Background
■ Definition: Interest rate swap is an agreement
between two parties to exchange one set of
interest rate payments for another
■ Usually an exchange of a stream of fixed-rate
interest payments for floating-rate payments
■ Characteristics
● Over-the-counter trading—coordinated and
negotiated by financial institution
● Contracts less standardized than other derivatives
like futures and options
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Provisions of a Swap
■ The notional principal value to which the
interest rates are applied to calculate the
interest payments
■ The fixed interest rate
■ The floating rate
■ The frequency of payments, such as every six
months or every year
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Background
■ Example of two financial institutions, one in
the U.S and one in Europe used to illustrate
swap concepts
■ A U.S. financial institution with liabilities
more rate-sensitive than assets is affected
adversely by rising interest rates
■ A European financial institution has access to
long-term, fixed-rate funds but makes floating
rate loans and has the opposite exposure as
compared to U.S. institution
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Exhibit 15.1 An Interest Rate Swap
Short-T
erm Fixed-Rate
Deposits Long-Term Loans
U.S. U.S. Financial U.S.
Depositors Institution Borrowers
Interest Fixed Interest
on Deposits Payments on Loans
Fixed Floating
Interest Interest
Payments Payments
Fixed-Rate
Long-T
erm Floating-Rate
Deposits Loans
European
European Financial European
Depositors Institution Borrowers
Interest Floating Interest
on Deposits Payments on Loans
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Background
■ If interest rates increase and the U.S. and
foreign institution negotiate a swap, the U.S.
institution gets higher interest payments as
rates rise to help offset the increased cost of
funds
■ If interest rates decline then the foreign
institution makes lower interest payments to
the U.S. which helps offset the lower interest
payments the European institution receives on
loans
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Participation by Financial Institutions
■ Institutions including banks, pension funds
and insurance companies exposed to interest
rate risk use swaps to manage it
■ Intermediaries match up firms
● Chargefees
● May provide a credit guarantee, for a fee
■ Dealer
● Takes a counterparty position to serve clients
● Results in risk exposure unless it has an offsetting
swap with another client
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Types of Interest Rate Swaps
■ Plain vanilla swap involves periodic exchange
of fixed-rate payments for floating-rate
payments
■ Basic exchange of payments for the U.S. and
European institution given in the example
information
■ LIBOR or London Interbank Offer Rate used
as the as the index
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Exhibit 15.3 Plain Vanilla Swap
Scenario of Declining
Level of Interest Payments
Level of Interest Payments
Scenario of Rising Interest Rates
Interest Rates Floating Inflow Payments
Fixed Outflow Payments Fixed Outflow Payments
Floating Inflow Payments
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Year End of Year
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Types of Interest Rate Swaps
■ A forward swap is an exchange of interest
payments that does not begin until some future
point in time
■ Used if an institution is currently insulated
against rate risk but anticipates risk beginning
at a future time
■ Swap period is delayed but institution locks in
future terms
■ Locks in at the prevailing rates based on
expectations about future interest rates
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Exhibit 15.5 Forward Swap
Scenario of Rising Scenario of Declining
Interest Rates Floating Inflow Payments Interest Rates
Level of Interest Payments
Level of Interest Payments
Fixed Outflow Payments Fixed Outflow Payments
Floating Inflow Payments
Forward Forward
Swap Is Swap Is
Arranged Swapping of Payments Arranged Swapping of Payments
at This Time Begins at This Time at This Time Begins at This Time
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
End of Year End of Year
Copyright© 2002 Thomson Publishing. All rights reserved.
Types of Interest Rate Swaps
■ Callable swaps are a swap option that allows
counterparty with fixed payments to terminate
prior to maturity
■ U.S. institution in the example could terminate
swap if rates decline and then capture the
benefits
■ Party with the right to terminate pays a
premium in the form of a higher fixed rate
■ May also involve a termination fee
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Exhibit 15.6 Callable Swap
Scenario of Rising Floating Inflow Scenario of Declining
Interest Rates Payments Interest Rates
Level of Interest Payments
Level of Interest Payments
Fixed Outflow Fixed Outflow Payments*
Payments*
Floating Inflow Payments
Option is exercised to
terminate the swap at
this time, because interest
rate trend is downward.
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Year End of Year
Copyright© 2002 Thomson Publishing. All rights reserved.
Types of Interest Rate Swaps
■ Putable swaps allow the counterparty with
floating-rate payments to terminate prior to
maturity
■ European institution in the example could
terminate swap if rates increase and then
capture the benefits
■ Party with the right to terminate pays a
premium in the form of a higher fixed rate
■ May also involve a termination fee
Copyright© 2002 Thomson Publishing. All rights reserved.
Exhibit 15.7 Putable Swap
Scenario of Rising Scenario of Declining
Interest Rates Interest Rates
Level of Interest Payments
Level of Interest Payments
Floating Inflow Payments
Fixed Outflow Payments* Fixed Outflow
Payments*
Floating Inflow
Payments
Option is exercised by
recipient of fixed outflow
payments to terminate
the swap at this time, because
interest rate trend is upward.
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Year End of Year
Copyright© 2002 Thomson Publishing. All rights reserved.
Types of Interest Rate Swaps
■ Extendable swaps allow the fixed-for-floating
party to extend the swap period
■ Benefits from the ability to extend a current
swap rather than negotiate a new swap at the
prevailing market rates in existence when the
initial swap matures
■ This feature involves a higher price
■ May have to pay fees if swap is extended
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Exhibit 15.8 Extendable Swap
Scenario of Rising Floating Inflow Scenario of Declining
Interest Rates Payments Interest Rates
Level of Interest Payments
Level of Interest Payments
Fixed Outflow Fixed Outflow
Payments Payments
Floating Inflow
At this time, the institution Payments
would likely extend
the swap period. At this time, the institution
would likely decide not to
extend the swap period.
