swaps copyright 2014 diane scott docking 1. learning objectives describe an interest rate swap...
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Swaps
Copyright 2014 Diane Scott Docking1
Learning Objectives
Describe an interest rate swap Understand swap terminology Be able to set up a simple plain vanilla
swap
Copyright 2014 Diane Scott Docking2
Copyright 2014 Diane Scott Docking
Definition – Swap
A swap is a financial contract whereby two _______________ agree to exchange periodic payments
The dollar amount of the payments exchanged is based on a pre-determined
_________________amount In a swap both parties are exposed to
________________________
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Copyright 2014 Diane Scott Docking
3 Common Types of Swaps Used by Banks
____________swap occurs when the counterparties swap payments in the same currency based on an base interest rate
_________ swap is used to hedge against exchange rate risk from mismatched currencies on assets and liabilities
_____________ swap, counterparties can buy or sell protection against particular types of events that can adversely affect the credit quality of a debt obligation The two parties are called __________________and
___________________ The specific credit-related events are identified in the contract is
called the credit event
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Copyright 2014 Diane Scott Docking
Provisions of an Interest Rate Swap
The notional principal - value to which the interest rates are applied to calculate the interest payments Payments equal the differential in rates multiplied by the
notational• This is called ___________________.
• Payments made based on net amounts• Reduces the potential damage if one party defaults on its obligation
No payment of notional principal The formula and type of index used to determine the
floating rate The ______________ of payments, such as every six
months or every year The _______________ of the swap
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Copyright 2014 Diane Scott Docking
Provisions of an Interest Rate Swap (cont.)
By definition/convention:Swap ________ agrees to pay fixed-rate
• If Buy a swap – entering into a SHORT hedge. Why?
• You are E(i) to increase (want to be paying the FR); therefore, Prices to decrease.
Swap ______agrees to pay floating-rate.• If Sell a swap – entering into a LONG hedge.
Why?• You are E(i) to decrease (want to be paying the VR);
therefore, Prices to increase. 6
Copyright 2014 Diane Scott Docking
Why are Swaps Used by Financial Institutions?
Allows FIs: To save money and hedge against interest-rate risk.
To better match the duration of assets and liabilities. Better match “funding” of assets. (Correct
mismatch of assets and liabilities)
To hedge against FX rate risk
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Swap Markets
Swaps are not standardized contracts Swap dealers (usually financial institutions)
keep markets liquid by matching counterparties or by taking positions themselves
The International Swaps and Derivatives Association (ISDA) is a 815 member association among 56 countries that sets codes of standards for swap documentation
Swaps are not standardized contracts Swap dealers (usually financial institutions)
keep markets liquid by matching counterparties or by taking positions themselves
The International Swaps and Derivatives Association (ISDA) is a 815 member association among 56 countries that sets codes of standards for swap documentation
Copyright 2014 Diane Scott Docking
Participation by Financial Institutions
Institutions including banks, pension funds and insurance companies exposed to interest rate risk use swaps to manage it
Intermediaries match up firms Charge fees May provide a credit guarantee, for a fee
Dealer Takes a counterparty position to serve clients Results in risk exposure unless it has an offsetting
swap with another client
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Copyright 2014 Diane Scott Docking
Plain Vanilla Interest Rate Swap
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Copyright 2014 Diane Scott Docking
Plain Vanilla Swap:Interest Rate Debt or Revenue Swap
Involves periodic exchange of fixed-rate payments for floating-rate payments No actual transfer of principal, only interest payments on debt or
investment/loan contracts. Useful in managing interest rate gap problems in FIs
BEFORE SWAP
Firm 1Fixed rate assetsVariable rate liabilities
Firm 2Variable rate assetsFixed rate liabilities
AFTER SWAP
Firm 1Fixed rate assetsFixed rate liabilities
Firm 2Variable rate assetsVariable rate liabilities
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Concerned if interest rates decrease
Concerned if interest rates increase
Copyright 2014 Diane Scott Docking
Risk of Interest Rate Swaps
Substantial Brokerage Fees Basis risk
the chance that the index (reference rate) does not move in perfect tandem with the floating-rate instruments
Credit or Counterparty risk exists because one of the firms may not meet its
payment obligations but this is minimized• If Counterparty 1 defaults and does not make a required
payment; then• Counterparty 2 would stop all subsequent payments
Disputes between counterparties:• International Swap Dealers Association (ISDA) offers an
advisory service to members.
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Copyright 2014 Diane Scott Docking
Risk of Interest Rate Swaps (cont.)
Price risk the risk that interest rate changes can cause the gap
position of a bank or firm to change. Thus, the swap’s effectiveness can change.
Market valuation risk In 1999 the Financial Accounting Standards Board
(FASB) required all derivatives, including swaps, to be stated at fair market value. Thus, they can affect a bank’s or firm’s financial condition.
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Copyright 2014 Diane Scott Docking
Advantages of Interest Rate Swaps
• Avoids refinancing costs• Avoids rigidity of maturity dates on futures• Can be negotiated to cover any length of
period• Can do a reverse swap.
