TTh 3:15-4:30 Gates B01

Final Exam MS&E 247S

Friday Aug 14 2009 12:15PM-3:15PM Gates B01 (alternate arrangement ???)
Or Saturday Aug 15 2009 7PM-10PM Gates B01 (official date and time ???)
Remote SCPD participants will also take the exam on Friday, 8/14.
Please Submit Exam Proctor’s Name, Contact info as SCPD requires, also c.c. to
ffuy@Stanford.edu, preferably a week before the exam.
Local SCPD students please come to Stanford to take the exam. Light
refreshments will be served.

Handout #16
Derivative Security Markets
Currency and Interest Rate Swaps
http://Stanford2009.pageout.net
 Reading Assignments for this Week

Scan Read

Levich Chap 13 Pages

Currency and Interest Rate Swaps
Luenberger Chap Pages

Solnik Chap Pages

McDonald Ch 8 Swaps Pages 219-246

Fundamentals of Derivative Markets

Wooldridge Chap Pages

13-2
 Derivative Security Markets
Currency and Interest Rate Swaps

MS&E 247S International Investments

Yee-Tien Fu
 Medical Swap vs. Financial Swap
http://www.pageout.net/user/www/s/t/stanford2007/medical%20swap.pdf

13-4
 Mileage Swap vs. Financial Swap

Frequent flier programs have been around

for nearly three decades and billions of
miles go unused. Airlines used to prohibit
swaps of frequent-flier miles - it's still in the
fine print of many loyalty programs. But
now some are perfectly fine with
exchanges like the one that Hintz made -
they collect a fee on every trade.
…NEXT PAGE…

13-5
 For some fliers, trading miles is the way to go
By DAVID KOENIG, AP Airlines Writer

DALLAS (AP) -- Scott Hintz needed more miles with

American Airlines to book a free trip to Morocco this
spring, and he had several thousand miles from another
carrier that he thought might be just the ticket. The San
Francisco travel executive went online, found a willing
trader for his Alaska Airlines miles and made a swap. In
May he was roaming North Africa. "I took miles out of
some programs I don't use and got some value out of
them," says Hintz, who calls himself "a miles junkie."

13-6
 Introduction to Swaps
• A capital market swap represents an
agreement to exchange cash flows between
two parties, usually referred to as
counterparties.
• A swap agreement commits each
counterparty to exchange an amount of
funds, determined by a formula, at regular
intervals until the swap expires.
• In the case of a currency swap, there is an
initial exchange of currency and a reverse
exchange at maturity.
13-7
 Introduction to Swaps
• Like futures and options, a swap is a
derivative security.
• A swap is equivalent to a collection of
forward contracts that call for an exchange
of funds at specified times in the future.
• Like forward contracts, a swap can be used
¤ to speculate,
¤ to hedge an exposure, or
¤ to replicate another security in an effort to
enhance investment returns or to lower
borrowing costs.
13-8
13-9
 Introduction to Swaps
• Since a swap can be replicated using forward
contracts, why does the swap market exist,
and why has it grown so popular?
A swap reduces transaction costs by allowing
the counterparties to combine many
transactions (forward contracts) into one (the
swap).
In addition, the legal structure of a swap
transaction may have advantages that reduce
the risk to each party in the event of a default
by the other party.
13-10
 Introduction to Swaps

• The cash flows of a swap were linked: if firm

A could not pay firm B, then firm B felt
excused from having to pay firm A.
Whether swaps always reflect this right-of-
offset is a critical point.
• In addition, as a new financial product, the
currency swap was not covered by any
accounting disclosure or security
registration requirements.

13-11
 Introduction to Swaps

• We will focus primarily on the economic

fundamentals and financial characteristics
of basic interest rate and currency swap
agreements.

13-12
 Structure of a Back-to-Back on Parallel Loan
Basic Swap
In the United Kingdom In the Netherlands

British Dutch
parent firm parent firm
Indirect
financing
Direct loan Direct loan
in pounds in guilders

Dutch firm’s British firm’s

affiliate in the affiliate in the
United Kingdom Netherlands

Figure 13.1 Pg 448

13-13
 The Role of Capital Controls
• Suppose a Brazilian affiliate wants to
transfer funds to its U.S. parent firm beyond
what it was allowed to repatriate home.
• It could effectively do so if it made a loan to
a Brazilian affiliate of a French firm and the
French parent simultaneously lent funds to
the U.S. parent.
• Since the legal barrier imposes a cost, the
U.S firm is willing to provide a financial
incentive to the French firm to take part in
the deal.
13-14
 Structure of a Back-to-Back on Parallel Loan
Variation
In the United States In Brazil

French U.S. firm’s

parent firm affiliate in Brazil
Indirect
financing
Direct loan Direct loan
in dollars in cruzados

