Swaps Pricing and Strategies

FIN 353 Lecture Notes Yea-Mow Chen Department of Finance San Francisco State University

I. Defining A Swap


A plain vanilla interest rate swap is a contract that involves two parties exchanging their interest payments obligations (no principal is exchanged) of two different kinds of debt instruments - one bearing a fixed interest rate (fixed-rate payer) and the other a floating rate (floating-rate payer) on a periodic basis over the fixed time period.

I. Defining A Swap


EX: A 3-year 11% fixed for six-month LIBOR floating $10 million swap settled every six months requires a fixed-rate payer to pay 11% fixed-rate interest on a notional principal of $10 million to a floating-rate payer in exchange for a variable-rate interest that depends on a pre-specific six-month LIBOR rate on $10 million principal.

I. Defining A Swap


Cash flows for the fixed-rate payer:

Cash inflows

$10m*LIBOR*1/2

Every 6 months
3 yrs
$10m*11 %*1/2

Cash outflows

I. Defining A Swap


Cash flows for the floating-rate payer:

Cash inflows
$10m*11 %*1/2

Every 6 months
3 yrs
$10m*LIBOR *1/2

Cash outflows

I. Defining A Swap


If the suitable LIBOR rate was 10%, the swap requires the fixed-rate-payer to pay $550,000 (= $10m * 11% * 0.5) to floating-rate-payer in exchange for receiving $500,000 (= $10m * 10% * 0.5) from floating-rate- payer.

I. Defining A Swap


In real practice, only the difference is transacted, that is, the swap requires fixedrate-payer to pay $50,000 net to floating rate payer. This exchange will take place every six months until the maturity.

I. Defining A Swap


The six-month LIBOR rate that is actually used on a payment date is the rate prevailing six months earlier. This reflects the way in which interest is paid on LIBOR-based loans. The first exchange of cash flows is know with certainty when the contract is negotiated.

II. Gains From Swaps



Typical transactions involve one party that is an established, highly rated issues that prefers floating rate obligations but can sell fixed-rate debt at a relatively low rate, while the other party is usually a lower-rated issuer preferring fixed-rate obligation. This arrangement allows each party to borrow with the preferred type of interest obligation usually at a lower overall cost of financing than each party could obtain on its own (to exploit "comparative advantage").

II. Gains From Swaps



This exploitation is possible because the existence of different relative costs in different maturity markets which is connected to differences in the credit ratings of swap partners. Investors require lowerrated borrowers to pay relatively high risk premiums when borrowing at a long-term fixed rate rather than at a short-term floating rate.

II. Gains From Swaps

 

Example: The Sallie Mae: A highly-rated institution prefers floating rate debt to match shortterm loan in its students loan portfolio but can sell fixed-rate debt at relatively low rate. A MSB: A relatively low-rated institution prefers to match its long-term, fixed-rate mortgage portfolio with fixed-rate funds.

II. Gains From Swaps

     

_______________________________________ Cost: Fixed Rate Floating-Rate Borrowing Cost Borrowing Cost _______________________________________ MSB 13% LIBOR+1.5% SALLIE MAE 11 LIBOR Quality Spread 2% 1.5% Quality Spread Difference or Arbitrage Opportunity 0.5% _______________________________________

  

II. Gains From Swaps

             

All-in-cost computation: ____________________________________________________ MSB Sallie Mae ____________________________________________________ Funding Cost: MSB issues floating L+1.5% Sallie Mae issues Fixed 11% Swap Payments: MSB pays fixed to Sallie Mae 11.3% L Sallie Mae pays floating to MSB -L -11.3% ____________________________________________________ All-in-cost 12.8% L - 0.3% Comparable Cost 13.0% L Cost Saving 0.2% 0.3% ____________________________________________________

II. Gains From Swaps


              

MSB Bank Sallie Mae _________________________________________________________ Funding Cost: MSB issues floating L+1.5% Sallie issues Fixed 11% Swap Payments: MSB pays fixed to Bank 11.3% -11.3% Bank pays floating to MSB - L L Bank pays fixed to Sallie Mae 11.2% -11.2% Sallie Mae pays floating to Bank -L L _________________________________________________________ All-in-cost 12.8% -0.1% L -0.2% Comparable Cost 13.0% 0% L Cost Saving 0.2% 0.1% 0.2% ________________________________________________________

III. Why Swap? Alternative Explanations



1. Underpriced Shifting:


Credit

Risk

or

Risk

It has been argued that credit risk is underpriced in floating-rate loans, which gives rise to the arbitrage opportunities. However, the arbitrage opportunities should disappear as the expansion of the swap market has effectively increased the demand for floating-rate debt by lower-rated companies and the demand for fixed-rate debt by higher-rated companies.

