Swaps and Interest Rate Options

 Outline
 Interest rate swaps
 Foreign currency swaps
 Circus swap
 Interest rate options

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 Both swaps and interest rate options are
relatively new, but extensively used
 In mid-2000, there was over $60 trillion
outstanding in interest rate swaps, foreign
currency swaps, and other interest rate options

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 Hedging with interest rate swaps
 Immunizing with interest rate swaps
 Exploiting comparative advantage in the
credit market

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 Popular with bankers, corporate treasurers,
and portfolio managers who need to
manage interest rate risk
 A swap enables you to alter the level of risk
without disrupting the underlying
portfolio:
▪ asset
▪ liability

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 The most common type of interest rate swap is the
fixed for floating rate swap
 One party makes a fixed interest rate payment to another
party making a floating interest rate payment
 Only the net payment is made (difference check)
 The firm paying the floating rate is the swap seller
 The firm paying the fixed rate is the swap buyer

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 Typically, the floating interest rate is linked
to a market rate such as
 LIBOR or
 T-bill rates
 BA’s in Canada
 The swap market is standardized partly by
the International Swaps and Derivatives
Association (ISDA)
 ISDA provisions are master agreements
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 A plain vanilla swap refers to a standard
contract with no unusual features or bells
and whistles
 The swap facilitator will find a counterparty
to a desired swap for a fee or take the other
side
 A facilitator acting as an agent is a swap broker
 A swap facilitator taking the other side is a swap
dealer (swap bank)

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 Plain Vanilla Swap Example

 A large firm pays a fixed interest rate to its bondholders, while a

smaller firm pays a floating interest rate to its bankers
 The two firms could engage in a swap transaction which results in
the larger firm paying floating interest rates to the smaller firm, and
the smaller firm paying fixed interest rates to the larger firm

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Large firm with a strong credit rating
 takes advantage of it s borrowing capacity
and borrows fixed term in the bond market
 interest rate outlook - declining rates
 enters into a swap agreement to move to
floating rate debt but still leveraging its
strong credit rating and borrowing capacity

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Smaller firm with weaker credit rating
 no/minimal access to long term bond market due to its
relatively weak credit rating
 typically borrows floating rate from its bank(s)
 would like to fix its borrowing rate as part of its risk
management program
 can achieve its fixed rate objectives by entering into a
swap agreement

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 Plain Vanilla Swap Example (cont’d)

LIBOR – 50 bp

Big Firm 8.05%

Smaller Firm

8.05% LIBOR +100 bp

Bondholders Bankers

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 Plain Vanilla Swap Example

A facilitator might act as an agent in the transaction and charge a

15 bp fee for the service.

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 Plain Vanilla Swap Example
LIBOR -50 bp LIBOR -50 bp

Big Firm Facilitator Smaller Firm

8.05% 8.20%

8.05% LIBOR +100 bp

Bondholders Bankers

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 Swaps can be entered into at same time the firm accesses
the bond market - e.g. 5 year fixed rate bond issue
immediately swapped into floating rate via a swap
agreement
or
 A swap can be negotiated at any time over the life of an
existing borrowing e.g. 7 year bond issue two years prior -
firm now expects interest rates to decline - 5 years
remaining on the bond issue - firm enters into a 5 year
fixed to floating rate swap

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 The swap price is the fixed rate that the two
parties agree upon
 The tenor is the term of the swap
 The notional value determines the size of
the interest rate payments
 Counterparty risk refers to the risk that one
party to the swap will not honor its part of
the agreement

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 Interest rate outlook over expected
borrowing horizon
 Use swaps where the borrowing horizon is
longer term
 use futures where the interest rate risk is short
term
 absolute interest rate levels and or yield
curve shape
 credit or ‘swap’ spreads

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 Interest rate swaps can be used by
corporate treasurers to adjust their
exposure to interest rate risk
 The duration gap is:

Total Liabilitie s
D gap  D asset   D liabilities
Total assets

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 A positive duration gap means a bank’s net
worth will suffer if interest rates rise
 The treasurer may choose to move the duration
gap to zero
▪ This could be accomplished by selling some of the
bank’s loans and holding cash equivalent securities
instead
or
▪ using interest rate swaps to close the duration gap

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 Interest rate swaps can be used to exploit
differentials in the credit market

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 Credit Market Example
AAA Bank and BBB Bank currently face the following borrowing
possibilities:
Firm Fixed Rate Floating Rate

AAA Current 5-yr LIBOR

T-bond + 25 bp

BBB Current 5-yr LIBOR + 30 bp

T-bond + 85 bp

Quality Spread 60 bp 30 bp

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 Credit Market Example (cont’d)

AAA Bank has an absolute advantage over BBB in both the fixed
and the floating rate markets. AAA has a comparative advantage in
the fixed rate market.

The total gain available to be shared among the swap participants

is the differential in the fixed rate market minus the differential in
the variable rate market, or 30 bps.

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 Credit Market Example (cont’d)

AAA Bank wants to issue a floating rate bond, while BBB wants to
borrow at a fixed rate. Both banks will borrow at a lower cost if they
agree to an interest rate swap.

AAA Bank should issue a fixed rate bond because it has a

comparative advantage in this market. BBB should borrow at a
floating rate. The swap terms split the rate savings 50-50. The
current 5-yr T-bond rate is 4.50%.

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 Credit Market Example (cont’d)

Treasury + 40 bp

AAA BBB
LIBOR

Treasury + 25 bp LIBOR +30 bp

Bondholders Bondholders

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 Credit Market Example (cont’d)

 The net borrowing rate for AAA is LIBOR – 15 bps

 The net borrowing rate for BBB is Treasury + 70 bps

 The net rate for both parties is 15 bps less than without the
swap.

