Capital Markets and Investments

Fixed Income 8

Sid Dastidar

Topics

Defaultable Risk: The Eurodollar Market and Libor

Swaps

The Eurodollar Market

The biggest interest rate market is the Eurodollar market, not the Treasury.

Questions:
What is this market and what is a Eurodollar?
Why does it exist?
What are the instruments and conventions?

What are Eurodollars?

A Eurodollar is a US$ (USD) denominated deposit outside of the U.S. The

primary market for these deposits is in London.

The market developed in 1960s and 1970s to skirt U.S. banking regulations
Europe typically has less regulation
Often beneficial tax advantages to doing $ denominated business
abroad (Cayman Islands)

What are the instruments?

Fixed and floating rate deposits over various maturities

CDs, time deposits, etc.

Market is benchmarked by the LIBOR rate

London Interbank Offered Rate: rate at which major banks are willing to offer
$ deposits to each other
London Interbank Bid Rate (LIBID): the rate at which major banks will take
$ deposits from each other.

How is it set?

BBA (British Bankers Association) polls panel banks and asks them at what
rate would they loan money to other panel banks

Panel is supposed to:

Produce a reference panel of banks which reflects the balance of the
market - by country and by type of institution. Individual banks are
selected within this guiding principle on the basis of reputation, scale of
market activity and perceived expertise in the currency concerned.

Current US$ Panel

For U.S. Dollar

Bank of America, Barclays Bank Plc, Citibank NA, Credit Suisse First
Boston, Deutsche Bank AG, HBOS, HSBC, JP Morgan Chase, Lloyds
TSB Bank Plc, Rabobank, Royal Bank of Canada, The Bank of TokyoMitsubishi Ltd, The Norinchukin Bank, The Royal Bank of Scotland
Group, UBS AG, Westdeutsche Landesbank AG

For other countries:

http://www.bba.org.uk/public/libor/

Why is LIBOR so important?

Easiest defaultable rate: the rate at which highly rated commercial banks can
borrow and lend

Short-term interest rate benchmarks

Overnight, 1 Week, 1-12 Months

Why is it the benchmark? Difficult to manipulate

Vast majority of interest rate derivatives and many bond issuances are linked to
LIBOR
Floating rates on bonds, forwards and swaps

Euro-(insert your favorite currency)

Off-shore deposit rates, set by BBA, exist for a number of other currencies:
Pound Sterling, Japanese Yen, Swiss Franc, Canadian Dollar,
Australian Dollar, Euro.

There are also deposit rates set in other localities: TIBOR (Tokyo interbank
offered rate), etc.

LIBOR as a benchmark

LIBOR is widely used because it is (or: was!!!) perceived as an

unbiased and incorruptible index of current rates

Eurodollars have long served as a benchmark interest rate for

corporate funding:
Currently around $300 trillion in mortgage loans, corporate debt
and other financial contracts that are tied to Libor rates

10

Examples of LIBOR indexing

Chrysler borrowed $20 billion from banks in July. Its loans were
indexed to Libor interest rates.

$3 trillion of commercial-paper loans used by banks are pegged to

the Libor

Lou Barnes, partner of Boulder West Financial Services, a Colorado

mortgage bank, has three Libor-linked mortgages of his own,
valued at more than $800,000 in all
he says he does worry that many [many] U.S. consumers have
fortunes tied to this interest rate that few understand. "They don't
know how to pronounce it. They don't know what it means," Mr.
Barnes says.

11

How unbiased is LIBOR?

Libor has recently come under fire:

In 2008 the WSJ published a study that questioned whether banks

were submitting honest bids

Why might banks may want to misreport cost of borrowing?

Two main reasons:

to make money, for example on derivative trades tied to Libor

by underreporting their actual borrowing cost they may avoid

appearing desperate for cash (particularly during the financial crisis)

12

The Barclays Settlement

In June 2012, Barclays admitted to the U.S. DOJ

to have manipulated Libor between 2005 and 2007 in response to

request from Barclays trading units

that some traders coordinated with other banks on Libor

submissions

that later, during the crisis, Barclays submitted artificially low bids

Barclays and the DOJ settled for $450m (see Canvas for settlement)

At least 12 other banks are currently under investigation

13

Libor Submissions 2005-2012

14

Libor Submissions Fall 2008

15

Reforming Libor?
Currently, a number of proposals discuss Libor reform
Wheatley Report (issued by FSA)
Gary Gensler (Head of CFTC, NYTimes Opinion piece)
Aims:
Measure funding costs more accurately, e.g., using actual
transactions (although this can be difficult when there is little
actual interbank lending)
Less scope for manipulation
Difficulty:
Any drastic changes in the rate system could create uncertainty
in markets and throw into doubt the legality of trillions in
mortgage loans, corporate debt and other financial contracts tied
to Libor rates.
16

Libor Contains Default Risk

Libor is a rate between banks and thus contains default risk

Default risk is compensated by an interests rate spread above
Treasuries (to bear default risk, you require more return)

More generally, default risk shows up in:

Libor
Corporate bonds
Sovereign bonds with default risk

Etc.

