Chapter 15

Interest Rate Derivative Markets

Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline

Background Participation by financial institutions Types of interest rate swaps Risks of interest rate swaps Pricing interest rate swaps Factors affecting the performance of interest rate swaps Interest rate caps, floors, and collars Globalization of swap markets
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Background

An interest rate swap is an arrangement whereby one party exchanges one set of interest payments for another

e.g., fixed-rate payments are exchanged for floating-rate payments The notional principal The fixed interest rate The formula and type of index to determine the floating rate The frequency of payments The lifetime of the swap

The provisions of a swap include:

Background (contd)

Amounts owed are typically netted out so that only the net payment is made The market for swaps is facilitated by over-the-counter trading

Swaps are less standardized than other derivatives

Swaps became popular in the early 1980s because of large fluctuations in interest rates

e.g., financial institutions traditionally had more interest rate-sensitive liabilities than assets and were adversely affected by rising interest rates e.g., some foreign financial institutions had access to long-term fixed rate funding but used funds primarily for floating rate loans By engaging in an interest rate swap, both institutions can reduce their exposure to interest rate risk (see next slide)

Background (contd)

A U.S. financial institutions could send fixed-rate payments to a European financial institution in exchange for floating-rate payments

If interest rates rise, the U.S. financial institution receives higher interest payments from the floating-rate portion, which helps to offset the rising cost of obtaining deposits If interest rates decline, the European institution provides lower interest payments in the swap, which helps to offset the lower interest payments received on its floating-rate loans The U.S. institution forgoes the potential benefits from a decline in interest rates The European institution forgoes the potential benefits from an increase in interest rates

Background (contd)

A primary reason for the popularity of swaps is market imperfections

A

lack of information about foreign institutions and convenience encourages individual depositors to place deposits locally

Swaps are sometimes used for speculative purposes

e.g.,

a firm could engage in a swap to benefit from rising interest rates even if its operations are not exposed to interest rate movements
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Participation by Financial Institutions

Financial institutions that are exposed to interest rate movements commonly engage in swaps to reduce interest rate risk Some commercial banks and securities firms serve as intermediaries by matching up firms and facilitating the swap arrangements
Charge

fees and may provide credit guarantees

Some institutions act as dealers in swaps

The

financial institution takes the counterparty position in order to serve a client

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Participation by Financial Institutions

Financial Institution
Commercial banks

Participation in Swap Market

Engage in swaps to reduce interest rate risk Serve as an intermediary by matching up two parties in a swap Serve as a dealer by taking the counterparty position to accommodate a party the desires to engage in a swap Engage in swaps to reduce interest rate risk Engage in swaps to reduce interest rate risk Serve as an intermediary by matching up two parties in a swap Serve as a dealer by taking the counterparty position to accommodate a party that desires to engage in a swap Engage in swaps to reduce interest rate risk Engage in swaps to reduce interest rate risk
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S&Ls and savings banks Finance companies Securities firms

Insurance companies Pension funds

Types of Interest Rate Swaps

Plain vanilla swaps

In

a plain vanilla swap (fixed-for-floating swap), fixed-rate payments are periodically exchanged for floating-rate payments Consider two scenarios:
A consistent rise in market interest rates A consistent decline in market interest rates

Types of Interest Rate Swaps (contd)

Plain vanilla swaps (contd)

Rising Interest Rates Declining Interest Rates
Floating Inflow Payments Fixed Outflow Payments Fixed Outflow Payments

Level of Interest Payments

Floating Inflow Payments

End of Year

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Using A Plain Vanilla Swap

Bruny Bank has negotiated a plain vanilla swap in which it will exchange fixed payments of 8 percent for floating payments equal to LIBOR plus 1 percent at the end of each of the next four years. Assume that the notional principal is $100 million. Fill in the table on the next slide for the two scenarios of rising and falling interest rates.
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Scenario 1
1 LIBOR Floating rate received Fixed rate paid 7.0% 2

Year
3 7.5% 8.5% 4 9.5%

Swap differential
Net dollar amount received Scenario 2 1 2 Year 3 4

LIBOR
Floating rate received Fixed rate paid Swap differential Net dollar amount received

6.5%

6.0%

5.0%

4.5%

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Scenario 1
1 LIBOR Floating rate received Fixed rate paid 7.0% 8.0% 8.0% 2

Year
3 7.5% 8.5% 8.0% 8.5% 9.5% 8.0% 4 9.5% 10.5% 8.0%

Swap differential
Net dollar amount received Scenario 2 1

0.0%
$0

0.5%
$500K 2 Year 3

1.5%
$1.5M

2.5%
$2.5M 4

LIBOR
Floating rate received Fixed rate paid Swap differential Net dollar amount received

6.5%
7.5% 8.0% 0.5% $500K

6.0%
7.0% 8.0% 1.0% $1M

5.0%
6.0% 8.0% 2.0% $2M

4.5%
5.5% 8.0% 2.5% $2.5M
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Types of Interest Rate Swaps (contd)

