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Understanding Interest Rate Risk and Swaps

The document discusses interest rate risk and swaps. It defines LIBOR and how it has played a central role in global markets. However, its accuracy has been questioned during financial crises when banks may report rates lower than actual rates. It also defines a credit risk premium as the additional rate above risk-free rate that a borrower pays depending on its credit rating. Credit spreads, or additional costs, rise for lower rated borrowers. Lower rated borrowers often access floating rate loans to shift interest rate risk to themselves. Forward rate agreements and interest rate swaps are discussed as ways for borrowers to manage interest rate risk.

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17 views2 pages

Understanding Interest Rate Risk and Swaps

The document discusses interest rate risk and swaps. It defines LIBOR and how it has played a central role in global markets. However, its accuracy has been questioned during financial crises when banks may report rates lower than actual rates. It also defines a credit risk premium as the additional rate above risk-free rate that a borrower pays depending on its credit rating. Credit spreads, or additional costs, rise for lower rated borrowers. Lower rated borrowers often access floating rate loans to shift interest rate risk to themselves. Forward rate agreements and interest rate swaps are discussed as ways for borrowers to manage interest rate risk.

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CHAPTER 8

INTEREST RATE RISK AND SWAPS

2. My Word is My LIBOR. Why has LIBOR played such a central role in


international business and financial contracts? Why has this been questioned in recent
debates over its value reported?

No single interest rate is more fundamental to the operation of the global financial
markets than the London Interbank Offered Rate (LIBOR). But beginning as early as
2007, a number of participants in the interbank market on both sides of the Atlantic
suspected that there was trouble with LIBOR. The three-month and six-month
maturities are the most significant maturities due to their widespread use in various
loan and derivative agreements, with the dollar and the euro being the most widely
used currencies.

The issues related to LIBOR have been increasingly complicated in recent years –
beginning with the origin of the rates submitted by banks. First, rates are based on
"estimated borrowing rates" to avoid reporting only actual transactions, as many
banks may not conduct actual transactions in all maturities and currencies each day.
As a result, the origin of the rate submitted by each bank becomes, to some degree,
discretionary.

Secondly, banks – specifically money-market and derivative traders within the banks
– have a number of interests that may be impacted by borrowing costs reported by the
bank that day. One such example can be found in the concerns of banks in the
interbank market in September 2008, when the credit crisis was in full-bloom. A bank
reporting that other banks were demanding it pay a higher rate that day would, in
effect, be self-reporting the market's assessment that it was increasingly risky. In the
words of one analyst, akin "to hanging a sign around one's neck that I am carrying a
contagious disease." Market analysts are now estimating that many of the banks in the
LIBOR panel were reporting borrowing rates which were anywhere from 30 to 40
basis points lower than actual rates throughout the financial crisis.

3. Credit Risk Premium. What is a credit risk premium?

The cost of debt for any individual borrower will therefore possess two components,
the risk-free rate of interest ( kUS$ ), plus a credit risk premium (RPM$ Rating ) reflecting
the assessed credit quality of the individual borrower. For an individual borrower in
the United States, the cost of debt ( kDebt $ ) would be:

kDebt $  k US$  RPM$ Rating


The credit risk premium represents the credit risk of the individual borrower. In credit
markets this assignment is typically based on the borrower’s credit rating as
designated by one of the major credit rating agencies, Moody’s, Standard & Poors,
and Fitch. An overview of those credit ratings is presented in Exhibit 8.3. Although
each agency utilizes different methodologies, all include the industry in which the
firm operates, its current level of indebtedness, its past, present, and prospective
operating performance, among a multitude of other factors.

5. Credit Spreads. What is a credit spread? What credit rating changes have the most
profound impact on the credit spread paid by corporate borrowers?

The cost of debt changes with credit quality, as a credit spread is added to the basic
Treasury rate for the maturity in question. The costs of credit quality – credit spreads
– are quite minor for borrowers of investment grade, but rise dramatically for
speculative grade borrowers.

8. Floating Rate Loan Risk. Why do borrowers of lower credit quality often find their
access limited to floating-rate loans?

As opposed to fixed rate loans, where the lender accepts both the risk of changing
interest rates and changing credit quality of the borrower on loan origination, a
floating-rate loan shifts interest rate risk to the borrower. Lenders are not generally
willing to accept both risks when lending to lower credit quality borrowers.

