Chapter 13

Swaps and Interest

Rate Options

1 © 2004 South-Western Publishing

 Outline
 Introduction
 Interest rate swaps
 Foreign currency swaps
 Circus swap
 Interest rate options

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 Introduction
 Both swaps and interest rate options are
relatively new, but very large
– In mid-2000, there was over $60 trillion
outstanding in interest rate swaps, foreign
currency swaps, and other interest rate options

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 Interest Rate Swaps
 Introduction
 Immunizing with interest rate swaps
 Exploiting comparative advantage in
the credit market

4
 Introduction
 Popular with bankers, corporate
treasurers, and portfolio managers
who need to manage interest rate risk

 A swap enables you to alter the level

of risk without disrupting the
underlying portfolio
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 Introduction (cont’d)
 The most common type of interest rate swap
is the fixed for floating rate swap
– One party makes a fixed interest rate payment to
another party making a floating interest rate
payment
– Only the net payment is made (difference check)
– The firm paying the floating rate is the swap seller
– The firm paying the fixed rate is the swap buyer

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 Introduction (cont’d)
 Typically, the floating interest rate is linked
to a market rate such as LIBOR or T-bill
rates

 The swap market is standardized partly by

the International Swaps and Derivatives
Association (ISDA)
– ISDA provisions are master agreements

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 Introduction (cont’d)
 A plain vanilla swap refers to a standard
contract with no unusual features or bells
and whistles
 The swap facilitator will find a counterparty
to a desired swap for a fee or take the other
side
– A facilitator acting as an agent is a swap broker
– A swap facilitator taking the other side is a swap
dealer (swap bank)

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 Introduction (cont’d)

Plain Vanilla Swap Example

A large firm pays a fixed interest rate to its bondholders,

while a smaller firm pays a floating interest rate to its
bondholders.

The two firms could engage in a swap transaction which

results in the larger firm paying floating interest rates to the
smaller firm, and the smaller firm paying fixed interest rates
to the larger firm.

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 Introduction (cont’d)

Plain Vanilla Swap Example (cont’d)

LIBOR – 50 bp

Big Firm 8.05%

Smaller
Firm

8.05% LIBOR +100 bp

Bondholders Bondholders

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 Introduction (cont’d)

Plain Vanilla Swap Example (cont’d)

A facilitator might act as an agent in the transaction and

charge a 15 bp fee for the service.

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 Introduction (cont’d)

Plain Vanilla Swap Example (cont’d)

LIBOR -50 bp LIBOR -50 bp

Big Firm Facilitator Smaller

8.05% 8.20%
Firm

8.05% LIBOR +100 bp

Bondholders Bondholders

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 Introduction (cont’d)
 The swap price is the fixed rate that the two
parties agree upon
 The tenor is the term of the swap
 The notional value determines the size of
the interest rate payments
 Counterparty risk refers to the risk that one
party to the swap will not honor its part of
the agreement

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 Immunizing With Interest Rate
Swaps
 Interest rate swaps can be used by
corporate treasurers to adjust their
exposure to interest rate risk
 The duration gap is:

Total Liabilities
D gap  D asset   D liabilities
Total assets

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 Immunizing With Interest Rate
Swaps (cont’d)
 A positive duration gap means a bank’s net
worth will suffer if interest rates rise
– The treasurer may choose to move the duration
gap to zero
 This could be accomplished by selling some of the
bank’s loans and holding cash equivalent securities
instead

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 Immunizing With Interest Rate
Swaps (cont’d)
 Using the bank’s balance sheet, we can
algebraically solve for the proportion of the
firm’s assets to be held in cash so that the
duration gap is zero:

D gap    x cash  0.00  1  x cash  average loan asset duration  -

 Total Liabilities 
  D liabilities   0
 Total assets 

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 Exploiting Comparative
Advantage in the Credit Market
 Interest rate swaps can be used to exploit
differentials in the credit market

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 Exploiting Comparative
Advantage in the Credit Market

Credit Market Example

AAA Bank and BBB Bank currently face the following
borrowing possibilities:
Firm Fixed Rate Floating Rate

AAA Current 5-yr LIBOR

T-bond + 25 bp

BBB Current 5-yr LIBOR + 30 bp

T-bond + 85 bp

Quality Spread 60 bp 30 bp

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 Exploiting Comparative
Advantage in the Credit Market

Credit Market Example (cont’d)

AAA Bank has an absolute advantage over BBB in both the

fixed and the floating rate markets. AAA has a comparative
advantage in the fixed rate market.

