The Interest Rate Swap

DESCRIPTION

An Interest Rate Swap is an exchange of cashflows for a prescribed period on prescribed dates. One Party receives a FIXED rate of interest in return for paying a FLOATING rate of interest. There is no exchange of principal but the interest amounts are calculated on a defined notional principal. The floating side of the swap is usually priced against Libor, although it depends on the local market convention.

An Interest Rate Swap is an agreement between two parties to exchange interest payments based upon a specified notional principal amount for a specified term. One interest payment is typically calculated using a floating rate index such as LIBOR or Prime. The other interest payment is based upon a fixed rate or a different floating rate index. In either case, there is no exchange of principal.

Suppose a borrower has a 7-year commercial mortgage tied to 1 month LIBOR. The company is concerned about rate volatility during the life of the loan. To mitigate the risk, the borrower decides to "swap" its floating rate for a fixed rate. In the swap transaction, the company pays a fixed rate of, say, 7.00% to its swap counterpart, HSBC Bank, in exchange for receiving LIBOR.  

The swap cash flows are based on a principal schedule that matches the outstanding loan. Therefore, the LIBOR payment that the company receives from HSBC offsets the LIBOR payment (excluding the credit margin) that the company owes to its lenders.

 Note that the borrower has engaged in two separate transactions: (1) a loan and (2) a swap. In the loan transaction, the company is making floating rate interest payments (LIBOR plus borrowing spread) to its lenders. In the swap transaction, the company is making or receiving payments based on the difference between LIBOR and the swap rate. 

The net result is that the borrower has effectively created a fixed rate on the loan, and is immunized against movements in LIBOR. This example is for illustrative purposes only and may not reflect current economic conditions or realities. 

This is not an offer to sell or a solicitation of an offer to purchase any security or other financial instrument described herein. Foreign exchange and interest rate derivatives involve a high degree of risk including, but not limited to, loss of principal, and may not be suitable for all investors or customers.

An Interest rate Swap can be thought of as a synthetic Bond: receiving a fixed rate of interest is akin to holding a bond, while payment of a floating rate resembles the funding costs of this long bond position. The reverse is also true - a "Pay Side" Interest Rate Swap synthesises a short bond position. Swaps are the most common form of interest rate derivative.

This is a short introduction to Interest Rate Swaps, the most widely traded Derivative product. The main uses of this instrument are as a risk hedge and in portfolio management. There are a number of different types of swaps as shown in the table below.We will explain in more detail the most common instrument used in Tokyo the 2-10 year (medium term) YEN-YEN swap.

Interest Rate Swap

 

CCY A

CCY B

Fixed

Floating

Fixed

Floating

CCY A

Fixed

None

Interest Rate Swap

Currency Swap

Cross Currency Swap

Floating

Interest Rate Swap

Basis Swap

Cross Currency Swap

Cross Currency Basis Swap

Characteristics of IRS

An interest rate swap is an agreement between two parties whereby the payment or receipt of fixed interest is exchanged for the payment or receipt of floating (Variable rate) interest

The interest payments are based on NOTIONAL PRINCIPAL which is used purely for the calculation of these payments. In IRS there is no exchange of capital therefore the trade does not appear on the asset or liabilities side of the balance sheet. Off Balance Sheet (OBS) and the resulting flexibility of credit risk has fuelled the phenomenal growth in this instrument.

2. An explanation of RATE

In a YEN-YEN swap a ten year 5% swap indicates the fixed rate for that tenor. The floating rate would usually be calculated against 6 month Euroyen, LIBOR (The calculation will be made semi-annually, 20 times within this tenor.).

Looked at another way 5% is the expected (implied) cumulative value of cashflow for twenty calculations of LIBOR, with respect to the value of todays LIBOR, expressed as a fixed rate.

The market rate will accurately reflect this calculation otherwise one of the parties in the exchange of fixed for floating interest will be at an undue advantage.

This rate is the expectation of future cashflows, as LIBOR changes this implied rate will change. There will be profit and loss exposure as market and non market factors affect short term interest rates.

