Interest rate risk management by yurtgc548


									  Interest rate risk management
            Chapter 10
• What is an interest rate swap and how is it
• What are interest rate floors and caps?
• Financial companies assets and liabilities
  are directly related to the interest rate
  – Banks, insurers
  – Debt of various companies
• Interest rate risk has become very important
• Various instruments have been developed to
  help companies deal with interest rate risk
               S&L Crisis
• Assets are long-term mortgages
• Liabilities are short-term deposits
• With normal yield curves, everything is
• In 1980s, yield curve inverted and hundreds
  of S&Ls failed
  Interest rate swap - The Basics
• An agreement between two parties to exchange (or
  swap) periodic cash flows
   – One party pays a fixed interest rate while receiving a
     floating rate payment
• The cash flows are based on a notional principal
  or notional amount
   – The notional amount is only used to determine the cash
     flows (it is never traded)
• At each payment date, the net value of cash flows
  is exchanged
           A Quick Example
• Assume a quarterly payments
• At payment dates, the floating side is
  determined by the (uncertain) future T-bill
• Cash flows are determined from interest
  rate times notional principal
                 Interest Rate Swap
                 Cash flows for fixed rate receiver

       NP*Rfix    NP*Rfix                       NP*Rfix NP*Rfix

0           1          2                              T-1      T

       NP*Rfloat NP*Rfloat                      NP*Rfloat NP*Rfloat
  Why use Interest Rate Swaps?
• Essentially translates a fixed cash flow into a
  floating cash flow (or vice versa)
• Companies with interest rate exposure can manage
  the risk
• S&Ls could have paid the fixed rate that they
  received on mortgages and received a floating rate
   – As interest increased, they would have received a
     higher floating rate offsetting the rate paid on deposits
     saving taxpayers a whole lot of cash
• Suppose IBM wants to borrow short and NuPC
  wants to borrow long
• IBM can issue 8% bonds while NuPC can issue at
• In the CP market, IBM issues at T-bills+10 bp, but
  NuPC issues at T-bills+60 bp
• Both can be made better off by issuing in the
  market that they have a comparative advantage
  and swapping
                   Example p.2
• Suppose IBM borrows long-term at 8% and NuPC
  uses the CP market at T-bills+60 bp
• IBM and NuPC enter into an interest rate swap
  where IBM pays a floating rate of T-bills + 20 bp
  and NuPC pays a fixed rate of 9%
                         IBM                NuPC
      Underlying        - 8%           - (T-bills+60 bp)
       Receive       + 9%        + (T-bills+20 bp)
      Pay swap - (T-bills+20 bp)       - 9%
         Net       - (T-bills-80 bp)        -9.4%
        Summary of Example
• Using swaps, the firms were able to lower
  their debt rate by exploiting the market that
  they had a comparative advantage
• Note that the total debt savings is equal to
  the difference in the rates in the debt market
  – 150 basis points in our example
              Interest rate caps
• An interest rate cap is a call option on an interest
   – Also called a ceiling
• If the interest rate exceeds the “strike rate,” the
  seller must pay the difference between the strike
  and the interest rate multiplied by the notional
• If you have an underlying loan that is tied to a
  floating rate, the option will “cap” the interest
• Suppose the strike rate on a one-year interest rate
  cap is 8%, the notional principal is $10 million,
  the reference rate is the T-bond rate, and the
  option settles quarterly
• At the end of each quarter, if the T-bond rate is
  below 8%, there is no payment
• If the T-bond rate is 12%, the cap seller must pay
  the buyer (0.12-0.08) x $10 million x 0.25 =
            Interest rate floor
• Like a put option on an interest rate
• If the interest rate is below the “strike rate,”
  the seller must pay the difference between
  the strike and the interest rate
• If you have an underlying asset that is tied
  to a floating rate, the option will provide a
  lower bound for interest earnings
          Interest rate collar
• Analogous to collars in options
• Suppose we have an underlying borrowing
  that is tied to the T-bill rate
• We want to put a maximum on interest
  expense by buying an interest rate cap
• We can finance the cap by selling a floor
• The end result is the we have upper and
  lower bounds on interest expense

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