LIBOR is Defaultable!

Deposits are not guaranteed by FDIC

If there is a banking crises
Example: Japanese banking system

LIBOR should always (or almost always) be higher than Treasury

rates.

Difference between them is the TED spread

Treasury over Eurodollar

Measure of health of banking sector (current crisis)

18

Historical Time series

19

TED Spread

20

LIBOR and 9/11

5.25
4.75
4.25
3.75
3.25
2.75
2.25
1.75
1-Aug

11-Aug

21-Aug

31-Aug
Overnight

10-Sep
1-Week

20-Sep

30-Sep

1-Month

10-Oct

20-Oct

30-Oct

3-month

21

How to model defaultable rates?

Model defaultable rates in a manner similar to equities: adjust discount

rates.

If we let rt denote the default-free rate, then the defaultable rate R is given
by: Rt=rt+st

s is the spread and is given equal to st=Ltht

L is the amount of par value lost
h is the probability of default.

The TED spread is one example of a spread, and swap spreads (next class)
are longer-dated versions.

22

Swaps
An

interest rate swap is an agreement between two parties

to exchange period cash flows
One party pays a fixed rate and receives a floating rate
The other party pays floating and receives fixed.

Uses

Gives indirect access to fixed or floating capital markets

Allows them to manage their asset/liability structure.
A tool for hedging risk and speculation

You

can swap anything (as Enron has showed us).

http://www.enron.com/wholesale/weather/three.html
23

Examples

Ex. 1: Suppose you have a floating-rate mortgage and fear that interest
rates will rise. How to get out of your floating-rate mortgage?
Re-finance: fees, down payments
Alternatively, swap fixed-for-floating payments

Ex. 2: GE Capital. After purchase of Heller financial, is worrying about

rising interest rates, wants to convert their floating bonds into fixed rate
bonds.

Ex. 3: A US corporation (Fannie Mae) issues fixed debt because the

insurance companies and pension funds that purchase the debt
demand it. Sometimes youd rather issue floating debt (why?). How to
convert the cashflows?

24

The uses of such instruments are threefold:

it allows participants to manage their asset/liability structure more effectively;
(iii) it provides a tool for hedging interest rate risk.
Example: Managing Assets and Liabilities
Consider a Bank with a very simple balance sheet:

Assets
$100 MM
10 year loan at 8%

Liabilities
$100 MM
6 mo. CDs at 5%

Every 6 months the Bank has to refinance the CDs, whose rates are typically tied to LIBOR.
Suppose, for simplicity, the CD rate is the LIBOR rate. Consider a SWAP whereby the Bank
exchanges their variable liability for a fixed rate liability at 7%.

LOANS

BANK
8%

SWAP DEALER
pays 7%
receives 6 mo. LIBOR

Now the bank only has to worry about the credit risk of the borrower and the SWAP dealer.
25

Who wants floating?

Wants to receive variable

and pay a fixed payment
a. Speculators who believe
Eurodollar rates will rise
b. Banks which have fixed
rate loans but variable rate
obligations (CDs)

c. Firms with variable rate

loans, yet steady cash flow
streams (e.g., drug firms)

Who wants fixed?

Wants to receive fixed and

pay variable
Speculators who believe
rates will fall
Banks which have
variable rate assets
(mortgages) and want to
reduce risk in this part of
their portfolio
Firms with variable
streams of income but
who have fixed obligations
and want to reduce risk

SWAPS can be thought of as insurance against rate changes.

26

Contractual Features of Swaps

What

is swapped? Fixed and Floating Rate payments

(net) on a given principal
Floating rate: corporate rates, mortgage rates, LIBOR rates
Fixed rate: Typically a Treasury rate (on contracting day) plus
some basis points (swap spread)

How

often? Reset/settlement period: usually 3 or 6

months.