Name

Expectation of interest
Rate movement

Fixed

Floating

Offer, Receiver

Fall

Receive

Pay

Bid, Payer

Rise

Pay

Receive

3. RATE movement.

The movement of medium term swaps are inexorably linked to the main indication of long term interest rates Japanese Government Bonds (JGB)

The main indicators followed by the market are JGB futures, an exchange traded instrument, and the current benchmark JGB cash yield. Some market participants are trading the differential between swaps and JGB instruments. This is called Spread trading.

4. Market application of IRS

Below are two potential scenarios of corporate demand.

Name

Current loan
requirement

Expectation of
interest
rate movement

Result without
swap hedge

Possible swap
hedge

A

Borrowing at Long
term fixed rate

Interest rates
to fall

No benefit due
to fixed cost
of funding

Receive Fixed
Pay Floating

B

Borrowing at short
term prime rate

Interest rates
to rise

Cost of borrowing
will increase

Pay Fixed
Receive Floating

Both corporates can benefit without the necessity of reviewing or changing the original loan agreement.
Company A pays floating rate to Company B against receiving fixed rate from company B. The cost of the fixed rate to equal current loan obligation. Company A will pay the floating rate to B at a reducing rate.
Company B receives floating rate from company A against paying fixed rate. The floating rate covers the cost of borrowing at current levels.

Usually Japanese Banks, except long term credit and trust Banks, are unable to fund themselves using medium and long term instruments. In a scenario where the Bank pays fixed-receives floating rate interest it is effectively the same as long term funding.

Money Flow for Bid (Payers) side


Opposite for Offer (Receivers) side.

A Bank extends a loan to a customer and wishes to fund this in the market. The traditional method followed is to borrow, consecutively for the life of the loan, for six month periods from the Euroyen deposit market. This funding action is known as ROLLOVER. For exampIe; in the life of a ten year loan there will be twenty separate but consecutive borrowings. The Interest the Bank receives is fixed at 6% but the cost to the bank is undecided as interest rate rise and falls are unpredictable.
When the Bank asks the Broker the Ten Year fixed rate if the offer is 5% it pays that offer.
The bank receives interest at 6% from the customer and pays 5% to the market counterparty he is guaranteed a profit of 1% over the life of the loan. The bank then receives floating rate interest every six months from the counterparty calculated against Euoryen futures LIBOR. This will equal the banks cost if he were to continue to fund in the Euroyen deposit market. This will continue for the life of the swap ensuring the banks 1% profit and hedging his floating rate risk.
This is a very effective hedging solution for Banks selling Mortgages and Corporate finance.

ALM is a total approach to the minimizing of risk and maximizing of return by holding and repositioning the combination of Assets and Liabilities held.

Attractive profits can be made by taking an open position on the future movements in interest rates and realizing the differential between the rate of the position and the future market rate.
However the leveraged nature of derivative products means the prospects of huge profits must be reconciled with the risk of huge losses. Extremely expensive hard and software solutions combined with highly qualified personnel are the only way to to control risk via speculation.

5.The Brokers Role

The strength of the Over The Counter (OTC) market where Brokers operate, as opposed to exchange based trading , is the flexibility of the Instruments Tenor, Start and End dates, Payment Cycle, Amount etc in fact while there are benchmark instruments bespoke contracts are common. Conversely matching the custom interests is complicated and time consuming. The Broker excels at this using his knowledge of the market, customers respective interests, credit concerns etc to provide depth and focus to an otherwise disjointed environment

6. Swaps. A brief history

While the origin of Swaps lie in the Parallel loan markets of the 1970's when many countries restricted cross border capital flows Swap trading began in earnest circa 1982. Yen-Yen swaps emerged about 2 years later. Initially accounting and tax regulations were unclear and this restricted growth in the market. Clarification of these regulations and liberalization of the yen market combined with worldwide growth in the use of swaps led to an explosion in the use of Yen-Yen swaps. Swaps have become one of the standard tools for corporates and financial institutions. The current size of the market (Notional Amount) is 50 Trillion yen per year.

