L2 - Interest Rate Swaps Flashcards
1
Q
How can you calculate the Net Interest Income of a bank?
A
- $ income of interest from assets - $ spent on interest payments of deposits and other liabilities
2
Q
What happens when there is an interest rate shock to a bank that only makes loans, fixed-rate mortgages and receives deposits?
A
- The mortgage is fixed so the interest rate doesn’t change
- However, there is an increase in income from the loan but also a larger interest payment required on the deposits
- This leads to a lower Net Interest Rate income –> this is an interest rate risk?
3
Q
What is a repricing gap?
A
- senstive assets are assets that reprice within a certain period of time e.g. 1 year when interest rates change
- Short-term loans, deposits
- Repricing gap = total sensitive assets ($) - total sensitive liabilities ($)
4
Q
What is the formula for the change in Net Interest Income?
A
ΔNII = Δi x the repricing gap
- interest rate is an exogenous shock –>, if it wasn’t it, would be a risk for banks it would be a tool.
- If the interest rate is going down its best to have more floating liabilities than assets
- banks should manage its gap (it’s budget make-up) based on expected interest changes: positive in E(i) is the same and vice versa.
- If E(i) is uncertain you would try to neutralise the gap
5
Q
How can you neutralise repricing gap in a bank?
A
- Commercial approach - this approach takes time but the balance sheet is transformed in a structured way –> have a zero gap for a longer time
- try to change the mix of the portfolio through commercial activities - buying and selling assets and liabilities to balance it
- change 100 of the deposits into 100 fixed-term bonds
- convince clients with a fixed mortgage to swap to a floating rate one instead.
- try to change the mix of the portfolio through commercial activities - buying and selling assets and liabilities to balance it
- interest rate swap - more immediate to implement, but will be depending on final positions that may not be a structural on
6
Q
How are interest rate swap (IRS) implemented?
A
- In our previous example, it was the mortgage of 5 years with annual cashflow that was fixed at 9%. Can we change this?
- Interest rate swap is made of two legs: a swap of two cashflows
- So on one leg, we have one fixed and the other a floating rate (this is a generic IRS) –> most liquid swaps are 30 years
- In this example we short the fixed interest rate leg charging 7% –> so we pay 7% every year
- We will then receive the floating (usually EURIBOR in EU zone)
- So at the end of each year you will receive EURIBOR + 2% –> (9-7) –> this is based on entering into a contract of exactly the same size as the bond.
- Or an IRS with a notional rate of 100.
- This makes the mortgage based on a floating rate.
- This helps us visualise it as an asset and liability but this is correct in accounting terms –> it is technically written off-balance-sheet
- Interest rate swap is made of two legs: a swap of two cashflows
7
Q
What is a interest rate swap?
A
- An interest rate swap is where one entity exchanges payment(s) in change for a different type of payment(s) from another entity.
- Typically, one party exchanges a series of fixed coupons for a series of floating coupons based on an index, in what is known as a vanilla interest rate swap
8
Q
How is an interest rate swap formally defined?
A
- The components of a typical interest rate swap would be defined in the swap confirmation which is a document that is used to contractually outline the agreement between the two parties.
- Although the frequency of the payments don’t need to be the same between the two parties (one pays quarterly but the other pays semi-annually(
- An interest rate swap (IRS) is a derivative agreement between two counterparties to exchange streams of cash flows based on interest rates to each other on defined dates.
- They are specific to each clients circumstance and needs and therefore are Over-the-Counter (OTC) agreements negotiated individually instead of standardized on an exchange.
- The most commonly traded IRS is the “plain vanilla” IRS which exchanges a fixed interest rate payment from one party for a floating LIBOR rate, the “London Interbank Offering rate” of high quality banks towards one another each day, of another
9
Q
What is the standards that all derivatives have too meet?
A
- Must meet the standards set out by the International Swaps and Derivatives Association, Inc. (“ISDA”)
10
Q
What are the mechanisms of a swap?
A
- Typical counterpart participants in a “vanilla” IRS are corporations, investors and commercial or investment banks. The IRS derivative contract allows a fixed rate to those parties with floating rates who wish to be otherwise or vice versa.
