Module 4.3 Flashcards
Background on Interest Rate Swaps
An interest rate swap is an arrangement whereby one party exchanges one set of interest payments for another. The provisions of an interest rate swap include: The notional principal value to which the interest rates are applied to determine the interest payments involved. The fixed interest rate. The formula and type of index used to determine the floating rate. The frequency of payments, such as every six months or every year. The lifetime of the swap.
Additional Background on Interest Rate Swaps
An example of a swap is an agreement to exchange 11% fixed-rate payments for floating payments at the prevailing 1-year Treasury bill plus 1% based on $30 million notional principal. Swap payments are usually netted. The market for swaps is facilitated by over-the-counter trading rather than trading on an organized exchange. Interest rate swaps became popular in the early 1980s when corporations were experiencing large fluctuations in interest rates
Use of Swaps for Hedging
Financial institutions in the U.S. with more interest rate sensitive liabilities than assets were adversely affected by increasing interest rates. Financial institutions in Europe had more access to long-term fixed rate funding and used the funds for floating-rate loans and were adversely affected by declining interest rates. Interest rate swaps allowed both types of financial institutions to reduce exposure to interest rate risk.(Exhibit 15.1 and 15.2)
Illustration of an Interest Rate Swap
Illustration of an Interest Rate Swap to Reconfigure Bond Payments
Use of Swaps for Speculating
§When the swap is used for speculating rather than for hedging, any loss on the swap positions will not be offset by gains from other operations.
Participation by Financial Institutions
§Financial institutions such as commercial banks, savings institutions, insurance companies, and pension funds that are exposed to interest rate movements commonly engage in swaps to reduce interest rate risk. (Exhibit 15.3)
Participation of Financial Institutions in Swap Markets
Types of Interest Rate Swaps
Plain Vanilla Swaps (fixed-for-floating swap)
§Fixed-rate payments are periodically exchanged for floating-rate payments. (Exhibits 15.4 & 15.5))
Forward Swaps
§Involve an exchange of interest payments that does not begin until a specified future time.
§Useful for financial institutions or other firms that expect to be exposed to interest rate risk at some time in the future. (Exhibit 15.6)
Illustration of a Plain Vanilla (Fixed-for-Floating) Swap
Possible Effects of a Plain Vanilla Swap Agreement (Fixed Rate of 9 Percent in Exchange for Floating Rate of LIBOR + 1 Percent)
Illustration of a Forward Swap
Callable Swaps
§Gives the party making the fixed payments the right to terminate the swap prior to its maturity.
§It allows the fixed-rate payer to avoid exchanging future interest payments if it desires. (Exhibit 15.7)
Putable Swaps
§Gives the party making the floating-rate payments the right to terminate the swap.
A putable swap allows the institution to terminate the swap in the event that interest rates rise. (Exhibit 15.8
Illustration of a Callable Swap
Illustration of a Putable Swap
Extendable Swaps
§Contains a feature that allows the fixed-for-floating party to extend the swap period. (Exhibit 15.9)
§The terms of an extendable swap reflect a price paid for the extendibility feature.
Zero-Coupon-for-Floating Swaps
The fixed-rate payer makes a single payment at the maturity date of the swap agreement, and the floating-rate payer makes periodic payments throughout the swap period. (Exhibit 15.10
Illustration of an Extendable Swap
Illustration of a Zero-Coupon-for-Floating Swap
15.11 Illustration of a Rate-Capped Swap
Framework for Explaining Net Payments Resulting from an Interest Rate Swap
Illustration of an Interest Rate Cap
Illustration of an Interest Rate Floor
Illustration of an Interest Rate Collar (Combined Purchase of Interest Rate Cap and Sale of Interest Rate Floor)
Impact of Currency Swaps
Illustration of a Currency Swap
