1- Using Interest Rate Swaps to Convert a Floating-Rate Loan to a Fixed-Rate Loan (and Vice Versa)

Transcription

1 READING 38: RISK MANAGEMENT APPLICATIONS OF SWAP STRATEGIES A- Strategies and Applications for Managing Interest Rate Risk Swaps are not normally used to manage the risk of an anticipated loan; rather, they are designed to manage the risk on a series of cash flows on loans already taken out or in the process of being taken out. 1- Using Interest Rate Swaps to Convert a Floating-Rate Loan to a Fixed-Rate Loan (and Vice Versa) Because much of the funding banks receive is at a floating rate, most banks prefer to make floating-rate loans. By lending at a floating rate, banks pass on the interest rate risk to borrowers. Borrowers can use forwards, futures, and options to manage their exposure to rising interest rates, but swaps are the preferred instrument for managing this risk. The net effect of this transaction is that the corporation ends up paying the swap fixed rate and whatever spread the bank has requested for the loan. But at the same time the corporation id increasing its sensitivity to variation in the interest rate (duration). The duration of a swap is equivalent to the duration of a long position in a floating-rate bond and a short position in a fixed-rate bond for the fixed rate payer. It is typically negative which means that the payer would benefit if interest rates rise and the value of the bond it holds falls and vice versa. 2- Using Swaps to Adjust the Duration of a Fixed-Income Portfolio When entity seeks to adjust the duration of its loans with swaps, there are several questions to be asked: Should the swap involve paying fixed, receiving floating or paying floating, receiving fixed? What should be the terms of the swap (maturity, payment frequency)? What should be the notional principal? As for whether the swap should involve paying fixed or receiving fixed, the value of the bond portfolio is inversely related to interest rates. To reduce the duration, it would be necessary to hold a position that 1

2 moves directly with interest rates. To do this we must add a negative-duration position. Hence, the swap should be a pay-fixed swap to receive floating. The terms of the swap will affect the need to renew it as well as its duration and the notional principal required. It would probably be best for the swap to have a maturity at least as long as the period during which the duration adjustment applies. The main formula for this section is Where, MV MDUR T = MV MDUR B + NP MDUR S So, MV = Market Value MDUR = Modified Duration NP = Notional Principal NP = MV(MDUR T MDUR B ) MDUR S Here first I choose the potential swap calculate the notional principal, see if it is reasonable, if not choose another potential swap and try again. 3- Using Swaps to Create and Manage the Risk of Structured Notes Structured notes are short- or intermediate-term floating-rate securities that have some type of unusual feature that distinguishes them from ordinary floating-rate notes. This unusual feature can be in the form of leverage, which results in the interest rate on the note moving at a multiple of market rates, or can be an inverse feature, meaning that the interest rate on the note moves opposite to market rates. Notations: FP: Principal/face value of the note ci Fixed interest rate on a bond FS Fixed interest rate on the swap a. Using Swaps to Create and Manage the Risk of Leveraged Floating-Rate Notes A leveraged floating-rate note, or leveraged floater has a coupon that is a multiple of a specific market rate of interest such as LIBOR. 2

3 The apparent arbitrage here is in effect the result of credit risk. b. Using Swaps to Create and Manage the Risk of Inverse Floaters An inverse floater pays a rate of b minus LIBOR, b L, on notional principal FP. The rate on the note moves inversely with LIBOR, but if LIBOR is at the level b, the rate on the note goes to zero. If LIBOR rises above b, the rate on the note is negative. The arbitrageur faces the risk of negative cash flows if LIBOR rises above b. This problem can be avoided with an interest rate cap that would pay L-b if L exceeds b. This would be an additional cost to be passed on in the form of a lower b. B- Strategies and Applications for Managing Exchange Rate Risk Currency swaps typically expand domestic borrowing advantages that companies hold to other countries. 3

4 The main characteristic of a foreign currency swap is that both the notional and the interest payments are exchanges in full; there is no netting in a foreign currency swap. 1- Converting a Loan in One Currency in to a Loan in another Currency This type of transaction is an extremely common use of currency swaps. The advantage of borrowing this way rather than directly in another currency lies in the fact that the borrower can issue a bond or loan in the currency in which it is better known as a creditor. Then, by engaging in a swap with a bank with which it is familiar and probably already doing business, it can borrow in the foreign currency indirectly. 2- Converting a Loan in One Currency in to a Loan in another Currency Companies with foreign subsidiaries regularly generate cash in foreign currencies. Some companies repatriate that cash back into their domestic currency on a regular basis. If these cash flows are predictable in quantity, the rate at which they are converted can be locked in using a currency swap. 4

5 3- Using Currency Swaps to Create and Manage the Risk of a Dual-Currency Bond A financial innovation in recent years is the dual-currency bond, on which the interest is paid in one currency and the principal is paid in another. Such a bond can be useful to a multinational company that might generate sufficient cash in a foreign currency to pay interest but not enough to pay the principal, which it thus might want to pay in its home currency. Dual-currency bonds can be shown to be equivalent to issuing an ordinary bond in one currency and combining it with a currency swap that has no principal payments. Consider the following transactions: Issue a bond in dollars. Engage in a currency swap with no principal payments. The swap will require the company to pay interest in the foreign currency and receive interest in dollars. Because the company issued the bond in dollars, it will make interest payments in dollars. The currency swap, however, will result in the company receiving interest in dollars to offset the interest paid on the dollar-denominated bond and making interest payments on the currency swap in the foreign currency. Effectively, the company will make interest payments in the foreign currency. At the maturity date of the bond and swap, the company will pay off the dollar-denominated bond, and there will be no payments on the swap. Of course, this example illustrates the synthetic creation of a dual-currency bond. C- Strategies and Applications for Managing Equity Market Risk Under certain circumstances, an investor could be constrained or at least feel constrained from selling a concentrated position. Equity swaps can be used to achieve diversification without selling the stock. 1- Diversifying a Concentrated Portfolio An equity swap consists of the exchange of the total equity return in a concentrated position or portfolio with the total return of an index. It is really a straightforward calculation. 5

