Lecture 11 SWAPs markets Agenda: I. Background of Interest Rate SWAP markets II. Types of Interest Rate SWAPs II.1 Plain vanilla swaps II.2 Forward swaps II.3 Callable swaps (Swaptions) II.4 Putable swaps (Swaptions) III. Applications of Interest Rate SWAPs III.1 Reduce interest rate risk (Hedge) III.2 Save borrowing cost
I. Background of Interest Rate SWAP markets ~ Background Many financial institutions have assets (cash inflow) and liabilities (cash outflow) that are not equally sensitive to interest rate changes. Thus, they are exposed to interest rate risk. Instead of using hedging tools (i.e., interest rate futures, options), they can use interest rate SWAP. Example 1: Assets U.S. Borrowers (i.e., 10-year business loans) Fixed-rate L-T loans Fixed Interest income on loans U.S. Financial Institution S-T deposits on deposits Liabilities U.S. Depositors (i.e. 3-month CDs) Is there any interest rate risk? DUR* of Assets > DUR* of liabilities Assets > Liabilities Loss Namely, as, interest cost will increase over time, but interest income is fixed. Overall, profits will decrease. $ $ Interest income Interest income As interest rates increase As interest rates decrease time time 1
Example 2: Assets Liabilities European Borrowers (i.e., 1-year business loans) Floating-rate loans Floating Interest income on loans European Financial Institution Fixed-rate L-T deposits on deposits European Depositors (i.e. 5-year CDs) Is there any interest rate risk? DUR* of Assets < DUR* of liabilities Assets < Liabilities Loss Namely, as, interest cost will increase over time, but interest income is fixed. Overall, profits will decrease. $ As interest rates increase $ As interest rates decrease Interest income Interest income time time 2
~ Definition An interest rate swap is an arrangement whereby one party exchanges one set of interest payments for another. Fixed-rate interest payments Floating-rate interest payments. Example 3: Assets U.S. Borrowers (i.e., 10-year business loans) Fixed-rate L-T loans Fixed Interest income on loans U.S. Financial Institution S-T deposits on deposits Liabilities U.S. Depositors (i.e. 3-month CDs) Fixed Interest Payments Floating Interest Payments European Borrowers (i.e., 1-year business loans) Floating-rate loans Floating Interest income on loans European Financial Institution Fixed-rate L-T deposits on deposits European Depositors (i.e. 5-year CDs) 3
Example 4: USA Commercial Bank Europe Commercial Bank Assets Liabilities Assets Liabilities Long-term loans Short-term deposits Short-term loans Long-term deposits (Fixed inflow) (variable outflow) (variable inflow) (fixed outflow) Suffer losses from interest rate increase Benefit from interest rate increase Benefit from interest rate increase Suffer losses from interest rate increase In order to avoid interest rate risk, they decide to enter into a SWAP contract. Notional Principal: $ 30 million Frequency: Payment will be made annually Lifetime: 6 years Current 1-year T-bill yield: 6% USA Europe Pay Fixed-rate: 7% Receive Receive Floating-rate: 1-year T-bill + 1% Pay T-bill USA Europe 1 5% $2.1 mil [30 mil * 7%] $1.8 mil [30 mil * (5%+1%)] Net $ 0.3 mil ($2.1 mil $1.8 mil) 2 7% Net $ 0.3 mil 3 9% Net $ 0.9 mil 4 6% Net $ 0 5 4% Net $ 0.6 mil 6 12% Net $ 1.8 mil 4
II. Types of interest rate SWAPs In response to firm s diverse needs, a variety of interest swaps have been created. II.1 Plain Vanilla Swaps (Fixed-for-floating swap): It involves the periodic exchange of fixed-rate payments for floating-rate payments. Fixed rate: 9% (for 5years) Bank A notional value: $100 Mil Bank B Floating rate: LIBOR+1% (for 5 years) For Bank A: when interest rates increase 1 2 3 4 5 LIBOR 7% 7.5% 8.5% 9.5% 10.0% Floating rate 8% 8.5% 9.5% 10.5% 11.0% Fixed rate 9% 9% 9% 9% 9% SWAP Differential -1.0% -0.5% +0.5% +1.5% +2.0% Net Amount -$1,000,000 -$500,000 +$500,000 +$1,500,000 +$2,000,000 For Bank A: when interest rates decrease 1 2 3 4 5 LIBOR 6.5% 6.0% 5.0% 4.5% 4.0% Floating rate 7.5% 7% 6% 5.5% 5% Fixed rate 9% 9% 9% 9% 9% SWAP Differential -1.5% -2.0% -3.0% -3.5% -4.0% Net Amount -$1,500,000 -$2,000,000 -$3,000,000 -$3,500,000 -$4,000,000 Interest payments 5
