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    B 5 Forwards IRS 21032023 PDF

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    B 5 Forwards IRS 21032023 PDF

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    B 5 Forwards IRS 21032023 PDF

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    © All Rights Reserved
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    Fixed Income and Credit Risk Prof. Michael Rockinger B -5- Interest Rate Swaps Learning Objectives @ Definition of an Interest Rate Swap (IRS) View Sune a a bakery FeA> Usefulness @ Determining the Swap Rate, by discounting payotil’ su are p baie yonille bout — Yoabry ote bole ( FEN @ Determining the Swap Rate, by decomposing payoffs @ Bootstrap of discount curves from swap rates Interest Rate Swap (PV171) A vanilla tixed-for-floating interest rate swap is a contract between two counterparties in which One counterparty agrees to make n fixed payments per year at an annualized swap rate c on a notional N up to a maturity date 7, i.e., the payment dates are 7),7,....T%m=T As usual, 7; = Tj-; + A, A = 1/n and assume i .m The other counterparty commits to make payments at the same dates linked to a floating rate index r,(T;-1, Ti) The net payoff for the counterparty which pays fixed at date 7; is: N-A-(r,(Tj-1,T;) - ©) What defines a counterparty is if it either pays fixed or receives fixed. Fixed is the reference. Thus: a if you have a payer swap, it means you pay fixed rate tenor ner T, 7 9 To Tmt Ton -—t b= T AT, Tm) T=0 T, Tr Tin a ang Interest Rate Swaps, Payoffs @ In real life the contract comes alive at To delivery date whereas price was set at ¢ = 0 value date @ Typically between ¢ = 0 and 7) there will be 2 days. We will assume To = 0 to make our algebra a tiny bit easier. @ There exist mini forward contracts for those 2 days. Spot-next and Tom-next Interest Rate Swap: example (PV174) A firm and bank decide to enter into a fixed for floating semi-annual 5-year swap with swap rate c = 5.46% and notional amount V = $200 min. The reference floating rate is the 6-month LIBOR. 1 Table 54 Example Cash Flows in Fixed forFloaing Swap fi’ Bcd || firm recive ‘aah icy fal || a pp ner Time LIOR \ Flow fiom Bank to Fim Flow ffomFinn to Bank Net Cash Flow o Firm 00 4951% [ni Pe Fixed po os tan | Nea $5.460:m $-0:509 m 10 2.040% $3.460m_ $5.460m $-2.000m 15 100% $2.040m_ $5.460m $-3.420m 20 133% $1800m $5.460m $-3.660m 25 1201% $1339m $5.460m $-4121m 30 1.170% $1201m $5.460m, $-4259m 35 1980% $1170m $5.460m $4290 m 40 3.190% $1980m. $5.460m $-3480m. 45 3.996% $3.190m $5.460m $.2270m 50 4976% $3996m $5.460m $-1.464m. 6119 Arm recave fa Bite 2/4 osimia Interest Rate Swap: another example +~— <—— fw pap asthe 4 no dfuudt» oy A more realistic example. Today is April 28, 2023 and a firm sold a piece of equipment to a highly rated corporation, The firm is due to receive payments in 10 equal semi-annual installments of $5.5 min each over next 5 years. st © The firm would like to use these $5.5 min semi-annual cash flows to hedge against oe ae the coupon payments needed to service a $200 min floating rate bond that it issued Gr oe fosw’ Ai in the past, which is expiring in 5 years. vi ofl Abe= Suppose t that the floating rate on the corporate bond is tied to the US LIBOR, at | \ A Cl (faji}—U1BOR +609. Po» B= 0.0004 « 0.9%}. a 5 oe (© The 6-month LIBOR on March 1, 2003 is at 4.95% and so the next interest rate payment the firm must make is: CORRODE S000 min = $49 mI. 657. “ goth = @ However, if the LIBOR were to increase by more than 0.51% in the next 5 years, the cash tows from the installments would not be sufficient to, service the debt, lat clo gon A is. He. fim An kesye again th iderp an Cn) You Lathradey a6 WO 718 Third pay (Fa ome be Lo db SF smh b 1a rg L es Interest Rate Swap: another example (continued foes eatin A solution is to enter into a fixed for floating swap with an investment bank, in which the firm pays the fixed semiannual swap rate c, over a notional of $200 million, and the bank pays the 6-month LIBOR to the firm. © On April 28, 2023, the swap rate for a 5-year fixed-for-floating swap is quoted at c= 5.46%. @ Inthis case, the net cash flow to the firm from the swap contract is: $200 min - 0.5 - (r2(T;-1, T;) — 5.46%). © The firm’s net cash flow at 7; from the