III. Why Swap? Alternative Explanations



Jan Loeys suggests that the quality spread is the result of risk being shifted from the lenders to the shareholders. To the extent that lenders have the right to refuse to roll over debt, more default risk is shifted from the lenders to the shareholders as the maturity of the debt decrease. With this explanation, the "gains" from a swap would instead be transfers from the shareholders of the lower-rated firm to the shareholders of the higher-rated firm.

III. Why Swap? Alternative Explanations

 

2. Information Asymmetries Arak, Estrella, Goodman, and Silver argue that the "issue short term - swap to fixed" combination would be preferred if the firm:


 

has information that would lead it to expect its own credit spread to be lower in the future than the market expectation changes in its credit spread than is the market; expects higher risk-free interest rates than does the market; is more risk-averse to changes in the risk-free rate than is the market.

III. Why Swap? Alternative Explanations

 

3. Differential Prepayment Options Borrowing fixed directly has a put option on interest rates (prepayment), while the "borrow floating - swap to fixed" does not. Thus the lower-rated firm can borrow at a fixed rate more cheaply by swapping from floating because the firm in effect has sold an interest rate option. At least a portion of the funding cost "savings" obtained by the lower-rated firm come from the premium on this option.

III. Why Swap? Alternative Explanations

 

4. Tax and Regulatory Arbitrage In the less-regulated Eurodollar market, the costs of issue could be considerably less than in the U.S. However, not all firms have direct access to the Eurodollar market. The swap contract provides firms with access and permits more firms to take advantage of this regulatory arbitrage.

IV. VALUATION OF INTEREST RATE SWAPS


           

1. Indication Pricing Schedule:

__________________________________________________ Bank Pays Bank Receives Current Maturity Fixed Rate Fixed Rate TN Rate __________________________________________________ 2 yrs 2 yr TN + 30 bps 2 yr TN +38 bps 7.52% 3 3 yr TN + 35 bps 3 yr TN + 44 bps 7.71 4 4 yr TN + 38 bps 4 yr TN + 48 bps 7.83 5 5 yr TN + 44 bps 5 yr TN + 54 bps 7.90 6 6 yr TN + 48 bps 6 yr TN + 60 bps 7.94 7 7 yr TN + 50 bps 7 yr TN + 63 bps 7.97 10 10 yr TN + 60 bps 10 yr TN + 75 bps 7.99 __________________________________________________

V. Returns and Risks of Swaps to End Users



On the positive side



1. Interest rate swaps primarily allow institutions to manage interest rate risk by swapping for preferred interest payment obligations. 2. Swaps also provide institutions with vehicles to obtain cheaper financing by exploiting arbitrage opportunities across financial markets. 3. Swaps allow institutions to gain access to debt markets that otherwise would be unattainable or too costly. 4. Relative to other alternative risk management, swaps are more flexible and costless.

V. Returns and Risks of Swaps to End Users

 

On the negative side: 1.Swaps are not standardized contracts, which leads to several problems:
 

a. Negotiating a mutually agreeable swap contract involved time, energy, and resources. b. A secondary market is not available, at a result, it is difficult and costly to "back out" of a swap agreement if the need arises.

2. Swaps holders are exposed to default risk. A default on one party exposes the other party to interest rate risk and possible lose of funds.

VI. Risks For Banks In Intermediating Swaps



1. As a Broker: in the early stages, commercial banks and investment banking firms found in their client bases those entities that needed swaps to accomplish funding or investing objectives, and they matched the two entities. 2. As a Guarantor: To reduce the risk of default, many early swap transactions required that the lower credit-rated entity obtain a guarantee from a highly rated commercial bank. 3. As a Dealer: Advanced in quantitative techniques and futures products for hedging complex positions such as swaps made the protection of large inventory positions feasible.

VI. Risks For Banks In Intermediating Swaps

 

Regulators Concern: a. Pricing Risk:  Pricing risk occurs from banks "warehousing swaps - from arranging a swap contract with one end-user without having arranged at offsetting swap with another end-user. Until an offsetting swap is arranged, the bank has an open swap position and is vulnerable to an adverse change is swap prices.

VI. Risks For Banks In Intermediating Swaps

 

Regulators Concern: b. Credit Risk:  A bank with perfectly matched swaps does not expose to price risk. If interest rates change, the value of one swap will fall while the value of the other rises an equal amount. But if one of the end-user defaults, the bank loses the hedging value of the offsetting swap and may suffer a capital loss.