- The components defined in this agreement would be:
- Notional - The fixed and floating coupons are paid out based on what is known as the notional principal or just notional. If you were hedging a loan with €100mm principal with a swap, then the swap would have a notional of €100mm as well. The notional is not exchanged and is only used for calculating cash-flow amounts
-
Fixed-Rate - This is the rate that will be used to calculate payments made by the fixed payer. This stream of payments is known as the fixed leg of the swap
- This is usually determined as the average of the expected floating rate
- Floating Index - This defines which index is used for setting the floating coupons. The most common index would be LIBOR. The term of the index will often match the frequency of the coupons. For example, 3 months LIBOR would be paid Quarterly while 6 months LIBOR would be paid Semi-Annually.
Most of the time the two parties don’t pay both the cashflows –> they work out the difference between them and when one rate is higher than the other that party will pay the other the difference
11
Q
What is the difference between credit and counterparty risk?
A
- in IRS you are exposed to counterparty risk not credit risk
- credit risk –> typically risk of a lender that the borrower will not return part or all of the principal of the loan (this in unilateral as the borrower is obliged to pay)
- counterparty risk –> this is a bilateral risk, there is no payment of credit (no credit risk) but there is an agreement of an exchange of cash flows.
- So if A doesn’t pay the 1% difference between the fixed and floating rate to B then it is a counterparty risk.
12
Q
What is substitution risk?
A
- if there is a default the party that is receiving the payment wants to substitute for a new IRS
- the issue is that interest rates have changed since the first IRS agreed so you will likely have to pay more as you wont find anyone in the swap market that will pay 1% –> or any value that you were owed by the other party when they defaulted
- You will have to start from zero again
- hence usually B will give A sometime to repay the debt as they don’t want to leave the IRS as it is worse off.
13
Q
What is coupon frequency?
A
This is how often coupons would be exchanged between the two parties, common frequencies are annual, semi-annual, quarterly and monthly though others are used such as based on future expiry dates or every 28 days. In a vanilla swap, the floating and fixed coupons would have the same frequency but it is possible for the streams to have different frequencies.
14
Q
What do the PV of both the fixed and floating payments need to be?
A
- Their NPV needs to be equal to each other
- you will be receiving the green arrows and paying a differing value each period (indicated by the red arrow –> if you were swapping
15
Q
What is the Effective Date and Maturity Date?
A
- Effective date –> This is the point at which all the single cashflows will be estimated
- this is the start date of a swap when interest will start accruing on the first coupon
- Maturity Date –> the date of the last coupon when the obligations between the two parties end
16
Q
Example of IRS?
A
- on march 5 20XX. Alpha and Beta agree to exchange fixed for floating interest rate cash flows. Alpha agrees to receive 6-month LIBR from BEta and pay fixed rate 5% (on annual basis) to Beta every 6 months for 3 years on a notional principal of $100 million
The IRS allow transforming:
- A liability (liability swap)
- from fixed to floating
- from floating to fixed
- An asset (asset swap) –> like the mortgage example
- From fixed to floating and vice versa
A liability or and asset from a floating rate to another floating rate (basis sqap)
17
Q
Example of a Liability from floating to fixed?
A
18
Q
Example of a Liability from fixed to floating?
A
Company B has a 3 year outstanding loan of $100 million on which it pays 5.2%. Is it possible to change the cash flow structure from fixed to floating? If yes, how? Suppose the fixed rate of the swap if 5%?
- The counterparty of the loan might not even know we have entered into a swap
- We could have entered into this swap for a number of reasons
- : 1. expect that the Euribor is going down thus making the payment of the debt ‘cheaper’
- 2: I have too many fixed exposures in our portfolio so you want to have a mix and diversify the liabilities with different interest rates.
19
Q
Example Asset swap from fixed to floating?
A
20
Q
What is the role of financial intermediaries in IRS?
A
- in the real world we don’t normally have one fixed rate and one floating as people have different needs for maturity, frequency etc.
- When you enter a swap a broker will connect you with a counterparty in which they will take a spread between the bid-ask for the floating rate
