Chapter 13

Swaps and Interest

Rate Options

2004 South-Western Publishing

Outline
Introduction
Interest

rate swaps
Foreign currency swaps
Circus swap
Interest rate options

Introduction
Both

swaps and interest rate options are

relatively new, but very large

In mid-2000, there was over $60 trillion

outstanding in interest rate swaps, foreign
currency swaps, and other interest rate options

Interest Rate Swaps

Introduction
Immunizing

with interest rate swaps

Exploiting comparative advantage in
the credit market

Introduction
Popular

with bankers, corporate

treasurers, and portfolio managers
who need to manage interest rate risk

swap enables you to alter the level

of risk without disrupting the
underlying portfolio

Introduction (contd)

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

Introduction (contd)
Typically,

the floating interest rate is linked

to a market rate such as LIBOR or T-bill
rates

The

swap market is standardized partly by

the International Swaps and Derivatives
Association (ISDA)

ISDA provisions are master agreements

Introduction (contd)
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)

Introduction (contd)
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
bondholders.
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.

Introduction (contd)
Plain Vanilla Swap Example (contd)
LIBOR 50 bp

Big Firm
8.05%

Bondholders

10

8.05%

Smaller Firm
LIBOR +100 bp

Bondholders

Introduction (contd)
Plain Vanilla Swap Example (contd)
A facilitator might act as an agent in the transaction and
charge a 15 bp fee for the service.

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Introduction (contd)
Plain Vanilla Swap Example (contd)
LIBOR -50 bp

Big Firm
8.05%

Bondholders

12

8.05%

LIBOR -50 bp

Facilitator

8.20%

Smaller
Firm

LIBOR +100 bp

Bondholders

Introduction (contd)
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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Immunizing With Interest Rate

Swaps
Interest

rate swaps can be used by

corporate treasurers to adjust their
exposure to interest rate risk
The duration gap is:

D gap
14

Total Liabilities
D asset
D liabilities
Total assets

Immunizing With Interest Rate

Swaps (contd)
A

positive duration gap means a banks 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

banks loans and holding cash equivalent securities
instead

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Immunizing With Interest Rate

Swaps (contd)
Using

the banks balance sheet, we can

algebraically solve for the proportion of the
firms assets to be held in cash so that the
duration gap is zero:

D gap x cash 0.00 1 x cash average loan asset duration Total Liabilities

D liabilities 0

Total assets

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Exploiting Comparative
Advantage in the Credit Market
Interest

rate swaps can be used to exploit

differentials in the credit market

17

Exploiting Comparative
Advantage in the Credit Market
Credit Market Example
AAA Bank and BBB Bank currently face the following
borrowing possibilities:

18

Firm

Fixed Rate

Floating Rate

AAA

Current 5-yr
T-bond + 25 bp

LIBOR

BBB

Current 5-yr
T-bond + 85 bp

LIBOR + 30 bp

Quality Spread

60 bp

30 bp

Exploiting Comparative
Advantage in the Credit Market
Credit Market Example (contd)
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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Exploiting Comparative
Advantage in the Credit Market
Credit Market Example (contd)
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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Exploiting Comparative
Advantage in the Credit Market
Credit Market Example (contd)
LIBOR

AAA

Treasury + 40 bp

Treasury + 25 bp

Bondholders

21

BBB
LIBOR +30 bp

Bondholders

Exploiting Comparative
Advantage in the Credit Market
Credit Market Example (contd)

22

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.

Foreign Currency Swaps

In

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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

Foreign Currency Swaps

(contd)
Cash

flows at origination:
FX Principal

Party 1

24

US $ Principal

Party 2

Foreign Currency Swaps

(contd)
Cash

flows at each settlement:

$ LIBOR

Party 1

25

FX Fixed Rate

Party 2

Foreign Currency Swaps

(contd)
Cash

flows at maturity:
US $ Principal

Party 1

26

FX Principal

Party 2

Foreign Currency Swaps

(contd)
Foreign Currency Swap Example
A multinational US corporation has a subsidiary in Germany.
It just signed a 3-year contract with a German firm. The
German firm will provide raw materials, with the US firm
paying 1 million Euros every 6 months for the 3-year period.
The current exchange rate is $0.90/Euro.
The contract is fixed in Euro terms, but if the dollar
depreciates against the Euro, dollar accounts payable would
increase.

