Module 4.3

Question 1

Background on Interest Rate Swaps

Answer 1

An interest rate swap is an arrangement whereby one party exchanges one set of interest payments for another. The provisions of an interest rate swap include: The notional principal value to which the interest rates are applied to determine the interest payments involved. The fixed interest rate. The formula and type of index used to determine the floating rate. The frequency of payments, such as every six months or every year. The lifetime of the swap.

Question 2

Additional Background on Interest Rate Swaps

Answer 2

An example of a swap is an agreement to exchange 11% fixed-rate payments for floating payments at the prevailing 1-year Treasury bill plus 1% based on $30 million notional principal. Swap payments are usually netted. The market for swaps is facilitated by over-the-counter trading rather than trading on an organized exchange. Interest rate swaps became popular in the early 1980s when corporations were experiencing large fluctuations in interest rates

Question 3

Use of Swaps for Hedging

Answer 3

Financial institutions in the U.S. with more interest rate sensitive liabilities than assets were adversely affected by increasing interest rates. Financial institutions in Europe had more access to long-term fixed rate funding and used the funds for floating-rate loans and were adversely affected by declining interest rates. Interest rate swaps allowed both types of financial institutions to reduce exposure to interest rate risk.(Exhibit 15.1 and 15.2)

Question 4

Illustration of an Interest Rate Swap

Answer 4

Question 5

Illustration of an Interest Rate Swap to Reconfigure Bond Payments

Answer 5

Question 6

Use of Swaps for Speculating

Answer 6

§When the swap is used for speculating rather than for hedging, any loss on the swap positions will not be offset by gains from other operations.

Participation by Financial Institutions

§Financial institutions such as commercial banks, savings institutions, insurance companies, and pension funds that are exposed to interest rate movements commonly engage in swaps to reduce interest rate risk. (Exhibit 15.3)

Question 7

Participation of Financial Institutions in Swap Markets

Answer 7

Question 8

Types of Interest Rate Swaps

Answer 8

Plain Vanilla Swaps (fixed-for-floating swap)

§Fixed-rate payments are periodically exchanged for floating-rate payments. (Exhibits 15.4 & 15.5))

Forward Swaps

§Involve an exchange of interest payments that does not begin until a specified future time.

§Useful for financial institutions or other firms that expect to be exposed to interest rate risk at some time in the future. (Exhibit 15.6)

Question 9

Illustration of a Plain Vanilla (Fixed-for-Floating) Swap

Answer 9

Question 10

Possible Effects of a Plain Vanilla Swap Agreement (Fixed Rate of 9 Percent in Exchange for Floating Rate of LIBOR + 1 Percent)

Answer 10

Question 11

Illustration of a Forward Swap

Answer 11

Question 12

Callable Swaps

Answer 12

§Gives the party making the fixed payments the right to terminate the swap prior to its maturity.

§It allows the fixed-rate payer to avoid exchanging future interest payments if it desires. (Exhibit 15.7)

Putable Swaps

§Gives the party making the floating-rate payments the right to terminate the swap.

A putable swap allows the institution to terminate the swap in the event that interest rates rise. (Exhibit 15.8

Question 13

Illustration of a Callable Swap

Answer 13

Question 14

Illustration of a Putable Swap

Answer 14

Question 15

Extendable Swaps

Answer 15

§Contains a feature that allows the fixed-for-floating party to extend the swap period. (Exhibit 15.9)

§The terms of an extendable swap reflect a price paid for the extendibility feature.

Zero-Coupon-for-Floating Swaps

The fixed-rate payer makes a single payment at the maturity date of the swap agreement, and the floating-rate payer makes periodic payments throughout the swap period. (Exhibit 15.10

Question 16

Illustration of an Extendable Swap

Answer 16

Question 17

Illustration of a Zero-Coupon-for-Floating Swap

Answer 17

Question 18

Rate-Capped Swaps

Answer 18

§Involves the exchange of fixed-rate payments for floating-rate payments that are capped. (Exhibit 15.11)

§Equity Swaps — Involves the exchange of interest payments for payments linked to the degree of change in a stock index.

Question 19

15.11 Illustration of a Rate-Capped Swap

Answer 19

Question 20

Other Types of Swaps

Answer 20

§Use of Swaps to Accommodate Financing Preferences

§Tax Advantage Swaps

Question 21

Risks of Interest Rate Swaps

Answer 21

Basis Risk

§The interest rate of the index used for an interest rate swap will not necessarily move perfectly in tandem with the floating-rate instruments of the parties involved in the swap.

§When this happens, the higher payments received do not offset the increase in the cost of funds.

§Basis risk prevents the interest rate swap from completely eliminating the financial institutions exposure to interest rate risk.

Question 22

Credit Risk

Answer 22

§There is risk that a firm involved in an interest rate swap will not meet its payment obligations.

Concerns about a Swap Credit Crisis — The willingness of large banks and securities firms to provide guarantees has increased the popularity of interest rate swaps, but it has also raised concerns that widespread adverse effects might occur if any of these intermediaries cannot meet their obligations

Question 23

Sovereign Risk

Answer 23

§Reflects potential adverse effects resulting from a country’s political conditions.

§Sovereign risk differs from credit risk because it depends on the financial status of the government rather than on the counterparty itself.

Question 24

Pricing Interest Rate Swaps

Answer 24

Prevailing Market Interest Rates

§The fixed interest rate specified in a swap is influenced by supply and demand conditions for funds having the appropriate maturity.

Availability of Counterparties

§When numerous counterparties are available for a particular desired swap, a party may be able to negotiate a more attractive deal.

Credit and Sovereign Risk

§A party involved in an interest rate swap must assess the probability of default by the counterparty.

