IC301 Seminar 8
IC301
Seminar 8
Interest rate swaps
Some types of risks
Market risk Credit risk
A risk of losses due to negative asset price movements. A risk of default on a debt that may arise from a borrower failing to make required payments.
Interest rate risk Default risk
Equity risk Credit rating downgrade risk
Currency risk Recovery risk
Commodity risk Counterparty risk
A risk of losses derived from the default of a counterparty in an over-the-counter (OTC) derivative transaction or in a repo transaction.
Interest rate swaps
The most common case is where a fixed swap rate is paid against the receipt of a floating Libor rate, in the same currency (plain vanilla interest rate swap).
Swap buyer (payer)
Fixed rate payer
Floating rate receiver
Long a swap
Swap seller (receiver)
Fixed rate receiver
Floating rate payer
Short a swap
Floating rate
Floating leg
FRN
Fixed rate
Fixed leg
Coupon bond
Fixed rate Floating rate
Client A 4.6% Libor +0.2%
Client B 4.0% Libor – 0.1%
You work at the swap trading desk of an investment bank and two of your clients are offered the following annual rates for an investment of £10 million for 5 years:
Client A requires a floating-rate investment and client B requires a fixed-rate investment. To benefit from the differences between rates and make the transaction equally attractive to both clients, you propose the following transactions to the clients, each of them with the same notional amount of £10 million:
Client A should invest the money at the fixed rate of 4.6% for 5 years
Client B should invest the money at Libor – 0.1% for 5 years
Client A should enter a 5-year swap with the bank in which the client receives Libor annually and pay the fixed swap rate of 4.3%
Client B should enter a 5-year swap with the bank in which the client would pay Libor annually and receive the fixed rate of 4.2%
Draw the cash flows between the clients and the bank as a result of the transactions above
b) What is the rate of return obtained by each client on their investments? And what is the compensation earned by the bank for the intermediation of the swaps?
c) Discuss the exposure of each counterparty to market risk, credit and counterparty risk when entering the transactions mentioned above.
• Client A should invest the money at the fixed rate of 4.6% for 5 years;
• Client B should invest the money at Libor – 0.1% for 5 years;
• Client A should enter a 5-year swap with the bank in which the client would receive Libor annually and pay the fixed swap rate of 4.3%;
• Client B should enter a 5-year swap with the bank in which the client would pay Libor annually and receive the fixed rate of 4.2%.
Client B
Libor – 0.1%
Bank
Client A
Libor
Libor
4.2%
4.3%
4.6%
Fixed rate Floating rate
Client A 4.6% Libor + 0.2%
Client B 4.0% Libor – 0.1%
a)
b) What is the rate of return obtained by each client on their investments? And what is the compensation earned by the bank for the intermediation of the swaps?
Client A: 4.6% + Libor – 4.3% = Libor + 0.3%
0.1% higher than he was offered
Client B: Libor – 0.1% + 4.2% – Libor = 4.1%
0.1% higher than he was offered
Bank: 4.3% – 4.2% – Libor + Libor = 0.1%
Fixed rate Floating rate
Client A 4.6% Libor + 0.2%
Client B 4.0% Libor – 0.1%
c) Discuss the exposure of each counterparty to market risk and credit risk when entering the transactions mentioned above.
Bank Client A Client B
Market risk Completely hedged, Libor cancelled out Nothing extra, as demanded initially Nothing extra, as demanded initially
Counterparty risk Exposed: any counterparty can default before the termination, hence 0.1% as compensation Exposed, but no direct exposure to client B Exposed, but no direct exposure to client A
Credit risk – Exists for the full amount, but does not differ from making deposits with other banks without the swap Exists for the full amount, but does not differ from making deposits with other banks without the swap
A company can invest funds for five years at LIBOR minus 10 basis points. The five-year swap rate is 2%. What fixed rate of interest can the company earn using the swap?
A) Depends on the Libor rate
B) 1.9%
C) 2.0%
D) 2.1%
Answer: B
When the company invests at LIBOR minus 0.1% and then enters into a swap where it pays LIBOR and receives 2% it earns 1.9% per annum.
A company enters into an interest rate swap where it is receiving fixed and paying LIBOR. When interest rates increase, which of the following is true?
A) The value of the swap to the company increases
B) The value of the swap to the company decreases
C) The value of the swap can either increase or decrease
D) The value of the swap does not change providing the swap rate remains the same
Answer: B
When interest rates increase paying Libor/floating rate can be expected to be higher and so the swap becomes less valuable. Receiving Fixed is like being long a fixed rate bond, which loses money when rates go up.
Buying a receiver interest rate swap provides protection to a borrower that pays periodically the Libor rate plus a spread.
One advantage of swap contracts is that the principal or notional amount is not exchanged at initiation; hence the credit risk is low.
A receiver I.R. swap can be decomposed into a long FRN and a short coupon bond.
A swap seller in an I.R. swap transaction is also a fixed rate receiver
In an I.R. swap transaction, the bank is not exposed to counterparty risk
True
True
False
False
False