Tài chính doanh nghiệp - Chapter 15: Interest rate derivative markets

Chapter 15Interest Rate Derivative MarketsFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.1Chapter OutlineBackgroundParticipation by financial institutionsTypes of interest rate swapsRisks of interest rate swapsPricing interest rate swapsFactors affecting the performance of interest rate swapsInterest rate caps, floors, and collarsGlobalization of swap markets2BackgroundAn interest rate swap is an arrangement whereby one party exchanges one set of interest payments for anothere.g., fixed-rate payments are exchanged for floating-rate paymentsThe provisions of a swap include:The notional principalThe fixed interest rateThe formula and type of index to determine the floating rateThe frequency of paymentsThe lifetime of the swap3Background (cont’d)Amounts owed are typically netted out so that only the net payment is madeThe market for swaps is facilitated by over-the-counter tradingSwaps are less standardized than other derivativesSwaps became popular in the early 1980s because of large fluctuations in interest ratese.g., financial institutions traditionally had more interest rate-sensitive liabilities than assets and were adversely affected by rising interest ratese.g., some foreign financial institutions had access to long-term fixed rate funding but used funds primarily for floating rate loansBy engaging in an interest rate swap, both institutions can reduce their exposure to interest rate risk (see next slide)4Background (cont’d)A U.S. financial institutions could send fixed-rate payments to a European financial institution in exchange for floating-rate paymentsIf interest rates rise, the U.S. financial institution receives higher interest payments from the floating-rate portion, which helps to offset the rising cost of obtaining depositsIf interest rates decline, the European institution provides lower interest payments in the swap, which helps to offset the lower interest payments received on its floating-rate loansThe U.S. institution forgoes the potential benefits from a decline in interest ratesThe European institution forgoes the potential benefits from an increase in interest rates5Background (cont’d)A primary reason for the popularity of swaps is market imperfectionsA lack of information about foreign institutions and convenience encourages individual depositors to place deposits locallySwaps are sometimes used for speculative purposese.g., a firm could engage in a swap to benefit from rising interest rates even if its operations are not exposed to interest rate movements6Participation by Financial InstitutionsFinancial institutions that are exposed to interest rate movements commonly engage in swaps to reduce interest rate riskSome commercial banks and securities firms serve as intermediaries by matching up firms and facilitating the swap arrangementsCharge fees and may provide credit guaranteesSome institutions act as dealers in swapsThe financial institution takes the counterparty position in order to serve a client7Participation by Financial InstitutionsFinancial InstitutionParticipation in Swap MarketCommercial banksEngage in swaps to reduce interest rate riskServe as an intermediary by matching up two parties in a swapServe as a dealer by taking the counterparty position to accommodate a party the desires to engage in a swapS&Ls and savings banksEngage in swaps to reduce interest rate riskFinance companiesEngage in swaps to reduce interest rate riskSecurities firmsServe as an intermediary by matching up two parties in a swapServe as a dealer by taking the counterparty position to accommodate a party that desires to engage in a swapInsurance companiesEngage in swaps to reduce interest rate riskPension fundsEngage in swaps to reduce interest rate risk8Types of Interest Rate SwapsPlain vanilla swapsIn a plain vanilla swap (fixed-for-floating swap), fixed-rate payments are periodically exchanged for floating-rate paymentsConsider two scenarios:A consistent rise in market interest ratesA consistent decline in market interest rates9Types of Interest Rate Swaps (cont’d)Plain vanilla swaps (cont’d)Rising Interest RatesDeclining Interest RatesLevel of Interest PaymentsEnd of YearFixed OutflowPaymentsFloating InflowPaymentsFixed OutflowPaymentsFloating InflowPayments10Using A Plain Vanilla SwapBruny Bank has negotiated a plain vanilla swap in which it will exchange fixed payments of 8 percent for floating payments equal to LIBOR plus 1 percent at the end of each of the next four years. Assume that the notional principal is $100 million. Fill in the table on the next slide for the two scenarios of rising and falling interest rates.11Scenario 1Year 1234LIBOR7.0%7.5%8.5%9.5%Floating rate received    Fixed rate paid    Swap differential    Net dollar amount received    Scenario 2Year 1234LIBOR6.5%6.0%5.0%4.5%Floating rate received    Fixed rate paid    Swap differential    Net dollar amount received    12Scenario 1Year 1234LIBOR7.0%7.5%8.5% 9.5%Floating rate received 8.0%  8.5%  9.5% 10.5% Fixed rate paid 8.0%  8.0%  8.0%  8.0% Swap differential0.0% 0.5%  1.5%  2.5% Net dollar amount received$0 $500K $1.5M $2.5M Scenario 2Year 1234LIBOR 6.5% 6.0% 5.0% 4.5%Floating rate received 7.5%  7.0%  6.0%  5.5% Fixed rate paid 8.0%  8.0%  8.0%  8.0% Swap differential–0.5% –1.0% –2.0% –2.5% Net dollar amount received–$500K –$1M –$2M –$2.5M 13Types of Interest Rate Swaps (cont’d)Forward swapsA forward swap involves