PowerPoint Presentation
IC301
Derivative Securities
IC301 – Topic 8
Interest Rate Swaps
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
Fixed rate payer
Floating rate receiver
Long a swap
Swap seller
Fixed rate receiver
Floating rate payer
Short a swap
Floating rate
Floating leg
FRN
Fixed rate
Fixed leg
Coupon bond
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Example: Liability Management
GBP 6m Libor + 2%
GBP 5.0%
Corporate Client has a £10m loan at a GBP floating interest rate and wants to pay fixed GBP interest rate for next 5 years
Interest Rate Swaps exchanges cashflows to convert the loan into a fixed rate liability
Net outcome
Floating swap payments matches loan payments
Client pays 5% fixed overall
Bank
Corporate Client
GBP £10m
Loan
Loan interest GBP 6m Libor + 2%
Corporate curve
%
Time
1 yr 2yr 3yr 5yr 7yr 10y 30y
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Government curve
“AA” rated
The “spread”
Libor rate mechanism
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Banks submit rates for where they can borrow/lend interbank
Outliers are removed
Interest Rate is averaged
Index has been discredited since the Financial Crisis
New rate fixing expected to be short-dated (OIS – Overnight Index Swaps)
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Comparison with mutual loans/bonds
5.00%
A swap can be ‘reconstructed’ with two loans/bonds* in the same currency
Intel borrow from Microsoft at ‘Libor flat’
Microsoft borrows from Intel at 5% fixed
Microsoft
Intel
Libor
* Intel/Microsoft could buy each other’s bonds instead of lending
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Comparison with mutual loans/bonds
5.00%
Microsoft
Intel
Libor
MSFT fixed rate payer : equivalent to short a bond, long FRN
INTEL floating rate payer : equivalent to long bond, short FRN
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The Link between Valuation and Funding
Client receives Floating and pays Fixed
Hedge executed in the interbank market under a perfect CSA
Bank
Libor
Libor
Interbank
Client
5%
5%
Collateralised
Uncollateralised
The Bank is not perfectly hedged because there are mismatches in the collateral and funding position as the swap changes value
CSA – credit support annex (regulates credit support/collateral for swaps
Nature of Swaps
A swap is an agreement to exchange cash flows at specified future times according to certain specified rules
Term
Notional amount
Frequency
No exchange of principal
Payments are netted
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An Example of a “Plain Vanilla” Interest Rate Swap
An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million
Next slide illustrates cash flows that could occur (Day count conventions are not considered)
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One Possible Outcome for Cash Flows to Microsoft (Table 7.1, page 177)
Date LIBOR Floating Cash Flow Fixed Cash Flow Net Cash Flow
Mar 5, 2014 4.20%
Sep 5, 2014 4.80% +2.10 −2.50 −0.40
Mar 5, 2015 5.30% +2.40 −2.50 −0.10
Sep 5, 2015 5.50% +2.65 −2.50 + 0.15
Mar 5, 2016 5.60% +2.75 −2.50 +0.25
Sep 5, 2016 5.90% +2.80 −2.50 +0.30
Mar 5, 2017 +2.95 −2.50 +0.45
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Microsoft, as the buyer of the swap, receives a floating rate and pays a fixed rate. In Table 3.1, we can see that, in buying the swap, Microsoft has benefitted from the transaction because the Libor interest rate has increased.
Interesting way to view the swap: 3rd column cash flows like cash flow from a long position in a floating rate bond, 4th column like cash flows from a short position in a fixed rate bond – could be viewed as an exchange of a fixed rate bond for a floating rate bond.
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Typical Uses of an Interest Rate Swap
Converting a liability from
fixed rate to floating rate
floating rate to fixed rate
Converting an investment from
fixed rate to floating rate
floating rate to fixed rate
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Transforming liabilities
Assume that Microsoft has borrowed $100m at Libor +10 basis points (bps). After entering into the swap with Intel (pays fixed 5%, receives floating Libor flat), Microsoft now:
pays Libor + 10bps to its outside lender;
receives Libor in the swap deal;
pays 5% in the swap deal.
Microsoft now pays 5.10% in total. The swap has effectively transformed borrowings of Libor + 10bps into a fixed rate borrowing with a 5.10% interest rate as the payment of Libor to the outside lender and receipt of Libor from Intel cancel each other out.
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Transforming liabilities (cont’d)
Assume Intel also has an outstanding three-year $100m loan on which it pays 5.20%. After entering the swap, Intel:
pays 5.20% to outside lenders;
pays Libor in the swap deal;
receives 5% in the swap deal.
So Intel pays Libor + 20bps in total and the swap has transformed 5.20% fixed rate borrowings into floating rate borrowings of Libor + 20bps.
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Interest Rate Swap (IRS)
5.00%
Transforming Liabilities
Net outcome
Intel pays:
Microsoft pays:
Libor + 20 5.10%
Microsoft
Intel
Libor
5.2%
Libor + 0.1%
Source: Hull, p177, Figure 7.2
Source: Adjusted from Hull, p179, Figure 7.4
Bank Intermediation
Libor
5.01%
Bank intermediation
Net outcome
Intel pays:
Microsoft pays:
Bank earns:
Libor + 21 bp 5.11%
2 bp
Bank
Microsoft
Intel
Libor
4.99%
5.2%
Libor + 0.10%
Quotes By a Swap Market Maker (Table 7.3, page 180)
Maturity Bid (%) Offer (%) Swap Rate (%)
2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850
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US$ screenshot – Bloomberg (Aug 20th 2019)
US$ IRS screenshot
To hedge in USTs or Eurodollar futures?
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US dollar swaps and US Treasuries yield curves
Bid –offer rates in the market and how swaps work
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If these rates in the table were available for Company A and Company B:
If Company A was borrowing three year fixed at 1.60%, what floating rate could they swap into?
If Company B was borrowing for 5 years at Libor + 25 bps, what fixed rate can it swap this floating rate for?
Market maker quotes in US$ swaps (adapted from slide 20)
Both company A and B want to transform their existing borrowings, and by going to the swaps market they can do this. Company A can pay LIBOR and receive 1.45% fixed for 3 years, by hitting the bid side of the market makers quote. It can then exchange a loan at 1.60% into a loan at LIBOR plus 15 bps. Company B can lift the offer in the 5-year swap and pay fix at 1.40% and receive LIBOR. So, they have exchanged a loan at LIBOR + 25 bps for a loan at 1.65%
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Day Count
A day count convention is specified for for fixed and floating payment
For example, LIBOR is likely to be actual/360 in the US because LIBOR is a money market rate
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Confirmations
Confirmations specify the terms of a transaction
The International Swaps and Derivatives has developed Master Agreements that can be used to cover all agreements between two counterparties
Many interest rate swaps are now cleared through a CCP such as LCH Clearnet or the CME Group
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