Interest Rate Swaps and Bank Regulation

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1 Interest Rate Swaps and Bank Regulation Andrew H. Chen Southern Methodist University SINCE THEIR INTRODUCTION in the early 1980s, interest rate swaps have become one of the most powerful and popular risk-management tools for banks and business corporations. In the past few years, the market for interest rate swaps has grown very rapidly. The notional amount of outstanding interest rate swaps has grown from about $680 billion at the end of 1987 to more than $10.6 trillion at the end of June 1995, an increase of more than 1,500 percent in less than eight years. 1 Banks, functioning as financial intermediaries, are natural users of interest rate swaps. They use swaps to hedge interest rate risk in their business operations and to meet the demands for swap transactions from their clients. Banks have emerged as the major players in the market for interest rate swaps. For instance, as of the end of 1995 the top seven U.S. commercial banks alone held about $4.8 trillion of the notional amount of interest rate swaps. 2 The U.S. commercial banks dominance in the swap markets has recently raised many concerns about the potential risk associated with large banks swap positions. The main concern is whether the failure of some large banks in the swap markets might lead to the collapse of the payments and credit systems, known as systemic risk. In addition to such dire consequences at the macroeconomic level, the swap transactions of an individual bank also have important implications for its stakeholders. Under the current regulations and reporting requirements, a bank s swap positions and the associated risks are not transparent to its outside stakeholders. Thus, it is difficult for outside stakeholders to assess and monitor the risk exposure of a bank s swap positions. I believe that a good understanding of the proper measures of the market value and risk of interest rate swaps is one of the most important elements for the success of external and internal efforts to regulate and manage banks swap transactions. Therefore, my brief remarks focus on how to determine the market value and risk of existing or previously established swap positions of a bank. Market values of swap positions Interest rate swaps are simple financial contractual agreements between two counterparties. In a plain vanilla fixed/floating interest rate swap, two counterparties exchange their interest payments on the Andrew H. Chen is a distinguished professor of finance at Southern Methodist University. 24 Federal Reserve Bank of Chicago

2 notional principal for a specified length of time. The first party that pays the fixed amount of interest and receives a floating amount of interest in a plain vanilla interest rate swap is said to have a long swap position and is known as the fixed rate payer, while the second party that pays the floating amount of interest and receives the fixed amount of interest in the swap is said to have a short swap position and is known as the floating rate payer. At the time of contract initiation of a fixed/floating interest rate swap, the swap contract is usually executed at-the-money and the counterparties are said to have positions in a par value swap because there is no initial cash exchange between the two counterparties. Thus, on the date of contract initiation, an interest rate swap contract is neither an asset nor a liability to either counterparty. However, subsequent to its initial date of agreement, any market interest rate movements can cause the market value of a swap contract to become positive to one counterparty and negative to the other counterparty. For instance, a fall in the market prices of the fixed/floating interest rate swaps (i.e., the fixed rate of interest on a swap) will make the existing swap contract a liability to the counterparty with a long swap position and an asset to the counterparty with a short swap position. Most of the existing fixed/floating interest rate swaps, especially those with the more active floating indices such as the London Inter Bank Offer Rate (LIBOR) and Treasury bill rates, can be readily traded in the secondary markets. Therefore, the market value of an existing interest rate swap is simply a dealer s assessment of the monetary value of the particular swap at a given time. More specifically, the market value of an existing swap is the dollar amount the dealer is willing to pay or to receive to be indifferent between stepping into the existing swap or executing a new at-the-money swap with the same maturity. 3 In the presence of dealer s bid-ask swap spreads, the market value of an existing fixed/floating interest rate swap to its long position holder will be different from that to its short position holder. The market value of an existing long interest rate swap (to the long position holder) is the present value of the stream of the net difference between the dealer s current bid swap price and the original fixed rate interest payments on the contract for the remaining maturity of the swap. The discount rates used to calculate the present value are the risk-free interest rates appropriate for the maturities of the net cash flows. On the other hand, the market value of an existing short interest rate swap is the present value of the stream of the net difference between the original fixed-rate interest payment and the dealer s current ask swap price for an at the money swap with the same maturity, discounted at the risk-free interest rates appropriate for the maturities of the net cash flows. I use the following example to illustrate how to determine the market values to its counterparties of an existing fixed/floating interest rate swap. Assume that a bank has on its book a long (short) position in a fixed/ floating interest rate swap with counterparty A (B). The terms of the existing swaps and the corresponding swap payment schedule for the bank are shown in table 1. The incremental cash flow to the dealer of the bank s long position in the existing swap is $60,000 {=$10 million x [(6.30% 7.50%)/2]} per semiannual period for the next three years. Given the currently observed period-specific yields on the zero-coupon bonds, the annuity factor is Thus, the current market value of the bank s long swap position is $324,705. We can also determine the market value of the bank s short Derivatives and Public Policy 25

