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

Cash inflows
10mLIBOR1/2
Every 6 months
3 yrs
10m111/2
Cash outflows
5
I. Defining A Swap

• Cash flows for the floating-rate payer

Cash inflows
10m111/2
Every 6 months
3 yrs
10mLIBOR 1/2
Cash outflows
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 LIBOR1.5
• 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 L1.5
• 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 L1.5
• 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 US100 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
• US9.5
•  
• 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.