Chapter 13
Swaps and Interest
Rate Options
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© 2002 South-Western Publishing
Outline
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Interest rate swaps
Foreign currency swaps
Circus swap
Interest rate options
Introduction
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Both swaps and interest rate options are
relatively new, but extensively used
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In mid-2000, there was over $60 trillion
outstanding in interest rate swaps, foreign
currency swaps, and other interest rate options
Interest Rate Swaps
Hedging with interest rate swaps
 Immunizing with interest rate swaps
 Exploiting comparative advantage in
the credit market
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Interest Rate Swaps
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:
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 asset
 liability
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Interest Rate Swaps
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The most common type of interest rate swap
is the fixed for floating rate swap
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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
Interest Rate Swaps
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Typically, the floating interest rate is linked
to a market rate such as
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The swap market is standardized partly by
the International Swaps and Derivatives
Association (ISDA)
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LIBOR or
T-bill rates
BA’s in Canada
ISDA provisions are master agreements
‘Plain Vanilla’ Swap – Hedging
Interest Rate Risk
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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
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A facilitator acting as an agent is a swap broker
A swap facilitator taking the other side is a swap
dealer (swap bank)
Plain Vanilla 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
Plain Vanilla Swap
Plain Vanilla Swap Example
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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
Plain Vanilla Swap - Motivations
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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Plain Vanilla Swap - Motivations
Smaller firm with weaker credit rating
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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
Plain Vanilla Swap
Plain Vanilla Swap Example (cont’d)
LIBOR – 50 bp
Big Firm
8.05%
Bondholders
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8.05%
Smaller
Firm
LIBOR +100 bp
Bankers
Plain Vanilla Swap
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
Plain Vanilla Swap Example
LIBOR -50 bp
Big Firm
8.05%
Bondholders
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8.05%
LIBOR -50 bp
Facilitator
8.20%
Smaller
Firm
LIBOR +100 bp
Bankers
Plain Vanilla Swaps - Timing
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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
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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
Interest Rate Risk Management Considerations
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Interest rate outlook over expected
borrowing horizon
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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
Interest Rate Risk Management
Considerations
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Interest Rate Outlook
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Absolute Levels and Yield Curve
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Floating rate alternative if outlook is lower
Fixed rate if outlook is higher
Borrow fixed rate – premium but no risk
Borrow floating rate – at lower rates at shorter end
of the yield curve – but with interest rate risk
Interest Rate Risk Management
Considerations
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Fixed to Floating interest rate swap
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Floating to Fixed interest rate swap
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Outlook for rates lower
Steeper yield curve – lower rates at short end
Absolute borrowing levels
Credit/swap spreads
Outlook for rates higher
Flatter yield curve
Absolute borrowing levels
Credit/swap spreads
Swap Timing – Anticipating Interest
Rate Changes
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Interest rate changes need to be anticipated
and swaps need to be negotiated ahead of the
actual interest rate movement for the buyer
to achieve the desired result
Immunizing With Interest Rate
Swaps
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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:
D gap
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Total Liabilitie s
 D asset 
 D liabilities
Total assets
Immunizing With Interest Rate
Swaps (cont’d)
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A positive duration gap means a bank’s net
worth will suffer if interest rates rise
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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
…how would this be done?
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Exploiting Comparative
Advantage in the Credit Market
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Interest rate swaps can be used to exploit
differentials in the credit market
Exploiting Comparative
Advantage in the Credit Market
Credit Market Example
AAA Bank and BBB Bank currently face the following
borrowing possibilities:
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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 (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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Exploiting Comparative
Advantage in the Credit Market
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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Exploiting Comparative
Advantage in the Credit Market
Credit Market Example (cont’d)
Treasury + 40 bp
AAA
Treasury + 25 bp
Bondholders
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LIBOR
BBB
LIBOR +30 bp
Bondholders
Exploiting Comparative
Advantage in the Credit Market
Credit Market Example (cont’d)
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The net borrowing rate for AAA is LIBOR – 15 bps
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The net borrowing rate for BBB is Treasury + 70 bps
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The net rate for both parties is 15 bps less than without
the swap.
Foreign Currency Risk
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1971 – the Breton Woods Agreement was suspended
by global monetary leaders
Currencies previously tied to the price of gold and to
the $US now floated freely
The result- currency volatility and currency risk
1972 – CME began trading currency futures
1981 – Salomon Bros brokered the first currency swap
between the World Bank and IBM (German marks
Swiss francs)
Foreign Currency Risk Today
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‘Euro’ volatility
Weakening US dollar
Strengthening Canadian dollar (other ‘resource
currencies)
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Impacted Canadian firms and individual investors
E.g. oil & gas producers selling commodities
denominated in $US and Canadian investors
investing in US securities
Foreign Currency Swaps
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In a currency swap, two parties
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Exchange currencies at the prevailing exchange
rate
Then make periodic interest payments to each
other based on a predetermined pair of interest
rates, and
Re-exchange the original currencies at the
conclusion of the swap
Foreign Currency Swaps
(cont’d)
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Cash flows at origination:
Euro Principal
Cdn. Co.
