Tutorial questions – Interest rate swap
• 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:
Fixed rate
Floating rate
Client A
4.6%
Libor +0.2%
Client B
4.0%
Libor – 0.1%
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
• 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?
• Discuss the exposure of each counterparty to market risk, credit and counterparty risk when entering the transactions mentioned above.
ANSWER to Q1
Fixed rate
Floating rate
Client A
4.6%
Libor + 0.2%
Client B
4.0%
Libor – 0.1%
• 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 A : 4.6% + Libor – 4.3% = Libor + 0.3% : Client A is making 0.1%
Client B : Libor – 0.1% + 4.2% – Libor = 4.1% : Client B is also making 0.1%
Bank : 4.3%-4.2% – Libor + Libor = Bank is making 0.1%
c) Market risk:
• Bank has none, Libor cancels out
• Client A and B have nothing extra, as demanded initially
Credit risk:
• Bank has none, just acted as intermediary
• Client A and B have risk on full amount, but same as a deposit with a bank, without the swap
Counterparty risk:
• Bank is exposed to default on either side, but has 0.1% compensation for the risk
• Client A and B are exposed, but not to each other because the bank is their counterparty
• 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?
• The value of the swap to the company increases
• The value of the swap to the company decreases
• The value of the swap can either increase or decrease
• The value of the swap does not change providing the swap rate remains the same
Answer: B
It is receiving fixed rate. When interest rates increase paying Libor/floating rate can be expected to be higher and so the swap becomes less valuable. Receiving Fix is like being long a fixed rate bond, which loses money when rates go up. The answer is therefore B.
• 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 by using the swap?
• Depends on the Libor rate
• 1.9%
• 2.0%
• 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.
• Buying a receiver interest rate swap provides protection to a borrower that pays periodically the Libor rate plus a spread.
False
It would be true for the payer I.R. swap because Libor would cancel out. In our case, by entering the receiver swap, investor would double it.
• One advantage of swap contracts is that the principal or notional amount is not exchanged at initiation; hence the credit risk is low.
True
It is the case for the most swap contracts, but for currency swaps, for instance, the notional is exchanged at initiation and at expiry; yet, the credit risk remains low because a notional of equal value but in a different currency is received in return.
• A receiver I.R. swap can be decomposed into a long FRN and a short coupon bond.
False
The holder of a receiver swap receives a fixed rate and pays the floating rate. Hence, it is equivalent to a long coupon bond plus a short FRN.
• A swap seller in an I.R. swap transaction is also a fixed rate receiver
True (refer to the table in the lecture/seminar)
• In an I.R. swap transaction, the bank is not exposed to counterparty risk
False
The bank is exposed to counterparty as they might default before the termination.