note (FRN) or, alternatively,  it  can purchase a yen-denominated  bond  coupled with a currency swap (fixed yen vs. six-month LIBOR).

VII. SWAP APPLICATIONS

Purchase Euroyen bond Yen 15,000 Yen 15,000 Investor Swap Counterparty US$ 100   Each year $ LIBOR + 22bp semiannual Euroyen bond Investor Swap Counterparty Yen 5,5% annual Yen 15,000 principal  At maturity US$ 100 return of initial investment Euroyen bond Investor Swap Counterparty Yen 15,000 principal Yen 15,000 principal

VII. SWAP APPLICATIONS 3. Asset-Liability Management: Swaps can also be used in an overall

portfolio or a balance sheet of  assets and liabilities to alter an institution's exposure  to interest  rate or currency movement. Entering into an interest rate  or currency  swap will result in one becoming longer or shorter the bond market, or longer or shorter a currency. This may  be  done to reduce or eliminate interest rate or currency exposure, or to take a view without having to actually buy or short a bond, which could be difficult.

VII. SWAP APPLICATIONS For  example,  a bank in Singapore has a

portfolio  of  Eurobonds that are largely funded with short-term Eurodollar deposits. The average maturity of the Eurobonds is 3.5 years. While the bank's asset-liability manager is pleased with the spread they have been making, he is now afraid that rates may soon rise.

 

VII. SWAP APPLICATIONS Rather  than sell off his carefully selected

Eurobond  portfolio, he  arranges to enter into a 3.5 year interest rate swap  to  receive three-month LIBOR and pay a fixed rate. He is now approximately hedged against interest rate increases, since he is receiving fixed (on the swap) and paying fixed  (on the  swap). Later on, if his view changes, he may cancel the swap in part  or in whole. Thus can he use the swap as a tool in  asset-liability management.

VII. SWAP APPLICATIONS 4. Hedging Future Liabilities - Forward Swaps: Swaps may also be done on a forward basis,

with interest beginning to  accrue  as of a date from one week to several  years  in  the future.

EX: A corporation has outstanding high coupon debt that is callable  in two years. The corporation thinks that  current  interest rate  levels are attractive and would like to lock in  today  the cost of refunding its debt on the call date. The corporate  could enter  into a forward swap in which it will pay a fixed rate  and receive a floating rate.