For

how long? 1 year, 5 years, 10 years,

27

Typical swap payments

Fixed payer: fixed rate is typically quoted as a spread: Treasury rate +

basis points
E.g. 10-year yield +50 b.p. (50 is swap spread)

Floating payer: floating rate can be any variable rate

Typically LIBOR

Exchange net on a given principal ($1mil)

28

Swap example
5-year

swap: between parties X and Y, swap rate 6%

X pays 6% per year to Y for the next 5 years

Y pays 6-month LIBOR
Notional amount: $10 mil (never exchanged)

Exchange

net payments every 6 months

X pays 10(0.06/2)=$0.3 million

Y pays 6 month LIBOR times $10 mil divided by 2

Terminology:

X is a fixed-rate payer/floating-rate receiver

Y is a floating rate payer/fixed-rate receiver
29

Cash flows in a swap

Swap rate:
Contract date:
Date
1/15/2007
7/15/2007
1/15/2008
7/15/2008
1/15/2009
7/15/2009
1/15/2010
7/15/2010
1/15/2011
7/15/2011
1/15/2012

6%
01/15/2007

Notional amount:

10,000,000

Fixed Payment 6-month LIBOR Floating Payment Net Payment (fixed payer)
4%
300,000
5%
200,000
100,000
300,000
6%
250,000
50,000
300,000
7%
300,000
300,000
8%
350,000
(50,000)
300,000
7%
400,000
(100,000)
300,000
6%
350,000
(50,000)
300,000
5%
300,000
300,000
4%
250,000
50,000
300,000
3%
200,000
100,000
300,000
2%
150,000
150,000

30

Market convention
Floating

payment in 6 months (1 year, ) is indexed to

the 6-month LIBOR rate today (LIBOR rate in six month,
)

This

is the typical arrangement and is the convention of

this course.
Why? Floating coupons on bonds are typically set in this manner.
Idea: you know 6-months in advance what

Swaps

are over-the-counter (OTC) products, other

variations
Indexed to 3-month LIBOR
Floating payment in 6-months is indexed to the 6-month LIBOR
in 6-months (instead of todays LIBOR). This is called LIBOR in
arrears swap.
31

The pricing intuition: a 2-year swap

Time

Fixed
Payment

6-Month
floating
rate

Floating
payment

Expected
floating
payment

Net expected swap

payment

1/15/2007

7/15/2007

6-mo.

s/2 $10mil

r0.5 at 0

r0.5/2$10mil

r0.5/2$10mil

(s/2-r.5/2)$10mil

1/15/2008

1-yr

s/2 $10mil

r0.5 in 6-mo

???

0.5f0.5/2$10mil

(s/2-0.5f0.5/2)$10mil

7/15/2008

1.5 yrs

s/2 $10mil

r0.5 in 1-yr

???

1f0.5/2$10mil

(s/2-1f0.5/2)$10mil

1/15/2009

2-rs

s/2 $10mil

r0.5 in 1.5yrs

???

1.5f0.5/2$10mil

(s/2-1.5f0.5/2)$10mil

Two

relevant parts:

Floating is indexed to 6-months ago 6-month rate

Substitute forward rates for expected floating rates.
32

How to price?

Question 1: what is the cost, today, of entering into a swap (or a

forward)?

Zero.

Question 2: if cost is zero, how to price?

1.

NPV fixed should equal NPV floating

2.

Or NPV of net swap payments is zero.

How to write this mathematically?

33

Previous Slides in Algebra

The expected net NPV of an N-year pay floating/receive

fixed swap is 0

1
s
0

2n
2
n 0.51 rn / 2
N

f
2

n -0.5 0.5

Same as
N

NPV fixed

N
s/2
n -0.5 f 0.5 / 2

NPV floating
2n
2n
n 0.51 rn / 2
n 0.51 rn / 2

34

Nice formula

Turns out, the swap rate has a particularly simple form:

s2

1 Z N
N

n 0.5

Zeroes come from spot rates, again, stressing the importance of spot rates.

We will derive this, in the case of a 1-year swap (easiest to see how it
works).

35

Solve for the swap rate

Consider a 1-year swap

NPV fixed

1 r

n 0.5

/ 2

2n

1
s
1

2 n 0.51 rn / 22 n

f
2

n -0.5 0.5

NPV floating

And recall that

1
Zn
and
2n
1 rn / 2

(1 rn /2) 2 n

1
n -0.5f .5 2
2n-1
(1 rn -0.5/2)

36

NPV floating

(1 rn /2) 2 n

2n
2n-1
n 0.51 rn / 2
(1 rn -0.5/2)

