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Chapter 15 Swap Markets Outline Background Use of Swap for Hedging Use of Swamp for Speculating Participation by Financial Institutions Types of Interest Rate Swaps Plain Vanilla Swaps Forward Swaps Callable Swaps Putable Swaps Extendable Swaps Zero-Coupon-for-Floating Swaps Rate-Capped Swaps Equity Swaps Other Types of Swaps Risks of Interest Rate Swaps Basis Risk Credit Risk Sovereign Risk Pricing Interest Rate Swaps Prevailing Market Interest Rates Availability of Counterparties Credit and Sovereign Risk Performance of Interest Rate Swaps Interest Rate Caps, Floors, and Collars Interest Rate Caps Interest Rate Floors Interest Rate Collars Credit Default Swaps Secondary Market for CDS Contracts Collateral on CDS Contracts Payments on a Credit Default Swap How CDSs Affect Debtor-Creditor Negotiations Development of the CDS Market Impact of the Credit Crisis on the CDS Market Reform of CDS Contracts Globalization of Swap Markets Currency Swaps Key Concepts 1. Remind students as to how interest rate movements can adversely affect the performance of various financial institutions. 2. Describe how financial institutions participate in swap markets. 3. Explain in general terms how interest rate swaps can hedge interest rate risk. 4. Identify the various types of interest rate swaps, and the advantages of each. POINT/COUNTER-POINT: Should Financial Institutions Engage in Interest Rate Swaps for Speculative Purposes? POINT: Yes. They have expertise in forecasting future interest rate movements and can generate gains for their shareholders by taking speculative positions. COUNTER-POINT: No. They should use their main business to generate gains for their shareholders. They should serve as intermediaries for swap transactions only to generate transaction fees, or take a position only if it is to hedge their exposure to interest rate risk. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Either argument has some validity. There is risk from speculating in interest rate swaps. A financial institution could incur losses from its speculative positions, which may offset some or all of its gains from its other operations. In addition, its credit rating may be reduced if it takes excessive risk. Questions 1. Hedging with Interest Rate Swaps. Bowling Green Savings & Loan uses short-term deposits to fund fixed-rate mortgages. Explain how Bowling Green can use interest rate swaps to hedge its interest rate risk. ANSWER: Bowling Green could engage in a fixed-for-floating swap. If interest rates rise, its inflow payments resulting from the swap will rise while its outflow payments will remain stable. Thus, its gain from the swap arrangement can offset any reduction in its profits that result from a higher cost of funds. 2. Decision to Hedge with Interest Rate Swaps. Explain the types of cash flow characteristics that would cause a firm to hedge interest rate risk by swapping floating-rate payments for fixed payments. Why would some firms avoid the use of interest rate swaps, even when they are highly exposed to interest rate risk? ANSWER: Interest rate swaps can possibly reduce potential returns. Consider a savings institution that uses short-term deposits to finance fixed-rate mortgages. This institution will typically experience higher profits when interest rates decline. Under these conditions, a fixed-for-floating interest rate swap would generate a loss, since its inflow payments from the swap would decline over time while its outflow payments would be stable. 3. Role of Securities Firms in Swap Market. Describe the possible roles of securities firms in the swap market. ANSWER: Securities firms can act as an intermediary by matching up firms that have opposite swap needs. They also can act as a dealer by taking the counter-position in a swap desired by a client. If a firm’s business resulted in fixed-rate outflows and floating-rate inflows, it would be adversely affected by a decline in interest rates. To hedge against this form of interest rate risk, it could swap floating-rate payments in exchange for fixed-rate payments. 