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Interest Rate Derivatives FINC 853 • Because of covered interest parity, when we talk about International Financial Management currency derivatives, we are really talking about interest rate derivatives. • For some counterparties (especially banks and Interest Rate Contracts Intro: corporations dealing with financing issues), dealing with interest rates directly is most useful FRAs, Caps, Floors, EDs, and Swaps o Only one currency may be involved Paul A. Laux o With cross-currency situations, may add simplicity or flexibility to be able to contract on interest rates directly. Professor of Finance University of Delaware • Prominent forward-style contracts for dealing with interest rates are: FRAs, caps and floors, ED futures, Don’t forget to check the website frequently! and swaps o Purpose of this slide set is to introduce only---use comes later. Teaching Note 2F Interest Rate Contracts Interest Rate Contracts 1 2 Forward Rate Agreements (FRAs) FRA Timeline • An interest rate based version of a forward contract • Extremely useful in bank financing • Provides for one party to pay the counterparty if an interest rate goes high at a date in the future, and to receive if the rate goes low. • Think of a bank that has collected deposits This is a 3 against 6 FRA (3 x 6) o FRA would be a forward-style hedge The above shows the payment amount received by the “buyer.” From Eun & Resnick, International Finance Interest Rate Contracts Interest Rate Contracts 3 4 FRAs (an interest rate version of forwards) FRA Example Calculations From Eun & Resnick, International Finance From Eun & Resnick, International Finance Interest Rate Contracts Interest Rate Contracts 5 6 EUR 3x9 FRA, USD Quotes 6x9 FRA, Tableau Historical Interest Rate Contracts Interest Rate Contracts 7 8 LIBOR, Caps and Floors. 11 AM What is payoff diagram for an FRA? fixings What if you owned half of it? history, British Bankers Assoc. (average of 8 banks out of 16 surveyed) Interest Rate Contracts Interest Rate Contracts 9 10 An important futures: Eurodollar (ED) Futures • Contract written on a hypothetical USD 1 million 90-day deposit of eurodollars • Quoted as 100 – yield, annualized • Cash settled • Trades on March, June, September, December cycle • Liquid for expiries several years into future • ED futures are a lot like an FRA at eurodollar rates. • Very much used in hedging swaps o What’re swaps? (hang on a couple slides!) Interest Rate Contracts Interest Rate Contracts 11 12 Interest Rate Swaps: A first swap Swaps The basic structure of an interest rate swap is shown in the diagram Why would you do such a thing? One reason would be to make a quick below. Payments are swapped on a regular basis (say every six months) and low-transactions cost adjustment in your interest rate exposure or for a predetermined period (or tenor). Payments are calculated by the maturity structure of your firm’s financing. Swapping from fixed to applying an interest rate to a predetermined number of dollars, the floating is a lot like retiring long term debt and borrowing short term. notional principal. The “floating rate payer” to an interest-rate swap will Thus swaps allow you to de-couple the maturity structure of your probably make payments at LIBOR, an interbank interest rate. The firm’s debt from its other characteristics, allowing you more flexibility “fixed rate payer” will make payments at some predetermined rate. The in your financing. Or you may think you can borrow most cheaply in, predetermined rate is often expressed as a T-Note rate plus a “swap say, the floating rate market but really desire fixed rate debt. More spread.” This way parties need only negotiate about the spread. They let generally, because adding a swap drastically changes the duration (i.e., the T-Note rate account for the importance of market conditions and for interest rate risk exposure) of your portfolio, they are a way to any changes in market conditions that occur during the negotiating speculate on or hedge against interest rate risk. For these and other process. If there is an intermediary, it will keep some of the swap spread reasons, the interest rate swaps market has become huge. Notional for its trouble. Floating Rate LIBOR LIBOR Fixed Rate principal is in the $10 trillion range, depending on what you include. Intermediary Payer Payer Fixed Fixed