Honors Thesis Proposal Sensitivity Test of Interest Rate Swaps Akua Amoah Advisor: Dr. John MacDonald April 19, 2003 Abstract The goal of this project is to undertake a sensitivity test that will exhibit the volatility of interest rate swap values using projected interest rates. The test will essentially reveal discrepancies between interest rate swap values reported on the balance sheets of selected firms and the resulting swap values produced from a simulation test using projected interest rates as a basis of valuating swaps. The firms are required under accounting regulations, specifically FAS No 133 (and its amendments FAS Nos. 137, 138) to use the intrinsic fair value method of valuing swaps. The main criteria upon which the firms chosen for this test will be selected include, the availability and accessibility of the firms' financial statements, the significance of the swap value amounts reported in their balance sheets. The scope of the test will be limited to about twelve to fifteen USA based firms. I will be using a Monte Carlo Simulation. By feeding in the swap values reported by the firms, and several projected interest rates, the simulation will provide multiple scenarios of new swap values for the firms. The results of this simulation will provide the foundation for an analysis of the discrepancies between the new swap values and the original swap values in the firms’ balance sheets. The analysis will include an explanation of the characteristics of interest rates fluctuations and a report of their effects on the swap values. My conclusion will be drawn from the results and may set an example of how interest rate swaps can be “truly valued”. I will be working under the guidance of Prof John MacDonald. Introduction Following the WorldCom and Enron scandals, accountants have witnessed an increased interest in off-balance sheet transactions and items. Consequently, accounting regulations regarding off-balance sheet items have become more stringent. The Financial Accounting Standards Board (FASB) implemented FAS No 133 ‘Accounting for Derivatives and Hedging Activities’, which requires that interest rate swaps together with a group of other former off-balance sheet derivatives, be reported in the balance sheets at fair value. FAS 133 was enacted in 1998 and fully implemented by June 2001. It has since had amendments No 138 and 137. This is just an indication of the great controversy surrounding FAS 133. Many firms engage in interest rate swaps mainly as a means of hedging and financing. Interest rate swaps currently accounts for about 75% of derivative hedging. An interest rate swap is an agreement between two parties (also known as counter parties) to exchange a series of interest payments over a period of time without exchanging the underlying principal amount. These payments are tied to different indexes such as LIBOR, the treasury rate, or some other index (Malhorta D.K, 1997). The underlying principal amounts, which are actually notional amounts, are usually not exchanged during swaps. These are the types of interest rate swaps my study will be based on. Below is a simple diagram to explain the fair value method of accounting for interest rate swaps, as specified under FAS 133. In light of the fact that FAS 133 is a fairly new regulation and has been described by some accountants and financial analysts as one of the most confusing FASB regulations, most research and studies are still in progress. However, much of what has been done include proposals of new interest rate swap valuations (Jensen R, http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm ), empirical studies of interest rates swaps (Minton B, 1994) and variations of interpretations and analyses of FAS 133 and its amendments (Jensen R, http://www.trinitv.edu/rjensen/acct5341/sQeakers/133glosf.htm). By factoring in projected interest rates with the given swap values derived from F AS 133 fair value method, my project will essentially imitate real-life scenarios of swap values if projected interest rates were factored in. It will also examine the effects of changes in the swap values of the chosen firms. To my knowledge this type of study is unprecedented. Tasks I will perform prior to running the simulation include the following: 1. Providing a critical analysis of FAS 133. 2. Deriving projected interest rates based on current and past trends of interest rates mainly from forward rate agreements, euro futures, LIBOR rates. 3. Closely monitoring interest rate fluctuation in the market. 4. Mastering the Monte Carlo simulation. 5. Drawing meaningful conclusions from results and comparisons. The scope of this test will be limited to about twelve to fifteen USA based firms. The criteria for picking the firms would be highly dependent upon the substantial amounts of the swap values reported in the balance sheets, and the availability of other information about the nature and the interest rate swaps. Objectives This research will uncover the volatility of the value interest rate swaps caused by the variable rate used in the swap valuations. It will also express the impact of interest rate fluctuations in certain types of interest rate swaps. The goal is to run a sensitivity test using projected interest rates and show the volatility of swap values. The research will in effect, provide real-life scenarios of what the swap values would be if projected interest rates were factored in the valuation of interest rate swaps. There has been considerable amount of research on the empirical studies of interest rate swaps, proposals of different valuation methods other than the FAS 133 fair value method, and variations of interpretations of FAS 133 regulations. Indeed, some research that deals with interest rate swap valuations propose that the FAS 133 fair value method is deficient in accounting for future fluctuations of interest rates. However, none