• If don’t like or regret what you did.
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Swap Example 1:
ABC Co. and XYZ Co. have entered into the following swap agreement: Term = 8 years, paid annually Notional amount = $200 million Swap legs:
• ABC Co. pays XYZ Co. LIBOR + 0.50%• XYZ Co. pays ABC Co. 6%
Questions?:1) What type of swap is this?
2) Who is the buyer of this swap?
3) What is the net payover rate? Who pays whom when and how much?
4) Suppose at the end of year 1 the LIBOR = 4%. Show the swap transactions.
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Solution to Swap Example 1:
1) What type of swap is this?
2) Who is the buyer of this swap?
Copyright 2014 Diane Scott Docking
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Solution to Swap Example 1:
3) What is the net payover rate? Who pays whom when and how much?
Payover Rate = FR – VR
= 6% – (L+0.5%) = 6% – L – 0.5% = ______________
If L _____________a wash
If L _____________; ABC pays XYZ: (_______________) x Notional Amount
If L _____________; XYZ pays ABC: (_______________) x Notional Amount
Copyright 2014 Diane Scott Docking
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XYZ ABC
Pay FR Receive FR
Receive VR Pay VR
Net Profit
Solution to Swap Example 1: (cont.)
4) Suppose, at the end of year 1, LIBOR = 4%. Show the swap transactions.
Since L < 5.5%; XYZ pays ABC: (5.5% - L) x Notional Amount
(5.5% - 4%) x $200 mill. = 1.5% x $200 mill. = $3,000,000
Copyright 2014 Diane Scott Docking18
Notional Amount = $200,000,000
XYZ ABC
Pay FR - $12,000,000 + $12,000,000 Receive FR
6% x $200 million
Receive VR +$ 9,000,000 - $ 9,000,000 Pay VR
(L+0.5%) x $200 million 4.5% x $200 million
Net Profit - $ 3,000,000 + $ 3.000,000
Swap Example 2:
TOP Bank has made a $200 million, 5 year, 6% fixed-rate loan (simple interest) to NBT Co. TOP Bank has funded this loan by borrowing $200 million for 5 years at a variable rate of LIBOR + 1%, adjusted annually. LIBOR is currently at 2%. TOP Bank has also entered into a swap agreement with GMAC with the following terms:
Term = 5 years, paid annually Notional amount = $200 million Swap legs:
• TOP Bank pays GMAC 3% annually• GMAC pays TOP Bank LIBOR + 0.50% annually
Questions?:1) What is TOP Bank’s risk if it does not enter into the swap with GMAC?
2) What type of swap is this?
3) Who is the buyer of this swap?
4) What is the net payover rate? Who pays whom when and how much?
5) Suppose at the end of year 1 the LIBOR = 6%. Show the swap transactions.
6) What did TOP Bank accomplish by entering into this swap?
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Solution to Swap Example 2:
1) What is TOP Bank’s risk if it does not enter into the swap with GMAC?
Loan revenue = 6% 6%
Funding costs = L+1% currently Libor = 2%, so 3%
Net spread = 5% - L currently 3%
Risk is that Libor will _________ to 5% or _________ and the loan becomes unprofitable.
2) What type of swap is this?
3) Who is the buyer of this swap?
Copyright 2014 Diane Scott Docking20
Solution to Swap Example 2: (cont.)
4) What is the net payover rate? Who pays whom when and how much?
Payover Rate = FR – VR
= 3% – (L+0.5%) = 3% – L – 0.5% = _______________
If L = 2.5%; a wash
If L ____ 2.5%; GMAC pays TOP Bank: (L - 2.5%) x Notional Amount
If L ____ 2.5%; Top Bank pays GMAC: (2.5% - L) x Notional Amount
Copyright 2014 Diane Scott Docking21
TOP Bank GMAC
Pay FR Receive FR
Receive VR Pay VR
Net Profit
Solution to Swap Example 2: (cont.)
5) Suppose, at the end of year 1, LIBOR = 6%. Show the swap transactions.
Since L > 2.5%; GMAC pays TOP Bank: (L – 2.5%) x Notional Amount
(6% - 2.5%) x $200 mill. = 3.5% x $200 mill. = $7,000,000
Copyright 2014 Diane Scott Docking22
Notional Amount = $200,000,000
Top Bank GMAC
Pay FR - $ 6,000,000 + $ 6,000,000 Receive FR
3% x $200 million
Receive VR +$ 13,000,000 - $ 13,000,000 Pay VR
(L+0.5%) x $200 million 6.5% x $200 million
Net Profit + $ 7,000,000 - $ 7.000,000
Solution to Swap Example 2: (cont.)
6) What did TOP Bank accomplish by entering into this swap?
Top Bank has changed the VR debt to FR debt and locked in a net spread of $5 million per year for the next 5 years.
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Top Bank For 5 years on $200 million
Loan revenue + 6%
Funding cost - (L+1%)
Net spread 5% - L
Swap payment - 3%
Swap receipt +(L+0.5%)
Net spread w/ swap 2.5% x $200 mill. = $5,000,000