Microsoft PowerPoint - IF2F FRAs and Swaps by leader6


									                                                                         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
                      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
• 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

3x9 FRA,
                                                                        6x9 FRA,

                  Interest Rate Contracts                                                  Interest Rate Contracts
                             7                                                                        8
                                                                     Caps and Floors.
 11 AM
                                                            What is payoff diagram for an FRA?
                                                              What if you owned half of it?
   of 8
  out of

                         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.
                      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.
                                                                                    • 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

                                 Interest Rate Contracts

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