(1 r0.5 /2) 1

(1 r1 /2) 2

1
1

1
1 r0.5 / 21 (1 r0 /2) 0 1 r1 / 22 (1 r0.5/2) 1
1

1
1
n -0.5 f 0.5

2n
2

r
/
2
n 0.5
n

1
1
1
1

0
1
1
2
(
1

r
/2)
(
1

r
/2)
1 r0.5 / 2
1 r1 / 2

0
0.5
1
1
1
1

(1 r0 /2) 0 1 r0.5 / 2 1 (1 r0.5/2) 1 1 r1 / 2 2

1

1 r1 / 2

1 Z1

37

NPV fixed and swap rate

NPV fixed:

s
1
s s
1
1

Z 0.5 Z1

2n
1
2
2 2 1 r0.5 / 2 1 r1 / 2 2
n 0.5 1 rn / 2
1

NPV fixed

Swap rate

s 1
Z n 1 Z1

2 n 0.5

1 Z1
s2
1

n 0.5

38

Swap rate N year swap

The general formula, given earlier, is

s2

1 Z N
N

n 0.5

Notice:

this coincides with the N-year par rate

Nothing new about swaps!

39

Duration of a SWAP

1. Consider an N-year SWAP

2. Duration of Fixed side
- Same duration as an N-year bond with coupon rate s
3. Duration of Floating side
- Always have a PV of $100. Intuition: when interest increases, you
receive more interest, but also discount more. The effect offsets each
other. Duration of floating side: 0.
4. Receive fixed/pay floating SWAP has a positive duration.
5. Receive floating/pay fixed SWAP has a negative duration.
6. SWAP can hedge interest rate risk via duration adjustment, just like an Nyear bond.
40

Trading swaps

If you pay fixed on a swap and receive floating:

If interest rates rise: you win
If interest rates fall: you lose
Like buying a bond

If you pay floating and receive fixed

If interest rates rise: you lose
If interest rates fall: you win.

Cash flows are very similar to trading bonds.

Why? Swap rates are just like par coupon bonds.

Trading swaps is just like trading par coupon bonds.

In practice, many market participants use swaps to manage their duration.

41

Questions and issues

1.

Swaps are indexed to LIBOR. How does this change

things?

Use LIBOR rates and LIBOR zero coupon bonds.

2.

What about counterparty risk?

3.

How to get LIBOR zeros?

LIBOR deposit rates exist only out to 1-year.

2 ways
1. LIBOR forward market exists and is very liquid. Get forward
rates on Bloomberg, and bootstrap the forward curve to get
LIBOR spot rates (next slide). LIBOR forward rates can be
found in Bloomberg as IMM Eurodollar Synthetic forward rates
2. Bootstrap the swap curve to get LIBOR zero prices. Get spot
rates from these.
42

LIBOR rates via forward rates

From forward formulas we know:

(1 r /2)
L
n

2n

(1 r

L
n -0.5

/2)

2n-1

(1 n -0.5f.5 /2)

Last lecture, we use the spot rates to find forward rates.

Now, we use forward rates to find spot rates.

Bootstrapping the forward curve

43

Bootstrap forward rates to get spot rates

(1 r /2) (1 r /2) (1 f
L
1

L
0.5 0.5

L
0.5

/2)

L
(1 r1.5
/2) 3 (1 r1L /2) 2 (11 f 0.5 /2)
L

(1 r /2) (1 r /2) (1 f
L
2

L
1.5

L
1.5 0.5

/2)

...
(1 r /2)
L
n

2n

(1 r

L
n -0.5

/2)

2n-1

(1

L
n -0.5 0.5

/2)

This allows us to compute all of the LIBOR rates via the

first LIBOR rate and LIBOR forward rates
44

10/4/2015

Dastidar

45

10/4/2015

Dastidar

46

Swap and Treasurys

47

Swap spreads

48

Summary

Forward rates as an interest rate risk hedge

LIBOR as a benchmark for defaultable rate/ financier cost of funds

Swaps, forwards, Treasuries, Treasury futures, Eurodollar futures are all

close substitutes add or subtract duration to a portfolio.
Swaps massive size with one phone call,
Treasury futures are exchange traded, so most transparent, but need to
be rolled every quarter.
Eurodollar Futures, exchange traded, go very far out

FRAs are not as liquid

49

Hedging with Eurodollar Futures

Here we illustrate the use of Eurodollar futures contracts as a

hedging instrument for bond portfolio insurance. The concept is
identical to the prior use of T-bill futures: the investor desiring to
hedge must write Eurodollar futures in the appropriate numbers.
These written contacts will become more valuable as rates rise
(prices fall). Aside from a few details/conventions of measurement,
the calculations mimic those of T-bill futures.

50

How the Eurodollar FP (futures price) is to be interpreted

1.

As of 1/27/09, 11:27 AM, we have the following information:

April 00
expiration
date of
futures
contract
2.

last
98.895

Futures Prices 2/28/08

open
high
98.915
98.915

low

vol.
178

Suppose we transacted for one contract at the current FP.