receivable, debt, and swap is: $5.5 min + $200 min - 0.5 + (r2(T; - 0.5, T;) - 5.46%) —$200 min - 0.5 (12(T; - 0.5, T;) + 0.04%) = 0. Interest Rate Swap example: illustration (PV174) 4 ss5m ¥ 4 ‘Swap: fixed leg y som 5 5.46% MARKET] + +H] & FIRM ee, Floating rate bond ‘Swap: floating leg S207 x (r2(Ti-1) + dbps) 298 x m(Ti-1) 9/19 Determining the Swap Rate There are two approaches to determine the swap rate. @ In the first approach, one considers the individual payoffs and one discounts those payoffs back to the initial date. This is something that we have already done since each payoff can be viewed as a forward rate agreement. Thus, it turns out that a swap is nothing but a basket of FRAs. @ Inthe second approach, one introduces a fictitious terminal payment of the notional N from counterparty A to counterparty B and an identical payment from counterparty B to counterparty A, and then one recognizes that the fixed leg corresponds to a good’ol constant coupon bond and the variable leg to a floating rate bond. @ Once one has discounted the payoffs at the various dates, one sets the initial value of the IRS to 0 and obtains the swap rate. @ Both approaches yield the same expression for the swap rate: it is the difference between the short discount factor and the long discount factor, the whole divided by an annuity! 10/19 FER opgrak & volun 2414p) Determining the Swap Rate: Discounting Payoffs f Qlj-2TI 200) -200,7 1 yo a o 1+ — — ~ @ How can one compute the present value of the payoff at time 7; wee Tang tNL Aen Aen 2lo2)__—_$____-__—_- @ Easy part: Discount Ac N which yields Ac N Z(0, T;) @- Ba lTia, TOY = Mater re we accout / — jae Tin Se AE SEP Yebue of t= 9 = wile ch amar ©» pu eh Gev o Hue Ty Da come accor AH ek Tt MELT 0) tt de oudikn , of to 9, Boy 199 frtin tl dot ft On thos ») ea i, “| auch Meh tT, gov pay WA bake: Tow opk Avdgy N20) ) t= (2 l0,73-2ox7)) ws AF GED / Gt fer oll Mh pte» Bd flor? fT i = on" py teor) - Woe Nu 1 Hb 2lo7) a pet _ _ eat i, Aw tele] + W[alecsl - CHE) for Te EEE ey 4 . 4 Gan pL ebacay ete] oT - cftele,™) { a, goat fine goer nN tld io mat Fave lng 6 [1- bie tel} = 2 N20 eel yYS 0b rolnnahy = iyaoor ghoet — i oe _ _4- 200, Tm) bfubo Hongp oh on dymvwinahe = annsity | Al alone #27) 7 hme |pcouels. ta hae bac lock ole . OF bond a por yale ‘70h 4K he aval that at cit oe, tnvel Jord Determining the Swap Rate: Discounting Payoffs @ How can one compute the present value of the payoff at time 7; Arn(Ti-1,T))N - AcN @ To generate A r,(7j_1,7;) N the insight is that this would be the interest, and only that, if one had placed at time 7;-; an amount N at rate rn(Ti-1,7;) If one places at time 7;-; an amount N one gets at time 7; (+ Arp(Ti-1,T))N Thus by subtracting N at time 7; one remains with the interest The ‘discounted value’ of Ar,,(7;-1,7;) N is therefore N-(Z0, T;-1) — ZO, T;)) 42/19 Determining the Swap Rate: Discounting Payoffs @ By considering all discounted payoffs and setting the swap rate so that the swap has a zero value, we obtain the swap rate! @ Value of swap is: m m Vo = Dd AcNZ0,7) - N -[Z(0, Ti-1) - Z,T))] = 0 =1 i=l @ Notice that Zo, T;-1) — ZO, T;)) = ZO, To) — ZO, Tm) = 1 - ZO, Tm) isl @ Setting the initial value Vo of the swap equal to zero yields: 1 -Z(0,Tn) c= ao A Xt, 20,7) 13/19 Interest Rate Swaps, Payoffs decomposed (approach 2) © Decompose the payments over the life of the swap into a floating and a fixed payment. Also add a terminal payment of the notional amount N (in red) which is just a trick so that both legs look like instruments we know (FRN and bond) aot ge an FRA Ibo Uibe an Ce ieee ile ated) bee bond (:0° 2.) hn plo.tn A = Merete oo) Ge) ike Nod Gen) Ge Counterparty A T . eno Te be Armaan! - t pe Counterparty B. Guacla \ t Jae, Yale ag a Fee toe0 Ts Tm cS ee 4. +} —+} +} —+-_}-- Time oe = We Hel,T9) Wel Aout) ee yam a bebe S wine Interest Rate Swaps, Payoffs decomposed @ Value at t = 0 of bond » Z(0, T)ACN + ZO,Tm)»N i=l @ Value at t = 0 of floater N @ Both legs must have same value, swap has an initial value of 0: N= 3520. T)ACN + ZO, Tn) NV i=l @ Simplify and get: 1-Z0O,Tm) c= A Xi: ZO, Ti) @ As promised, this is exactly what we were supposed to get before. 15/19 Value of Interest Rate, Swaps aiicr Vad ff oumgon drotun dos Inn bee p i=? © Suppose 7};

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