Interest Rate Derivative Markets

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					  Interest Rate
Derivative Markets
     Chapter 15



                  1
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 provisions of a swap include:
       The notional principal (Principle contractual amount)
       The fixed interest rate
       The formula and type of index to determine the floating rate
       The frequency of payments
       The lifetime of the swap


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Background (cont’d)
   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



                                                             3
 Participation by Financial
 Institutions
Financial Institution                  Participation in Swap Market
Commercial banks         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
S&Ls and savings banks   Engage in swaps to reduce interest rate risk
Finance companies        Engage in swaps to reduce interest rate risk
Securities firms         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
Insurance companies      Engage in swaps to reduce interest rate risk
Pension funds            Engage in swaps to reduce interest rate risk

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Types of Interest Rate Swaps
   Plain vanilla swaps
     Ina 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




                                                         5
  Types of Interest Rate Swaps
  (cont’d)
     Plain vanilla swaps (cont’d)
           Rising Interest Rates            Declining Interest Rates
Level of
Interest Payments         Floating Inflow
                          Payments

                          Fixed Outflow                     Fixed Outflow
                          Payments                          Payments



                                                             Floating Inflow
                                                             Payments

                          End of Year                                   6
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.

                                                    7
Scenario 1                                     Year
                             1          2          3          4
LIBOR                            7.0%       7.5%       8.5%       9.5%
Floating rate received
Fixed rate paid
Swap differential
Net dollar amount received
Scenario 2                                     Year
                             1          2          3          4
LIBOR                            6.5%       6.0%       5.0%       4.5%
Floating rate received
Fixed rate paid
Swap differential
Net dollar amount received                                               8
Scenario 1                                     Year
                             1          2          3          4
LIBOR                            7.0%       7.5%       8.5%       9.5%
Floating rate received           8.0%       8.5%       9.5%   10.5%
Fixed rate paid                  8.0%       8.0%       8.0%       8.0%
Swap differential                0.0%       0.5%       1.5%       2.5%
Net dollar amount received       $0     $500K      $1.5M      $2.5M
Scenario 2                                     Year
                             1          2          3          4
LIBOR                            6.5%       6.0%       5.0%       4.5%
Floating rate received           7.5%       7.0%       6.0%       5.5%
Fixed rate paid                  8.0%       8.0%       8.0%       8.0%
Swap differential            –0.5%      –1.0%      –2.0%      –2.5%
Net dollar amount received   –$500K         –$1M      –$2M    –$2.5M     9
Types of Interest Rate Swaps
(cont’d)
   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




                                                             10
  Types of Interest Rate Swaps
  (cont’d)
     A forward swap beginning in year 3:
           Rising Interest Rates                Declining Interest Rates
Level of
Interest Payments
                          Floating Inflow
                          Payments
                                                                 Fixed Outflow
                          Fixed Outflow
                                                                 Payments
                          Payments
                                                                 Floating Inflow
                                                                 Payments
       0       3         End of Year        0       3
                                                                           11
Types of Interest Rate Swaps
(cont’d)
   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 swap options (or
      swaptions)

                                                                    12
  Types of Interest Rate Swaps
  (cont’d)
     A callable swap terminated in year 3:
           Rising Interest Rates            Declining Interest Rates
Level of
Interest Payments
                          Floating Inflow
                          Payments
                                                             Fixed Outflow
                          Fixed Outflow
                                                             Payments
                          Payments
                                                             Floating Inflow
                                                             Payments
                         End of Year               3
                                                                       13
Types of Interest Rate Swaps
(cont’d)
   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




                                                          14
  Types of Interest Rate Swaps
  (cont’d)
     A putable swap terminated in year 3:
           Rising Interest Rates         Declining Interest Rates
Level of
Interest Payments

                    Floating Inflow
                    Payments                              Fixed Outflow
                    Fixed Outflow                         Payments
                    Payments
                                                          Floating Inflow
                                                          Payments

                3          End of Year
                                                                    15
Types of Interest Rate Swaps
(cont’d)
   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

                                                                     16
  Types of Interest Rate Swaps
  (cont’d)
     A zero-coupon-for-floating swap:
           Rising Interest Rates            Declining Interest Rates
Level of
Interest Payments         Single Fixed
                          Outflow Payment
                          Floating Inflow                    Single Fixed
                          Payments                           Outflow
                                                             Payment

                                                             Floating Inflow
                                                             Payments
                             End of Year
                                                                       17
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
   Credit 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 country’s political conditions
     e.g.,the government may take over one of the parties
      of the swap
                                                          18
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
    party’s 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
   Indicators monitored by participants in the swap market
       Economic growth indicators
       Inflation indicators
       Indicators of government borrowing


                                                                          19
Interest Rate Caps, Floors, and Collars
   Interest rate cap
     Offers payments in periods when a specified interest
      rate index exceeds a specified ceiling (cap) interest
      rate.
   Interest rate floor
     Offers payments in periods when a specified interest
      rate index falls below a specified floor interest rate.
   Interest rate Collar
     Involvespurchase of an interest rate cap and
      simultaneous sale of an interest rate floor.

                                                                20
Globalization of Swap Markets
   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


                                                                   21
Globalization of Swap Markets
(cont’d)
   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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