Swaps Chapter 26

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SwapsChapter 26

• Financial Institutions Management, 3/e
• By Anthony Saunders

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Introduction

• Market for swaps has grown enormously
• Serious regulatory concerns regarding credit risk
  exposures
• Motivated BIS risk-based capital reforms
• Growth in exotic swaps such as inverse floater
  generated controversy (e.g., Orange County, CA).
• Generic swaps in order of quantitative
  importance interest rate, currency, commodity.

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Interest Rate Swaps

• Interest rate swap as succession of forwards.
• Swap buyer agrees to pay fixed-rate
• Swap seller agrees to pay floating-rate.
• Purpose of swap
• Allows FIs to economically convert variable-rate
  instruments into fixed-rate (or vice versa) in
  order to better match assets and liabilities.

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Interest Rate Swap Example

• Consider money center bank that has raised 100
  million by issuing 4-year notes with 10 fixed
  coupons. On asset side CI loans linked to
  LIBOR. Duration gap is negative.
• DA - kDL lt 0
• Second party is savings bank with 100 million in
  fixed-rate mortgages of long duration funded with
  CDs having duration of 1 year.
• DA - kDL gt 0

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Example (continued)

• Savings bank can reduce duration gap by buying a
  swap (taking fixed-payment side).
• Notional value of the swap is 100 million.
• Maturity is 4 years with 10 fixed-payments.
• Suppose that LIBOR currently equals 8 and bank
  agrees to pay LIBOR 2.

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Realized Cash Flows on Swap

• Suppose realized rates are as follows
• End of Year LIBOR
• 1 9
• 2 9
• 3 7
• 4 6

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Swap Payments

• End of LIBOR MCB Savings
• Year 2 Payment Bank Net
• 1 11 11 10 1
• 2 11 11 10 1
• 3 9 9 10 - 1
• 4 8 8 10 - 2
• Total 39 40 - 1

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Off-market Swaps

• Swaps can be molded to suit needs
• Special interest terms
• Varying notional value
• Increasing or decreasing over life of swap.
• Structured-note inverse floater
• Example Government agency issues note with
  coupon equal to 7 percent minus LIBOR and
  converts it into a LIBOR liability through a swap.

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Macrohedging with Swaps

• Assume a thrift has positive gap such that
• DE -(DA - kDL)A DR/(1R) gt0 if rates rise.
• Suppose choose to hedge with 10-year swaps.
  Fixed-rate payments are equivalent to payments on
  a 10-year T-bond. Floating-rate payments repriced
  to LIBOR every year. Changes in swap value DS,
  depend on duration difference (D10 - D1).
• DS -(DFixed - DFloat) NS DR/(1R)

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Macrohedging (continued)

• Optimal notional value requires
• DS DE
• -(DFixed - DFloat) NS DR/(1R)
• -(DA - kDL) A DR/(1R)
• NS (DA - kDL) A/(DFixed - DFloat)

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Pricing an Interest Rate Swap

• Example
• Assume 4-year swap with fixed payments at end of
  year.
• We derive expected one-year rates from the yield
  curve treating the individual payments as
  separate zero-coupon bonds and iterating forward.

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Currency Swaps

• Fixed-Fixed
• Example U.S. bank with fixed-rate assets
  denominated in dollars, partly financed with 50
  million in 4-year 10 percent (fixed) notes. By
  comparison, U.K. bank has assets partly funded by
  100 million 4-year 10 percent notes.
• Solution Enter into currency swap.
• Fixed-Floating currency swaps.

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Credit Swaps

• Credit swaps designed to hedge credit risk.
• Total return swap
• Pure credit swap
• Interest-rate sensitive element stripped out
  leaving only the credit risk.

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Credit Risk Concerns

• Credit risk concerns partly mitigated by netting
  of swap payments.
• Netting by novation
• When there are many contracts between parties.
• Payment flows are interest and not principal.
• Standby letters of credit may be required.