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Plain Vanilla Interest Rate Swaps: Terms 3. Reset Frequency: Semiannual 4. Principal: No exchange of principal 5. Notional Principal (NP): Interest is applied to a notional principal; the NP is used for calculating the swap payments.
Plain Vanilla Interest Rate Swaps: Terms 6. Maturity ranges between 3 and 10 years. 7. Dates: Payments are made in arrears on a semiannual basis: Effective Date is the date interest begins to accrue Payment Date is the date interest payments are made
Plain Vanilla Interest Rate Swaps: Terms 8. Net Settlement Basis: The counterparty owing the greater amount pays the difference between what is owed and what is receivedonly the interest differential is paid. 9. Documentation: Most swaps use document forms suggested by the International Swap Dealer Association (ISDA) or the British Bankers Association. The ISDA publishes a book of definitions and terms to help standardize swap contracts.
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Web Site
For information on the International Swap and Derivative Association and size of the markets go to www.isda.org
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Swap Terminology
Note: Fixed-rate payer can also be called the floating-rate receiver and is often referred to as having bought the swap or having a long position. Floating-rate payer can also be referred to as the fixed-rate receiver and is referred to as having sold the swap and being short.
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Plain Vanilla Interest Rate Swap: Example Example: Fixed-rate payer pays 5.5% every six months Floating-rate payer pays LIBOR every six months Notional Principal = $10 million Effective Dates are 3/1 and 9/1 for the next three years
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Interest Rate Swaps Fundamental Use One of the important uses of swaps is in creating a synthetic fixed- or floating-rate liability or asset that yields a better rate than a conventional or direct one:
Synthetic fixed-rate loans and investments Synthetic floating-rate loans and investments
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A synthetic fixed-rate loan is formed by combining a floating-rate loan with a fixedrate payers position Conventional FloatingRate Loan Swap: Fixed-Rate Payer Position Swap: Fixed-Rate Payer Position Synthetic Fixed Rate Pay Floating Rate Pay Fixed Rate Receive Floating Rate
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11 1 / /Y 11 1 . 1 11 1 / /Y 11 1 . 1 $11111 ,1 11 1 / /Y 11 1 . 1 $11111 ,1 11 1 / /Y 22 2 . 2 $11111 ,1 11 1 / /Y 11 1 . 1 $11111 ,1 11 1 / /Y 11 1 . 1 $11111 ,1 11 1 / /Y $11111 ,1 * (LIBOR/ 1 11 ,111 )($ ,111 ) ** (. 111 11 ,111 /1 )($ ,111 ) *** 1(Payment on Swap and Loan)/$11 ,111 , 111
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A synthetic floating-rate loan is formed by combining a fixed-rate loan with a floating-rate payers position. Conventional Fixed-Rate Loan Swap: Floating-Rate Payer Position Swap: Floating-Rate Payer Position Pay Fixed Rate Pay Floating Rate Receive Fixed Rate
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1 /Y1 /1 11 .11 1 /Y1 /1 11 .11 $11111 ,1 1 /Y1 /1 11 .11 $11111 ,1 1 /Y1 /1 22 .22 $11111 ,1 1 /Y1 /1 11 .11 $11111 ,1 1 /Y1 /1 11 .11 $11111 ,1 1 /Y1 /1 $11111 ,1 * (LIBOR/ 1 11 , 111 )($ , 111 ) ** (. 111 11 , 111 /1 )($ , 111 ) *** 1 (Payment on Swap and Loan)/$ 11 , 111 , 111
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From the previous example, the fixed-rate payers swaps CFs can be replicated by:
1. Selling at par a 3-year bond, paying a 5.5% fixed rate and a principal of $10,000,000 (semiannual payments) and 2. Purchasing a 3-year, $10,000,000 FRN with the rate reset every six months at the LIBOR.
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From the previous example, the floating-rate payers swaps CFs can be replicated by:
1. Selling a 3-year, $10,000,000 FRN paying the LIBOR and 2. Purchasing 3-year, $10,000,000, 5.5% fixed-rate bond at par
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The next slide shows the cash flows at the expiration dates from closing the 10 short Eurodollar contracts at the same assumed LIBOR used in the previous swap example, with the Eurodollar settlement index being 100 LIBOR.