THE BROKER

In the following scenario the two year Yen-Yen swap is;

2 Year Swap

Offer

Bid

1.51%, A Bank

1.495%, B Bank

Bank A wants to receive fixed rate interest at 1.51% -pay floating rate (6 month Euroyen LIBOR) . Bank A is expecting interest rates to fall and wishes to hedge against this possibility.

Bank B wants to pay fixed rate at 1.495% -receive floating rate (6 month Euroyen LIBOR). Bank B is expecting interest rates to rise and wishes to hedge against this possibility.

To bring this rate to the market the brokers will quote to their customers as follows, "Two year fifty one -forty nine and a half" . The market custom is to not quote the elements of the price that are mutually understood .

When two parties agree on a rate they must immediately check their credit line for each other. Unlike a deposit where the money lender checks the creditworthiness of the borrower both parties must check because funds will move to and from each party.

Each party will then confirm the Notional Amount and check which documentation will validate the trade. Medium term swaps invariably use ISDA Documentation while short swaps (within two years) vary between ISDA and BBA documentation.

Immediately following the deal Ueda Butler will send a fax or Telex to both parties confirming the most important details.

The confirmation will always include a disclaimer to the effect that we are acting as agents between interested parties and our function is limited to their mutual introduction. We are not responsible for or imply any guarantee of the creditworthiness of our clients nor for the performance of the transaction in the future. Ueda Butler do not take any positions as a principal so its credit is not questioned.

EXAMPLE 2

An investor is of the view that interest rates in Germany will decline over the course of the year, particularly in the five year sector of the yield curve. The investor could enter into a five year interest rate swap where they RECEIVE fixed rate on say Dem10mm semi-annually, and pay German 6mth Libor. No monies are exchanged at the inception of the deal, but the Libor rate would be set according to a "Fixing" index, such as that prepared by the British Bankers Association on Telerate page 3750. At the end of the first six-month period, there is just one net interest payment. The investor would receive the difference if the Libor rate set at the beginning of the period was lower than the Fixed rate on the Swap, and would pay the difference if Libor was higher.

If after one year, rates have actually fallen, and the investor wants to take profit, they may close out the swap. The main influence on the profit/loss will be the four year swap rate, and whether it is higher or lower than the established fixed rate on the swap agreement. If the prevailing four year rate is lower than the fixed rate, then the investor would receive the difference of the discounted cashflows. The movement in Libor will also affect the price.

Borrowers commonly use swaps to convert the interest rate exposure of loans from floating rate to fixed and vice versa. A corporate may have a 3yr Esp loan on which they pay Libor plus 50bp. If they believe that interest rates are going to rise over the next 3 years, they can enter into an interest rate swap where they RECEIVE Esp Libor to compensate for the payment on the loan, and PAY a fixed rate for 3 yrs. The net cost of funds to the borrower has now been converted from Esp Libor plus 50bp to the 3yr Esp Fixed swap rate plus 50bp.

The swap agreement is completely separate from the underlying asset or liability and is used as an "overlay" product to manage the exposures created.

PRICING

The price of an Interest Rate Swap is that level at which the market is indifferent between paying a FIXED rate of interest, and a stream of Libor. It therefore depends wholly on the implied forward libor rates (see "Implied Forwards"). A swap can be therefore be thought of as a series of FRAs all with the same strike.

In the professional market, a "Swap Bid" is that price that they would "Buy" a stream of Libor-linked cashflows, and the "Offer" is the price at which they would be willing to "sell" a stream of Libor-linked cashflows.

TARGET MARKET

Because there is no principal exchanged with an interest rate swap, there can be no foreign exchange risk on that principal. This is a major advantage when comparing to alternative strategies (buying bonds for example).
Swaps can be used as a hedge to lock in the future cost of borrowing or to lock in the future rate of return on an investment. They can also be used as a speculative tool for those wishing to take a view on the future direction of interest rates.

Unlike caps and floors, the loss potential on swaps is not limited and therefore are inherently more risky, but also provide larger potential returns.

A swap is an ideal alternative to those who buy Bonds with many advantages. Swap markets exist in all major and most minor currencies.

ADVANTAGES

DISADVANTAGES

PRODUCT SUITABILITY

Complex Defensive, Complex Aggressive.