U.S. French firm’s

parent firm affiliate in Brazil

Figure 13.1 Pg 448

13-15
 The Role of Capital Controls
Though useful, back-to-back and parallel loans
present certain drawbacks :
1 Identifying a counterparty is both time
consuming and costly.
2 Legally, the two loans are separate and
distinct. Hence, one party’s default will not
release the other party from its commitments
under the other loan.
3 For accounting and regulatory purposes, the
loans are “loans”. Thus, the firm’s borrowing
capacity, credit rating etc can be affected.
13-16
Factors Favoring the Risk of Swaps
• The currency swap evolved as a way to
simplify and speed up the exchange of
currency cash flows between counterparties.
• In addition, it linked the two cash flows :
¤ Only the net difference between the two cash
flows is paid.
¤ If A cannot pay B, then B may be excused
from paying A.
• As a new financial product, it was not
covered by any accounting disclosure or
security registration requirements.
13-17
 The Swap Market
• The notional value of outstanding swaps is
the underlying amount on which swap
payments are based.
• A more meaningful indicator of the economic
significance of outstanding swaps is the
gross market value, which reflects the cost
that one party would pay to replace a swap at
market prices in the event of a default.
• Gross market value represents the gross
exposure associated with swap contracts.
13-18
 The Basic Cash Flows of a Currency Swap
Difference
• Firms A and B Firm A Firm B (A-B)
can each US$
issue a 7-year finance 10% 11.5% -1.5%
bond in either SFr
the US$ or finance 5% 6% -1.0%
SFr market. -0.5%
• Firm A has a comparative advantage
in borrowing US$ while firm B has a
comparative advantage in borrowing SFr.
• By borrowing in their comparative advantage
currencies and then swapping, lower cost
financing is possible.
Figure 13.2 Pg 453
13-19
 The Basic Cash Flows of a Currency Swap
$ at t 0
SFr at t 0

10.75% (US$)
A B
5.5% (SFr)

Borrows $ $ at t 7 Borrows SFr

at 10% at 6%
SFr at t 7

• Together, A and B save 0.5%. Note that if a

bank or swap dealer intermediates the
transaction and charges a fee, the
aggregate interest savings will be reduced.
Figure 13.2 Pg 453
13-20
The Basic Cash Flows of a Currency Swap:
Result of Strategy
Firm A pays 5.5% (to B) on its SFr150 million loan.
But firm A also pays 10.0% interest on its US$ bonds
while receiving 10.75% interest on its US$100 million
loan to B -- or a net inflow of 0.75%. Thus, A pays
(approximately) 4.75% net interest on its SFr loan.
This represents a 0.25% savings in relation to its own
cost of borrowing SFr.
Note that the calculation is approximate because 1%
interest on US$ is not precisely the same as 1%
interest on SFr.
13-21
The Basic Cash Flows of a Currency Swap:
Result of Strategy
Firm B pays 10.75% (to A) on its US$100 million loan.
But B also pays 6.0% interest on its SFr bonds and
receives 5.5% interest on its SFr 150 million loan to A
-- or a net outflow of 0.5%. Thus, B pays
(approximately) 11.25% net interest on its US$ loan.
This represents a 0.25% savings in relation to its own
cost of borrowing US$.
Note that the calculation is approximate because 1%
interest on US$ is not precisely the same as 1%
interest on SFr.
13-22
 A Summary of the IBM / World Bank Currency Swap
World
• IBM and the IBM Bank Difference
World Bank can $ U.S. U.S.
Treasury Treasury 5bp
finance + 45 bp + 40 bp
each issue a 7-
year bond in Swiss
SFr Treasury Swiss
Treasury - 20bp
either the US$ finance + 0 bp + 20 bp
or SFr market. 25bp

• The World Bank had an absolute advantage

in the US$ market, while IBM had an absolute
advantage in the SFr bond market.
• Examining these borrowing costs, we see
that the firms could save 25bp by entering
into a currency swap.
Box 13.1 Pg 455
13-23
 A Summary of the IBM / World Bank Currency Swap
$ at t 0
SFr at t 0
U.S. Treas.+40
World
Bank Swiss Treas.+10 IBM

Borrows $ $ at t 7 Borrows SFr

at U.S. at Swiss
Treasury + 40 SFr at t 7 Treasury + 0

• The total cost for IBM was (Swiss T. + 0bp) +

(U.S. T. + 40bp) - (Swiss T. + 10bp) = U.S. T. +
30bp. So IBM saved 15bp.
• The total cost for the World Bank was (U.S. T. +
40bp) + (Swiss T. + 10bp) - (U.S. T. + 40bp) =
Swiss T. + 10bp. So, the Bank saved 10bp. 13-24
Box 13.1 Pg 455
 Saturation and scarcity value
In 1981, both IBM and the World Bank were rated
AAA for credit risk. But in the real world, all AAA
credits are not necessarily awarded the same interest
cost of funds, even if the bond issues share similar
characteristics. The reasoning is based, in part, on
saturation and scarcity value.
Other things being equal, investors seeking a portfolio
of AAA bonds prefer to hold bonds from a broad set
of issuers in order to diversify the idiosyncratic risks
of any single issuer. An issuer who has not saturated
the market may enjoy a scarcity value and be able to
issue bonds at a lower rate. This effect is more likely
among AAA-rated issuers, given the small universe of
AAA-rated issuers. 13-25
 Saturation and scarcity value

Until 1981, the World Bank was a frequent issuer of

bonds in the Swiss market in order to capture the low
nominal interest rate in SFr.
With the demand for World Bank bonds saturated at
prevailing rates, Swiss investors demanded a higher
interest rate to hold additional World Bank bonds.
IBM, on the other hand, viewed themselves as a
US$-based firm and borrowed exclusively in the US$
bond markets.
Swiss investors were willing to pay a premium
(reflecting a scarcity value) to bring IBM as a new
AAA-issuer into their portfolios.
13-26
13-27
 Interest Rate Swap