Fixed
Rate
Interest
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Bondholders
C$ Principal
C$
Swap Dealer
Foreign Currency Swaps
(cont’d)
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Cash flows at each settlement:
Euro Fixed Rate
Cdn. Co.
C$
Fixed Rate
Interest
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C$ - Fixed Rate
Swap Dealer
Foreign Currency Swaps
(cont’d)
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Cash flows at maturity:
Euro Principal
Cdn. Co.
C $ Principal
Retire C$
Issue
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Swap Dealer
Circus Swap
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Combining both interest rate and currency
swaps
Circus Swap
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A circus swap combines an interest rate
and a currency swap
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Involves a plain vanilla interest rate swap and an
ordinary currency swap
Both swaps might be with the same
counterparty or with different counterparties
Circus Swap
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Interest associated with original currency
swap
Euro - Fixed
Cdn. Co.
Swap Dealer
C$ - Fixed
Fixed C$
Interest
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Bondholders
Circus Swap
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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
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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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Swap Variations
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Deferred or ‘forward’ swap
Floating for floating swap
Amortizing swap
Accreting swap
Deferred 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
Deferred Swap - Example
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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
Deferred Swap - Example
Pay 7 year
Fixed
Pay 2 year
Fixed
Swap
Dealer
ABC Co.
Pay
BA’s
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Swap
Dealer
Receive
BA’s
Deferred Swap - Example
...in two years time
Pay 7 year (5 years remaining)
Fixed
ABC Co.
Receive
BA’s
Borrow
Floating
Rate BA’s
Bankers
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Swap
Dealer
Deferred Swap 
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Rate is established today and ‘deferred’ for a
period of time
Dealer factors in the ‘cost of carry’ in offering the
deferred 5 year rate (one swap)
Considerations
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interest rate outlook
time frame
cost of carry - the cost of the ‘hedge’
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steep yield curve - higher cost of carry
flat yield curve - minimal cost of carry
Floating for Floating Swap
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In a floating for floating swap, both parties
pay a floating rate, but with difference
benchmark indices
Amortizing Swap
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In an amortizing swap, the notional value
declines over time according to some
schedule
Accreting Swap
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In an accreting swap, the notional value
increases through time according to some
schedule
Interest Rate Options
Interest rate cap
 Interest rate floor
 Calculating cap and floor payoffs
 Interest rate collar
 Swaption
………similar instruments available on
commodities such as oil and gas
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Interest Rate Options
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Most of the trading done off the exchange
floors
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The interest rate options market is
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Very large
Highly efficient
Highly liquid
Easy to use
Interest Rate Options
Growth in Interest Rate Options
Notional Value
(Trillions)
15
10
5
0
1992 1993 1994 1995 1996 1997 1998 1999 2000
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Interest Rate Cap
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An interest rate cap
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Is like a portfolio of European call options
(caplets) on an interest rate
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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
Interest Rate Cap (cont’d)
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Long interest rate cap (exercise price 7%)
$ Payoff
Payoff
Option expires worthless
7%
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Floating Rate
Interest Rate Cap (cont’d)
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Short interest rate cap (exercise price 7%)
$ Payoff
Option expires worthless
7%
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Payout
Floating Rate
Interest Rate Floor
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An interest rate floor
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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
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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
Interest Rate Floor (cont’d)
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Long interest rate floor (exercise price 6.5%)
$ Payoff
Payoff
Option expires worthless
6.5%
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Floating Rate
Interest Rate Floor (cont’d)
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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
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There are no universally acceptable terms
to caps and floors – OTC instruments
customized to meet needs of both parties
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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
Calculating Cap and Floor
Payoffs (cont’d)
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Cap payout formula:
days in payment period
cap payout  (notional value) 

360
(benchmark rate - striking price)
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If the benchmark rate is less than the exercise price, the
payout is zero
…..all in borrowing cost will be hedged at the strike price plus
the option premium
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Calculating Cap and Floor
Payoffs (cont’d)
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Floor payout formula:
days in payment period
floor payout  (notional value) 

360
(striking price - benchmark rate)
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Interest Rate Collar
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An interest rate collar is simultaneously
long an interest rate cap and short an
interest rate floor
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Sacrifices some upside potential in
exchange for a lower position cost
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Premium from writing the floorlets reduces
position costs
Interest Rate Collar (cont’d)
Long cap
$ Payoff
Inflow
No payout
Outflow
k1
Short floor
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k2
Floating Rate
Swaption
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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