an exchange of interest payments that does not begin until a specified future point in timeUseful for institutions that expect to be exposed to interest rate risk at a future point in timeThe fixed rate on a forward swap may differ from the fixed rate on a swap beginning immediatelyInstitutions may be able to negotiate a fixed rate today that is less than the expected fixed rate on a swap negotiated in the future14Types of Interest Rate Swaps (cont’d)A forward swap beginning in year 3:Rising Interest RatesDeclining Interest RatesLevel of Interest PaymentsEnd of YearFixed OutflowPaymentsFloating InflowPaymentsFixed OutflowPaymentsFloating InflowPayments030315Types of Interest Rate Swaps (cont’d)Callable swapsA callable swap provides the party making the fixed payments with the right to terminate the swap prior to its maturityAllows the fixed-rate payer to avoid exchanging future interest payments if it desiresThe fixed-rate payer pays a premium in the form of a higher interest rate than without the call featureCallable swaps are an example of swaptions16Types of Interest Rate Swaps (cont’d)A callable swap terminated in year 3:Rising Interest RatesDeclining Interest RatesLevel of Interest PaymentsEnd of YearFixed OutflowPaymentsFloating InflowPaymentsFixed OutflowPaymentsFloating InflowPayments317Types of Interest Rate Swaps (cont’d)Putable SwapsA putable swap provides the party making the floating-rate payments with a right to terminate the swapThe floating-rate payer pays a premium in the form of a higher floating rateExtendable swapsAn extendable swap contains a feature that allows the fixed-for-floating party to extend the swap periodThe terms of an extendable swap reflect a price paid for the extendability feature18Types of Interest Rate Swaps (cont’d)A putable swap terminated in year 3:Rising Interest RatesDeclining Interest RatesLevel of Interest PaymentsEnd of YearFixed OutflowPaymentsFloating InflowPaymentsFixed OutflowPaymentsFloating InflowPayments319Types of Interest Rate Swaps (cont’d)An extandable swap after year 8:Rising Interest RatesDeclining Interest RatesLevel of Interest PaymentsEnd of YearFixed OutflowPaymentsFloating InflowPaymentsFixed OutflowPaymentsFloating InflowPayments8Extend8Don’t Extend20Types of Interest Rate Swaps (cont’d)Zero-coupon-for-floating swapsIn a zero-coupon-for-floating swap:The fixed-rate payer makes a single payment at the maturity dateThe floating-rate payer makes periodic payments throughout the swap periodAn institution that expects interest rates to increase would prefer to be the fixed-rate payerAn institution that expects interest rates to decline would prefer to be the floating-rate payer21Types of Interest Rate Swaps (cont’d)A zero-coupon-for-floating swap:Rising Interest RatesDeclining Interest RatesLevel of Interest PaymentsEnd of YearSingle FixedOutflow PaymentFloating InflowPaymentsFloating InflowPaymentsSingle FixedOutflow Payment22Types of Interest Rate Swaps (cont’d)Rate-capped swapsA rate-capped swap involves the exchange of fixed-rate payments for floating-rate payments that are cappedThe floating-rate payer pays an up-front fee for this featureThe fixed-rate payer may allow the cap if it believes interest rates will not exceed the cap and receives the up-front feeEquity swapsAn equity swap involves the exchange of interest payments linked to the degree of change in a stock index Appropriate for portfolio managers of insurance companies or pension funds that are managing stocks and bonds23Types of Interest Rate Swaps (cont’d)A rate-capped swap:Rising Interest RatesDeclining Interest RatesLevel of Interest PaymentsEnd of YearFixed OutflowPaymentsFloating InflowPaymentsFixed OutflowPaymentsFloating InflowPaymentsCap level24Types of Interest Rate Swaps (cont’d)Other types of swapsUse of swaps to accommodate financing preferencesSome swaps are combined with other transactions such as the issuance of bondsCorporate borrowers may be able to get a more attractive rate when using floating-rate debtOther corporate borrowers may prefer to borrow at a floating-rate but find it advantageous to borrow at a fixed rateFinancial intermediaries may match up participants and sometimes assume the default risk involved25Types of Interest Rate Swaps (cont’d)Other types of swaps (cont’d)Tax advantage swapsFirms with expiring tax loss carryforwards from previous years can engage in a swap that calls for receipt of a large up-front payment with less favorable terms over timeFirms would realize an immediate gain and possible losses in future yearsFirms expecting large future losses but large gains this year could engage in a swap requiring a large payment now and more favorable terms over time26Risks of Interest Rate SwapsBasis risk is the risk that the interest rate of the index used for an interest rate swap will not move perfectly in tandem with the floating-rate instruments of the parties involved in the swapDefault risk is the risk that a firm involved in the swap will not meet its payment obligationsUsually not pronounced because the nondefaulting party will discontinue its paymentsSovereign risk reflects potential adverse effects resulting from a country’s political conditionse.g., the government may take over one of the parties of the swap 27Pricing Interest Rate SwapsPrevailing market interest ratesThe fixed rate in the swap is influenced by supply and demand conditions for fundsGenerally, the interest rates of the swap reflect the