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Int erest Rate Swaps:Int erest Rate Swaps:

OverviewOverview

FINC 456

Interest Rat e SwapsInterest Rat e Swaps

In general, a swap is a contr act specifying the exchange inth e futu re of one cashflow for another . The am ount of thecashflow usua lly depends on t he m ovement of some ma rketvalue.

Swaps ar e pervasive in n early all markets, prima rily curr ency,comm odity, and int erest ra tes, but also (more exotically) inequity, credit an d such th ings as weather.

All tha t is typically required is tha t both counterparties agree towhen a nd h ow the cash flows will be set and p aid.

An interest rat e swap involves th e periodic exchange ofcashflows linked to interest rat es.

Interest ra te swaps dominate t he interest rat e derivativemarket

$60 trillion dollars notional outsta ndin g/ IRS ar e about 40%

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Describing In ter est Rat e SwapsDescribing In ter est Ra te Swaps

Interest rat e swaps can be described by: Term sheets (contract specifications)

Cash flows/Inflow-outflow diagr am s

swap boxes

exposure diagrams

Int erest ra te swa ps most comm only involve onepar ty paying a fixed interest r at e and t he oth erpar ty paying a float ing interest rat e. For exam ple 6M LIBOR vs. fixed (I.e. 6.25%) semi-

an nu ally for 10 year s.

The cash a mount of paymen ts is calculat ed by applyingth e rates to some notional amount .

In ter est Rat e Swaps : Mecha nicsIn ter est Rat e Swaps: Mecha nics

For th e stan dard (plain van illa) interest ra te swap,

one pa rty pays a fixed rat e, and th e oth er pays a

float ing ra te, linked to some index (usua lly LIBOR)

Ea ch payment str eam is called a leg of the swa p

The pa yment on t he fixed rat e leg is easy to

calculat e, wher e the n otional is Q, an d th e F is the

fixed swap r at e:

The float ing side, with R a s th e forwa rd r at e is:

= basisdays

FQpaymentfixed

=+ basis

daysRQpaymentfloating tt 1

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In ter est Rat e Swap: Mecha nics,In ter est Rat e Swap: Mecha nics, contcont

So at each paym ent dat e, the net cash flow is

Ques tion: from wh ose perspective is th is cash flow?

By conven tion, long swa ps pa y fixed an d r eceive float ing

So a short swap pays floating and receives fixed.

Note that th e index interest rat e (th ink LIBOR here)

is set at t he beginn ing of th e period, and t he pa yment

is realized at t he end. This is exactly the way th at floatin g rat e bonds /loans work

( )

= basis

daysRFQCashflow tt 1

Int erest Rat e Swaps: Comm on usesInt erest Rat e Swaps: Comm on uses

Corpora tions employ inter est ra te swaps todyna mically cha nge th eir finan cing stru ctu re fromfloat ing ra te exposure to fixed, and vice versa . If int erest r ates ar e projected t o rise, swaps provide a low-

cost met hod to lock in cur rent ra tes.

If int erest r ates ar e projected t o fall, swaps can a llowcorporations to take advantage of the lower financing costs.

Swaps can also more pr ecisely ma tch fina ncing riskswith operational risks.

Swaps can be used to lengthen or sh orten theavera ge ma tu rity of a port folio or liability str uctu re.

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In ter est Ra te Swa ps: Swap BoxesIn ter est Ra te Swa ps: Swap Boxes

Swaps ar e often described by using boxes to

represent counterparties and flows

Note: this doesnt give an y informa tion about t he

frequ ency of flows

Bondholders

Corporation Swap Dealer

LIBOR+spread (200 bp)

LIBOR

Fixed (Swap) Rate

Valuing Int erest Rat e SwapsValuing Inter est Rate Swaps

The swa p (fixed) ra te is usu ally set so tha t th e

presen t va lue of both sides of the swa p equa l zero.

A swap can be th ought of as t he interest pa yments

due from borrowing at a float ing rat e an d lending at

a fixed ra te (or vice versa).

Anot h e r w ay o f s t a t i ng t h i s : a sw a p i s a p o r t fo l io o f a

c o u p o n b o n d a n d a flo a t i n g -r a t e n o t e ( F R N ).

The p aying fixed side of a swa p gains value if

inter est ra tes rise; it loses value when ra tes fall.

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Interest Rat e Swaps:Interest Rat e Swaps:

A word about creditA word about credit

Swa p books (th at is, the t otal swa p position of a

ban k) are often far in excess of th e ban ks capita l,

on a n otional basis.

What a re the credit risks associated with swaps?

Are they similar t o corresponding bond tr an sactions?

How might corr elation factor int o this?

To mitigate concerns, ba nk s often set u p AAA

subsidiaries to tra nsact th eir swaps.

Interest Rat e Swaps:Interest Rat e Swaps:GeneralizationsGeneralizations

Interest rat e swaps are extremely customizable and

ha ve spawned a nea r infinite fam ily of products.

All types of indicesTrea sur y, LIBOR, Prime, CP , etc.

Used t o closely match opera tional exposures

Pa yments in different currencies

To take ad vant age of fina ncing opportu nities (recent ly, in

Ja pa n)

Match financing with expenditures for multinationals Notiona l amount s tha t accrete/amortize, or a re linked to

other ma rket quan tities

Frequen tly found in m ortgage/financing related indu stries

where pr e-payments are possible