Chapter 10 - Interest Rate Swaps

Question 1

What is an amortizing swap?

Answer 1

An interest rate swap in which the
notional principal amount is reduced
over time until it reaches zero.

Question 2

What is an arrears swap?

Answer 2

An arrangement where interest
payments are made on the day the
floating rate is determined (in contrast
to the plain vanilla swap where the
floating rate is determined prior to the
interest payment date).

Question 3

What is a basis swap?

Answer 3

An interest rate swap where
the interest payments for both
counterparties are determined by a
floating rate.

Question 4

What is bilateral netting?

Answer 4

The consolidation of all swap
agreements between two
counterparties.

Question 5

What is collateral?

Answer 5

A form of credit enhancement.
Collateral would have to be pledged
by the party for which the swap has
a negative value. The collateral could
be pledged in the form of assets such
as securities and real estate or a line
of credit provided by another financial
institution. Its value should be at
least equal to the size of the liability
stemming from the swap agreement.

Question 6

What is a comparative advantage with respect to swaps?

Answer 6

The mechanism through which the
cost of new or existing debt may be
reduced by an interest rate or currency
swap. Specifically, two companies with
complementary relative advantages
may come together and design a swap
to reduce the financing costs of both
companies.

Question 7

What are credit enhancements?

Answer 7

In order to control credit risk, dealers
often require credit enhancements
such as collateral from their
counterparties.

Question 8

What is credit risk?

Answer 8

For a counterparty, credit risk
stems from the possibility that
the swap dealer may default. For
the swap dealer, credit risk stems
from the possibility that one of the
counterparties may default.

Question 9

What is an index swap?

Answer 9

A swap where payments of one
counterparty are tied to the value of a
particular index.

Question 10

What is an indication pricing schedule?

Answer 10

A schedule of rates provided by a swap
dealer.

Question 11

What is a payer swaption?

Answer 11

Option giving its holder the right
but not the obligation to enter into a
predetermined swap agreement to pay
the fixed rate and receive the floating
rate.

Question 12

What is a quanto swap?

Answer 12

An interest rate swap where the
interest rate payments on the
notional principal are determined
based on the interest rate of a currency
other than the one the notional is
denominated in.

Question 13

What is a receiver swaption?

Answer 13

Option giving its holder the right
but not the obligation to enter into
a predetermined swap agreement to
pay the floating rate and receive the
fixed rate.

Question 14

What are triggering events?

Answer 14

A swap contract may call for collateral
to be posted or increased if a triggering
event takes place such as a downgrade
of a counterparty’s credit rating.

Question 15

Explain what an interest rate swap is

Answer 15

An interest rate swap is an agreement between two counterparties. In a typical plain vanilla interest rate swap,
one of the counterparties agrees to pay periodic cash flows based on a fixed rate of interest in return for periodic
cash flows from the other counterparty based on a floating rate of interest. Interest rate swaps only require a
net payment from the counterparty that owes the larger of the two cash flows.
Other interest rate swaps can be an exchange of payments based on two different fixed rates or two different
floating rates.

Question 16

Explain how interest rate swaps are priced

Answer 16

Interest rate swaps are priced according to bond pricing techniques. In a plain vanilla interest rate swap, the
counterparty that pays interest at a floating rate and receives interest at a fixed rate has a position that is
equivalent to a long position in a bond with a coupon equal to the fixed rate and a short position in a bond with
a coupon equal to the floating rate. The other counterparty has the exact opposite position.
The pricing of an interest rate swap involves choosing the fixed rate coupon in such a manner that the value of
the fixed rate bond equals the value of the floating rate bond.

Question 17

Calculate interest rate swap cash flows given all the inputs

Answer 17

The inputs required are the two interest rates, the notional principal amount and the number of days in the
period. Two separate payments can be calculated, one with the floating rate of interest and one with the fixed
rate. The party that is required to make the larger of the two payments makes the only payment equal to the
difference between the two amounts.
Alternatively, the net payment can be calculated directly by applying the following formula:

Payment = Notional Principal × (Fixed Rate − Floating Rate) × (Number of Days / 360)

If this number is positive, the party making the fixed-rate payments makes the single net payment. If it is
negative, the party making the floating-rate payments makes the single net payment.

NOTE:
Most U.S. dollar interest rate swaps base the fixed-rate payment on a 365-day year and the floating-rate
payment on a 360-day year. Any cash flow questions on the exam will provide you with the correct day count
to use.

Question 18

Calculate a company’s post-swap cost of financing.

Answer 18

Most end-users who are using interest rate swaps do so in conjunction with some kind of borrowing or lending.
The swap is intended to change the effective cash flows on the borrowing or lending to a fixed rate or floating
rate, whatever the particular case may be.
To calculate a company’s post-swap cost of financing, three different interest rates are required: the fixed and
floating rates from the swap and the interest rate on the borrowing or lending. Two of these rates – either two
fixed or two floating – will “net” out, leaving some small residual. This residual should be either added to or
deducted from the third interest rate to arrive at the company’s post-swap cost of financing.