VI. Risks For Banks In Intermediating Swaps



c. As a way to exploit deposit insurance subsidies: The swaps market may offer banks some opportunities for exploitation of the deposit insurance system. Specifically, banks can leave their swaps unhedged and thereby speculate on interest rate movements, or they can engage in swaps with unusually risky counterparties.

VI. Risks For Banks In Intermediating Swaps



c. As a way to exploit deposit insurance subsidies: Regulators have recognized the risk inherent in swaps and have taken it into account in the new risk-based capital requirements for banks. They reduce incentives for risk-taking through swaps by including swaps in the calculation of risk-adjusted assets. The requirements state that half of the sum of (1) 0.5 percent of the notional principal of a swap with a life of more than one year and (2) the market value of the swap, if it is positive, is to be included in risk-adjusted assets. Thus, investment in a swap requires some commitment of capital, and this reduces the risk of bank failures because capital acts as a cushion against losses.

VI. Risks For Banks In Intermediating Swaps

 

d. Systematic Risk to the Financial System: The capital requirement also reduces the possibility of a destabilizing disruption to the financial markets as a result of systemic risk from swaps because swaps dealers tend to have numerous swaps deals with each of the other dealers, a problem at one bank could be transmitted to other banks and ultimately cause multiple failures.

VII. SWAP APPLICATIONS




1. Minimizing Financing Costs:

A U.S. Co. - wants to borrow an amount of US $100 million for seven years. Having issued bonds heavily in the recent past, US Co. would have to borrow at a relatively unattractive rate in the U.S.market. On the other hand, it could obtain favorable terms on a private placement issue in Dutch marks where, for a variety of reasons, there is a strong demand for US Co.'s paper. In this environment, US Co. will be wise to issue DM-denominated seven-year bonds and arrange a currency swap with a financial intermediary to exchange DM and U.S. dollar cash flows.

VII. SWAP APPLICATIONS

            

DM 190m Private Placement Investor swap Counterparty

US$100 million Issuer U.S. Company DM 190 million

Each year DM 6.5% Investor Counterparty U.S. Company US$9.5% At Maturity Investor Counterparty DM 190 m U.S. Company DM 190 million Swap US$ 100 million DM 6.5% Swap

VII. SWAP APPLICATIONS

 

2. Synthetic Asset Creation: Synthetic assets are created through a combination of a bond and a swap. A common structure is a bond denominated in a non-dollar currency and a currency swap. For example, a U.S. dollar-based investor wants an attractive spread over six-month LIBOR, which is the rate at which it can fund its investments. For this, it can purchase a dollar denominated floating-rate note (FRN) or, alternatively, it can purchase a yendenominated bond coupled with a currency swap (fixed yen vs. six-month LIBOR).

VII. SWAP APPLICATIONS

             

Purchase Euroyen bond Yen 15,000 Yen 15,000 Investor US$ 100 Each year Euroyen bond Yen 5,5% annual At maturity Euroyen bond Yen 15,000 principal

Swap Counterparty

$ LIBOR + 22bp semiannual Investor Swap Counterparty Yen 15,000 principal

US$ 100 return of initial investment Investor Swap Counterparty Yen 15,000 principal

VII. SWAP APPLICATIONS

 

3. Asset-Liability Management: Swaps can also be used in an overall portfolio or a balance sheet of assets and liabilities to alter an institution's exposure to interest rate or currency movement. Entering into an interest rate or currency swap will result in one becoming longer or shorter the bond market, or longer or shorter a currency. This may be done to reduce or eliminate interest rate or currency exposure, or to take a view without having to actually buy or short a bond, which could be difficult.

VII. SWAP APPLICATIONS



For example, a bank in Singapore has a portfolio of Eurobonds that are largely funded with short-term Eurodollar deposits. The average maturity of the Eurobonds is 3.5 years. While the bank's asset-liability manager is pleased with the spread they have been making, he is now afraid that rates may soon rise.

VII. SWAP APPLICATIONS



Rather than sell off his carefully selected Eurobond portfolio, he arranges to enter into a 3.5 year interest rate swap to receive three-month LIBOR and pay a fixed rate. He is now approximately hedged against interest rate increases, since he is receiving fixed (on the swap) and paying fixed (on the swap). Later on, if his view changes, he may cancel the swap in part or in whole. Thus can he use the swap as a tool in asset-liability management.

VII. SWAP APPLICATIONS

 

4. Hedging Future Liabilities - Forward Swaps: Swaps may also be done on a forward basis, with interest beginning to accrue as of a date from one week to several years in the future.
EX: A corporation has outstanding high coupon debt that is callable in two years. The corporation thinks that current interest rate levels are attractive and would like to lock in today the cost of refunding its debt on the call date. The corporate could enter into a forward swap in which it will pay a fixed rate and receive a floating rate.