T (April 09)

t=0

T + .25
April
Libor

f.25

FP = 98.895

.01105

We interpret 98.895 as identifying the (annualized!) forward 3 month LIBOR rate relative to April
2009 as being
100 98.895 = 1.105%, or .01105 (1.105%).
The contract amount is $1,000,000 for 3 months.

How the Eurodollar FP (futures price) is to be interpreted

3.

Suppose you signed (went long) in a futures contract when FP = 98.895, and
during the life of the contract, the FP rises to 99 (forward LIBOR falls to 1%);
then:
Long position receives (1,000,000) (.00105) (.25) = +$262.50

99 98.895

100

Short position receives: (1,000,000) (.00105) (.25) = $262.50.

(There is only cash settlement.)

52

How the Eurodollar FP (futures price) is to be interpreted

4.

Suppose at some point, the FP falls to 97 (forward LIBOR rises to 3%,

annualized); then,
Long position receives (1,000,000) (.01895) (.25) = $4737.50
97 98.895

100

Short position receives: (1,000,000) (. 01895) (.25) = $4737.50.

As with any of our hedging instruments (T-bonds, T-bill futures), short
positions in Eurodollar futures increase in value as rates rise.

53

Hedging with Eurodollar Futures

1.

Your problem: you will need to borrow $10M for 3 months, and you will need the loan 4 months from now. Your
firm is sufficiently secure financially that you can effectively borrow at LIBOR.

2.

Currently, forward LIBOR (3 month rate) is 5.14% relative to t = 4 months (.33 year). This corresponds to FP =
94.86.

t=0

t (4 months)

FP = 94.86
Libor
.33 f.25

.0514

(4 months) (3 months)
You would like to lock in this rate so that you will know what your future loan cost will be. If 5.14% can be
locked in, your cost will be
(.0514) (.25) ($10M) = $128,500.
rate, number amount of
annualized of years the loan
54

Hedging with Eurodollar Futures

To lock it in, write 10 Eurodollar futures contracts at FP = 94.86 (corresponds to
5.14%).
At t = .33 years, suppose LIBOR has risen to 6.14% (futures price falls to 93.86)

Payoff to short position:

10 contracts (1,000,000/contracts) (.25) (.01) = $25,000
Since the loan cost at the new rate is

93.86 94.86
100

($10M) (.0614) (.25) = $153,500,

the net cost is $153,500 $25,000 = $128,500.

55

Two Questions
1.
Suppose the loan rate for you is LIBOR + 1%; would this
affect the number of contracts you write?

2.
What rate changes can you insure against using Eurodollar
futures? What rate changes can you not insure against?

56

Hedging a Bond Portfolio with 3-Month LIBOR Futures

1.

Consistent with our hedging context, suppose the term structure is

flat. The Term structure of LIBOR rates and the forward LIBOR
curve would be essentially flat as well.

2.

An Example:

You own $10M of bonds of D = 6 when the interest rate (LIBOR)

environment is flat at r = 5.14%. You are concerned that rates may
rise by .5%. Hedge your position with Eurodollar futures.

57

Hedging a Bond Portfolio with 3-Month LIBOR Futures

3. What is your estimated loss if you do not hedge?
VP

D
6
VP r
10(.005)
(1 r)
(1.0514)

$285,334

58

Hedging a Bond Portfolio with 3-Month LIBOR Futures

4. Perfectly hedging using Eurodollar futures means DP = 0. How
many contracts would you write to bring this about?
VP DP n1P1D1 n EDF DEDF $1,000,000
0 10MM 6 n EDF (.25) (1,000,000
10MM 6
n EDF
240 contracts; i.e.,
(.25) (1MM)

you receive gains

and losses relative
to $1 MM

write 240 contracts.

59

Hedging a Bond Portfolio with 3-Month LIBOR Futures

Suppose rates do rise as feared.
Approximate loss on portfolio =
Gain on futures:
- (240) (1,000,000) (.25) (-.005) =
.94.36 94.86
100

$285,334
+ $300,000

+ $15,000

We are slightly overhedged, as theory reminds us must be the case.

60

Conclusions
1. We have illustrated the use of Eurodollar futures as a hedging
instrument, even in the case of a T-bond portfolio. Notice an
implicit assumption, however: LIBOR and UST rates for the same
maturity instruments (their respective term structures must move
in lockstep): a .5% increase in LIBOR rates must accompany
a .5% increase in T-bill rates. If this relationship breaks down, the
hedge will become less effective.

61