Fixed-Rate Payer Floating-Rate Payer

Pays fixed rate in the swap Pays floating rate in the swap

Receives floating in the swap Receives fixed in the swap

Has bought a swap Has sold a swap

Is long a swap Is short a swap

Is short the bond market Is long the bond market

13-28
 Interest Rate Swap
In Figure 13.3, we show two firms, A and B, that can
issue a US$ denominated bond in either fixed-rate or
floating-rate terms.
The annual interest costs are assumed to be 9.0%
and 10.5% respectively, for A and B in the fixed-rate
bond market. In addition, each firm can arrange
floating rate financing, perhaps through bank lending
or a commercial paper (CP) program. We assume
that firm A pays six-month LIBOR plus zero basis
points, while firm B pays six-month LIBOR plus 50
basis points.
This example assumes that interest is paid
semiannually and the floating interest rate is reset
every six months. 13-29
 The Basic Cash Flows of an Interest Rate Swap
Difference
Firm A Firm B (A-B)
Fixed-
rate 9% 10.5% -1.5%
finance
Floating- LIBOR LIBOR
rate -0.5%
finance +0.0% +0.5%
-1.0%

9.75%
A B
LIBOR + .25

Borrows at Borrows at
9.0% fixed LIBOR + 0.50%
floating

Figure 13.3 Pg 456

13-30
 The Basic Cash Flows of an Interest Rate Swap
To explain the transactions in an interest rate swap,
assume that in period t0, firm A issues a seven-year
bond for $100 million at a fixed rate of 9% and B
obtains bank financing for $100 million at a floating
rate equal to six-month LIBOR + 0.5%.
In our example, the principal amounts are identical,
so there is no need to actually exchange principal as
in the currency swap example.
However (and as if there were an exchange of
principal), A agrees to pay LIBOR + 0.25% interest on
$100 million to B, while B agrees to pay 9.75%
interest on $100 million to A.
13-31
 The Basic Cash Flows of an Interest Rate Swap

In years t1 until t7, firms A and B make interest

payments to each other as stipulated in the swap
agreement, plus paying interest on the original bonds
they have issued.

At time t7, the swap contract matures. A and B make

their final interest payments to each other, A retires
its outstanding bond issue, and B pays off its bank
loan.

13-32
 The Basic Cash Flows of an Interest Rate Swap

What is the result of this strategy?

Firm A pays LIBOR + 0.25% interest (to B) and 9.0%
on its fixed-rate bonds, while receiving 9.75% interest
from B -- or a net interest cost of LIBOR - 0.50%.
Thus, A saves 0.50% in relation to its own cost of
floating-rate funds.

13-33
 How is the value of a swap determined?

Once the swap transaction is completed, changes

in market interest rates will change the payments
of the floating-rate side of the swap. The value of
an interest-rate swap is the difference between
the present value of the payments of the two
sides of the swap. The three-month LIBOR
forward rates from the current Eurodollar CD
futures contracts are used to (i) calculate the
floating-rate payments and (ii) determine the
discount factors at which to calculate the
present value of the payments.
13-34
 What factors affect the swap rate?
For the swap rate, we have:
swap rate =
present value of floating-rate payments
N
days in period t
∑
t =1
notional amount ×
360
× forward discount factor for period t

.
From this equation, we see that the swap rate is
determined by the present value of floating-rate
payments, the notional amount, the number of
periods in a year, and the forward discount factor.

13-35
The present value of floating-rate payments is also
determined by the notional amount, the number of
periods in a year, and the forward discount factor. It is
also determined by the reference rate (such as
LIBOR) and forward rates based on this benchmark.
It is important to emphasize that the reference rate at
the beginning of period t determines the floating rate
that will be paid for the period. However, the floating-
rate payment is not made until the end of period t. We
should also point out that the same forward rates that
are used to compute the floating-rate payments—
those obtained from the Eurodollar CD futures
contract—are used in computing the forward discount
factors for each period t.

13-36
13-37
13-38
13-39
 Profit and Loss from Entering into an Interest Rate
Swap When Interest Rates Are Variable

Behavior of Floating Interest Rates

Interest Rates Interest Rates
Rise Relative to Fall Relative to
Expectations Expectations
Speculative Pay floating Speculative loss, Speculative gain,
position and receive swap has negative swap has position
fixed value, out-of-the- value, in-the-
money swap money swap
Pay fixed Speculative gain, Speculative loss,
and receive swap has position swap has
floating value, in-the- negative value,
money swap out-of-the-money
swap
Table 13.4 Pg 464
13-40
13-41
13-42
 Behavior of Short-Term Interest Rates
and the Valuation of Fixed Floating Swap
Valuation Effects for Paying Fixed and Receiving Floating

Period 1 Period 2 Period 3 Period 4 Period 5

mo n ey i 5,5 = 5.42
the
Initial Euro-$ a lu e, In
s i tive v
Interest Rate P o i 5,4 = 5.32
i 1 = 5.22
i 5,3 = 5.22

N eg a i 5,2 = 5.12
tive
va lue,
Out
of th i 5,1 = 5.02
e mo
n ey

Figure 13.5 Pg 465

13-43
 The Amortization Effect and the Diffusion Effect
in a Long-Term Interest Rate Swap
Potential Exposure (%)

