MECHANICS OF AN INTEREST RATE SWAP
Ahmad Sharif Pour
Date: June 1, 2011
AGENDA Overview of Interest Rate Swap Valuing Interest Rate Swap Risks Associated with Interest Rate Swap Reasons for the Rapid Growth of Interest Rate
Swap Market.
INTEREST RATE SWAP Interest rate swap transactions began in
1981 Eurobond as principal security
The largest component of the OTC interests rate derivatives market As of December 2010, national amount
outstanding ($364 trillion) Gross market value ($13 trillion)
AN OVERVIEW OF INTEREST RATE SWAPS An agreement between two counterparties
Exchange periodic interest payments based on predetermined principal value Time frame Notional principal amount Fixed interest rate (Fixed-rate payer) Floating interest rate (Floating-rate payer)
Treasury bills, LIBOR (London Interbank Offered Rate), commercial paper, bankers acceptance, certificates of deposit, federal funds rate, and prime rate
Payment dates
Firm A (Payer) Firm B (Receiver)
Floating Rate
Fixed Rate
Time Frame: 5 yearsNotional principal amount: $50 MillionFixed rate: 10%Floating rate: six-month LIBORPayment dates: Every six months
HOW INTEREST RATE SWAPS ARE USED
Applications of Interest Rate Swaps Alter Cash flow of asset to provide a better
match between assets and liabilities Asset Swap
Alter cash flow of assets from fixed to floating or from floating to fixed without affecting the underlying assets.
Liability Swap Alter cash flow of liabilities from fixed to floating
or from floating to fixed without affecting the underlying assets
ASSET SWAP
Firm A Financial Intermediary
LIBOR + 40 bps
10%
Firm B
LIBOR + 150 bps
Bond Bond
9.5%10%
LIBOR + 60 bps
Net = [(LIBOR + 150 bps + 10%) - LIBOR + 60bps] = 10.9%
Net = [(10%+ LIBOR + 40bps) – 9.5%] = LIBOR + 90bps
Financial Intermediary Net: .7%
INTEREST RATE SWAP VALUATION Summing the present value of cash flow
1st step: calculate the present value of floating rate payments
2nd step: calculate the present value of the notional principal. Then, multiply it by the days in the period LIBOR futures rate as discount rate
3rd step: calculate the swap rate Divide the results from step 1 by results from step 2
Result is the fixed rate that the party is willing to pay in return for receiving the 6-month LIBOR
INTEREST RATE SWAP RISKS
Interest rates increase
Interest rates decrease
Fixed-rate payer Gain Loss
Floating-rate payer Loss Gain
Interest Risk
INTEREST RATE SWAP RISKS-CONT. Credit risk
Occurs when counterparties default on the swap agreement
Only one party at a time will be subject to credit risk
Example Suppose company A pays 8% and company B pays 6-
month LIBOR Now, if market rate on swaps falls below 8%, company
B benefits and company A may default. Company B suffers a credit loss if company A goes
bankrupt What happens if the interest rate increase to
9%?
REASONS FOR THE RAPID GROWTH OF INTEREST RATE SWAP MARKET
Ability of institutional investors and corporate borrowers to changes the nature of their assets and liabilities Credit arbitrage opportunities Comparative advantage
Increased volatility of interest rates Caused borrowers and lenders to hedge or
manage their risk exposure Interest rate swap is more liquid than forward
rate contract
TAKE-AWAY Interest rate swap is an agreement between two
counterparties to exchange periodic interest payment Notional principal amount is not exchanged. Rather
the interest rate times notional principal amount is exchanged.
Alter cash flow of assets from fixed to floating or from floating to fixed without affecting the underlying assets.
Interest rate valuation methods: Summing present value of cash flows YTM and zero coupon method
Interest rate swaps risks Interest risk Credit risk
QUESTIONS
REFERENCES 5/24/2011, Amounts outstanding of over-the-counter (OTC)
derivatives, http://www.bis.org/statistics/otcder/dt1920a.pdf
Fabozzi, Frank. Modigliani, Franco. and Jones, Frank. 2010, Foundations of Financial Markets and Institutions(Pearson Prentice Hall)
5/24/2011, Understanding Interest Rate Swap Math and Pricing, http://www.treasurer.ca.gov/cdiac/publications/math.pdf
Beidleman, Carl R. I991, Interest Rate Swaps (Richard D. Irwin, INC.)
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