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fT
$22222 ,2 $11111 ,1 $11111 ,1 $11111 ,1 $11111 ,1
1[f1 fT ] 1
-$11 , 111 $1 $11 , 111 $11 , 111 $11 , 111
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Party A
Party B
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Party A
Swap Bank
Fixed Rate Payer
Party B
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Party B NP = $1m 1
Fixed Rate Payer
Party A NP = $1m 1
Swap Bank
Fixed Rate Payer
Floating Rate Payer
Fixed Rate Payer
Party C NP = $1m 1
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Party A
1. 2. 3. 4. 5. 6. 7.
Swap Bank
Party B
Swap Agreement:
Initiation Date = June 10, Y1 Maturity Date = June 10, Y6 Effective Dates: 6/10 and 12/10 NP = $20,000,000 Fixed-Rate Payer: Pay = 6.26% (semiannual)/ receive LIBOR Floating-Rate Payer: Pay LIBOR/Receive 6.20% (semiannual) LIBOR determined in advance and paid in arrears
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Offsetting Swap: Floating Payers Position Pay LIBOR Offsetting Swap: Floating Payers Position Receive 5.0%
Pay 0.5% (annual) 0.5% Pay 0.25% (annual) (semiannually) 0.25% (semiannually
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Fix V1
Fix 1
Swap Valuation
At origination, most plain vanilla swaps have an economic value of zero. This means that neither counterparty is required to pay the other to induce that party into the agreement. An economic value of zero requires that the swaps underlying bond positions trade at parpar value swap. If this were not the case, then one of the counterparties would need to compensate the other. In this case, the economic value of the swap is not zero. Such a swap is referred to as an off-market swap.
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Swap Valuation
Whereas most plain vanilla swaps are originally par value swaps with economic values of zero, as we previously noted, their economic values change over time as rates change. That is, existing swaps become off-market swaps as rates change.
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Swap Valuation
In the preceding example, the fixed-payers position on the 5.5%/LIBOR swap had a value of $94,049 one year later when the fixed-rate on new 2-year par value swaps was 5%; that is, the holder of the fixed position would have to pay the swap bank at least $94,049 to assume the swap. On the other hand, the fixed-payers position on the 5.5%/LIBOR swap had a value of $92,927 when the fixed-rate on the new 2-year par value swap was 6%; that is, the holder of the fixed position would have receive $92,927 from the swap bank.
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Swap Valuation
Just the opposite values apply to the floating position. Continuing with our illustrative example, if the fixed rate on new 2year par value swaps were at 5%, then a swap bank who assumed a floating position on a 5.5%/LIBOR swap and then hedged it with a fixed position on a current 2-year 5.5%/LIBOR swap would gain $25,000 semiannually over the next two year. As a result, the swap bank would be willing to pay $94,049 for the floating position. Thus, the floating position on the 5.5% swap would have a value of $94,049:
Fl 1
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Swap Valuation
Offsetting Swap Positions Original Swap: Floating Payers Position Original Swap: Floating Payers Position Offsetting Swap: Fixed Payers Position Offsetting Swap: Fixed Payers Position Pay LIBOR Receive 5.5% Pay 5% Receive LIBOR Receive 0.5% (annual) LIBOR +5.5% 5% +LIBOR 0.5% (annual)
Fl V1 =
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Swap Valuation
If the fixed rate on new 2-year par value swaps were at 6%, then a swap bank assuming the floating position on a 5.5%/LIBOR swap and hedging it with a fixed position on a current 2-year 6%/LIBOR swap would lose $25,000 semiannually over the next year. As a result, the swap bank would charge $92,927 for assuming the floating position. Thus, the floating position on the 5.5% swap would have a negative value of $92,927:
Fl V1
Swap Valuation
Offsetting Swap Positions Original Swap: Floating Payers Position Original Swap: Floating Payers Position Offsetting Swap: Fixed Payers Position Offsetting Swap: Fixed Payers Position Pay LIBOR Receive 5.5% Pay 6% Receive LIBOR Pay 0.5% (annual) LIBOR +5.5% 6% +LIBOR 0.5% (annual)
Fl V1
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Swap Valuation
In general, the value of an existing swap is equal to the value of replacing the swapreplacement swap.