Amortization Diffusion
Effect Effect

Time

Figure 13.6A Pg 466

13-44
 The Overall Risk in a Long-Term
Interest Rate Swap
Potential Exposure (%)
Interaction of
Amortization
and Diffusion
Effect

Time

Figure 13.6B Pg 466

13-45
 Expected Credit Exposures on Interest Rate Swaps:
The Maturity Effect
10
Percent of Notional Principal

10-year
4
7-year
5-year
2 3-year
1-year

0 4 8 12 16 20
Semiannual Periods
Figure 13.7A Pg 467
13-46
 Expected Credit Exposures on 10-Year
Interest Rate Swaps: The Interest Rate Level Effect
10
Percent of Notional Principal

13%
8 11%

9%
6
7%

0 4 8 12 16 20
Semiannual Periods
Figure 13.7B Pg 468
13-47
 Swaps & Linkages Across International Capital Markets
Interest Rate Base
Fixed Rate Floating Rate
Currency of Asset or Liability Asset or Liability
Denomination
A Interest Rate Swap B

Currency X

Floating-Floating Currency Swap

Fixed-Fixed Currency Swap
Cross Interest
Currency Rate Swap

Examples Cross Interest

Currency Y

A Dollar-denominated Currency Rate Swap

straight Eurobond
B Eurodollar floating-
rate note (FRN)
C Samurai bond
D Euroyen floating-
Interest Rate Swap
C D
rate note (FRN)
Figure 13.8 Pg 469
13-48
13-49
An Example of Price Quotations in the Swap Market

Table 13.5 presents a sample of swap quotations

from a major dealer.
Various interest rate swap quotations within the US$
segment are shown in panel A of Table 13.5.
Various cross-currency interest rate swap quotations
for the US$ against other currencies are shown in
panel B of Table 13.5.
A diagram illustrating how the quotation apply to the
dealer and the counterparties is in panel C.

13-50
 An Example of Price Quotations in the Swap Market

Panel A: U.S. Dollar Interest Rate Swaps

Maturity Treasury Yield Treasury vs. LIBOR

2 5.94 Bid Offer
18 20

Treasury vs. T-Bills Treasury vs. CP

Bid Offer Bid Offer
-21 -16 12 16

Note: Quotes are in basis points over/under Treasury bond yield.

Table 13.5 Pg 470

13-51
 An Example of Price Quotations in the Swap Market

Panel B: Non-U.S. Dollar Interest Rate Swaps

Maturity Japanese Yen Pound Sterling

2 Bid Offer Bid Offer
1.49 1.53 6.507 6.557

Deutsche Mark Swiss Franc

Bid Offer Bid Offer
4.035 4.085 2.990 3.090

Note: Quotes are on an actual/365 day semi-annual basis.

Table 13.5 Pg 470
13-52
 Price Quoting Conventions in the Swap Market

Swap Quotes
Bid Quote Offer Quote

Swap dealer Swap dealer

pays fixed receives
rate fixed rate
Counter Swap Counter
Party A Dealer Party B
Swap dealer Swap dealer
receives pays
floating rate floating rate

Quotes are given from the perspective of the swap dealer.

The convention is to quote only the fixed side of the swap.
All fixed quotes are against LIBOR unless otherwise stated.

Panel C of Table 13.5 Pg 470

13-53
 Constructing a Fixed-Fixed Currency Swap
Suppose a US firm (A) issues a seven-year Euro-Y straight
bond with a coupon of 3.80%, and that a Japanese firm (B)
issues a seven-year Euro-$ straight bond with a coupon of
7.40%.
Assume that A wishes to obtain fixed-rate US$ financing
and that B wishes to obtain fixed-rate Y financing and that
both are willing to trade at the quotes in Table 13.5 from
the swap dealer at Merrill Lynch.
The relevant prices to use will be the seven-year T-bond
versus LIBOR quotes for US$ interest rate swaps in panel
A, and the Japanese yen cross-currency swap in panel B.

13-54
 Construction of a Fixed-Fixed Currency Swap

3.10%(¥) 3.14%(¥)

U.S. LIBOR ($) Merrill LIBOR ($) Japanese

Firm A LIBOR ($) Lynch LIBOR ($) Firm B

6.67%($) 6.65%($)

Borrows Borrows
fixed-rate fixed-rate
¥ bond at $ bond at
3.80% 7.40%

Table 13.6 Pg 472

13-55
 Construction of a Fixed-Fixed Currency Swap

To convert its fixed-rate Euro-Y bond into a fixed-rate

US$ liability, firm A enters into two swaps with Merrill
Lynch:
1. A cross-currency swap paying $-LIBOR and
receiving 3.10% in Y.
2. An interest rate swap paying 6.67% in $ (equal to
6.32% T-bond rate + 0.35%) and receiving $-
LIBOR.
We can see that the two LIBOR portions cancel,
leaving firm A with a fixed-rate US$ liability costing
7.37%.
13-56
 Construction of a Fixed-Fixed Currency Swap

Firm B also enters into two swaps with Merrill Lynch:

1. A cross-currency swap receiving $-LIBOR and
paying 3.14% in Y.
2. An interest rate swap receiving 6.65% in $
(equal to 6.32% T-bond rate + 0.33%) and paying
$-LIBOR.
Again, we can see that the two LIBOR portions
cancel, leaving firm B with a fixed-rate Y liability
costing 3.89%.

