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Swaps and Interest
Rate Options
© 2004 South-Western Publishing

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Outline
 Introduction
 Interest rate swaps
 Foreign currency swaps
 Circus swap
 Interest rate options

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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

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Interest Rate Swaps
 Introduction
 Exploiting comparative advantage in the credit market

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Introduction
 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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Introduction (cont’d)
 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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Introduction (cont’d)
 Typically, the floating interest rate is linked to a market rate such as LIBOR
 The swap market is standardized partly by the International Swaps and Derivatives
Association (ISDA)
– ISDA provisions are master agreements

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Introduction (cont’d)
 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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Introduction (cont’d)
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.

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Introduction (cont’d)
Plain Vanilla Swap Example (cont’d)
Big Firm
LIBOR – 50 bp
8.05%
8.05%
Smaller
Firm
LIBOR +100 bp
Bondholders Bondholders

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

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Introduction (cont’d)
Big Firm
Plain Vanilla Swap Example (cont’d)
LIBOR -50 bp
8.05%
8.05%
Facilitator
LIBOR -50 bp
8.20%
Smaller
Firm
LIBOR +100 bp
Bondholders
Bondholders

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Introduction (cont’d)
 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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Exploiting Comparative
Advantage in the Credit Market
 Interest rate swaps can be used to exploit differentials in the credit market

Exploiting Comparative
Advantage in the Credit Market
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Credit Market Example
AAA Bank and BBB Bank currently face the following borrowing possibilities:
Firm
AAA
Fixed Rate
Current 5-yr
T-bond + 25 bp
Floating Rate
LIBOR
BBB LIBOR + 30 bp
Quality Spread
Current 5-yr
T-bond + 85 bp
60 bp 30 bp

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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
AAA
Credit Market Example (cont’d)
LIBOR
BBB
Treasury + 40 bp
Treasury + 25 bp LIBOR +30 bp
Bondholders Bondholders

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Exploiting Comparative
Advantage in the Credit Market



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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Foreign Currency Swaps
 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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Foreign Currency Swaps
(cont’d)
 Cash flows at origination:
FX Principal
Party 1
US $ Principal
Party 2

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Foreign Currency Swaps
(cont’d)
 Cash flows at each settlement:
$ LIBOR
Party 1
FX Fixed Rate
Party 2

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Foreign Currency Swaps
(cont’d)
 Cash flows at maturity:
US $ Principal
Party 1
FX Principal
Party 2

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Foreign Currency Swaps
(cont’d)
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.

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Foreign Currency Swaps
(cont’d)
Foreign Currency Swap Example (cont’d)
A currency swap is possible with the following terms:




Tenor = 3 years
Notional value = 25 million Euros ($22.5 million)
Floating rate = $ LIBOR
Fixed rate = 8.00% on Euros

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Foreign Currency Swaps
(cont’d)
Foreign Currency Swap Example (cont’d)
The swap will result in the following payments every six months:


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

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Foreign Currency Swaps
(cont’d)
Foreign Currency Swap Example (cont’d)
Cash Flows at Origination
25 million euros
Party 1 Party 2
$22.5 million

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Foreign Currency Swaps
(cont’d)
Foreign Currency Swap Example (cont’d)
Cash Flows at Each Settlement
$ LIBOR
Party 1 Party 2
1 million euros

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Foreign Currency Swaps
(cont’d)
Foreign Currency Swap Example (cont’d)
Cash Flows at Maturity
$22.5 million
Party 1 Party 2
25 million euros

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Circus Swap
 Introduction
 Swap variations

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Introduction
 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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Introduction (cont’d)
 Circus swap with two counterparties:
8% on Euros
Party 1 Party 2
$ LIBOR

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Introduction (cont’d)
 Circus swap with two counterparties
(cont’d):
$ LIBOR
Party 1 Party 3
6.50% US

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Introduction (cont’d)
 Circus swap with two counterparties
(cont’d):
8% on Euros
Party 1 Net
6.50% US

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Introduction (cont’d)
 Circus swap with two counterparties
(cont’d):
– Party 1 is effectively paying 8% on Euros and receiving 6.5% in U.S. dollars

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Swap Variations
 Deferred swap
 Floating for floating swap
 Amortizing swap
 Accreting swap

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Deferred Swap
 In a deferred swap ( forward start swap ), the cash flows do not begin until sometime after the initiation of the swap agreement
– If the swap begins now, the deferred swap is called a spot start swap

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Floating for Floating Swap
 In a floating for floating swap , both parties pay a floating rate, but with different benchmark indices

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Amortizing Swap
 In an amortizing swap , the notional value declines over time according to some schedule

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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

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Introduction
 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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Introduction (cont’d)
Growth in Interest Rate Options
Notional Value
15
10
5
0
1992 1993 1994 1995 1996 1997 1998 1999 2000

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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
Is useful to firms with floating rate liabilities
– Caps the periodic interest payments at the caplet’s exercise price

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Interest Rate Cap (cont’d)
 Long interest rate cap (exercise price 7%)
$ Payoff
Option expires worthless
7%
Payoff
Floating Rate

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Interest Rate Cap (cont’d)
 Short interest rate cap (exercise price 7%)
$ Payoff
Option expires worthless
7% Payout
Floating Rate

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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
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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Interest Rate Floor (cont’d)
 Long interest rate floor (exercise price 6.5%)
$ Payoff
Payoff
6.5%
Option expires worthless
Floating Rate

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Interest Rate Floor (cont’d)
 Short interest rate floor (exercise price 6.5%)
$ Payoff
Payout
6.5%
Option expires worthless
Floating Rate

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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 (cont’d)
 Cap payout formula:
Cap payout

(notional value)

Days in payment period
360

(benchmark rate striking price)
 If the benchmark rate is less than the exercise price, the payout is zero

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Calculating Cap and Floor
Payoffs (cont’d)
 Floor payout formula:
Floor payout

(notional value)

Days in payment period
360

(striking price benchmark rate)

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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
– Premium from writing the floorlets reduces position costs

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Interest Rate Collar (cont’d)
Long cap
$ Payoff
Outflow K
1
No payout
K
2
Inflow
Short floor
Floating Rate

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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