2012 WINDY CITY
SUMMIT
I N T E R E S T R AT E S WA P S
P R E S E N TAT I O N
Copyright 2012 Wintrust Financial Corporation. All Rights Reserved.
I N T E R E S T R AT E S W A P S
Table of Contents
• Derivatives Overview
– Derivatives and Interest Rate Risk
• The Interest Rate Swap
– What is it?
– Purpose and Functionality
• Swaps and Me…
– Why should today’s borrower consider it?
• Other Types of Protection
– Caps and Collars
• Where’s the Crystal Ball?
– Historical and expected rates
• Q&A
Copyright 2012 Wintrust Financial Corporation. All Rights Reserved.
2
D E R I VAT I V E S
OVERVIEW
I N T E R E S T R AT E S W A P S
Derivatives—What are They?
– Derivatives are financial instruments whose value is derived from
another "underlying" financial security.
– An interest rate derivative gains or loses value based on the movements
of a specific interest rate index (U.S. Dollar Prime, LIBOR, Fed Funds,
Treasury yields, etc.).
• There are two broad categories of derivative products:
– Exchange-traded products
– Often used by traders & speculators (and dealers looking to balance
their books)
– Standardized contract sizes & terms
– Not typically used for customized hedging solutions
– Over-the-counter (OTC) products
– Developed to meet hedging demand by companies & investors
– Customized contracts between 2 counterparties
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4
I N T E R E S T R AT E S W A P S
Derivatives—Growth in the OTC Market
Source: BIS
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5
I N T E R E S T R AT E S W A P S
Derivatives—Why? One word—RISK!
• Example of interest rate exposure on a $100 million, 10-year
financing. The present value
of every basis point change in interest
10 YEAR UST
rates prior to locking the rate
is worth
June 1995
- Current about $82,000!
8.00%
Increase of $10.4mm in interest
cost in six weeks (127bps * $82k)
7.00%
6.00%
5.00%
4.00%
3.00%
Decrease of $12.1mm in interest
cost in four months (148bps * $82k)
2.00%
0
1
2
3
4
5
0
1
2
3
4
95
96
97
99
95
96
97
98 998
99
00
00 /2 00
00 /2 00
00 /2 00
00 /2 00
00 /2 00
19
19
19
1
19
19
19
19
19
19
2
2
2
2
2
2
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
6
4
3
2
1
15
13
12
11
10
6/9 12/8
6/8 12/7
6/7 12/6
6/6 12/5
6/4 12/3
6/3
6/1 12/
6/1 12/
6/1 12/
6/1 12/
6/1 12/
Source: Chatham Financial
10-Year UST
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6
I N T E R E S T R AT E S W A P S
Interest Rate Markets
Term Structure of Interest Rates:
• When you hear “interest rates moved lower today” – which
rates are being discussed??
– Short-term deposit rates?
– Intermediate maturity rates?
– Long-term mortgage rates?
• Interest rates differ across the maturity spectrum due to:
– Liquidity
– Market expectations
• Concept known as the “Yield Curve”
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7
I N T E R E S T R AT E S W A P S
Source: Wintrust Financial
Copyright 2012 Wintrust Financial Corporation. All Rights Reserved.
8
THE INTEREST
R AT E S W A P
I N T E R E S T R AT E S W A P S
What is an OTC Interest Rate Swap?
• An agreement between two parties in which one party agrees
to pay a fixed rate of interest and the other agrees to pay a
floating rate of interest on an agreed upon notional amount
– No principal changes hands, simply an exchange (“swap”) of interest
payments for a set period of time
– Swap rate is derived from market expectations
– The FIXED rate is the Present Value of Expected Future FLOATING
rates
– LIBOR is the foundation of the swap market
Fixed Rate
Party B
Party A
LIBOR
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I N T E R E S T R AT E S W A P S
How Does an Interest Rate Swap Work?
• Overview: Interest rate swaps allow borrowers to effectively
lock-in an interest rate on an existing or future variable rate
financing
• Method: Separate contract from the loan that effectively fixes
the rate by creating a stream of cash flows that perfectly offsets
any rise in rates
• Cost: There are no incremental fees associated with the
interest rate swap
Fixed Rate
Borrower
Floating Rate
Bank
Floating Rate
Loan
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11
I N T E R E S T R AT E S W A P S
How are Swap Rates Determined?
• How does the market demand what the proper fixed rate is for
an interest rate swap?
• A swap is simply an exchange of cash flows: therefore, the
party paying a fixed rate should demand a rate that is, on a
present value basis, the average of the market’s expected
floating rate settings over the term of a particular swap
contract.