Question 25

Performance of Interest Rate Swaps

Answer 25

§When strong economic forces cause interest rates to rise, the party that is swapping fixed-rate payments for floating-rate payments will benefit. §Because the performance of a particular interest rate swap position is normally influenced by future interest rate movements, participants in the interest rate swap market closely monitor indicators that may affect these movements.

Question 26

Framework for Explaining Net Payments Resulting from an Interest Rate Swap

Answer 26

Question 27

Interest Rate Caps, Floors, and Collars

Answer 27

Interest Rate Caps (Exhibit 15.13) §Offers payments in periods when a specified interest rate index exceeds a specified ceiling (cap) interest rate. §The payments are based on the amount by which the interest rate exceeds the ceiling, multiplied as usual by the notional principal specified in the agreement. §The buyer of a cap is a financial institution that would be adversely affected by rising interest rates. The seller of a cap receives the fee and is obligated to provide payments when rates exceed the ceiling rate

Question 28

Illustration of an Interest Rate Cap

Answer 28

Question 29

Interest Rate Floors

Answer 29

§Offers payments in periods when a specified interest rate index falls below a specified floor rate. §The payments are based on the amount by which the interest rate falls below the floor rate, which is multiplied by the notional principal specified in the agreement. §The buyer of an interest rate floor will receive payments when interest rates decline below the floor. The seller of an interest rate floor receives a fee and is obligated to provide periodic payments when the interest rate falls below the floor rate specified in the agreement

Question 30

Illustration of an Interest Rate Floor

Answer 30

Question 31

Interest Rate Collars

Answer 31

§Involves the purchase of an interest rate cap and the simultaneous sale of an interest rate floor. §Because the collar also involves the sale of an interest rate floor, the financial institution is obligated to make payments if interest rates decline below the floor.

Question 32

Illustration of an Interest Rate Collar (Combined Purchase of Interest Rate Cap and Sale of Interest Rate Floor)

Answer 32

Question 33

Credit Default Swaps

Answer 33

§A privately negotiated contract that protects investors against the risk of default on particular debt securities. §The main participants in the CDS market are commercial banks, insurance companies, hedge funds, and securities firms. §One party is the buyer, who is willing to provide periodic (usually quarterly) payments to the other party, the seller. §The seller receives the payments from the buyer but is obligated to reimburse the buyer if the securities specified in the swap agreement default. §The buyer of a CDS is protected if the securities specified in the CDS contract default.

Question 34

Secondary Market for CDS Contracts

Answer 34

■The secondary market allows financial institutions participating in a CDS contract to pass on their obligations to other willing parties. Collateral on CDS Contracts ■The lack of transparency in CDS pricing has caused conflicts regarding the levels of collateral to be held and has resulted in lawsuits.

Question 35

Payments on a Credit Default Swap

Answer 35

§When economic growth is strong, the payments required on most CDS should be relatively low because the default risk is usually low. §When economic conditions are weak, the payments required on most CDS should be relatively high because the default risk is high. How CDS Contracts Affect Debtor-Creditor Negotiations §When a firm encounters financial problems, its creditors attempt to work with the firm to prevent bankruptcy.

Question 36

Development of the CDS Market

Answer 36

§Credit default swaps were created in the 1990s as a way to protect bondholders from default risk. §Over time, CDS contracts were adapted to protect investors that purchased mortgage-backed securities. Impact of the Credit Crisis on the CDS Market As the housing market began to weaken in 2006, investors purchased CDS contracts as protection against the default of these mortgage-backed securities

Question 37

Impact of the Credit Crisis on the CDS Market (cont.)

Answer 37

§Using CDS Contracts to Bet on Mortgage Defaults §Financial institutions that anticipated a major decline in housing prices purchased CDS contracts on MBS even when they had no exposure to MBS. §During the credit crisis, many MBS defaulted; this generated large profits for the buyers of CDS contracts and major losses for the sellers. Insufficient Margins on CDS Contracts — During the credit crisis, many credit default swaps did not have a sufficient margin backing the agreement

Question 38

§Impact of Lehman Brothers’ Failure

Answer 38

§When Lehman Brothers went bankrupt in September 2008, it did not cover all of its CDS obligations. Thus, many financial institutions that had purchased CDS contracts from Lehman were not protected. §Another impact of the Lehman Brothers failure was that participants recognized that the government will not automatically rescue all large financial institutions. §Impact of AIG’s Financial Problems — The Fed injected billions of dollars into AIG because it feared major damage to the financial sector.

Question 39

Reform of CDS Contracts

Answer 39

■As a result of the Financial Reform Act of 2010, derivative securities are to be traded on an exchange. ■Derivative contracts should become more standardized. ■The pricing of these contracts should become more transparent. ■The use of standardized contracts should increase the trading volume. ■Market participants and regulators should be more informed about the use of particular swap contracts if they are traded on an exchange.

Question 40

Globalization of Swap Markets

Answer 40

1.Currency Swaps §Arrangements whereby currencies are exchanged at specified exchange rates and at specified intervals.(Exhibit 15.16) §Using Currency Swaps to Hedge Bond Payments §Although currency swaps are commonly used to hedge payments on international trade, they may also be used in conjunction with bond issues to hedge foreign cash flows. (Exhibit 15.17)

Question 41

Impact of Currency Swaps

Answer 41

Question 42

Illustration of a Currency Swap

Answer 42

Question 43

Risk of Currency Swaps

Answer 43

§— The same types of risk that apply to interest rate swaps may also apply to currency swaps. ■There may be basis risk if the firm cannot obtain a currency swap on the currency to which it is exposed and instead uses a related currency. ■Currency swaps can also be subject to credit risk, which reflects the possibility that the counterparty may default on its obligation. ■A third type of risk is sovereign risk, which reflects the possibility that a country may restrict the convertibility of a particular currency.