Pmt. Pmt. Interest Rate Contracts Interest Rate Contracts 13 14 What market forces drive the numbers that determine the terms of a swap deal? Given your knowledge about forward contracts, you already have Suppose the settlement rates for FRAs are 7% for one period and 9% for two the tools to figure this out. Let’s see how. periods. If one purchases both FRAs, then one will receive (LIBOR - 0.07) × Consider a very simple interest rate swap. It has a notional principal $100 in the first period and (LIBOR - 0.09) × $100 in the second period. of $100 and involves the swap of LIBOR for an 8% per period fixed rate over each of the next two periods. How can you tell if this is fair, in the sense that What about the swap? The fixed rate payer in the swap will net (LIBOR - each side gets the same present value out of the deal (from today’s point of 0.08) × $100 in the first period and (LIBOR - 0.08) × $100 in the second. view)? The fixed rate receiver, of course, gets the opposite. One way to tell is to compare the swap to a package (LEGOs, again) of forward contracts on LIBOR. Recall that forward contracts on interest Both the strip of FRAs and the swap are means to exchange fixed for rates are called forward rate agreements, or FRAs. floating in two future periods. If you purchase the FRA scheme and become An FRA on one-period LIBOR would specify the notional principle, the fixed rate receiver in the swap, you are promising to both receive and say $100, and a fixed agreement rate, say 7%. Then if settlement LIBOR > pay LIBOR, so these will net out. You will be left with a fixed set of cash 7% one period in the future, the purchaser receives payment of (LIBOR - flows: 0.07) × $100 from the seller. If LIBOR < 7%, then the purchaser pays the One Period from Now Two Periods from Now calculated difference to the seller. The purchaser is, in effect, long the FRA strip purchase (LIBOR - 0.07) × $100 (LIBOR - 0.09) × $100 interest rate risk in the same sense that the purchaser of a forward contract Fix rate receiver -(LIBOR - 0.08) × $100 -(LIBOR - 0.08) × $100 on corn is long the corn risk. Total 0.01 × $100 = +$1 -0.01 × $100 = -$1 Interest Rate Contracts Interest Rate Contracts 15 16 Banks, swaps and cost of funds In the absence of arbitrage opportunities, the present value of this setup should be zero. Otherwise, someone can get a free lunch, and will eat until everyone else gets tired of paying. It should be clear that, with the • Earlier, we examined FRAs as a way for banks to deal with the swap’s fixed coupon at 8%, this deal is a loser. To be specific, suppose that timing mismath of deposit and loan portfolios. r1 = .075 and r2 = .085 are the appropriate rates for discounting promised o Banks tend to have short term deposits and make longer term loans. So they are concerned about the chance that rates rise, cash flows of similar credit risk one and two periods from now, respectively. leaving them to fund an unprofitable loan portfolio with (The cash flows in “Total” are riskless, except for credit risk.) Then the expensive deposits. present value of the setup is 1.075-1 – 1.085-2 = 0.08078. o They are natural buyers of FRAs, to generate hedge payoffs if The swap market’s rate of 8 percent is not fair in comparison to the rates rise. rates for FRAs. It is too high, and it will change as traders execute the • The above example shows that being the fixed rate payer on a swap arbitrage implied in the table above. (You should be able to say specifically is effectively the same as buying a strip of FRAs. what the arbitrage is—what would you do to make money at the original o So banks are also naturals as fixed rate payers on interest rate swaps, to generate hedge payoffs if rates rise. rates.) • This means that a bank’s cost of funds is, in effect, the swap rate This idea underlies the markets method of pricing swaps. Actually, (trasury + swap spread). It will make its loan decisions, pricing, etc. because the Eurodollar (ED) futures market, which trades LIBOR FRA-like based on that. futures contracts, is active for even fairly long maturities, the swap rates and o Swaps spreads are customarily quoted for a Single-A ED rates are closely linked. counterparty, so a viable bank had better not get a lower rating! Interest Rate Contracts Interest Rate Contracts 17 18 4 year swap spreads in basis points (USD notional principal) Interest Rate Contracts 19