INTEREST RATE SWAP

INTRODUCTION

An interest rate swap (IRS) is a popular and highly liquid financial derivative

instrument in which two parties agree to exchange interest rate cash flows,

based on a specified notional amount from a fixed rate to a floating rate (or

vice versa) or from one floating rate to another. Interest rate swaps are

commonly used for both hedging and speculating.

It is an over-the-counter derivative transaction. The two parties to the trade

periodically exchange interest payments. There is no principal exchange.

One party pays a fixed rate of interest; the other pays a floating rate of

interest. The fixed interest payment remains unchanged throughout the life

of the deal. It is paid annually, semi-annually or quarterly in arrears. The

floating interest is paid on a three or six monthly basis. Because it is reset

using the relevant Libor rate it will vary depending on short term interest

rates. It too is paid in arrears.

What documentation is used for interest rate swaps?

The standard documentation is the International Securities Dealers

Agreement, (ISDA master agreement). This is negotiated and signed by both

parties. Confirmations then cover individual transactions and refer to the

master agreement.

Structure:

In an interest rate swap, each counterparty agrees to pay either a fixed or

floating rate denominated in a particular currency to the other counterparty.

The fixed or floating rate is multiplied by a notional principal amount (say,

USD 1 million) and an accrual factor given by the appropriate day count

convention. When both legs are in the same currency, this notional amount

is typically not exchanged between counterparties, but is used only for

calculating the size of cashflows to be exchanged. When the legs are in

different currencies, the respective notional amounts are typically

exchanged at the start and the end of the swap.

The most common interest rate swap is one where one counterparty A pays

a fixed rate (the swap rate) to counterparty B, while receiving a floating rate

indexed to a reference rate (such as LIBOR or EURIBOR). By market

convention, the counterparty paying the fixed rate is called the "payer"

(while receiving the floating rate), and the counterparty receiving the fixed

rate is called the "receiver" (while paying the floating rate).

A pays fixed rate to B (A receives floating rate)

B pays floating rate to A (B receives fixed rate)

Currently, A borrows from Market @ LIBOR +1.5%. B borrows from Market @

8.5%.

Consider the following swap in which Party A agrees to pay Party B periodic

fixed interest rate payments of 8.65%, in exchange for periodic variable

interest rate payments of LIBOR + 70 bps (0.70%) in the same currency.

Note that there is no exchange of the principal amounts and that the interest

rates are on a "notional" (i.e. imaginary) principal amount. Also note that the

interest payments are settled in net (e.g. Party A pays (LIBOR + 1.50%)

+8.65% - (LIBOR+0.70%) = 9.45% net). The fixed rate (8.65% in this

example) is referred to as the swap rate.

At the point of initiation of the swap, the swap is priced so that it has a net

present value of zero. If one party wants to pay 50 bps above the par swap

rate, the other party has to pay approximately 50bps over LIBOR to

compensate for this.

Party A is currently paying floating rate, but wants to pay fixed rate. Party B

is currently paying fixed rate, but wants to pay floating rate. By entering into

an interest rate swap, the net result is that each party can 'swap' their

existing obligation for their desired obligation.

TYPES OF INTEREST RATE SWAP

Being OTC instruments, interest rate swaps can come in a huge number of

varieties and can be structured to meet the specific needs of the

counterparties. For example, the legs of the swap can be in the same

currency or in different currencies. The notional of the swap could be

amortized over time. The reset dates of the floating rate could be non-

regular, etc. However, in the interbank market, just a few, standardized

types are traded. They are listed below. Each currency has its own standard

market conventions regarding the frequency of payments, the day count

conventions and the end-of-month rule.

Normally the parties do not swap payments directly, but rather each sets up

a separate swap with a financial intermediary such as a bank. In return for

matching the two parties together, the bank takes a spread from the swap

payments (in this case 0.30% compared to the above example)

Fixed for Floating

Investors call the parts of interest swap agreements “legs.” In a fixed-for-

floating swap agreement, one party agrees to pay the fixed leg of the swap,

with the other party agreeing to pay the floating leg of the swap. The fixed

rate is the interest charged over the life of a loan and does not change. The

floating rate is an interest rate pegged to an international reference rate

index and is subject to change. The most commonly used reference rate is

London Interbank Offered Rate or LIBOR.

Fixed-for-floating rate swap, same currency

Fixed-for-floating swaps in same currency are used to convert a fixed rate

asset/liability to a floating rate asset/liability or vice versa. For example, if a

company has a fixed rate USD 10 million loan at 5.3% paid monthly and a

floating rate investment of USD 10 million that returns USD 1M Libor +25bps

monthly, it may enter into a fixed-for-floating swap. In this swap, the

company would pay a floating rate of USD 1M Libor+25bps and receive a

5.5% fixed rate, locking in 20bps profit.