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 In a currency swap, two parties

 Exchange currencies at the prevailing exchange

rate
 Then make periodic interest payments to each
other based on a predetermined pair of interest
rates, and
 Re-exchange the original currencies at the
conclusion of the swap

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 Cash flows at origination:

Euro Principal

C$ Principal
Cdn. Co. Swap Dealer

Fixed
Rate C$
Interest

Bondholders
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 Cash flows at each settlement:

Euro Fixed Rate

Cdn. Co. Swap Dealer

C$ - Fixed Rate

C$
Fixed Rate
Interest

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 Cash flows at maturity:

Euro Principal

Cdn. Co. Swap Dealer

C $ Principal

Retire C$
Issue

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 Combining both interest rate and currency
swaps

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 A circus swap combines an interest rate and
a currency swap

 Involves a plain vanilla interest rate swap and

an ordinary currency swap
 Both swaps might be with the same
counterparty or with different counterparties

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 Interest associated with original currency
swap

Euro - Fixed

Cdn. Co. Swap Dealer

C$ - Fixed

Fixed C$
Interest

Bondholders
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 Interest rate swap to move from fixed
euros to floating rate euros
Euro Fixed

Cdn. Co. Swap Dealer

Euro Floating

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 Circus swap with two counterparties = net
position of:
Floating Rate Euros

Cdn. Co. Swap Dealer

Fixed Rate C$

Fixed C$
Interest

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 Deferred swap
 Floating for floating swap
 Amortizing swap
 Accreting swap

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 In a deferred swap (forward start swap), the
cash flows do not begin until sometime
after the initiation of the swap agreement
 Motivation - desire to manage future
interest rate risk but reflecting today’s
interest rate conditions

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 ABC corporation has a required borrowing 2
years from now
 interest rate outlook is for rates trending
upward
 deferred swap could lock in today’s fixed
rates for a premium
 a deferred or forward swap is in effect 2
swaps

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 Pay 2 year Pay 7 year
Fixed Fixed
Swap ABC Co. Swap
Dealer Dealer

Pay Receive
BA’s BA’s

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 ...in two years time

Pay 7 year (5 years remaining)

Fixed

ABC Co. Swap

Dealer
Receive
Borrow BA’s
Floating
Rate BA’s

Bankers

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 Dealer factors in the ‘cost of carry’ in
offering the deferred 5 year rate (one swap)
 Considerations
 interest rate outlook
 time frame
 cost of carry - the cost of the ‘hedge’
▪ steep yield curve - higher cost of carry
▪ flat yield curve - minimal cost of carry

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 In a floating for floating swap, both parties
pay a floating rate, but with difference
benchmark indices

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 In an amortizing swap, the notional value
declines over time according to some
schedule

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 In an accreting swap, the notional value
increases through time according to some
schedule

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 Interest rate cap
 Interest rate floor
 Calculating cap and floor payoffs
 Interest rate collar
 Swaption

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 Most of the trading done off the exchange
floors

 The interest rate options market is

 Very large
 Highly efficient
 Highly liquid
 Easy to use

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 Growth in Interest Rate Options
Notional Value
15
(Trillions)

10

0
1992 1993 1994 1995 1996 1997 1998 1999 2000
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 An interest rate cap

 Is like a portfolio of European call options

(caplets) on an interest rate
▪ On each interest payment date over the life of the
cap, one option in the portfolio expires
 Is useful to firms with floating rate liabilities
 Caps the periodic interest payments at the
caplet’s exercise price

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 Long interest rate cap (exercise price 7%)

$ Payoff

Option expires worthless Payoff

Floating Rate
7%

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 Short interest rate cap (exercise price 7%)

$ Payoff

Option expires worthless

Floating Rate
7% Payout

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 An interest rate floor
 Is related to a cap in the same way that a put is
related to a call
 like a portfolio of European put options
(floorlets) on an interest rate
▪ On each interest payment date over the life of the
cap, one option in the portfolio expires
 Is useful to firms with floating rate assets
 Puts a lower limit on the periodic interest
payments at the floorlet’s exercise price

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 Long interest rate floor (exercise price 6.5%)

$ Payoff

Payoff Option expires worthless

Floating Rate
6.5%

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 Short interest rate floor (exercise price 6.5%)

$ Payoff

Option expires worthless

Floating Rate
Payout 6.5%

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 There are no universally acceptable terms
to caps and floors

 However, frequently the terms provide for

the cash payment on an in-the-money
caplet or floorlet to be based on a 360-day
year

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 Cap payout formula:
days in payment period
cap payout  (notional value)  
360
(benchmark rate - striking price)

 If the benchmark rate is less than the

exercise price, the payout is zero

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 Floor payout formula:
days in payment period
floor payout  (notional value)  
360
(striking price - benchmark rate)

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 An interest rate collar is simultaneously
long an interest rate cap and short an
interest rate floor

 Sacrifices some upside potential in

exchange for a lower position cost
 Premium from writing the floorlets reduces
position costs

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 Long cap
$ Payoff

No payout Inflow
Floating Rate
Outflow k1 k2

Short floor

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 A swaption is an option on a swap
 Can be either American or European style
 A payer swaption (put swaption) gives its
owner the right to pay the fixed interest
rate on a swap
 A receiver swaption (call swaption) gives its
owner the right to receive the fixed rate
and pay the floating rate

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