4. Hedging with Swaps. Chelsea Finance Company receives floating inflow payments from its provision of floating-rate loans. Its outflow payments are fixed because of its recent issuance of long-term bonds. Chelsea is concerned that interest rates will decline in the future. Yet, it does not want to hedge its interest rate risk, because it believes interest rates may increase. Recommend a solution to Chelsea’s dilemma. ANSWER: Chelsea could negotiate a putable swap, which represents a floating payment in exchange for fixed payments, with an option to terminate the swap. If interest rates rise, Chelsea could terminate the swap. If interest rates fall, Chelsea will benefit from the swap. 5. Basis Risk. Comiskey Savings provides fixed-rate mortgages of various maturities, depending on what customers want. It obtains most of its funds from issuing certificates of deposit with maturities ranging from one month to five years. Comiskey has decided to engage in a fixed-for-floating swap to hedge its interest rate risk. Is Comiskey exposed to basis risk? ANSWER: Yes. Comiskey’s liabilities are more rate-sensitive than its assets, but it is difficult to determine the degree. Thus, the interest rate swap will not completely eliminate its interest rate risk. 6. Fixed-for-Floating Swaps. Shea Savings negotiates a fixed-for-floating swap with a reputable firm in South America that has an exceptional credit rating. Shea is very confident that there will not be a default on inflow payments because of the very low credit risk of the South American firm. Do you agree? Explain. ANSWER: No. While the credit risk is low, the sovereign risk may be high, since the government could possibly restrict the firm from sending payments. 7. Fixed-for-Floating Swaps. North Pier Company entered into a two-year swap agreement, which would provide fixed-rate payments for floating-rate payments. Over the next two years, interest rates declined. Based on these conditions, did North Pier Company benefit from the swap? ANSWER: No. The fixed-rate payments owed by North Pier over the two years would likely have exceeded the floating-rate payments received as a result of the swap arrangement. 8. Equity Swap. Explain how an equity swap could allow Marathon Insurance Company to capitalize on expectations of a strong stock market performance over the next year without altering its existing portfolio mix of stocks and bonds. ANSWER: An equity swap involves the exchange of interest payments (based on a specified interest rate) for payments linked to the degree of change in a stock index. Marathon Insurance Company could engage in an equity swap in which it exchanges interest payments for payments linked to the appreciation in the S&P 500 index. If the S&P 500 index appreciates over the next year by a percentage that exceeds the interest rate specified in the swap arrangement, Marathon will receive a dollar amount that equals the differential (percentage increase in stock index value minus the specified interest rate) multiplied by the notional principal value specified in the swap arrangement. 9. Swap Network. Explain how the failure of a large commercial bank could cause a worldwide swap credit crisis. ANSWER: Assume the commercial bank has taken positions in numerous swaps and guaranteed payments on other swaps. As it fails, it will default on its swap payments. The counterparties of these swaps may experience cash flow problems if they do not receive the payments dictated by the swap agreement. Consequently, they may default on other swap agreements or on other financial agreements, causing cash flow problems for other firms. The globalized swap network could allow the problems of one large intermediary to spread across countries. 10. Currency Swaps. Markus Company purchases supplies from France once a year. Would Markus be favorably affected if it establishes a currency swap arrangement and the dollar strengthens? What if it establishes a currency swap arrangement and the dollar weakens? ANSWER: Markus could engage in a currency swap arrangement in which it agrees to swap dollars for euros once a year. The currency swap arrangement would have backfired on Markus in the period when the dollar strengthened. However, it would have been beneficial to Markus in the period when the dollar weakened. 11. Basis Risk. Explain basis risk as it relates to a currency swap. ANSWER: Basis risk would reflect the hedging of a position in a foreign currency with a swap in a highly correlated currency (assuming that a swap does not exist for the currency in which the firm has a position). Basis risk occurs because the two currencies probably do not move in perfect tandem. 12. Sovereign Risk. Give an example of how sovereign risk is related to currency swaps. ANSWER: An example of sovereign risk is that the government of a country could suspend the convertibility of the home currency. Consequently, a counterparty on a currency swap arrangement may be restricted from meeting its obligation. 