27

Foreign Currency Swaps

(contd)
Foreign Currency Swap Example (contd)
A currency swap is possible with the following terms:

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Tenor = 3 years
Notional value = 25 million Euros ($22.5 million)
Floating rate = $ LIBOR
Fixed rate = 8.00% on Euros

Foreign Currency Swaps

(contd)
Foreign Currency Swap Example (contd)
The swap will result in the following payments every six
months:

29

Fixed rate payment = 25,000,000 Euros x 8.00% x 0.5 =

1,000,000 Euros
Floating rate payment = $22.5 million x 0.5 x LIBOR

Foreign Currency Swaps

(contd)
Foreign Currency Swap Example (contd)
Cash Flows at Origination
25 million euros

Party 1

Party 2
$22.5 million

30

Foreign Currency Swaps

(contd)
Foreign Currency Swap Example (contd)
Cash Flows at Each Settlement
$ LIBOR

Party 1

Party 2
1 million euros

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Foreign Currency Swaps

(contd)
Foreign Currency Swap Example (contd)
Cash Flows at Maturity
$22.5 million

Party 1

Party 2
25 million euros

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Circus Swap
Introduction
Swap

33

variations

Introduction
A

circus swap combines an interest rate

and a currency swap

34

Involves a plain vanilla interest rate swap and an

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

Introduction (contd)
Circus

swap with two counterparties:

8% on Euros

Party 1

Party 2
$ LIBOR

35

Introduction (contd)
Circus

swap with two counterparties

(contd):
$ LIBOR

Party 1

Party 3
6.50% US

36

Introduction (contd)
Circus

swap with two counterparties

(contd):
8% on Euros

Party 1

Net
6.50% US

37

Introduction (contd)
Circus

swap with two counterparties

(contd):

38

Party 1 is effectively paying 8% on Euros and

receiving 6.5% in U.S. dollars

Swap Variations
Deferred

swap
Floating for floating swap
Amortizing swap
Accreting swap

39

Deferred Swap
In

a deferred swap (forward start swap), the

cash flows do not begin until sometime
after the initiation of the swap agreement

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If the swap begins now, the deferred swap is

called a spot start swap

Floating for Floating Swap

In

a floating for floating swap, both parties

pay a floating rate, but with different
benchmark indices

41

Amortizing Swap
In

an amortizing swap, the notional value

declines over time according to some
schedule

42

Accreting Swap
In

an accreting swap, the notional value

increases through time according to some
schedule

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Interest Rate Options

Introduction
Interest

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

44

Introduction
Most

of the trading done off the exchange

floors

The

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interest rate options market is

Very large
Highly efficient
Highly liquid
Easy to use

Introduction (contd)
Growth in Interest Rate Options
Notional Value

(Trillions)

15
10
5
0
1992 1993 1994 1995 1996 1997 1998 1999 2000

46

Interest Rate Cap

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

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Is useful to firms with floating rate liabilities

Caps the periodic interest payments at the
caplets exercise price

Interest Rate Cap (contd)

Long

interest rate cap (exercise price 7%)

$ Payoff

Payoff
Option expires worthless
7%

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Floating Rate

Interest Rate Cap (contd)

Short

interest rate cap (exercise price 7%)

$ Payoff

Option expires worthless

7%

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Payout

Floating Rate

Interest Rate Floor

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

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Is useful to firms with floating rate assets

Puts a lower limit on the periodic interest
payments at the floorlets exercise price

Interest Rate Floor (contd)

Long interest rate floor (exercise price 6.5%)

$ Payoff

Payoff

Option expires worthless

6.5%

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Floating Rate

Interest Rate Floor (contd)

Short interest rate floor (exercise price 6.5%)

$ Payoff

Option expires worthless

Payout

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6.5%

Floating Rate

Calculating Cap and Floor

Payoffs
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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Calculating Cap and Floor

Payoffs (contd)
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

54

Calculating Cap and Floor

Payoffs (contd)
Floor

payout formula:

Days in payment period

Floor payout (notional value)

360
(striking price - benchmark rate)

55

Interest Rate Collar

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

56

Premium from writing the floorlets reduces

position costs

Interest Rate Collar (contd)

Long cap

$ Payoff

Inflow
No payout
Outflow

K1
Short floor

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K2

Floating Rate

Swaption
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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