3 swap position (vis-à-vis counterparty B) as follows. The incremental cash flow to the dealer of the bank s existing short position is $62,500 {=$10 million x [(7.65% 6.40%)/2]} per semiannual period for the next three years. Using the same annuity factor of , we know that the current market value of the bank s short swap position is $338,234. Therefore, as the market prices of interest rate swap fall, the bank s long swap position has become Table 1 a liability, while its short swap position has become an asset. The net market value of the bank s two swap positions in this example is $13,529. Since the beginning of 1990, U.S. commercial banks have been required to provide information about their swap positions in the call report to the bank regulators. More specifically, banks are required to report the positive replacement costs of their swap contracts to the regulators. 4 It should be noted that there is a difference between the market value and the replacement cost of an interest rate swap. The market value of a swap portfolio is the sum of the market values of all swap contracts whether they are assets or liabilities, while the replacement cost of a swap portfolio only includes the market values of swap contracts that are classified as assets. In the above example, the replacement cost of the bank s two swap positions is $338,234, while the net market value is $13,529. Therefore, requiring banks to report the replacement costs instead of Bank s long position Bank s short position with A with B (1) Original swap: 1. Notional principal: $10 million $10 million 2. Fixed rate pay/receive: 7.50% 7.65% 3. Floating rate receive/pay: 6-month LIBOR 6-month LIBOR 4. Remaining maturity: 3 years 3 years (2) Bank s swap payment schedule: Semiannual period Payment Receipt Payment Receipt 1, 2,...,6 $375,000 $10 million $10 million $382,500 x (LIBOR/2) x (LIBOR/2) (3) Current market condition: 1. Yield on 3-year par value Treasury Bond: 6.00% 2. 3-year par value fixed/floating swap prices: a) Dealer s bid price: 3-year T-Bond + 30 bp or 6.30% b) Dealer s ask price: 3-year T-Bond + 40 bp or 6.40% 3. The annuity factor for 6 periods: the market values of interest rate swaps has greatly overstated the bank equity and understated the required capital for the bank. 5 This asymmetrical treatment of swap positions in the reporting requirement tends to encourage banks to develop a heads-i-win-and-tails-you-lose attitude and to engage in more speculative activities in interest rate swaps. Market risks of swap positions Market risk and credit risk are the two major types of risk inherent in an interest rate swap position. Since interest rate swaps are private, contractual agreements between two counterparties, they are, of course, subject to a credit or default risk. However, the credit risks in interest rate swaps are relatively less important compared to the market risk for the following two reasons. First, because entering into an interest rate swap agreement is a voluntary transaction performed by two counterparties, a counterparty s credit standing must be acceptable 26 Federal Reserve Bank of Chicago