13. Use of Interest Rate Swaps. Explain why some companies that issue bonds engage in interest rate swaps in financial markets. Why do they not simply issue bonds that require the type of payments (fixed or variable) that they prefer to make? ANSWER: In some cases, the premium paid by a risky firm when issuing fixed-rate bonds may be higher than if it issues variable-rate bonds. Thus, it may prefer to issue variable-rate bonds even if it desires to make fixed payments. An interest rate swap will allow the firm to receive variable-rate inflows for fixed-rate outflows. The inflows could be used to cover its payments to bondholders. Some firms may prefer to issue a variable-rate bond but have an advantage in issuing fixed-rate bonds. Thus, it would issue fixed-rate bonds and engage in a swap to exchange variable-rate payments for fixed-rate payments. The fixed-rate payments received could be used to make payments to bondholders. 14. Use of Currency Swaps. Explain why some companies that issue bonds engage in currency swaps. Why do they not simply issue bonds in the currency that they would prefer to use for making payments? ANSWER: Companies may not be well known in the country where the bonds denominated in a particular currency could most easily be placed. Therefore, they may issue bonds in a different country and denominated in a different currency. They could agree to swap whatever currency they normally receive in the form of cash inflows for the currency they will need to pay coupon payments or principal on the bonds at specified points in time. Advanced Questions 15. Rate-Capped Swaps. Bull and Finch Company wants a fixed-for-floating swap. It expects interest rates to rise far above the fixed rate that it would pay and remain very high until the swap maturity date. Should it consider negotiating for a rate-capped swap with the cap set at two percentage points above the fixed rate? Explain. ANSWER: Bull and Finch should not consider the rate-capped swap because it would restrict the potential interest payments received. Based on its expectations, it would forgo large payments with a cap, which would more than offset the up-front fee received for agreeing to a cap. 16. Forward Swaps. Rider Company negotiates a forward swap to begin two years from now, in which it will swap fixed payments for floating-rate payments. What will be the effect on Rider if interest rates rise substantially over the next two years? That is, would Rider be better off by using this forward swap than if it had simply waited two years before negotiating the swap? Explain. ANSWER: Rider would have been better off with the forward swap, because the fixed rate specified in the forward swap would be lower than the fixed rate specified two years later (since the fixed rate negotiated at any time will be somewhat dependent on prevailing rates at that time). By using a forward swap, Rider would have been able to lock in a lower rate on its fixed outflow payments in the swap arrangement. 17. Swap Options. Explain the advantage of a swap option to a financial institution that wants to swap fixed payments for floating payments. ANSWER: A swap option would allow the financial institution to terminate the swap arrangement prior to maturity. If interest rates were declining instead of rising, this institution may be better off without a swap arrangement. 18. Callable Swaps. Back Bay Insurance Company negotiated a callable swap involving fixed payments in exchange for floating payments. Assume that interest rates decline consistently up until the swap maturity date. Do you think Back Bay might terminate the swap prior to maturity? Explain. ANSWER: Back Bay Co. would probably have terminated the swap since the inflow payments received were consistently declining while the outflow payments made were constant. 19. Credit Default Swaps. Credit default swaps were once viewed as a great innovation for making mortgage markets more stable. Yet, the swaps were sometimes criticized for making the credit crisis worse. Why? ANSWER: Credit default swaps protect securities against default, but the protection is only as strong as the seller of the swaps. Some financial institutions that sold credit default swaps were subject to failure, which means that all the securities that they were protecting might not be protected. Therefore, the credit default swaps encouraged some investors to take the risk of buying risky mortgage-backed securities that they thought were backed by the swap, which led to even more risk when considering that the sellers of swaps might default. 