Forward swaps
A

forward swap involves an exchange of interest payments that does not begin until a specified future point in time
Useful for institutions that expect to be exposed to interest rate risk at a future point in time The fixed rate on a forward swap may differ from the fixed rate on a swap beginning immediately

Institutions may be able to negotiate a fixed rate today that is less than the expected fixed rate on a swap negotiated in the future
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Types of Interest Rate Swaps (contd)

A forward swap beginning in year 3:

Rising Interest Rates Declining Interest Rates

Level of Interest Payments Floating Inflow Payments Fixed Outflow Payments Fixed Outflow Payments Floating Inflow Payments 0 3 End of Year 0 3
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Types of Interest Rate Swaps (contd)

Callable swaps
A

callable swap provides the party making the fixed payments with the right to terminate the swap prior to its maturity

Allows the fixed-rate payer to avoid exchanging future interest payments if it desires

The

fixed-rate payer pays a premium in the form of a higher interest rate than without the call feature Callable swaps are an example of swaptions
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Types of Interest Rate Swaps (contd)

A callable swap terminated in year 3:

Rising Interest Rates Declining Interest Rates

Level of Interest Payments Floating Inflow Payments Fixed Outflow Payments Fixed Outflow Payments Floating Inflow Payments End of Year 3
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Types of Interest Rate Swaps (contd)

Putable Swaps
A

putable swap provides the party making the floating-rate payments with a right to terminate the swap

The floating-rate payer pays a premium in the form of a higher floating rate

Extendable

swaps

An extendable swap contains a feature that allows the fixedfor-floating party to extend the swap period The terms of an extendable swap reflect a price paid for the extendability feature
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Types of Interest Rate Swaps (contd)

A putable swap terminated in year 3:

Rising Interest Rates Declining Interest Rates

Level of Interest Payments Floating Inflow Payments Fixed Outflow Payments

Fixed Outflow Payments Floating Inflow Payments

End of Year
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Types of Interest Rate Swaps (contd)

An extandable swap after year 8:

Rising Interest Rates Declining Interest Rates

Level of Interest Payments Floating Inflow Payments Fixed Outflow Payments

Fixed Outflow Payments Floating Inflow Payments

8 End of Year Extend

8 Dont Extend

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Types of Interest Rate Swaps (contd)

Zero-coupon-for-floating swaps
In

a zero-coupon-for-floating swap:
The fixed-rate payer makes a single payment at the maturity date The floating-rate payer makes periodic payments throughout the swap period

An

institution that expects interest rates to increase would prefer to be the fixed-rate payer An institution that expects interest rates to decline would prefer to be the floating-rate payer
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Types of Interest Rate Swaps (contd)

A zero-coupon-for-floating swap:
Rising Interest Rates Declining Interest Rates

Level of Interest Payments

Single Fixed Outflow Payment

Floating Inflow Payments Single Fixed Outflow Payment Floating Inflow Payments End of Year
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Types of Interest Rate Swaps (contd)

Rate-capped swaps

A rate-capped swap involves the exchange of fixed-rate payments for floating-rate payments that are capped The floating-rate payer pays an up-front fee for this feature The fixed-rate payer may allow the cap if it believes interest rates will not exceed the cap and receives the up-front fee An equity swap involves the exchange of interest payments linked to the degree of change in a stock index Appropriate for portfolio managers of insurance companies or pension funds that are managing stocks and bonds

Equity swaps

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Types of Interest Rate Swaps (contd)

A rate-capped swap:
Rising Interest Rates Declining Interest Rates

Level of Interest Payments Cap level Floating Inflow Payments Fixed Outflow Payments

Fixed Outflow Payments Floating Inflow Payments

End of Year
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Types of Interest Rate Swaps (contd)

Other types of swaps

Use

of swaps to accommodate financing preferences

Some swaps are combined with other transactions such as the issuance of bonds

Corporate borrowers may be able to get a more attractive rate when using floating-rate debt Other corporate borrowers may prefer to borrow at a floatingrate but find it advantageous to borrow at a fixed rate

Financial intermediaries may match up participants and sometimes assume the default risk involved

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Types of Interest Rate Swaps (contd)

Other types of swaps (contd)

Tax

advantage swaps

Firms with expiring tax loss carryforwards from previous years can engage in a swap that calls for receipt of a large up-front payment with less favorable terms over time

Firms would realize an immediate gain and possible losses in future years

Firms expecting large future losses but large gains this year could engage in a swap requiring a large payment now and more favorable terms over time
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Risks of Interest Rate Swaps

Basis risk is the risk that the interest rate of the index used for an interest rate swap will not move perfectly in tandem with the floating-rate instruments of the parties involved in the swap Default risk is the risk that a firm involved in the swap will not meet its payment obligations
Usually

not pronounced because the nondefaulting party will discontinue its payments

Sovereign risk reflects potential adverse effects resulting from a countrys political conditions
e.g.,

the government may take over one of the parties of the swap
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Pricing Interest Rate Swaps

