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
Rate-Capped Swaps
§Involves the exchange of fixed-rate payments for floating-rate payments that are capped. (Exhibit 15.11)
§Equity Swaps — Involves the exchange of interest payments for payments linked to the degree of change in a stock index.
15.11 Illustration of a Rate-Capped Swap
Other Types of Swaps
§Use of Swaps to Accommodate Financing Preferences
§Tax Advantage Swaps
Risks of Interest Rate Swaps
Basis Risk
§The interest rate of the index used for an interest rate swap will not necessarily move perfectly in tandem with the floating-rate instruments of the parties involved in the swap.
§When this happens, the higher payments received do not offset the increase in the cost of funds.
§Basis risk prevents the interest rate swap from completely eliminating the financial institutions exposure to interest rate risk.
Credit Risk
§There is risk that a firm involved in an interest rate swap will not meet its payment obligations.
Concerns about a Swap Credit Crisis — The willingness of large banks and securities firms to provide guarantees has increased the popularity of interest rate swaps, but it has also raised concerns that widespread adverse effects might occur if any of these intermediaries cannot meet their obligations
Sovereign Risk
§Reflects potential adverse effects resulting from a country’s political conditions.
§Sovereign risk differs from credit risk because it depends on the financial status of the government rather than on the counterparty itself.
Pricing Interest Rate Swaps
Prevailing Market Interest Rates
§The fixed interest rate specified in a swap is influenced by supply and demand conditions for funds having the appropriate maturity.
Availability of Counterparties
§When numerous counterparties are available for a particular desired swap, a party may be able to negotiate a more attractive deal.
Credit and Sovereign Risk
§A party involved in an interest rate swap must assess the probability of default by the counterparty.
Performance of Interest Rate Swaps
§When strong economic forces cause interest rates to rise, the party that is swapping fixed-rate payments for floating-rate payments will benefit.
§Because the performance of a particular interest rate swap position is normally influenced by future interest rate movements, participants in the interest rate swap market closely monitor indicators that may affect these movements.
Framework for Explaining Net Payments Resulting from an Interest Rate Swap
Interest Rate Caps, Floors, and Collars
Interest Rate Caps (Exhibit 15.13)
§Offers payments in periods when a specified interest rate index exceeds a specified ceiling (cap) interest rate.
§The payments are based on the amount by which the interest rate exceeds the ceiling, multiplied as usual by the notional principal specified in the agreement.
§The buyer of a cap is a financial institution that would be adversely affected by rising interest rates.
The seller of a cap receives the fee and is obligated to provide payments when rates exceed the ceiling rate
Illustration of an Interest Rate Cap
Interest Rate Floors
§Offers payments in periods when a specified interest rate index falls below a specified floor rate.
§The payments are based on the amount by which the interest rate falls below the floor rate, which is multiplied by the notional principal specified in the agreement.
§The buyer of an interest rate floor will receive payments when interest rates decline below the floor.
The seller of an interest rate floor receives a fee and is obligated to provide periodic payments when the interest rate falls below the floor rate specified in the agreement
Illustration of an Interest Rate Floor
Interest Rate Collars
§Involves the purchase of an interest rate cap and the simultaneous sale of an interest rate floor.
§Because the collar also involves the sale of an interest rate floor, the financial institution is obligated to make payments if interest rates decline below the floor.
Illustration of an Interest Rate Collar (Combined Purchase of Interest Rate Cap and Sale of Interest Rate Floor)
Credit Default Swaps
§A privately negotiated contract that protects investors against the risk of default on particular debt securities.
§The main participants in the CDS market are commercial banks, insurance companies, hedge funds, and securities firms.
§One party is the buyer, who is willing to provide periodic (usually quarterly) payments to the other party, the seller.
§The seller receives the payments from the buyer but is obligated to reimburse the buyer if the securities specified in the swap agreement default.
§The buyer of a CDS is protected if the securities specified in the CDS contract default.
Secondary Market for CDS Contracts
■The secondary market allows financial institutions participating in a CDS contract to pass on their obligations to other willing parties.
Collateral on CDS Contracts
■The lack of transparency in CDS pricing has caused conflicts regarding the levels of collateral to be held and has resulted in lawsuits.
Payments on a Credit Default Swap
§When economic growth is strong, the payments required on most CDS should be relatively low because the default risk is usually low.
§When economic conditions are weak, the payments required on most CDS should be relatively high because the default risk is high.
How CDS Contracts Affect Debtor-Creditor Negotiations
§When a firm encounters financial problems, its creditors attempt to work with the firm to prevent bankruptcy.
Development of the CDS Market
§Credit default swaps were created in the 1990s as a way to protect bondholders from default risk.
§Over time, CDS contracts were adapted to protect investors that purchased mortgage-backed securities.
Impact of the Credit Crisis on the CDS Market
As the housing market began to weaken in 2006, investors purchased CDS contracts as protection against the default of these mortgage-backed securities
Impact of the Credit Crisis on the CDS Market (cont.)
§Using CDS Contracts to Bet on Mortgage Defaults
§Financial institutions that anticipated a major decline in housing prices purchased CDS contracts on MBS even when they had no exposure to MBS.
§During the credit crisis, many MBS defaulted; this generated large profits for the buyers of CDS contracts and major losses for the sellers.
Insufficient Margins on CDS Contracts — During the credit crisis, many credit default swaps did not have a sufficient margin backing the agreement
§Impact of Lehman Brothers’ Failure
§When Lehman Brothers went bankrupt in September 2008, it did not cover all of its CDS obligations. Thus, many financial institutions that had purchased CDS contracts from Lehman were not protected.
§Another impact of the Lehman Brothers failure was that participants recognized that the government will not automatically rescue all large financial institutions.
§Impact of AIG’s Financial Problems — The Fed injected billions of dollars into AIG because it feared major damage to the financial sector.
Reform of CDS Contracts
■As a result of the Financial Reform Act of 2010, derivative securities are to be traded on an exchange.
■Derivative contracts should become more standardized.
■The pricing of these contracts should become more transparent.
■The use of standardized contracts should increase the trading volume.
■Market participants and regulators should be more informed about the use of particular swap contracts if they are traded on an exchange.
Globalization of Swap Markets
1.Currency Swaps
§Arrangements whereby currencies are exchanged at specified exchange rates and at specified intervals.(Exhibit 15.16)
§Using Currency Swaps to Hedge Bond Payments
§Although currency swaps are commonly used to hedge payments on international trade, they may also be used in conjunction with bond issues to hedge foreign cash flows. (Exhibit 15.17)
Impact of Currency Swaps
Illustration of a Currency Swap
Risk of Currency Swaps
§— The same types of risk that apply to interest rate swaps may also apply to currency swaps.
■There may be basis risk if the firm cannot obtain a currency swap on the currency to which it is exposed and instead uses a related currency.
■Currency swaps can also be subject to credit risk, which reflects the possibility that the counterparty may default on its obligation.
■A third type of risk is sovereign risk, which reflects the possibility that a country may restrict the convertibility of a particular currency.