prevailing interest rates at the time of the agreementAvailability of counterpartiesWhen many counterparties are available, a more attractive deal might be negotiatedAvailability of counterparties can change in response to economic conditionsCredit and sovereign riske.g., a firm that desires a fixed-for-floating swap will require a lower fixed rate applied to its outflow payments if the credit risk or sovereign risk of the counterparty is high28Factors Affecting the Performance of Interest Rate SwapsThe most important are forces that influence interest rate movementsThe impact of the underlying forces depends on the party’s swap positione.g., strong economic growth can increase rates, which is beneficial for a party that is swapping fixed-rate payments for floating-rate payments but not for the counterpartyIndicators monitored by participants in the swap marketEconomic growth indicatorsInflation indicatorsIndicators of government borrowing29Interest Rate Caps, Floors, and CollarsInterest rate capsAn interest rate cap offers payments in periods when a specified interest rate index exceeds a specified ceiling (cap) interest ratePayments are based on the amount by which the interest rate exceeds the ceilingTypical purchasers are institutions that are adversely affected by rising interest ratesThe seller of an interest rate cap received an up-front fee and is obligated to provide period payments as neededTypical sellers are institutions that expect interest rates to decline or remain stableCommercial banks and securities firms serve as dealers and/or brokers for interest rate caps30Using An Interest Rate CapBungee Bank purchases a three-year cap for a fee of 3 percent of notional principal valued at $50 million, with an interest rate ceiling of 10 percent. The agreement specified LIBOR to be used to represent the prevailing market interest rate. LIBOR is currently 8 percent and is expected to increase by 1 percent in each of the next three years. Fill in the table below.End of Year 0123LIBOR9.0%10.0%11.0%Interest rate ceiling   LIBOR’s percent above ceiling   Payments received   Fee paid   31Using An Interest Rate Cap (cont’d)End of Year 0123LIBOR9.0%10.0%11.0%Interest rate ceiling 10.0%10.0% 10.0% LIBOR’s percent above ceiling 0%0% 1.0% Payments received $0$0 $500,000 Fee paid$1,500,000   32Interest Rate Caps, Floors, and Collars (cont’d)Interest rate floorsAn interest rate floor offers payments when a specified interest rate index falls below a specified floor ratePayments are based on the amount by which the interest rate falls below the floors rateInterest rate floors can be used to hedge against lower interest ratesSellers of interest rate floors receive an up-front fee and are obligated to provide periodic payments as neededCommercial banks and securities firms serve as dealers and/or brokers for interest rate caps33Using An Interest Rate FloorPurage Bank purchases a three-year floor for a fee of 3 percent of notional principal valued at $50 million, with an interest rate floor of 8 percent. The agreement specified LIBOR to be used to represent the prevailing market interest rate. LIBOR is currently 6 percent and is expected to increase by 1 percent in each of the next three years. Fill in the table below.End of Year 0123LIBOR7.0%8.0%9.0%Interest rate floor   LIBOR’s percent below floor   Payments received   Fee paid   34Using An Interest Rate Floor (cont’d)End of Year 0123LIBOR7.0%8.0%9.0%Interest rate floor8.0%8.0% 8.0% LIBOR’s percent below floor 1%0% 1.0% Payments received $500,000$0 $0 Fee paid$1,500,000   35Interest Rate Caps, Floors, and Collars (cont’d)Interest rate collarsAn interest rate collar involves the purchase of an interest rate cap and the simultaneous sale of an interest rate floorThe fee received from selling the floor can be used to pay the fee for purchasing the capInstitutions wishing to hedge against rising interest rates purchase collarsIf interest rates rise as expected and remain above the floor, the institution will not have to make payments36Globalization of Swap MarketsForeign financial institutions and manufacturing corporations from various counties that are exposed to interest rate risk engage in interest rate swapsSwaps are executed in various countries and denominated in many different currenciesDollar-denominated swaps account for about half the value of all swaps outstandingBanks and securities firms that serve as intermediaries have a globalized network of subsidiariesA barrier to the global swap market is the lack of information about participants based in other countries37Globalization of Swap Markets (cont’d)Currency swapsA currency swap is an arrangement whereby currencies are exchanged at specified exchange rates and at specified intervalsA combination of currency futures contractsCurrency swaps are commonly used by firms to hedge their exposure to exchange rate fluctuationsSome currency swaps allow for early terminationUsing currency swaps to hedge bond paymentsCurrency swaps can be used in conjunction with bond issues to hedge foreign cash flows38Globalization of Swap Markets (cont’d)Risks of currency swapsBasis risk can exist if the firm cannot obtain a currency swap on the currency it is exposed to and uses a related currency insteadCredit risk reflects the possibility that the counterparty may default on its obligationSovereign risk reflects the possibility that a county may restrict the convertibility of a particular currency39