4 to the other counterparty. If one counterparty s credit standing has not reached the par, then a letter of credit from a guarantor is usually required before the signing of the swap contract. Second, an interest rate swap contract calls for a periodic payment of the net amount of the difference between the fixed and the floating interests on the notional principal. Thus, the amount that might be defaulted is relatively small in relation to the notional principal of the interest rate swap. Bank regulators and bank managers should not underestimate the importance of the market risks of financial derivatives. As we have observed, the dramatic collapse of Barings was due to the excessive market risk, and not the credit risk, undertaken by one of its employees. Let me briefly comment on the proper measures of the market risk of interest rate swap positions of a bank in the following example. Value at risk (VAR) and duration are two well-known approaches to measuring the market risks of financial instruments used by banking firms. Value at risk is a single number estimate of how much a bank could lose due to the price volatility of the assets and liabilities it holds over a certain period of time. It was first developed for financial institutions to quantify the market risk of financial instruments and trading portfolios that are very liquid. With a strong endorsement by the Group of 30 (1993), VAR has become the industry standard in measuring the market risk of financial instruments. The popularity of VAR as a measure of market risk is due mainly to its simplicity and its portfolio approach. However, the traditional VAR model is based upon a couple of rather restrictive assumptions, namely that the portfolio returns are assumed to be normally distributed and the volatility is assumed to be stable. Thus, one should note that the traditional VAR model may not be appropriate for quantifying the market risk for financial instruments that have leptokurtic, or so-called fat-tail, distributions or during the periods where the market conditions are not normal and stable. In my opinion, the traditional VAR model is an ad hoc approach with covariance matrix constructed from historically-based estimates and, therefore, may not provide consistent measures of market risk for different banks in different time periods. Duration has been used to measure the interest sensitivity of the value of an asset (or liability). The traditional, or Macaulay s, duration can be simply defined as a percentage change in the price or value of an asset (or liability) with respect to a percentage change in the asset s yield to maturity. Therefore, the traditional duration is an internal-yield specific, and it is a valid measure of interest rate risk caused by a parallel shift in the yield curve. The stochastic duration, proposed by Cox, Ingersoll, and Ross (1979), provides a more general measure of interest rate risks of financial instruments under any level or shape changes in the yield curve. Thus, the stochastic duration is a better measure of interest rate risk of financial instruments and is consistent with an equilibrium theory of term structure of interest rates. As shown in Chen and Chaudhury (1996), the market risk of an existing swap position can be measured by the stochastic duration using the one-factor general equilibrium term structure model of Cox, Ingersoll, and Ross (1985). The simulation results show that the interest rate risk of a swap position is substantially greater than that of the same maturity coupon bond and that the shorter maturity swaps can often exhibit greater volatility to unanticipated interest rate variations than that of the longer maturity ones. Derivatives and Public Policy 27

5 Conclusion Interest rate swaps have become the major components of contingent assets and contingent liabilities of large U.S. commercial banks. Both the market value and risk of the existing interest rate swap positions of a bank should be reported for better internal management and external regulations. The valuation and risk measurement framework discussed above should be useful for achieving more effective bank regulation. Notes 1 Source: International Swaps and Derivatives Association (ISDA). 2 The top seven U.S. commercial banks are Chemical Bank, J.P. Morgan, Bankers Trust, Citicorp, BankAmerica, Chase Manhattan, and First Chicago. 3 This is essentially the same as the ISDA Code s agreement value. 4 According to the Call Report instructions to banks, the replacement cost is defined as follows:... the replacement cost [is] the mark-to-market value, for only those interest rate and foreign exchange rate contracts with a positive replacement cost... not those contracts with negative mark-to-market values. 5 Banks are required to provide capital only for those interest swap contracts with maturities longer than one year. References Chen, Andrew H., and Mohammed M. Chaudhury, The market value and dynamic interest rate risk of swaps, Cox School of Business, Southern Methodist University, manuscript, October Cox, John, Jonathan Ingersoll, Jr., and Stephen Ross, Duration and the measurement of basis risk, Journal of Business, Vol. 52, 1979, pp , A theory of the term structure of interest rates, Econometrica, Vol. 53, 1985, pp Group of 30, Global Derivatives Study Group, Derivatives: Practice and principles, Washington DC, manuscript, July Federal Reserve Bank of Chicago