has delved into the area of providing scenarios based on actual values of existing firms via simulations using the projected interest rates that FAS 133 method lacks. My contention is that the FAS 133 method does not depict the true value of interest rate swaps because it does not take into account future fluctuations of interest rates. I will expect discrepancies between the swap values reported under FAS 133 and the swap values results produced from my simulations. I will then provide evaluations and draw conclusions from the discrepancies. My research will be an exhibition of interest rate swap valuations using projected interest rates. It will reflect in the swap valuations, the volatility of the interest rates. It will also define the cause and origins of attaining the resulting swap values after the projected rates have been factored in. In addition, it will explain in detail how the new values were arrived at. My study will serve as a basis for analysts to derive information regarding influences of interest rate fluctuations of swap values. My study will also suggest ways by which projections of fluctuations may be accounted for in interest rate swaps. It will also explain the nature of the relationship between swap values and current, projected and historical interest rates. Methods In order to attain the expected and desired results I will undertake this research in an orderly manner as indicated below. Pick the firms to use for this research. Some factors that will be considered include o The geographical boundary will be USA based firms o The availability and accessibility of the firms most recent financial statements o Firms using similar types of interest rate swaps o The amount of the swap value reported in balance sheets Monitor the market to determine interest rate trends and transactions under related derivatives. Derive the projected interest rates. o These rates will be based on an analysis of current and historical trends in the market o Calculations will use rates from forward rate agreements, LIBOR rates from the spot market, euro futures and others For each firm, I will conduct a Monte-Carlo simulation o The Monte Carlo simulation is a software program that calculates multiple scenarios of a model by repeatedly sampling values from the probability distributions for the uncertain variables. The Monte Carlo simulation is in my view appropriate because it models the real life situation; it is able to generate several results under various conditions. It is an efficient method as it has the capability to simplify tedious computations within a few seconds. o It will use the swap values given in the balance sheets o The simulation will run several thousands times under various rates Record the findings or results for each firm. The results obtained from the simulation will be evaluated, analyzed and compared to the swap values from the firm's balance sheets. Draw conclusions based on each firm. Summarize the findings for all firms and draw a conclusion from a broader perspective. Management plan This research will be taken under the guidance of my advisor - Prof. John MacDonald. With his expertise in finance, he will be a great wealth of information and assistance for me. I will need his assistance especially when deriving projected interest rates. The bulk of my work will stem from the increment of my theoretical knowledge on derivatives and hedging, and from the use of analytical skills to detect pertinent points. I have gained substantial accounting skills from upper level accounting courses like Intermediate Accounting. I am presently taking a finance course that has facilitated my comprehension of interest rates and derivates. By spring 2004, I will be equipped with a sufficient financial background and I would have enhanced my accounting skills, as I will be taking other upper level finance and accounting courses like Advanced Accounting, Auditing and Money and Banking. The nature of my research is such that it does not limit me to stay in a particular location. This gives me the liberty to work anywhere provided that I have access to the Internet and to the literature that I will need to enhance my comprehension on the subject. While away during the summer, I will be corresponding with my advisor and updating him on my progress. I am keeping journals to record the summary of each reading that I do. This will be especially beneficial to me when I need to make evaluations and draw conclusions. My advisor and I are in the process of designing a mutually agreeable time line. However the table below outlines the tentative schedule for now. Tentative Research Time Outline I will maintain a journal in which I will keep account of my progress; it will particularly be useful for analysis of my findings. While away, I will correspond with my advice via email and telephone. I will also continue to meet with my advisor on a weekly basis while in school and designate a weekly time slot to for my individual work on this research. Literature search The literature search I have conducted to date includes the following: Books: Kapner R. Kenneth, Marshall F. John, 1993, The Swap Market, 2nd Edition, Kolb Publishing Company, FL, 1993. Journals: Malhorta D.K., spring 1997, An Empirical Examination of the Interest Rate Swap Market, Quarterly Journal of Business economics v36, n2, Minton B., July 1997, An Empirical examination of basic valuation models for plain vanilla U.S. interest rate swaps, Journal of Financial Economics, v44 251-277 Samant A., 1996, An Empirical Study of Interest Rate Swap Usage by Nonfinancial Corporate Business, Journal of Financial Services Research 10:43-57 Websites: http://www.trinity.edu/rjersen/accts34l/speakers/133swapvalue.htm#introduction http://www.decisioneering.com/monte-carlo-simulation http://www.fasb.org http://www/smartmoney.com/onebond/index.cfm?story=yieldcurve