13-57
 Construction of a Fixed-Fixed Currency Swap

As the intermediary in this transaction, Merrill Lynch

earns 0.04% in Y and another 0.02% in US$ on a per
annum basis over the seven-year life of the swap.
In addition, Merrill Lynch receives a fee for originating
each swap.
All of these transactions are summarized in Table
13.6.

13-58
Applications of Swaps: Magnifying Risk and Return

Many of the illustrations in this chapter have linked a

swap with a bond issue, but these decisions are
separable.
A firm can issue a bond in one year and then decide
to swap later, using the swap as a risk management
tool.
However, a firm could enter into a swap without a
prior bond issue. This transaction is the same as a
pure speculation on the direction of exchange rates or
interest rates.

13-59
Applications of Swaps: Magnifying Risk and Return
The swaps discussed in the chapter could be termed
“plain vanilla” as the payoffs are governed by the
simple differential between two specific interest rates.
But more exotic swaps could be designed, with
payoffs proportional to twice the interest differential,
or the square of the interest differential.
In principle, these exotic contracts could reduce the
firm’s exposure to risk from its core business
activities. But it is also true that exotic swaps are a
way to enhance speculative return and risk, if these
contracts are not tempered with other hedging
transactions.
13-60
 An Unsuccessful Exotic Swap

Procter and Gamble (P&G) (based in Cincinnati and

with $30 billion in annual sales) lost $157 million on
an exotic swap whose payments (“in most cases”)
were defined by the formula:

17.0415 x (5-year Treasury rate)

- (price of 6.25 percent Treasury due 8/2023)
- 0.75%

The amount of interest that P&G would pay under this

formula is shown in Table 13.7.
13-61
Table 13.7 Interest Cost (Premium over the CP Rate)
in the Procter & Gamble/Bankers Trust
Interest Rate Swap

30-Year Interest Rate

5-year Int 6% 7% 8%
5% -0.75% -0.75% 4.20%
6% -0.75% 10.80% 21.20%
7% 15.10% 24.90% 38.20%

13-62
 An Unsuccessful Exotic Swap
This arrangement would have reduced P&G’s funding
costs below the commercial paper rate if short-term
interest rates fell. But if interest rates rose, P&G was
subject to enormous borrowing costs on its $200
million notional value.
P&G closed its swap position to cap their loss, and
filed suit against the swap dealer (Bankers Trust),
alleging that the dealer failed to make sufficient
disclosures of the risks involved in the transaction.
Bankers Trust claimed that it had acted in good faith
and that it was dealing with a sophisticated investor
with extensive experience in exotic derivatives.
13-63
 An Unsuccessful Exotic Swap

P&G added a second money-losing DM interest rate

swap to its lawsuit, bringing its total claim against
Bankers Trust to $200 million.
P&G and Bankers Trust settled their dispute in May
1996, after Bankers Trust agreed to absorb at least
$150 million of P&G’s loss.
Around this time, it was reported that some banks
had chosen to absorb losses on swap transactions,
rather than risk bad publicity or litigation.

13-64
Assignment from Chapter 13
Exercises 1, 2.

13-65
1. Suppose Firm ABC can issue 7-year bonds in the US at the fixed
rate of 8% and in France at 13%. Suppose Firm XYZ can issue 7-
year bonds at the fixed rate of 10% in the US in US$ and at 14%
in France in FFr.

a. Which firm has a comparative advantage in the French capital

market?

b. How would you advise both firms so that they take advantage of
each other's comparative advantage in the US and French capital
markets?

c. How much could be saved in borrowing costs by both firms?

d. What could cause the relative comparative advantages in

international credit markets?
13-66
SOLUTION:

a. ABC XYZ Difference

US$ 8% 10% -2%
FFr 13% 14% -1%
-1%
XYZ has a comparative advantage in the French franc market;
ABC has a comparative advantage in the US$ market.

b. Each firm has a comparative advantage in different markets. They

should take advantage of that edge, then swap the proceeds, thus
realizing borrowing cost savings.

13-67
c. Total Costs:
ABC Pays 8.0% XYZ Pays 14.0%
Pays 13.5% Pays 9.0%
Receives 9.0% Receives 13.5%
Net 12.5% Net 9.5%

Savings .5% Savings .5%

Total Savings: 1%

d. Different comparative advantage for both firms may arise because a

firm's local credit market is saturated with the firm’s debt and would
place value in the availability of debt issues by a foreign firm.

Different valuation on the same credit instrument could also arise

because the French and US credit markets make different assessments
of the riskiness of the same firms.

13-68
2. Suppose two parties enter a 5-year interest rate swap to
exchange one-year LIBOR plus 50 basis points (bp) for a fixed
rate on $100 million notional principal.

a. If LIBOR turns out to be 10% in year 1, 9% in year 2, 9% in

year 3, 8% in year 4 and 8.5% in year 5, what cash flows will be
exchanged between the two parties? Assume a flat Eurodollar
yield curve at 10%.

b. What is the value of the swap?

c. What fixed rate in the swap agreement will make the value of
the swap equal to zero?