Question 19

Explain why interest rate swaps are used.

Answer 19

Interest rate swaps are a flexible and low-cost hedging and risk management tool. Some of the popular uses are
to reduce financing costs and to reverse previous financial decisions

Question 20

Describe the basic features of deliverable interest rate swap futures.

Answer 20

The CME’s deliverable interest rate swap futures contract (DSF) allows parties to set in advance the fixed rate
on a plain vanilla interest rate swap to be delivered at maturity of the contract. Upon delivery of the underlying
swap, the buyer of the DSF will be the floating-rate payer (and fixed-rate receiver) and the seller of the DSF will
be the fixed-rate payer (and floating-rate receiver)

Question 21

Describe some variations to the basic interest rate swap.

Answer 21

• An arrears swap is a swap in which interest payments are made on the day the floating rate is determined
  (in contrast to the plain vanilla swap where the floating rate is determined prior to the interest payment date).
• A basis swap is an interest rate swap where the interest payments for both counterparties are based on
  different floating rates of interest.
• An amortizing swap is an interest rate swap in which the notional principal amount is reduced over time until
  it reaches zero.
• A quanto swap is an interest rate swap where the interest rate payments on the notional principal are
  determined based on the interest rate of a currency other than the one the notional is denoted in.
• An index swap is a swap where the payments of one counterparty are tied to the value of a particular index
  such as the S&P 500 or the S&P/TSX 60 Index.

Question 22

Describe the key features of payer and receiver swaptions.

Answer 22

A payer swaption gives the holder the right but not the obligation to enter into a predetermined swap
agreement to pay the fixed rate and receive the floating rate.
A receiver swaption gives the holder the right but not the obligation to enter into a predetermined swap
agreement to pay the floating rate and receive the fixed rate.

Question 23

Math Notes

Answer 23

Total gain = the sum of what each person saves/gains (including the dealer)

Total gain = firm B fix - firm A fix MINUS (firm b floating - firm a floating)

Difference = total gain

Value of Swap

V = Bl - Bs

V = value of swap
Bl = vlaue of bond in long position
Bs = value of bond in short position

Question 24

Why is the initial value of a swap zero?

Answer 24

The value of a swap is zero at inception because the terms of the swap are set so that the present value of the expected payments from both parties is equal. This means:

Fair Market Rates: The fixed rate and floating rate are chosen based on current market conditions, ensuring that neither party has an advantage.
No Initial Advantage: Both parties agree to the swap terms because the expected values of what they will pay and receive over the life of the swap are balanced.
Equal Present Values: The present value of the fixed rate payments equals the present value of the floating rate payments, making the initial net value of the swap zero.

This fair setup ensures that the swap is equitable for both parties right from the start.

Bond pricing of this chapter explains it well. Two bonds. Fixed rate coupon has to be price in a way so that both bonds have the same present value.

Question 25

Which of the following derivative products can best be used to arbitrage any mispricing of interest rate swaps?

Answer 25

Forward rate agreements.

Question 26

Maximum combined savings.

Answer 26

The maximum combined savings available to ABC and XYZ is equal to the difference between the quote differentials.

In the fixed-rate market, the quote differential between ABC and XYZ is 25 basis points ((5-year Treasury note rate + 0.75%) - (5-year Treasury note rate + 0.50%)). In the floating-rate market, the quote differential is 75 basis points ((6-month SOFR + 1.24%) - (6-month SOFR + 0.50%)). The difference between 75 basis points and 25 basis points is 50 basis points.

Question 27

Tough question

Answer 27

XYZ Corp. and ABC Co. have entered into an interest rate swap. XYZ Corp. will pay 6-month SOFR + 0.50% to original lenders and will receive 6-month SOFR + 0.75% from ABC Co. ABC Co. will pay the 5-year Treasury note rate + 0.75% to original lenders and will receive the 5-year Treasury note rate + 0.45% from XYZ Corp. What are XYZ’s and ABC’s post-swap cost of financing, respectively?

XYZ pays:
(6-month SOFR + 0.50%) - (6-month SOFR + 0.75%) + (5-year Treasury note rate + 0.45%) = 5-year Treasury note rate + 0.20%
(Note that by knowing this answer, you know the correct answer to the whole question.)
ABC pays:
5-year Treasury note rate + 0.75%) - (5-year Treasury note rate + 0.45%) + (6-month SOFR + 0.75%) = 6-month SOFR + 1.05%.

Question 28

What is LIBOR and SOFR?

Answer 28

LIBOR, the acronym for London Interbank Offer Rate, is the global reference rate for unsecured short-term borrowing in the interbank market. It acts as a benchmark for short-term interest rates.

Secured Overnight Financing Rate is a secured overnight interest rate. SOFR is a reference rate established as an alternative to LIBOR.