Fixed-for-floating rate swap, different currencies

Fixed-for-floating swaps in different currencies are used to convert a fixed

rate asset/liability in one currency to a floating rate asset/liability in a

different currency, or vice versa. For example, if a company has a fixed rate

USD 10 million loan at 5.3% paid monthly and a floating rate investment of

JPY 1.2 billion that returns JPY 1M Libor +50bps monthly, and wants to lock in

the profit in USD as they expect the JPY 1M Libor to go down or USDJPY to go

up (JPY depreciate against USD), then they may enter into a Fixed-Floating

swap in different currency where the company pays floating JPY 1M

Libor+50bps and receives 5.6% fixed rate, locking in 30bps profit against the

interest rate and the FX exposure.

Floating for Floating

In a floating-for-floating interest rate swap agreement, both parties agree to

pay a floating rate on their respective legs of the swap. The floating rates for

each leg of the swap generally come from different reference rate indexes,

but can also come from the same index. If both parties choose the same

index, generally they then choose different payment dates. The two main

indexes investors use in a floating for floating interest rate swap are the

LIBOR and the Tokyo Interbank Offered Rate or TIBOR

Floating-for-floating rate swap, same currency

Floating-for-floating rate swaps are used to hedge against or speculate on

the spread between the two indexes widening or narrowing. For example, if a

company has a floating rate loan at JPY 1M LIBOR and the company has an

investment that returns JPY 1M TIBOR + 30bps and currently the JPY 1M

TIBOR = JPY 1M LIBOR + 10bps. At the moment, this company has a net

profit of 40bps. If the company thinks JPY 1M TIBOR is going to come down

(relative to the LIBOR) or JPY 1M LIBOR is going to increase in the future

(relative to the TIBOR) and wants to insulate from this risk, they can enter

into a float-float swap in same currency where they pay, say, JPY TIBOR +

30bps and receive JPY LIBOR + 35bps. With this, they have effectively locked

in a 35 bit/s profit instead of running with a current 40bps gain and index

risk. The 5bpss difference (w.r.t. the current rate difference) comes from the

swap cost which includes the market expectations of the future rate

difference between these two indices and the bid/offer spread which is the

swap commission for the swap dealer.

Floating-for-floating rate swap, different currencies

Party P pays/receives floating interest in currency A indexed to X to

receive/pay floating rate in currency B indexed to Y on a notional N at an

initial exchange rate of FX for a tenure of T years. The notional is usually

exchange at the start and at the end of the swap. This is the most liquid

type of swap with different currencies. For example, you pay floating USD

3M LIBOR on the USD notional 10 million quarterly to receive JPY 3M

TIBOR quarterly on a JPY notional 1.2 billion (at an initial exchange rate of

USDJPY 120) for 4 years; at the start you receive the notional in USD and

pay the notional in JPY and at the end you pay back the same USD

notional (10 millions) and receive back the same JPY notional (1.2

billions).

Fixed for Fixed

In fixed-for-fixed interest rate swaps, both parties agree to a fixed interest

for their respective legs of the swap. The interest rate does not change over

the life of the loan for both parties. Investors most commonly use fixed-for-

fixed interest rate swaps when they are dealing with different currencies.

Companies often use fixed-for-fixed interest rate swaps when they are

building or expanding their business in a foreign country.

Party P pays/receives fixed interest in currency A to receive/pay fixed rate in

currency B for a term of T years. For example, you pay JPY 1.6% on a JPY

notional of 1.2 billion and receive USD 5.36% on the USD equivalent notional

of 10 million at an initial exchange rate of USDJPY 120.

USES OF INTEREST RATE SWAPS

Interest rate swaps were originally created to allow multi-national companies

to evade exchange controls. Today, interest rate swaps are used to hedge

against or speculate on changes in interest rates.

Speculation

Interest rate swaps are also used speculatively by hedge funds or other

investors who expect a change in interest rates or the relationships between

them. Traditionally, fixed income investors who expected rates to fall would

purchase cash bonds, whose value increased as rates fell. Today, investors

with a similar view could enter a floating-for-fixed interest rate swap; as

rates fall, investors would pay a lower floating rate in exchange for the same

fixed rate.

Interest rate swaps are also very popular due to the arbitrage opportunities

they provide. Due to varying levels of creditworthiness in companies, there is

often a positive quality spread differential which allows both parties to

benefit from an interest rate swap.