13-69
SOLUTIONS:
a. The cash-flow pattern is as follows:
1 2 3 4 5
Fixed 10% 10% 10% 10% 10%
Cash-Flows 10 10 10 10 10
LIBOR +50 bp 10.5% 9.5% 9.5% 8% 8.5%
Cash-Flows 10.5 9.5 9.5 8 8.5
Difference -.5 .5 .5 2 1.5

b. The NPV at 10% yields a positive value of $2.63 for the fixed-
rate payer.

c. A fixed-rate of approximately 9.375% will make the NPV equal

to zero.

13-70
Interest Rate Swap (from Fabozzi: Bond Markets, Analysis and Strategies)

14. Consider the following interest-rate swap:

• the swap starts today, January 1 of year 1 (swap

settlement date)
• the floating-rate payments are made quarterly based on
actual / 360
• the reference rate is three-month LIBOR
• the notional amount of the swap is $40 million
• the term of the swap is three years

Answer the following questions.

(a) Suppose that today’s three-month LIBOR is 5.7%. What will the fixed-rate
payer for this interest rate swap receive on March 31 of year 1 (assuming that
year 1 is not a leap year)?

The quarterly floating-rate payments are based on an actual or 360-day count

convention. This convention means that 360 days are assumed in a year, and that in
computing the interest for the quarter the actual number of days in the quarter is used.
The floating-rate payment is set at the beginning of the quarter but paid at the end of
the quarter—that is, the floating-rate payments are made in arrears.

For our problem, today’s three-month LIBOR is 5.7%. Thus, the fixed-rate payer
receives payment based on this rate on March 31 of year 1—the date when the first
quarterly swap payment is made. There is no uncertainty about what this floating-rate
payment will be. In general, the floating-rate payment is given as:

floating-rate payment = notional amount × three-month LIBOR ×

number of days in period
.
360

In our problem, assuming a non-leap year, the number of days from January 1 of year
1 to March 31 of year 1 (the first quarter) is 90. If three-month LIBOR is 5.7%, then
the fixed-rate payer will receive a floating-rate payment on March 31 of year 1 as
shown below:

1
 90
floating-rate payment = $40,000,000 × 0.057 × = $570,000.
360

(b) Assume the Eurodollar CD futures price for the next seven quarters is as
follows:

Number of Days Eurodollar CD

Quarter Starts Quarter Ends in Quarter Futures Price
April 1 year 1 June 30 year 1 91 94.10
July 1 year 1 Sept 30 year 1 92 94.00
Oct 1 year 1 Dec 31 year 1 92 93.70
Jan 1 year 2 Mar 31 year 2 90 93.60
April 1 year 2 June 30 year 2 91 93.50
July 1 year 2 Sept 30 year 2 92 93.20
Oct 1 year 2 Dec 31 year 2 92 93.00

Compute the forward rate for each quarter.

Forward rate for period 1 is:

number of days in period

three-month LIBOR today × .
360

Inserting our values, we have:

90
5.70% × = 1.425%.
360

The forward rate for periods 2 through 8 is given by:

100 − Eurodollar CD Futures price for that period

forward rate = ×
100
number of days in period
.
360

Inserting the value for period two (i.e., April 1 year1 to June 30 year 1), we have:

100 − 94.10 91
forward rate = × = 0.0149138 or 1.4913889%.
100 360

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Similarly, for periods 3, 4, 5, 6, 7, and 8, the respective forward rates are:
1.5333333%, 1.6100%, 1.6000%, 1.6430556%, 1.7377778%, and 1.7888889%.

(c) What is the floating-rate payment at the end of each quarter for this
interest-rate swap?

The floating-rate payment for each period is the forward rate for that period, as given
in the part (b), times the notional amount of $40 million.

For period 1, we have

forward rate for period 1 × notional amount = 0.01425 × $40,000,000 = $570,000.00.

For period 2, we have:

forward rate for period 2 × notional amount = 0.014913889 × $40,000,000 =

$596,555.56.

Similarly, for periods 3, 4, 5, 6, 7, and 8, the respective forward rates are: $613,333.33,
$644,000.00, $640,000.00, $657,222.22, $695,111.11, and $715,555.56.

15. Answer the following questions.

(a) Assume that the swap rate for an interest-rate swap is 7% and that the
fixed-rate swap payments are made quarterly on an actual or 360-day basis. If
the notional amount of a two-year swap is $20 million, what is the fixed-rate
payment at the end of each quarter assuming the following number of days in
each quarter?

Period Quarter Days in Quarter

1 92
2 92
3 90
4 91
5 92
6 92
7 90
8 91

3
The fixed-rate payment for each quarter is given by:

number of days in period

fixed-rate payment = notional amount × swap rate ×
360

where the notional amount is $20 million, the swap rate is 7%, and the number of
days is the number for that period.

For period 1, we have:

number of days in period

fixed-rate payment = notional amount × swap rate × .
360

Inserting our values, we have:

92
fixed-rate payment for period 1 = 0.07 × $20,000,000 × = $357,777.78.
360

Similarly, for periods 2, 3, 4, 5, 6, 7, and 8, the respective fixed-rate payments are:

$357,777.78, $350,000.00, $353,888.89, $357,777.78, $357,777.78, $350,000.00, and
$353,888.89.

(b) Assume that the swap in part (a) requires payments semiannually rather
than quarterly. What is the semiannual fixed-rate payment?