II. 2 Forward SWAPs (SWAPs for future): It involves an exchange of interest payments that does not begin until a specified future point in time. A forward SWAP allows a financial institution to lock in current favorable interest rates today, even though the swap period is delayed. A commercial bank plans to increase its fixed-rate loans and reduce its floating-rate loans three years later. Thus, if interest rate rises three years later, the bank will suffer losses. To prevent the adverse effects of rising interest rates after that point in time, the bank can arrange a fixed-for-floating swap. By doing so, the bank will pay the fixed rate based on current interest rate levels that is expected to be lower than those of three years later. Interest payments Floating 3 4 5 3 4 5 Forward Swap is arranged at this time. Swapping of payments begins at this time. 6
II. 3 Callable Swaps (Swap Options or swaptions) It provides the party making the fixed payments with the right to terminate the swap prior to its maturity, if interest rates decline. The disadvantage of a callable swap is that the party with the right needs to pay higher premium and termination fee. Interest payments Terminate 1 2 3 4 1 2 3 4 Swaption is exercised to terminate the swap at this time, because interest rates decrease. 7
II. 4 Putable Swaps (Swap Options or swaptions) It provides the party making the floating payments with the right to terminate the swap prior to its maturity, in case interest rates increase. The disadvantage of a putable swap is that the party with the right needs to pay higher premium and termination fee. Interest payments Termiate 1 2 3 4 1 2 3 4 Swaption is exercised to terminate the swap at this time, because interest rates increase. 8
III. Applications of interest rate swaps: III. 1 SWAPs are hedging tools against interest rate risk. No Hedging Interest payments Interest spread Floating interest expense Fixed interest income Fixed interest income Floating interest expense 0 Hedging Interest payments Floating interest income Fixed interest income Floating interest expense Fixed interest income Floating interest income Floating interest expense Interest spread 0 9
III. 2 Swaps are the tools to save borrowing costs. Fixed rate bond Variable-rate bond Preference Quality company 9% LIBOR + ½% Variable Risky company 10 ½% LIBOR + 1% Fixed Quality company has a greater advantage in fixed-rate bonds. In order to save the borrowing cost, Quality company may issue fixed rate bond then arrange a floating-for-fixed swap with Risky company. Quality Co. Fixed-rate Payments at 9% Variable-rate payments at LIBOR + ½ % Fixed-rate payments at 9 ½ % Risky Co. Variable-rate Payments at LIBOR +1% Investors in Fixedrate bonds issued by Quality Co. Investors in variable-rate bonds issued by Risky Co. Receive Pay Net cost Save Quality Co. 9 ½ % (9% + LIBOR+½%) LIBOR ½% Risky Co. LIBOR+½% (LIBOR+1% + 9 ½ % ) 10% ½% Without the SWAP, Quality Co. needs to pay LIBOR +½%, and Risky Co., 10 ½%. Through the SWAP, both of them can save ½% interest costs. 10
??? How to identify the cost saving opportunities through SWAP in financial markets???? How to calculate (arrange) the SWAP payments between two parties? Fixed rate bond Variable-rate bond Preference Quality company 9% LIBOR + ½% Variable Risky company 10 ½% LIBOR + 1% Fixed Difference 1 ½% ½% (gap: 1 ½% ½% =1%) As long as these two differences are not identical, there is a chance reduce borrowing costs through SWAP. The total cost saving is the gap between the two differences. If these two companies agree to equally share the gap (1%), then the payment arrangements can be solved by: Receive Pay Net cost Quality Co. R (9% + Q) LIBOR+½% ½% Risky Co. Q (LIBOR+1% + R) 10 ½% ½% Where: R: the payments made by Risky Co. to Quality Co. Q: the payments made by Quality Co. to Risky Co. Solving these two equations, R = 9 ½ % Q = LIBOR + ½ % 11