11. Forward Rate Agreement. How can a business firm that has borrowed on a
floating-rate basis use a forward rate agreement to reduce interest rate risk?
A forward rate agreement (FRA) is an interbank-traded contract to buy or sell
interest rate payments on a notional principal. These contracts are settled in cash. The
buyer of an FRA obtains the right to lock in an interest rate for a desired term that
begins at a future date. The contract specifies that the seller of the FRA will pay the
buyer the increased interest expense on a nominal sum (the notional principal) of
money if interest rates rise above the agreed rate, but the buyer will pay the seller the
differential interest expense if interest rates fall below the agreed rate. Maturities
available are typically 1, 3, 6, 9, and 12 months, much like traditional forward
contracts for currencies.

12. Plain Vanilla. What is a plain vanilla interest rate swap? Are swaps a significant
source of capital for multinational firms?
A plain vanilla interest rate swap is a swap to pay fixed/receive floating, or
alternatively, pay floating/receive fixed. The plain vanilla interest rate swap is not a
source of capital; it only alters the interest rate price on repayment of a theoretical –
notional – debt principal.

Common questions

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Industry operational performance influences credit ratings by reflecting a firm's ability to continue generating revenue and servicing debt. A stable or improving operational performance generally supports better credit ratings, thus lowering credit risk premiums. Conversely, poor industry performance can negatively impact credit ratings, leading to higher borrowing costs due to elevated risk premiums required by lenders .

The credit risk premium influences a borrower's cost of debt by adding to the risk-free rate, thus reflecting the borrower's assessed credit quality. Credit rating agencies such as Moody's, Standard & Poor's, and Fitch consider factors like the industry in which the firm operates, its current debt levels, and past, present, and future operating performance in assessing the premium. These assessments shape the credit risk premium incurred above the base interest rate .

Forward rate agreements (FRAs) can mitigate interest rate risk for businesses with floating-rate loans by allowing them to lock in an interest rate for a future period. This agreement enables the business to hedge against the possibility of rising interest rates, which would increase their borrowing costs. In such contracts, the seller pays the buyer if interest rates rise above the agreed rate, protecting buyers from increased expenses .

The discretionary nature of LIBOR submissions arises because banks estimate borrowing rates instead of reporting actual transactions, as they may not conduct actual transactions in all maturities and currencies daily. This estimation allows banks to influence the rate they report, creating a potential conflict of interest as traders within the banks might have interests impacted by reported borrowing costs . As a result, during the financial crisis, many banks reported borrowing rates lower than actual to avoid signaling they were financially distressed, affecting the reliability of LIBOR as an indicator of market conditions .

During the 2008 financial crisis, suspicions arose that many banks were underreporting their true borrowing rates, providing rates 30 to 40 basis points lower than actual to avoid appearing risky. This manipulation, driven by banks' desire not to signal financial distress, potentially undermined confidence in LIBOR as a reliable benchmark, impairing market perception and possibly affecting financial stability as LIBOR is extensively used in global financial contracts .

Credit spreads are added to the base Treasury rate to determine the overall cost of debt, representing the premium for a borrower's credit risk. Credit rating changes profoundly influence the spread; a downgrade increases it, raising borrowing costs, while an upgrade decreases the spread, lowering costs. These dynamics reflect lenders' assessment of default risks and the compensation sought for such credit risks .

A plain vanilla interest rate swap involves exchanging fixed-rate for floating-rate payments or vice versa. These swaps are not a substantial source of capital because they serve primarily to alter the interest rate exposure on a notional principal rather than raising actual funds. They modify the characteristics of debt already held rather than generating capital .

Speculative-grade borrowers experience substantial increases in credit spreads compared to investment-grade borrowers because lenders demand higher compensation for the increased risk of default. This substantial increase in credit spread significantly elevates their borrowing costs compared to those with better credit ratings, which could limit access to favorable interest terms and impact financial flexibility .

Lower credit quality borrowers are often restricted to floating-rate loans because lenders are typically unwilling to accept the dual risk of interest rate changes and the borrower's credit quality deterioration inherent in fixed-rate loans. Floating-rate loans transfer interest rate risk to the borrower, allowing lenders to mitigate their exposure to changing economic conditions .

The estimation of borrowing rates by banks affects the integrity of LIBOR significantly, as it introduces discretionary elements that can destabilize this benchmark's reliability. Given LIBOR's central role in global financial markets, inaccuracies due to estimation or manipulation can lead to widespread mistrust in financial instruments based on LIBOR, potentially triggering broader market instability and loss of confidence in interest rate benchmarks .

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