6 Equity swaps pose some difficulties not faced in interest rate and currency swaps. In particular, equity swaps can generate significant cash flow problems, resulting from the fact that equity returns can be negative, meaning that one party can be required to make both sides of payments. In addition, equity swaps can involve tracking error, in which the swap returns, which are pegged to an index, do not match the returns on the actual equity portfolio that is combined with the swap. Tracking error here is the failure of the derivative cash flow to match precisely the cash flow from the underlying portfolio. An equity swap can be used to change the allocation between stock and bond asset classes by having the party pay the return on the asset class in which it wants to reduce its exposure and receive the return on the asset class in which it wants to increase its exposure. A corporate insider can use an equity swap to reduce exposure to his company by paying the return on the company s stock and receiving the return on a diversified portfolio benchmark or a fixed- or floatingrate interest payment. There can be important implications if corporate insiders use equity swaps. Insiders can reduce their exposure without giving up their voting rights, which can lead to significant agency costs. Although it is clearly necessary for investors and analysts to gauge the exposure of corporate insiders, equity swaps can make this task more difficult. D- Strategies and Applications Using Swaptions A swaption is an option to enter into a swap. There are two types of swaptions, payer swaptions and receiver swaptions, which are analogous to puts and calls. A payer swaption is an option that allows the holder to enter into a swap as the fixed-rate payer, floating-rate receiver. A receiver swaption is an option that allows the holder to enter into a swap as the fixed-rate receiver, floating-rate payer. In both cases, the fixed rate is specified when the option starts. The buyer of a swaption pays a premium at the start of the contract and receives the right to enter into a swap. The counterparty is the seller of the swaption. The seller receives the premium at the start and grants the right to enter into the swap at the specified fixed rate to the buyer of the swaption. A swaption is based on an underlying swap. The underlying swap has a specific set of terms: the notional principal, the underlying interest rate, the time it expires, the specific dates on which the payments will be made, and how the interest is calculated. All of the terms of the underlying swap must be specified. Although an ordinary option on an asset has an exercise price, a swaption is more like an interest rate option in that it has an exercise rate. The exercise rate is the fixed rate at which the holder can enter into the swap as either a fixed-rate payer or fixed-rate receiver. When a swaption expires, the holder decides whether to exercise it based on the relationship of the then-current market rate on the underlying swap to the exercise rate on the swaption. A swaption can be exercised either by actually 6

7 entering into the swap or by having the seller pay the buyer an equivalent amount of cash. The method used is determined by the parties when the contract is created. In this section, we will use the notation FS(1,3) for the fixed rate on a swap established at time 1 and ending at time Using an Interest Rate Swaption in Anticipation of a Future Borrowing This is a situation in which a company anticipates taking out a loan at a future date. The company expects that the bank will require the loan to be at a floating rate, but the company would prefer a fixed rate. It will use a swap to convert the payment pattern of the loan. A swaption will give it the flexibility to enter into the swap at an attractive rate. 2- Using an Interest Rate Swaption to Terminate a Swap When a company enters a swap, it knows it may need to terminate the swap before the expiration day. It can do so by either entering an offsetting swap or buying a swaption. As with any over-the-counter option, the holder of a swap can terminate the swap by entering into an identical swap from the opposite perspective at whatever rate exists in the market. The second way of terminating a swap is for a company to buy a swaption before it wants to offset the swap. 7

8 Typically the price of the swaption offsets any potential benefits from exercising it. 3- Synthetically Removing (Adding) a Call Feature in Callable (Noncallable) Debt A callable bond is a bond in which the issuer has the right to retire it early. The issuer has considerable flexibility to take advantage of declining interest rates. This feature is like a call option on the bond. As interest rates fall, bond prices rise. By calling the bond, the issuer essentially buys back the bond at predetermined terms, making it equivalent to exercising a call option to buy the bond. The issuer pays for this right by paying a higher coupon rate on the bond. An interest rate receiver swaption is equivalent to a call option on a bond. A party that has issued a callable bond and believes it will not call the bond can sell an interest rate receiver swaption to offset the call feature. The swaption premium received at the start offsets the higher coupon paid for the call feature on the bond. If interest rates fall enough to trigger the bond being called, the swaption will also be exercised. The party must enter into the underlying swap and can enter into an opposite swap at the market rate. The net effect is that the party ends up paying the same rate it would have paid if it had not called the bond. A party that has issued a noncallable bond can synthetically add a call feature by purchasing an interest rate receiver swaption. The premium paid for the swaption effectively raises the coupon rate on the bond. If rates fall sufficiently, the receiver swaption is exercised and the party enters into the underlying swap. The party then enters into a swap in the market at the market rate. The net effect is that the party pays a lower fixed rate, as though the bond had been called. 8