The total gain available to be shared among the swap

participants is the differential in the fixed rate market minus
the differential in the variable rate market, or 30 bps.

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 Exploiting Comparative
Advantage in the Credit Market

Credit Market Example (cont’d)

AAA Bank wants to issue a floating rate bond, while BBB

wants to borrow at a fixed rate. Both banks will borrow at a
lower cost if they agree to an interest rate swap.

AAA Bank should issue a fixed rate bond because it has a

comparative advantage in this market. BBB should borrow at
a floating rate. The swap terms split the rate savings 50-50.
The current 5-yr T-bond rate is 4.50%.
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 Exploiting Comparative
Advantage in the Credit Market

Credit Market Example (cont’d)

LIBOR

AAA Treasury + 40 bp
BBB

Treasury + 25 bp LIBOR +30 bp

Bondholders Bondholders

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 Exploiting Comparative
Advantage in the Credit Market

Credit Market Example (cont’d)

 The net borrowing rate for AAA is LIBOR – 15 bps

 The net borrowing rate for BBB is Treasury + 70 bps

 The net rate for both parties is 15 bps less than without
the swap.

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 Foreign Currency Swaps
 In a currency swap, two parties
– Exchange currencies at the prevailing exchange
rate
– Then make periodic interest payments to each
other based on a predetermined pair of interest
rates, and
– Re-exchange the original currencies at the
conclusion of the swap

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 Foreign Currency Swaps
(cont’d)
 Cash flows at origination:

FX Principal

Party 1 Party 2
US $ Principal

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 Foreign Currency Swaps
(cont’d)
 Cash flows at each settlement:

$ LIBOR

Party 1 Party 2
FX Fixed Rate

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 Foreign Currency Swaps
(cont’d)
 Cash flows at maturity:

US $ Principal

Party 1 Party 2
FX Principal

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 Foreign Currency Swaps
(cont’d)

Foreign Currency Swap Example

A multinational US corporation has a subsidiary in Germany.

It just signed a 3-year contract with a German firm. The
German firm will provide raw materials, with the US firm
paying 1 million Euros every 6 months for the 3-year period.
The current exchange rate is $0.90/Euro.

The contract is fixed in Euro terms, but if the dollar

depreciates against the Euro, dollar accounts payable would
increase.

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 Foreign Currency Swaps
(cont’d)

Foreign Currency Swap Example (cont’d)

A currency swap is possible with the following terms:

 Tenor = 3 years
 Notional value = 25 million Euros ($22.5 million)
 Floating rate = $ LIBOR
 Fixed rate = 8.00% on Euros

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 Foreign Currency Swaps
(cont’d)

Foreign Currency Swap Example (cont’d)

The swap will result in the following payments every six

months:

 Fixed rate payment = 25,000,000 Euros x 8.00% x 0.5 =

1,000,000 Euros
 Floating rate payment = $22.5 million x 0.5 x LIBOR

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 Foreign Currency Swaps
(cont’d)
Foreign Currency Swap Example (cont’d)
Cash Flows at Origination

25 million euros

Party 1 Party 2
$22.5 million

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 Foreign Currency Swaps
(cont’d)
Foreign Currency Swap Example (cont’d)
Cash Flows at Each Settlement

$ LIBOR

Party 1 Party 2
1 million euros

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 Foreign Currency Swaps
(cont’d)
Foreign Currency Swap Example (cont’d)
Cash Flows at Maturity

$22.5 million

Party 1 Party 2
25 million euros

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 Circus Swap
 Introduction
 Swap variations

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 Introduction
 A circus swap combines an interest rate
and a currency swap
– Involves a plain vanilla interest rate swap and an
ordinary currency swap
– Both swaps might be with the same
counterparty or with different counterparties

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 Introduction (cont’d)
 Circus swap with two counterparties:
8% on Euros

