Swaps Pricing and Strategies

1. Swaps Pricing and Strategies FIN 353 Lecture Notes Yea-Mow Chen Department of Finance San Francisco State University

2. 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.

3. 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.

4. I. Defining A Swap Cash flows for the fixed-rate payer:

5. I. Defining A Swap Cash flows for the floating-rate payer:

6. 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.

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

8. 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.

9. 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").

10. 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� lower-rated� borrowers� to pay relatively high risk premiums when borrowing at a long-term fixed rate rather than at a short-term floating rate.

11. II. Gains From Swaps Example: The� Sallie Mae:� A highly-rated institution prefers floating� rate debt to match short-term 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.

12. 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% _______________________________________

13. 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% ____________________________________________________

14. 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% ________________________________________________________

15. III. Why Swap? Alternative Explanations 1. Underpriced Credit Risk or Risk Shifting: 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.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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 __________________________________________________

21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. 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.

29. 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.

30. VII. SWAP APPLICATIONS DM 190m US$100 million Private Placement Investor Issuer U.S. Company swap Counterparty DM 190 million � Each year DM 6.5% DM 6.5% Investor U.S. Company Swap Counterparty US$9.5% � At Maturity DM 190 m DM 190 million Investor U.S. Company Swap Counterparty US$ 100 million

31. 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 yen-denominated �bond �coupled with a currency swap (fixed yen vs. six-month LIBOR).

32. VII. SWAP APPLICATIONS Purchase Euroyen bond Yen 15,000 Yen 15,000 Investor Swap Counterparty US$ 100 � Each year $ LIBOR + 22bp semiannual Euroyen bond Investor Swap Counterparty Yen 5,5% annual Yen 15,000 principal �At maturity US$ 100 return of initial investment Euroyen bond Investor Swap Counterparty Yen 15,000 principal Yen 15,000 principal

33. 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.

34. 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. �

35. 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.

36. 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.