First, we need the days for each of the four semiannual periods for the two years.
Period 1’s days are 92 + 92 = 184. Period 2’s days are: 90 + 91 = 181. Period 3’s days
are: 92 + 92 = 184. Period 4’s days are 90 + 91 = 181.

We use the formula given above as:

number of days in period

fixed-rate payment = notional amount × swap rate × .
360

where the notional amount and swap rate are the same but the number of days change
as given above. Inserting our values, we get for the first period:

4
 184
fixed-rate payment for period 1 = 0.07 × $20,000,000 × = $715,555.56.
360

Similarly, for periods 2, 3, and 4, the respective fixed-rate payments are: $703,888.89,
$715,555.56, and $703,888.89.

(c) Suppose that the notional amount for the two-year swap is not the same in
both years. Suppose instead that in year 1 the notional amount is $20 million, but
in year 2 the notional amount is $12 million. What is the fixed-rate payment
every six months?

The fixed-payments for the first two six-month periods are the same as given in part
(b) as $715,555.56 and $703,888.89. For period 3, the fixed-rate payment is:

184
fixed-rate payment for period 3 = 0.07 × $12,000,000 × = $429,333.33.
360

Similarly, for period 4, the fixed-rate payment is:

181
fixed-rate payment for period 4 = 0.07 × $12,000,000 × = $422,333.33.
360

16. Given the current three-month LIBOR and the Eurodollar CD futures prices
shown in the table below, compute the forward rate and the forward discount
factor for each period.

Current Eurodollar
Period Days in Quarter 3-month LIBOR CD Futures Price
1 90 5.90%
2 91 93.90
3 92 93.70
4 92 93.45
5 90 93.20
6 91 93.15

For period 1, we have:

5
 number of days in period
forward rate for period 1 = three-month LIBOR today × .
360

Inserting our values, we get:

90
5.90% × = 1.475%.
360

The forward rate for periods 2 through 6 is given by:

100 − Eurodollar CD Futures price for that period

forward rate = ×
100
number of days in period
.
360
Inserting the value for period 2, we have:

100 − 93.90 91
forward rate for period 2 = × = 0.015419444 or 1.5419444%.
100 360

Similarly, for periods 3, 4, 5, and 6, the respective forward rates are: 1.6100%,
1.6738889%, 1.7000%, and 1.7315278%.

The forward discount factor for period t is given by:

1 / [(1 + forward rate period 1)(1 + forward rate period 2) . . . (1 + forward rate period
t)].

For period 1, the forward discount factor is:

forward discount factor = 1 / (1 + forward rate for period 1) = 1 / 1.01475 =

0.98546440.

For period 2, the forward discount factor is:

forward discount factor = 1 / [(1 + forward rate period 1)(1 + forward rate period 2)] =
1 / [(1.01475)(1.015419444)] = 0.97049983.

Similarly for periods 3, 4, 5, and 6, the respective forward discount factors are:
0.95512236, 0.93939789, 0.92369507, and 0.90797326.

6
17. Answer the following questions.

(a) Suppose that at the inception of a five-year interest-rate swap in which the
reference rate is three-month LIBOR, the present value of the floating-rate
payments is $16,555,000. The fixed-rate payments are assumed to be semiannual.
Assume also that the following is computed for the fixed-rate payments (using
the notation in the chapter):

N
days in period t
∑ notional amount
t =1
×
360
× forward discount factor for period t =

$236,500,000.

What is the swap rate for this swap?

The swap rate is given by:

swap rate =
present value of floating-rate payments
N
.
days in period t
∑
t =1
notional amount ×
360
× forward discount factor for period t

Inserting our values we get:

$16,555,000
swap rate = = 0.0700 or 7.00%.
$236,500,000

(b) Suppose that the five-year yield from the on-the-run Treasury yield curve is
6.4%. What is the swap spread?

Given the swap rate, the swap spread can be determined. For example, since this is a
five-year swap, the convention is to use the five-year on-the-run Treasury rate as the
benchmark. Because the yield on that issue is 6.40%, the swap spread is 7.00% –
6.40% = 0.6% or 60 basis points.

18. An interest-rate swap had an original maturity of five-years. Today, the swap
has two years to maturity. The present value of the fixed-rate payments for the
remainder of the term of the swap is $910,000. The present value of the
floating-rate payments for the remainder of the swap is $710,000.

7
Answer the following questions.

(a) What is the value of this swap from the perspective of the fixed-rate payer?

We have: present value of fixed-rate payments = $910,000 and present value of

floating-rate payments = $710,000. The two present values are not equal, therefore,
for one party the value of the swap increased while for the other party the value of the
swap decreased.

The fixed-rate payer (or floating-rate receiver) will receive the floating-rate payments.
These floating-rate payments have a present value of $710,000. The present value of
the payments that must be made by the fixed-rate payer and received by floating-rate
payer is $910,000. Thus, the swap has a negative value for the fixed-rate payer equal
to the difference in the two present values of $710,000 – $910,000 = −$200,000.00.
This is the value of the swap to the fixed-rate payer.

(b) What is the value of this swap from the perspective of the fixed-rate receiver?