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Swap Valuation
Chapter 17
Formally, the values of the fixed and floating swap positions are:
SV
fix
M K P KS = NP P t + t =1(1 K )
M KS K P SV fl = NP P t + t =1(1 K )
KS = Fixed rate on the existing swap KP = Fixed rate on current par-value swap SVfix = Swap value of the fixed position on the existing swap SVfl = Swap value of the floating position on the existing swap
where:
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Swap Valuation
Note that these values are obtained by discounting the net cash flows at the current YTM (KP). As a result, this approach to valuing off-market swaps is often referred to as the YTM approach.
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Swap Valuation
The equilibrium price of a bond is obtained not by discounting the bonds cash flows by a common discount rate, but rather by discounting each of the bonds cash flows by their appropriate spot ratesthe rate on a zero-coupon bond. Valuing bonds by using spot rates instead of a common YTM ensures that there are no arbitrage opportunities from buying bonds and stripping them or buying zero-coupon bonds and bundling them.
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Swap Valuation
The argument for pricing bonds in terms of spot rates also applies to the valuation of off-market swaps. Similar to bond valuation, the equilibrium value of a swap is obtained by discounting each of the swaps cash flows by their appropriate spot rates. The valuation of swaps using spot rates is referred to as the zero-coupon approach.
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Comparative Advantage
Swaps are often used by corporations and financial institutions to take advantage of arbitrage opportunities resulting from capital-market inefficiencies. To see this consider the following case.
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Comparative Advantage
Case:
ABC Inc. is a large conglomerate that is working on raising $300,000,000 with a 5-year loan to finance the acquisition of a communications company. Based on a BBB credit rating on its debt, ABC can borrow 5-year funds at either
A 9.5% fixed the 9% rate represents a spread of 250 bp over a 5-year T-note yield Or A floating rate set equal to LIBOR + 75
Comparative Advantage
Suppose: The treasurer of ABC contacts his investment banker for suggestions on how to obtain a lower rate. The investment banker knows the XYZ Development Company is looking for 5-year funding to finance its $300,000,000 shopping mall development. Given its AA credit rating, XYZ could borrow for 5 years at either
A fixed rate of 8.5% (150 bp over T-note) Or A floating rate set equal to the LIBOR + 25 bp
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Comparative Advantage
Fixed Rate ABC 1% .1 XYZ 1% .1 Credit Spread 11 1 bp Floating Rate LIBOR + 1 bp 1 LIBOR + 1 bp 1 1 bp 1 preference Fixed Floating
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Comparative Advantage
The Investment banker realizes there is a comparative advantage.
XYZ has an absolute advantage in both the fixed and floating market because of its lower quality rating, but it has a relative advantage in the fixed market where it gets 100 bp less than ABC. ABC has a relative advantage (or relatively less disadvantage) in the floating-rate market where it only pays 50 bp more than XYZ.
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Comparative Advantage
Thus, it appears that investors/lenders in the fixed-rate market assess the difference between the two creditors to be worth 100 bp, whereas investors/lenders in the floating-rate market assess the difference to be 50 bp. Arbitrage opportunities exist whenever comparative advantage exist. In this case, each firm can borrow in the market where it has a comparative advantage and then swap loans or have the investment banker set up a swap.
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Comparative Advantage
Note: The swap wont work if the two companies pass their respective costs. That is: ABC swaps floating rate at LIBOR + 75bp for 9.5% fixed XYZ swaps 8.5% fixed for floating at LIBOR + 25bp Typically, the companies divide the differences in credit risk, with the most creditworthy company taking the most savings.
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Comparative Advantage
Given total savings of 50 bp (100 bp on fixed 50bp float), suppose the investment banker arranges an 8.5%/LIBOR swap with a NP of $300,000,000 in which ABC takes the fixed-rate position and XYZ takes the floating-rate payer position.