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Year End of Year
Copyright© 2002 Thomson Publishing. All rights reserved.
Types of Interest Rate Swaps
■ Zero-coupon-for-floating swaps involve a
fixed-rate payer that makes a single payment
at the maturity of the swap
■ Floating-rate payer makes periodic payments
■ An example is a U.S. institution with short-
term deposits funding zero coupon bonds
■ The risk is that an interest rate increase causes
the bond prices to fall and increases the cost of
funds on the liability side of the balance sheet
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Exhibit 15.9 Zero-Coupon-For-Floating
Swap
Scenario of Rising • A Single Lump-Sum Scenario of Declining
Interest Rates Fixed Outflow Payment Interest Rates •A Single Lump-Sum
Floating Inflow Payments Fixed Outflow Payment
Level of Interest Payments
Level of Interest Payments
Floating Inflow
Payments
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Year End of Year
Copyright© 2002 Thomson Publishing. All rights reserved.
Types of Interest Rate Swaps
■ Rate-capped swaps exchange fixed-rate
payments for floating-rate payments that are
capped and involve up-front fees
■ Example of U.S. and European firm
● European firm may want to limit its possible
payments with the cap and know what its
maximum payments will be
● U.S. firm may believe rates will not go above cap
and if they do, swap’s effectiveness is limited
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Exhibit 15.10 Rate-Capped Swap
Scenario of Rising Purple Line Reflects
Floating Inflow Payments Scenario of Declining
Interest Rates Interest Rates
If a Cap Did Not Exist
Cap Floating Inflow Payments Cap
Level Based on Cap Level Fixed
Fixed Outflow Payments Outflow
Payments
Floating
Inflow
Payments
Payer of Fixed Outflow Payments Payer of Fixed Outflow Payments
Receives Premium atThis Time Receives Premium atThis Time
for Agreeing to Cap for Agreeing to Cap
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End ofY ear End ofY ear
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Types of Interest Rate Swaps
■ Equity swaps involve the exchange of interest
payments for payments linked to the degree of
change in a stock index
■ Example
● Company with a fixed 7% interest rate
● Swaps a fixed rate for rate of appreciation in an
index over a period of time
● If index appreciates by 9% a year, differential is
2%
● For use by portfolio managers
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Other Types of Interest Rate Swaps
■ Rate swaps to accommodate financing needs
● Corporations with varied debt ratings swap fixed
for floating interest payments
● Swap parties benefit from considerable differential
in capital market rates for parties
Tax swaps
● Firm with expiring loss carryforwards swaps with
● Firm expects future losses but has large gains from
operations this year
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Exhibit 15.11 Interest Rate Swap
Variable-Rate Payments at LIBOR + ½%
Quality Co. Risky Co.
Fixed-Rate Payments at 9½%
Fixed-Rate Variable-Rate
Payments Payments
at 9% at LIBOR + 1%
Investors in Investors in
Fixed-Rate Variable-Rate
Bonds Issued Bonds Issued
by Quality Co. by Risky Co.
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Risk of Interest Rate Swaps
■ Basis risk is the chance that the index does not
move in perfect tandem with the floating-rate
instruments
■ Credit risk exists because one of the firms
may not meet its payment obligations but this
is minimized
● Ifcounterparty 1 defaults it does not make a
required payment
● Counterparty 2 would stop all subsequent
payments
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Risk of Interest Rate Swaps
■ Credit risk concerns exist for those that
guarantee swaps
● Regulators are considering how to respond
● Large growth in swaps market so this concern will
receive continued attention
■ Sovereign risk is the potential adverse effect
from a country’s political conditions that could
prevent one party from fulfilling its obligations
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Pricing Interest Rate Swaps
■ Prevailing market interest rates determine
swap rates
■ Availability of counterparties influences
pricing
● If there are numerous potential counterparties it
increases the chance of negotiating favorable
terms
● This will change as economic conditions change
■ Credit and sovereign risk also influence prices
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Factors Affecting the Performance of
Interest Rate Swaps
■ Swap performance is affected by several
underlying forces
■ Indicators monitored by participants in the
swaps markets include any that would affect
interest rates
● U.S. economic conditions
● International economic conditions
● Monetary and fiscal policy
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Globalization of Swap Markets
■ Counter-parties for interest rate swaps extends
beyond United States, where interest rate
changes may vary
■ Manufacturing corporations from various
countries also engage in swaps
■ Interest rate swaps are denominated in many
currencies
■ Lack of information and credit risk concerns
reduced if intermediaries back payments
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Globalization of Swap Markets
■ Currency swap is an arrangement in which
currencies are exchanged at specified foreign
exchange rates and at specified intervals
■ Used by firms to hedge their risks from
foreign currency exposure caused by inflows
and outflows denominated in different
currencies
■ Currency swaps available in several variations
and may involve intermediaries
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Globalization of Swap Markets
■ Hedging bond payments with currency swaps
involves Firm 1 issuing a bond denominated in euros
to fund its euro operations
■ Firm 1 receives euros in the course of business that
would be used to repay the bonds
■ Investors in the euro market do not know Firm 1 very
well
■ Firm 1 swaps with Firm 2, a company that wants to
issue dollar debt but is not well known by investors
who buy dollar-denominated debt
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Globalization of Swap Markets
■ Risks of currency swaps involve the same
risks as other interest rate swaps
● Basis risk
● Credit risk
● Sovereign risk
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