• One mechanism for predicting the future path of rates is by
observing the interest rate futures market.
– In general, 3-month LIBOR serves as a baseline rate for calculating
an interest rate swap’s fixed rate.
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I N T E R E S T R AT E S W A P S
LIBOR is the Foundation of the Swap Market
London Inter-Bank Offered Rate:
– Rate at which banks lend to one another for various terms
– Resets each day at 11:00 a.m. (London time) based on average of
16 contributor banks
– 3-Month LIBOR = Fed Funds + 0.25%* (historical avg.)
– Prime = 3-Month LIBOR + 2.75%* (historical avg.)
– Any variations in OTC structures (1-month LIBOR, Prime, etc.) are
taken into account by calculating a specific spread, or “basis”, to the
3-month LIBOR futures market
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I N T E R E S T R AT E S W A P S
How is the Fixed Swap Rate Determined?
• Fixed rates are derived from the present value average of the market’s expectation of future floating
rates over a given term
• If the market’s prediction of rates is CORRECT, there is no difference between paying fixed or
paying floating on the same notional
• If the market’s prediction of rates is NOT CORRECT, the swap will gain or lose value
Copyright 2012 Wintrust Financial Corporation. All Rights Reserved.
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I N T E R E S T R AT E S W A P S
• Valuation of an Interest Rate Swap
• At inception, the swap has no value because the swap rate
represents the average of what the market believes variable
rates will be over the life of the swap
• As rates change, the swap will begin to take on or lose value
• If the swap holder needs to break the contract before maturity,
it may be subject to breakage provisions:
– Rates Rise: Replacement Swap Rate > Actual Swap Rate, swap is
an asset to the swap holder. The swap holder will receive payment
from the Counterparty for the value of the swap.
– Rates Fall: Replacement Swap Rate < Actual Swap Rate, swap is a
liability to swap holder. The swap holder will make a payment to the
Counterparty for the value of the swap.
Copyright 2012 Wintrust Financial Corporation. All Rights Reserved.
15
S WA P S A N D M E …
I N T E R E S T R AT E S W A P S
• What are the Benefits of an Interest Rate Swap?
– Flexibility:
• All or a portion of the term
• All or a portion of the notional
– Duration:
• Longer term financing available
– Certainty:
• Known debt service costs
– Bi-lateral Prepayment:
• Retain benefit if rates rise
• Prepayment often less than traditional yield maintenance if rates fall
– Core-Competency:
• Swaps allow borrowers to focus on their “line of business” and not fluctuations in the
interest rate markets
– Current Rate Environment:
• Swaps allow borrowers to take advantage of below-market rates when compared to
traditional fixed loan rates
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17
I N T E R E S T R AT E S W A P S
• What Types of Debt can be Hedged?
• Over-the-counter Interest Rate hedging products are
customized contracts
– Provide great flexibility to borrower
– Loan amortization characteristics can be matched in a derivative
hedge contract:
•
•
•
•
•
•
Construction loans
Forward Starting
Irregular/ uncertain draw schedule
Permanent financing
Monthly, quarterly, or semi-annual payments
Mortgage, Hybrid, Straight-line, I/O, Custom amortization
Copyright 2012 Wintrust Financial Corporation. All Rights Reserved.
18
OTHER TYPES OF
PROTECTION
I N T E R E S T R AT E S W A P S
• Other Types of Hedging Products
• An interest rate CAP will:
– Guarantee the borrower a maximum fixed rate, yet allow the
borrower to retain the properties of a floating rate loan under a
specific strike rate
– Cost the borrower a premium to purchase, paid upfront
– Be most cost-effective for terms under 5 years and/or when
providing “worst case” disaster protection at a high cap strike rate
• An interest rate COLLAR will:
– Guarantee the borrower a maximum fixed rate, yet also require the
borrower to pay a certain minimum rate (even if market rates fall
below this pre-determined floor strike rate)
– Help or fully offset the cost of a cap by borrower selling a floor to
Bank
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20
I N T E R E S T R AT E S W A P S
• What is an Interest Rate Cap?
• Example of a $5MM Cap struck at 1.25%
Copyright 2012 Wintrust Financial Corporation. All Rights Reserved.
21
W H E R E ’ S T H E C R Y S TA L
BALL?
I N T E R E S T R AT E S W A P S
Source: WSJ
Historical Average (since 1989) = 3.9219%
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23
I N T E R E S T R AT E S W A P S
Source: Wintrust Financial
Copyright 2012 Wintrust Financial Corporation. All Rights Reserved.
24
I N T E R E S T R AT E S W A P S
Source: FRB
Historical Average (since 2000) = 3.8737%
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25
QUESTIONS?