Prevailing market interest rates

The fixed rate in the swap is influenced by supply and demand conditions for funds Generally, the interest rates of the swap reflect the prevailing interest rates at the time of the agreement

Availability of counterparties

When many counterparties are available, a more attractive deal might be negotiated Availability of counterparties can change in response to economic conditions
e.g., a firm that desires a fixed-for-floating swap will require a lower fixed rate applied to its outflow payments if the credit risk or sovereign risk of the counterparty is high

Credit and sovereign risk

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Factors Affecting the Performance of Interest Rate Swaps

The most important are forces that influence interest rate movements The impact of the underlying forces depends on the partys swap position

e.g., strong economic growth can increase rates, which is beneficial for a party that is swapping fixed-rate payments for floating-rate payments but not for the counterparty
Economic growth indicators Inflation indicators Indicators of government borrowing

Indicators monitored by participants in the swap market

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Interest Rate Caps, Floors, and Collars

Interest rate caps

An interest rate cap offers payments in periods when a specified interest rate index exceeds a specified ceiling (cap) interest rate

Payments are based on the amount by which the interest rate exceeds the ceiling

Typical purchasers are institutions that are adversely affected by rising interest rates The seller of an interest rate cap received an up-front fee and is obligated to provide period payments as needed Typical sellers are institutions that expect interest rates to decline or remain stable Commercial banks and securities firms serve as dealers and/or brokers for interest rate caps
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Using An Interest Rate Cap

Bungee Bank purchases a three-year cap for a fee of 3 percent of notional principal valued at $50 million, with an interest rate ceiling of 10 percent. The agreement specified LIBOR to be used to represent the prevailing market interest rate. LIBOR is currently 8 percent and is expected to increase by 1 percent in each of the next three years. Fill in the table below.

End of Year 0 LIBOR Interest rate ceiling LIBORs percent above ceiling Payments received Fee paid
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1 9.0%

2 10.0%

3 11.0%

Using An Interest Rate Cap (contd)

End of Year 0 LIBOR Interest rate ceiling LIBORs percent above ceiling 1
9.0% 10.0% 0%

2
10.0% 10.0% 0%

3
11.0% 10.0% 1.0%

Payments received
Fee paid
$1,500,000

$0

$0

$500,000

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Interest Rate Caps, Floors, and Collars (contd)

Interest rate floors

An interest rate floor offers payments when a specified interest rate index falls below a specified floor rate

Payments are based on the amount by which the interest rate falls below the floors rate

Interest rate floors can be used to hedge against lower interest rates Sellers of interest rate floors receive an up-front fee and are obligated to provide periodic payments as needed Commercial banks and securities firms serve as dealers and/or brokers for interest rate caps

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Using An Interest Rate Floor

Purage Bank purchases a three-year floor for a fee of 3 percent of notional principal valued at $50 million, with an interest rate floor of 8 percent. The agreement specified LIBOR to be used to represent the prevailing market interest rate. LIBOR is currently 6 percent and is expected to increase by 1 percent in each of the next three years. Fill in the table below.

End of Year 0 LIBOR Interest rate floor LIBORs percent below floor Payments received Fee paid
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1 7.0%

2 8.0%

3 9.0%

Using An Interest Rate Floor (contd)

End of Year 0 LIBOR Interest rate floor LIBORs percent below floor 1
7.0% 8.0% 1%

2
8.0% 8.0% 0%

3
9.0% 8.0% 1.0%

Payments received
Fee paid
$1,500,000

$500,000

$0

$0

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Interest Rate Caps, Floors, and Collars (contd)

Interest rate collars

An

interest rate collar involves the purchase of an interest rate cap and the simultaneous sale of an interest rate floor

The fee received from selling the floor can be used to pay the fee for purchasing the cap

Institutions

wishing to hedge against rising interest rates purchase collars

If interest rates rise as expected and remain above the floor, the institution will not have to make payments
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Globalization of Swap Markets

Foreign financial institutions and manufacturing corporations from various counties that are exposed to interest rate risk engage in interest rate swaps Swaps are executed in various countries and denominated in many different currencies

Dollar-denominated swaps account for about half the value of all swaps outstanding

Banks and securities firms that serve as intermediaries have a globalized network of subsidiaries A barrier to the global swap market is the lack of information about participants based in other countries

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Globalization of Swap Markets (contd)

Currency swaps
A

currency swap is an arrangement whereby currencies are exchanged at specified exchange rates and at specified intervals

A combination of currency futures contracts

Currency

swaps are commonly used by firms to hedge their exposure to exchange rate fluctuations Some currency swaps allow for early termination Using currency swaps to hedge bond payments

Currency swaps can be used in conjunction with bond issues to hedge foreign cash flows

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Globalization of Swap Markets (contd)

Risks of currency swaps

Basis

risk can exist if the firm cannot obtain a currency swap on the currency it is exposed to and uses a related currency instead Credit risk reflects the possibility that the counterparty may default on its obligation Sovereign risk reflects the possibility that a county may restrict the convertibility of a particular currency

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