The floating-rate payer (or fixed-rate receiver) will receive the fixed-rate payments.
These fixed-rate payments have a present value of $910,000. The present value of the
payments that must be made by the floating-rate payer and received by fixed-rate
payer is $710,000. Thus, the swap has a positive value for the floating-rate payer
equal to the difference in the two present values of $910,000 – $710,000 =
$200,000.00. This is the value of the swap to the floating-rate payer.

10. Suppose that a life insurance company has issued a three-year GIC with a
fixed-rate of 10%. Under what circumstances might it be feasible for the life
insurance company to invest the funds in a floating-rate security and enter into a
three-year interest-rate swap in which it pays a floating rate and receives a
fixed-rate?

If the life insurance can enter a swap that guarantees a satisfactory spread above the
10% it is committed to pay, then it would not only be feasible but desirable to enter
into the swap.

Suppose the life insurance company can enter into a swap with a bank which has a

8
portfolio consisting of three-year term commercial loans with a fixed interest rate.
The principal value of bank’s portfolio is $10 million, and the interest rate on all its
loans in its portfolio is 11%. The loans are interest-only loans; interest is paid
semiannually, and the principal is paid at the end of three years. That is, assuming no
default on the loans, the cash flow from the loan portfolio is $550,000 million every
six months for the next three years and $10 million at the end of three years (in
addition to the $1.1 million interest). To fund its loan portfolio, assume that the bank
is relying on the issuance of six-month certificates of deposit. The interest rate that the
bank plans to pay on its six-month CDs is six-month LIBOR plus 40 basis points.

The risk that the bank faces is that six-month LIBOR will be 10.6% or greater. To
understand why, remember that the bank is earning 11% annually on its commercial
loan portfolio. If six-month LIBOR is 10.6%, it will have to pay 10.6% plus 40 basis
points, or 11%, to depositors for six-month funds and there will be no spread income.
Worse, if six-month LIBOR rises above 10.6%, there will be a loss; that is, the cost of
funds will exceed the interest rate earned on the loan portfolio. The bank’s objective
is to lock in a spread over the cost of its funds.

The life insurance company can seize this opportunity to cover its commitment to pay
a 10% rate for the next three years on the $10 million GIC it has issued. The amount
of its GIC is $10 million. Suppose that the life insurance company has the opportunity
to invest $10 million in what it considers an attractive three-year floating-rate
instrument in a private placement transaction. The interest rate on this instrument is
six-month LIBOR plus 160 basis points. The coupon rate is set every six months.

The risk that the life insurance company faces in this instance is that six-month
LIBOR will fall so that the company will not earn enough to realize a spread over the
10% rate that it has guaranteed to the GIC holders. If six-month LIBOR falls to 8.4%
or less, no spread income will be generated. To understand why, suppose that
six-month LIBOR at the date the floating-rate instrument resets its coupon is 8.4%.
Then the coupon rate for the next six months will be 10% (8.4% plus 160 basis
points). Because the life insurance company has agreed to pay 10% on the GIC policy,
there will be no spread income. Should six-month LIBOR fall below 8.4%, there will
be a loss.

We can summarize the asset/liability problems of the bank and the life insurance
company as follows.

9
Bank:

(i) Has lent long term and borrowed short term.

(ii) If six-month LIBOR rises, spread income declines.

Life Insurance Company:

(i) Has lent short term and borrowed long term.

(ii) If six-month LIBOR falls, spread income declines.

Now let’s suppose the market has available a three-year interest-rate swap with a
notional principal amount of $10 million. The swap terms available to the bank are as
follows:

(i) Every six months the bank will pay 9.45% (annual rate).
(ii) Every six months the bank will receive LIBOR.

The swap terms available to the insurance company are as follows:

(i) Every six months the life insurance company will pay LIBOR.
(ii) Every six months the life insurance company will receive 9.40%.

What has this interest-rate contract done for the bank and the life insurance company?
Consider first the bank. For every six-month period for the life of the swap agreement,
the interest-rate spread will be as follows:

Annual Interest Rate Received:

From commercial loan portfolio 11.00%
From interest-rate swap six-month LIBOR
Total 11.00% + six-month LIBOR
Annual Interest Rate Paid:
To CD depositors six-month LIBOR
On interest-rate swap 9.45%
Total 9.45% + six-month LIBOR
Outcome:
To be received 11.00% + six-month LIBOR
To be paid 9.45% + six-month LIBOR
Spread income 1.55% or 155 basis points

10
Thus, whatever happens to six-month LIBOR, the bank locks in a spread of 155 basis
points.

Now let’s look at the effect of the interest-rate swap from the perspective of the life
insurance company:

Annual Interest Rate Received:

From floating-rate instrument 1.6% + six-month LIBOR
From interest-rate swap 9.40%
Total 11.00% + six-month LIBOR
Annual Interest Rate Paid:
To GIC policyholders 10.00%
On interest-rate swap Six-month LIBOR
Total 10.00% + six-month LIBOR
Outcome:
To be received 11.00% + six-month LIBOR
To be paid 10.00% + six-month LIBOR
Spread income 1.00% or 100 basis points

Thus, whatever happens to six-month LIBOR, the insurance company locks in a

spread of 100 basis points.

The interest-rate swap has allowed each party to accomplish its asset/liability
objective of locking in a spread.

It permits the two financial institutions to alter the cash flow characteristics of its
assets: from fixed to floating in the case of the bank, and from floating to fixed in the
case of the life insurance company.

11