The interest rate swap market in USD is closely linked to the Eurodollar

futures market which trades among others at the Chicago Mercantile

Exchange.

Risks

Interest rate swaps expose users to interest rate risk and credit risk.

Market Risk: A typical swap consists of two legs, one fixed, the other floating.

The risks of these two components will naturally differ. Newcomers to market

finance may think that the risky component is the floating leg, since the

underlying interest rate floats, and hence, is unknown. This first impression

is wrong. The risky component is in fact the fixed leg and it is very easy to

see why this is so.

The discussion of pricing interest rate swaps illustrated an important point.

Regardless of what happens to future Libor rates, the value of a rolling

deposit or FRN always equals the notional amount N at the reset dates.

Between the reset dates this value may be different than N, but the

discrepancy cannot be very large since the δ will be 3 or 6 months. Interest

rate fluctuations have minimal effect on the values of fixed instruments with

such maturities. In other words, the value of the floating leg changes very

little during the life of a swap.

On the other hand the fixed leg of a swap is equivalent to a coupon bond and

fluctuations of the swap rate may have major effects on the value of the

future fixed payments.

Credit risk on the swap comes into play if the swap is in the money or not. If

one of the parties is in the money, then that party faces credit risk of

possible default by another party.

What Can Interest Rate Swaps Be Used For?

Interest rate swaps can be used to manage interest rate risk, an example

follows. A bond issuer can sell a fixed rate bond to an investor. The fixed

funding cost of the borrower is then swapped to a floating rate using an IRS.

The investor obtains a fixed rate asset; this may suit interest rate

expectations or match investment criteria. But many borrowers prefer to

fund on a floating rate basis with the cost of borrowing expressed as a

spread over or under Libor. By using a swap the issuer and investor can both

get the interest basis they want. The net floating rate cost of funds to the

issuer, (Libor plus/minus), is dependent on the difference between the fixed

cost of funding and the swap rate. If the fixed cost of funds is below the

equivalent swap rate then the floating rate funding cost is Libor less a

margin. If the fixed cost of funds is above the equivalent swap rate then the

floating rate funding cost is Libor plus a margin.

How Are Interest Rate Swaps Used For Trading?

If a trader anticipates interest rates to fall he could receive fixed interest on

a swap and pay floating. If rates do fall the trader will now be receiving a

higher interest rate than the market rate. The interest rate swap will have a

positive value. But the trader has taken risk. This could have gone wrong,

rates could have risen. Interest rate swaps can also be used to trade the

shape of the yield curve. This can include the difference between the 2 year

swap rate and the 5 year rate, the 2 year rate and the 10 year rate, the 5

year rate and 10 year rate and the 10 year rate and the 30 year rate. If the

trader thinks the relative yields between two parts of the curve are "out of

line" he can receive fixed interest in one maturity and pay fixed in the other.

The nominal amounts of the two swaps are adjusted by the duration of the

swaps. (This means the nominal amount of the near dated swap is greater

than that of the far dated swap). This type of trade will benefit the trader if

the slope of the yield curve moves as expected. A variation on this trade

takes three points on the yield curve trading the spread differential between

centre point and the outside two points.

Can You Lose Money With Interest Rate Swaps?

You can make and lose money with interest rate swaps. The current value of

a swap is called the mark-to-market value. This is what the swap is worth

using current market interest rates. For banks daily valuation is important. It

provides profit and loss figures, shows whether hedging is effective and

provides information for collateral support. And should you need to cancel or

break a swap before it has matured the valuation will provide the basis of the

cost you pay or the benefit you receive. If it is in your favor you should

receive a payment from your counterparty that equals the market value. If

you are losing money on the swap you will have to pay the market value to

your counterparty. This has a practical significance. Let's suppose you used a

swap to convert floating rate funding to a fixed rate and that funding was

linked to the purchase of an asset.

If you sell the asset and make money you will be left with the swap.

If interest rates have fallen you will be losing money on the swap. You will

have to pay your counterparty to cancel it. You need to include this cost in

the realization of your asset. If you don't like the cost of cancellation do not fall into

the trap of leaving the interest rate swap in place hoping that it will improve.

Otherwise your hedge will become a speculative trade.

The case study on Currency Rate Swap Between IBM and World Bank

Abstract: The case study Currency Rate Swap Between IBM and World Bank, discusses the first ever standard currency swap deal between IBM and World Bank. The case study explains how appreciation in dollar during the late 1980s against European currencies gave an opportunity to IBM to earn capital gains on the existing loans in Swiss Franc (CHF) and German Mark (DEM). However, it was possible only if IBM swapped its existing loans in CHF and DEM with someone. For this, Salomon Brothers started looking for a party on behalf of IBM. At last, it could find World Bank was the right candidate for the proposed swap. After few initial hurdles, World Bank and IBM agreed for the first ever standard swap transaction planned by Salomon Brothers.