ABC
Swap Bank
XYZ
Fixed Rate = 1 % .1
Fixed Rate = 1 % .1
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Comparative Advantage
ABC would issue a $300,000,000 FRN paying LIBOR + 75bpthe FRN combined with the fixed-rate swap would give ABC a synthetic fixed-rate loan paying 9.25%:
ABC' s Synthetic Fixed Rate Loan FRN Swap Swap Pay LIBOR + 1% 1 Pay 1 % Fixed .1 Re ceive LIBOR Pay 1 % + .1% .1 1 Direct Loan Rate = 1 % .1
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Comparative Advantage
XYZ would issue a $300,000,000, 8.5% fixed-rate bond this fixed-rate loan combined with the floating-rate swap would give XYZ a synthetic floating-rate loan paying LIBOR.
XYZ' s Synthetic Floating Rate Loan Loan Swap Swap Pay 1 % fixed .1 = 1% .1 Pay LIBOR = LIBOR Re ceive 1 % Fixed Rate = + 1 % .1 .1 Pay LIBOR = LIBOR
Comparative Advantage
Points:
1. For a swap to provide arbitrage opportunities, at least one of the counterparties must have a comparative advantage in one market. The total arbitrage gain available to each party depends on the comparative advantage. If one party has an absolute advantage in both markets, then the arbitrage gain is the difference in the comparative advantages in each market the above case. If each party has an absolute advantage in one market, then the arbitrage gain is equal to the sum of the comparative advantages.
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Hidden Option
The comparative advantage argument has often been cited as the explanation for the growth in the swap market. This argument, though, is often questioned on the grounds that the mere use of swaps should over time reduce the credit interest rate differentials in the fixed and flexible markets, taking away the advantages from forming synthetic positions.
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Hidden Option
With observed credit spreads and continuing use of swaps to create synthetic positions, some scholars have argued that the comparative advantage that is apparently extant is actually a hidden option embedded in the floating-rate debt position that proponents of the comparative advantage argument fail to include.
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Hidden Option
Scholars argue that the credit spreads that exit are due to the nature of contracts available to firms in fixed and floating markets. In the floating market, the lender usually has the opportunity to review the floating rate each period and increase the spread over the LIBOR if the borrowers creditworthiness has deteriorated. This option, though, does not exist in the fixed market.
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Hidden Option
In the preceding example, the lower quality ABC Company is able to get a synthetic fixed rate at 9.5% (.25% less than the direct loan). However, using the hidden option argument, this 9.5% rate is only realized if ABC can maintain its creditworthiness and continue to borrow at a floating rate that is 100 bp above LIBOR. If its credit ratings were to subsequently decline and it had to pay 150 bp above the LIBOR, then its synthetic fixed rate would increase.
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Hidden Option
Studies have shown that the likelihood of default increases faster over time for lower quality companies than it does for higher quality. In our example, this would mean that the ABC Companys credit spread is more likely to rise than the XYZ Companys spread and that its expected borrowing rate is greater than the 9.5% synthetic rate. As for the higher quality XYZ Company, its lower synthetic floating rate of LIBOR does not take into account the additional return necessary to compensate the company for bearing the risk of a default by the ABC Company. If it borrowed floating funds directly, the XYZ Company would not be bearing this risk.
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Swap Applications In general, swaps can be used in three ways: 1. Arbitrage 2. Hedging 3. Speculation
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Arbitrage
In the above case, the differences in credit spreads among markets made it possible for the corporations to obtain better rates with synthetic positions than with direct. This example represents an arbitrage use of swaps.
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Arbitrage
In general, the presence of comparative advantage makes it possible to create not only synthetic loans with lower rates than direct, but also synthetic investments with rates exceeding those from direct investments. To illustrate this, four cases showing how swaps can be used to create synthetic fixed-rate and floating-rate loans and investments are presented below.