Party 1 Party 2
$ LIBOR

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 Introduction (cont’d)
 Circus swap with two counterparties
(cont’d):
$ LIBOR

Party 1 Party 3
6.50% US

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 Introduction (cont’d)
 Circus swap with two counterparties
(cont’d):
8% on Euros

Party 1 Net
6.50% US

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 Introduction (cont’d)
 Circus swap with two counterparties
(cont’d):
– Party 1 is effectively paying 8% on Euros and
receiving 6.5% in U.S. dollars

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 Swap Variations
 Deferred swap
 Floating for floating swap
 Amortizing swap
 Accreting swap

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 Deferred Swap
 In a deferred swap (forward start swap), the
cash flows do not begin until sometime
after the initiation of the swap agreement
– If the swap begins now, the deferred swap is
called a spot start swap

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 Floating for Floating Swap
 In a floating for floating swap, both parties
pay a floating rate, but with different
benchmark indices

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 Amortizing Swap
 In an amortizing swap, the notional value
declines over time according to some
schedule

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 Accreting Swap
 In an accreting swap, the notional value
increases through time according to some
schedule

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 Interest Rate Options
 Introduction
 Interest rate cap
 Interest rate floor
 Calculating cap and floor payoffs
 Interest rate collar
 Swaption

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 Introduction
 Most of the trading done off the exchange
floors

 The interest rate options market is

– Very large
– Highly efficient
– Highly liquid
– Easy to use

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 Introduction (cont’d)
Growth in Interest Rate Options
Notional Value
15

10
(Trillions)

0
1992 1993 1994 1995 1996 1997 1998 1999 2000
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 Interest Rate Cap
 An interest rate cap
– Is like a portfolio of European call options
(caplets) on an interest rate
 On each interest payment date over the life of the cap,
one option in the portfolio expires
– Is useful to firms with floating rate liabilities
– Caps the periodic interest payments at the
caplet’s exercise price

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 Interest Rate Cap (cont’d)
 Long interest rate cap (exercise price 7%)
$ Payoff

Payoff
Option expires worthless
Floating Rate
7%

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 Interest Rate Cap (cont’d)
 Short interest rate cap (exercise price 7%)
$ Payoff

Option expires worthless

Floating Rate
7% Payout

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 Interest Rate Floor
 An interest rate floor
– Is related to a cap in the same way that a put is
related to a call
– Like a portfolio of European put options
(floorlets) on an interest rate
 On each interest payment date over the life of the cap,
one option in the portfolio expires
– Is useful to firms with floating rate assets
– Puts a lower limit on the periodic interest
payments at the floorlet’s exercise price

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 Interest Rate Floor (cont’d)
 Long interest rate floor (exercise price 6.5%)

$ Payoff

Payoff Option expires worthless

Floating Rate
6.5%

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 Interest Rate Floor (cont’d)
 Short interest rate floor (exercise price 6.5%)

$ Payoff

Option expires worthless

Floating Rate
Payout 6.5%

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 Calculating Cap and Floor
Payoffs
 There are no universally acceptable terms
to caps and floors

 However, frequently the terms provide for

the cash payment on an in-the-money
caplet or floorlet to be based on a 360-day
year

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 Calculating Cap and Floor
Payoffs (cont’d)
 Cap payout formula:

Days in payment period

Cap payout  (notional value)  
360
(benchmark rate - striking price)

 If the benchmark rate is less than the

exercise price, the payout is zero

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 Calculating Cap and Floor
Payoffs (cont’d)
 Floor payout formula:

Days in payment period

Floor payout  (notional value)  
360
(striking price - benchmark rate)

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 Interest Rate Collar
 An interest rate collar is simultaneously
long an interest rate cap and short an
interest rate floor

 Sacrifices some upside potential in

exchange for a lower position cost
– Premium from writing the floorlets reduces
position costs

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 Interest Rate Collar (cont’d)

Long cap
$ Payoff

Inflow
No payout
Floating Rate
Outflow K1 K2

Short floor

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 Swaption
 A swaption is an option on a swap
 Can be either American or European style
 A payer swaption (put swaption) gives its
owner the right to pay the fixed interest rate
on a swap
 A receiver swaption (call swaption) gives its
owner the right to receive the fixed rate and
pay the floating rate

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