Introduction:On Tuesday, August 25, 1981, IBM and World Bank entered into a currency swap deal, whose net effects were that (1) IBM was able to earn capital gain without paying a single cent as tax on it and (2) the World Bank was able to get low cost funding, which was not possible through direct borrowing. Earlier, on Tuesday, August 11, 1981, in connection with the swap deal, US bond market investors got a unique instrument for investment which had almost zero default risk and the coupon rate was more than that of treasury bills. It was one of those satisfying financial deals where each party (the World Bank and IBM) believed it had emerged as the clear winner.

Swap was originally developed by banks in the UK to help large clients circumvent UK exchange controls in the 1970s. Earlier, currency swaps were in existence in the form of back-to-back/parallel loans. Parallel loans/back-to-back loans are currency exchange agreements wherein a UK holding company will lend Pounds (GBP) to the US subsidiary in the UK, and the US firm will lend US Dollars (USD) to the UK subsidiary in the US to avoid exchange controls. The first standard swap deal was a currency swap deal between the World Bank and IBM, which was arranged by Salomon Brothers .

Experts

The International Business Machines Corporation (IBM) IBM is one of the oldest Information Technology (IT) companies with worldwide operations. Some of the segments in which IBM has major operations are Global Technology Services (GTS), Global Business Services (GBS), Software, Systems and Technology, and Global Financing.

The financial Dilemma During the late 1970s, IBM issued bonds in Swiss Franc (CHF) and German Mark (DEM), whose maturity date was March 30, 1986. The issue amounts of 6(3/16)% CHF bonds and 10% DEM bonds were CHF 200 million and DEM 300 million respectively. The interest payment date of the bonds was March 30 of each year. In the early 1980s, the US dollar (USD) had appreciated considerably against most European currencies. This appreciation brought an opportunity for US-based IBM to enjoy capital gains on foreign exchange transactions between USD and European currencies. For example, on August 1, 1980, one DEM was available for 0.5574 USD. It had fallen to 0.4061 USD for each DEM by the end of August 1, 1981 (Refer to Exhibit I for see the movement of USD to DEM). As a result, the USD cost of interest payment of DEM 100 had fallen from $55.74 to $40.61...

2. Interest Rate Swaps: A Deal Between B.F. Goodrich and Rabobank

Introduction:Interest rate swaps are one of the most commonly used credit derivatives , with an estimated notional market value of US$ 400 trillion worldwide. Nobody even knew about interest rate swaps till the first swap deal occurred nearly three decades ago, in 1982. Under the deal, Student Loan Marketing Association (Sallie Mae) swapped the interest payments on an issue of intermediate term, fixed rate debt for floating rate payments indexed to the three-month treasury bill yield.

However, the first interest rate swap deal between two corporates occurred a few months after the first deal, in March 1983. This deal was arranged by Salomon Brothers, a Wall Street investment bank, between B. F. Goodrich and Rabobank. At that time, both parties to the swap deal were experiencing hard times. The financial engineering of this deal helped them in a unique way and opened new doors for corporates to manage their finances.

Abstract: The case study 'Interest Rate Swaps: A deal between B.F. Goodrich and Rabobank', discusses the first ever interest rate swap deal between two corporates – B.F. Goodrich (Goodrich) and Rabobank. The case study explains how Goodrich encountered financial problems at the beginning of the 1980s. After suffering a net loss of US$ 33 million, the company decided to borrow US$ 50 million as a long-term loan. However, with a deteriorating financial position and a BBB- rating, it was impossible for the company to get a long-term loan at favorable rates. Salomon Brothers (Salomon), an investment banker, suggested to Goodrich that it issue floating rate notes and then swap them with fixed rate financing.

At the same time, one of the leading European banks – Rabobank -- wanted to borrow the same amount in fixed rate Eurobonds. Salomon approached Rabobank and at last the bank agreed to the swap deal in principle. However, the bank voiced its concern over Goodrich’s low rating, which could expose the bank to a credit risk. It was at this juncture that Morgan Guaranty Bank (Morgan) came into the picture. Morgan acted as a swap dealer between Goodrich and Rabobank and executed two swap deals, one each with Goodrich and Rabobank for a one time initial fee and annual fees for 8 years. Morgan undertook to guarantee of payment in case of default by any party. At last, the swap deal was executed successfully.