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Or
2. Create a synthetic fixed-rate bond by issuing a 5year FRN paying LIBOR plus 100 bp combined with a fixed rate payers position
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Swap Applications Arbitrage: Synthetic Fixed-Rate Loan A synthetic fixed-rate loan formed with a 5-year, 9%/LIBOR swap with NP of $20,000,000 and a 5-year, FRN paying LIBOR plus 100 bp is equivalent to 10% fixed rate loan.
Synthetic Fixed Rate Loan FRN Pay LIBOR + 1 % Swap Pay 1 Fixed % Swap Re ceive LIBOR Pay 1 + 1 % % Direct Loan Rate = 1% 1 = LIBOR 1 % = 1 % = + LIBOR = 1% 1
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= LIBOR 1 % = 1 % = + LIBOR = 1 %
Arbitrage Example: Synthetic Floating-Rate Loan Bank with an AA rating has made a 5-year, $20,000,000 loan that is reset every six months at the LIBOR plus bp. The bank could finance this by Selling CDs every 6 months at the LIBOR
Or
Create a synthetic floating-rate loan by selling a 5-year fixed note and taking a floating-rate payers position on a swap.
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Arbitrage Example: Synthetic Floating-Rate Loan The synthetic floating-rate loan will be equivalent to the direct floating-rate loan paying LIBOR if the swap has a fixed rate that is equal to the 9% fixed rate on the note:
Synthetic Floating Rate Loan Loan Pay 1 fixed % = 1 % Swap Pay LIBOR = LIBOR Swap Re ceive 1 Fixed Rate = + 1 % % Pay LIBOR = LIBOR Rate on Direct Floating Loan = LIBOR
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Synthetic Fixed Rate Investment FRN Swap Swap Re ceive LIBOR + 1 % Pay LIBOR Re ceive 1 Fixed Rate % Re ceive 1 Fixed Rate % = = = = LIBOR + 1 % LIBOR +1 % 1 %
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Swap ApplicationsHedging
Hedging Example 1:
One alternative would be to refund the floating-rate debt with fixed-rate debt. This, though, would require the cost of issuing new debt (underwriting, registration, etc.), as well as calling the current FRN or buying the FRN in the market. Problem: Very costly.
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Swap ApplicationsHedging
Hedging Example 1:
Another alternative would be to hedge the floating-rate debt with short Eurodollar futures contracts (strip), put options on Eurodollar futures, or an interest rate call. Problem: Standardization of futures and options creates hedging risk.
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Swap ApplicationsHedging
Hedging Example 1:
Third alternative would be to combine the floating-rate debt with a fixed-rate payers position on a swap to create a synthetic fixed -rate debt. Advantage: Less expensive and more efficient than issuing new debt and can be structured to create a better hedge than exchange options and futures.
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Swap ApplicationsHedging
Hedging Example 2:
Suppose a companys current long-term debt consist primarily of fixed-rate bonds, paying relatively high rates. Suppose interest rates have started to decrease.
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Swap ApplicationsHedging
Hedging Example 2:
One alternative would be to refund the fixed-rate debt with floating-rate debt. This, though, would require the cost of issuing FRN (underwriting, registration, etc.), as well as calling the current fixed rate bonds or buying them in the market if they are not callable Problem: Very costly.
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Swap ApplicationsHedging
Hedging Example 2:
Another alternative would be to hedge the fixed-rate debt with long Eurodollar futures contracts (strip), put options on Eurodollar futures, or an interest rate call. Problem: Standardization of futures and options creates hedging risk.
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Swap ApplicationsHedging
Hedging Example 2:
Third alternative would be to combine the fixed-rate debt with a floating-rate payers position on a swap to create synthetic floating-rate debt. Advantage: Less expensive and more efficient than issuing new debt and can be structured to create a better hedge than exchange options and futures.
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Swap ApplicationsSpeculation
Swaps can be used to speculate on short-term interest rate.
Speculators who want to profit on short-term rates increasing can take a fixed-rate payers position alternative to a short Eurodollar futures strip. Speculators who want to profit on short-term rates decreasing can take a floating-rate payers position alternative to a long Eurodollar futures strip.
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Swap ApplicationsChanging a Fixed-Income Funds Interest Rate Exposure For financial and non-financial corporations, speculative positions often take the form of the company changing the exposure of its balance sheet to interest rate changes. For example, suppose a fixed income bond fund with a portfolio measured against a bond index wanted to increase the duration of its portfolio relative to the indexs duration based on an expectation of lower interest rate across all maturities. The fund could do this by selling its short-term Treasuries and buying longer-tern ones or by taking long positions in Treasury futures. With swaps, the fund could also change in portfolios duration by taking a floating-rate payers position on a swap.
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Swap ApplicationsChanging a Fixed-Income Funds Interest Rate Exposure If they take a floating-rate position and rates were to decrease as expected, then not only would the value of the companys bond portfolio increase but the company would also profit from the swap. On the other hand, if rates were to increase, then the company would see decreases in the value of its bond portfolio, as well as losses from its swap positions. By adding swaps, though, the fund has effectively increased its interest rate exposure by increasing its duration.
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Swap ApplicationsChanging a Fixed-Income Funds Interest Rate Exposure Instead of increasing its portfolios duration, the fund may want to reduce or minimized the bond portfolios interest rate exposure based on an expectation of higher interest rate. In this case, the fund could effectively shorten the duration of its bond fund by taking a fixed-rate payers position on a swap. If rates were to later increase, then the decline in the value of the companys bond portfolio would be offset by the cash inflows realized from the fixed-payers position on the swap.
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Credit Risk
As noted, swaps have less credit risk than the equivalent fixed and floating bond positions. Credit Risk: Swaps fall under contract law and not security law. Consider a party holding a portfolio consisting of a short FRN and a long fixed-rate bond. If the issuer of the fixed-rate bond defaults, the party still has to meet its obligations on the FRN. On a swap, if the other party defaults, the party in question no longer has to meet her obligation. Swaps therefore have less credit risk than combinations of equivalent bond positions.
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Credit Risk
The mechanism for default on a swap is governed by the swap contract, with many patterned after ISDA documents.
When a default does occur, the non-defaulting party often has the right to give up to a 20-day notice that a particular date will be the termination date. This gives the parties time to determine a settlement amount.
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Credit Risk
Suppose the fixed payer on a 9.5%/LIBOR swap with NP of $10,000,000 runs into severe financial problems and defaults on the swap agreement when there are 3 years and 6 payments remaining. Question: How much would the fixed-payer lose as a result of the default? Answer: Depends on the value of an existing swap, which depends on the terms of a replacement swap.
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Credit Risk
Suppose a current three-year swap calls for an exchange of 9% fixed for LIBOR. By taking a floating position on the 9%/LIBOR swap, the floating payer would be receiving only $450,000 each period instead of $475,000 on the defaulted swap. Thus, the default represents a loss of $25,000 for three years and six periods. Using 9% as the discount rate, the present value of this loss is $128,947:
1 (1.111 $1,11 11 / 1) PV = = $1,11 1 1 1,11 = $11 1 t .11 1 + 1 )) t =1(1 (.1 / 1
1
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Credit Risk
Thus, given a replacement fixed swap rate of 9%, the actual credit risk exposure is $128,947 (this is also the economic value of the original swap). If the replacement fixed swap rate had been 10%, then the floating payer would have had a positive economic value of $126,892.
1 (1.1) 1 $1,11 11 / 1 PV = = $1,11 1 1 1,11 = $11 1 t .1 1 t =11 (.1 / 1 ( + 1 ))
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The increase in rates has made the swap an asset instead of a liability.
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Credit Risk
The example illustrates that two events are necessary for default loss on a swap: Actual default on the agreement Adverse change in rates Credit risk on a swap is therefore a function of the joint likelihood of financial distress and adverse interest rate movements.
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Credit Risk
The negotiated fixed rate on a swap usually includes an adjustment for the difference in credit risk between the parties. A less risky firm (which could be the swap bank acting as dealer) will pay a lower fixed rate or receive a higher fixed rate the riskier the counterparty. In addition to rate adjustments, credit risk is also managed by requiring the posting of collateral or requiring maintenance margins.
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