20. Credit Default Swap Prices. Explain why the failures of Lehman Brothers caused prices on credit default swap contracts to increase. ANSWER: The credit crisis illustrated how protection provided to buyers of a CDS is only as good as the creditworthiness of the CDS seller. Participants recognized that the government will not automatically rescue all large financial institutions. Sellers of new CDS contracts required higher payments because the risk premium on the CDS contracts increased. The sellers were only willing to sell CDS contracts if they received higher payments in order to compensate for the higher risk. 21. Reform of CDS Contracts. Explain how the Financial Reform Act of 2010 attempted to reduce the risk in the financial system resulting from the use of credit default swaps. ANSWER: As a result of the Financial Reform Act of 2010, derivative securities such as swaps are to be traded on an exchange or clearinghouse. One obvious result of having derivatives traded on an exchange or clearinghouse instead of over-the-counter is that the derivative contracts should become more standardized. Second, the pricing of these contracts should become more transparent, as the exchange should post prices paid for the standardized derivative contracts that are traded on the exchange. Third, the use of standardized contracts should increase the trading volume, which should reduce the uncertainty surrounding the price of a standardized derivative contract. Fourth, market participants and regulators should be more informed about the usage of particular swap contracts if they are traded on an exchange, because the exchange should publicize the trading volume per contract. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The swaps market is another Wall Street-developed house of cards.” There is a concern that the swaps market could overexpose some banks so if swap arrangements are adversely affected, banks will be devastated. Many swap arrangements are linked in various ways, so that defaults could cause a domino effect throughout the banks in this market. b. “As a dealer in interest rate swaps, our bank takes various steps to limit our exposure.” Any provisions that could force clients to meet their swap obligations would help protect banks. Regulators could assess the historical default rate on swaps and force banks to maintain a capital level that would absorb the possible losses under most conditions. c. “The regulation of commercial banks, securities firms, and other financial institutions that participate in the swaps market could create a regulatory war.” Regulations vary across financial institutions, so that one dealer in swaps may receive more favorable treatment (less regulation) than another dealer. Managing in Financial Markets As a manager of a commercial bank, you have just purchased a three-year interest rate collar, with LIBOR as the interest rate index. The interest rate cap specifies a fee of 2 percent of notional principal valued at $100 million and an interest rate ceiling of 9 percent. The interest rate floor specifies a fee of 3 percent of the $100 million notional principal and an interest rate floor of 7 percent. Assume that LIBOR is expected to be 6 percent, 10 percent, and 11 percent, respectively, at the end of each of the next three years. Determine the net fees paid, and also determine the expected net payments to be received as a result of purchasing the interest rate collar. The net payments are derived as follows: End of Year:
0 1 2 3
LIBOR 6% 10% 11%
Purchase of Interest Cap: Interest Rate Ceiling 9% 9%` 9%
LIBOR’s Percentage Points Above the Ceiling 0% 1% 2%
Payments Received (Based on $100 Million of Notional Principal) $0 $1,000,000 $2,000,000
Fee Paid $2,000,000
Sale of Interest Rate Floor: Interest Rate Floor 7% 7% 7%
LIBOR’s Percentage Points Below the Floor 1% 0% 0%
Payments Made (Based on $100 Million of Notional Principal) $1,000,000 $0 $0
Fee Received $3,000,000
Fees Received Minus Fee Paid $1,000,000
Payments Received Minus Payments Made $1,000,000 $1,000,000 $2,000,000
b. Assuming you are very confident that interest rates will rise, should you consider purchasing a callable swap instead of the collar? Explain. The interest collar is most appropriate if you are confident that interest rates will rise. The callable swap allows you flexibility to terminate the swap agreement in the event that interest rates do not rise. However, you pay a premium for this flexibility in the form of a higher fixed interest rate. You should not be willing to pay this premium if you do not expect to capitalize on the flexibility. c. Explain the conditions under which your purchase of an interest rate collar could backfire. If interest rates decline rather than rise, you will not receive any payments on the interest rate cap. Yet, you would have to make payments because of your obligation to the party that purchased an interest rate floor from you. Problems 1. Vanilla Swaps. Cleveland Insurance Company has just negotiated a three-year plain vanilla swap in which it will exchange fixed payments of 8 percent for floating payments of LIBOR + 1 percent. The notional principal is $50 million. LIBOR is expected to 7 percent, 9 percent, and 10 percent, respectively, at the end of each of the next three years. a. Determine the net dollar amount to be received (or paid) by Cleveland each year. ANSWER: End of Year:
1 2 3
LIBOR 7% 9% 10%
Floating Rate Received 8% 10% 11%
Fixed Rate Paid 8% 8% 8%
Swap Differential 0% 2% 3%
Net Dollar Amount Received (Based on a Notional Value of $50 Million) $0 $1,000,000 $1,500,000
b. Determine the dollar amount to be received (or paid) by the counterparty on this interest rate swap each year based on the assumed forecasts of LIBOR. ANSWER: Year 1 = $0; Year 2 = $1,000,000 paid; Year 3 = $1,500,000 paid 2. Interest Rate Caps. Northbrook Bank purchases a four-year cap for a fee of 3 percent of notional principal valued at $100 million, with an interest rate ceiling of 9 percent, and LIBOR as the index representing the market interest rate. Assume that LIBOR is expected to be 8 percent, 10 percent, 12 percent, and 13 percent, respectively, at the end of each of the next four years. a. Determine the initial fee paid, and also determine the expected payments to be received by Northbrook if LIBOR moves as forecasted. ANSWER: End of Year:
0 1 2 3 4
LIBOR 8% 10% 12% 13%
Interest Rate Ceiling 9% 9% 9% 9%
LIBOR’s Percentage Points Above the Ceiling 0% 1% 3% 4%
Payments to be Received (Based on $100 Million of Notional Principal $0 $1,000,000 $3,000,000 $4,000,000
Fee Paid $3,000,000
b. Determine the dollar amount to be received (or paid) by the seller of the interest rate cap based on the assumed forecasts of LIBOR. ANSWER: End of Year 0 = $3,000,000 received Year 1 = $0 Year 2 = $1,000,000 paid Year 3 = $3,000,000 paid Year 4 = $4,000,000 paid 3. Interest Rate Floors. Iowa City Bank purchases a three-year interest rate floor for a fee of 2 percent of notional principal valued at $80 million, with an interest rate floor of 6 percent, and LIBOR representing the interest rate index. The bank expects LIBOR to be 6 percent, 5 percent, and 4 percent respectively at the end of each of the next three years. a. Determine the initial fee paid, and also determine the expected payments to be received by Iowa City if LIBOR moves as forecasted. ANSWER: End of Year:
0 1 2 3
LIBOR 6% 5% 4%
Interest Rate Floor 6% 6% 6%
LIBOR’s Percentage Points Below the Floor 0% 1% 2%
Payments to be Received (Based on $80 Million of Notional Principal) $0 $800,000 $1,600,000
Fee Paid $1,600,000
b. Determine the dollar amounts to be received (or paid) by the seller of the interest rate based on the assumed forecasts of LIBOR. ANSWER: End of Year 0 = $3,000,000 received Year 1 = $0 Year 2 = $1,000,000 paid Year 3 = $3,000,000 paid Year 4 = $4,000,000 paid Flow of Funds Exercise Hedging with Interest Rate Derivatives Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. Carson currently relies mostly on commercial loans with floating interest rates for its debt financing. It has contacted Blazo Bank about the use of interest rate derivatives to hedge the risk. How could Carson use interest rate swaps to reduce the exposure of its cost of debt to interest rate movements? Carson could engage in a swap of fixed interest rates in exchange for floating interest rates. If interest rates increased as anticipated, Carson would receive higher inflow payments from the swap arrangement over time, but its outflow payments would remain constant. This would help to offset its higher cost of debt financing as the interest rate charged on its floating-rate loans increases. b. What is a possible disadvantage of Carson using the interest rate swap hedge as opposed to no hedge? If interest rates decline, Carson would incur lower debt financing costs on its floating-rate loans. Yet, the reduction in debt financing costs would be partially offset by the cost of an interest rate swap, as its fixed outflow payments would exceed its floating inflow payments from the swap. c. How could Carson use an interest rate cap to reduce the exposure of its cost of debt to interest rate movements? Carson could purchase an interest rate cap, in which it would receive payments if market interest rates increased beyond a specified level. These payments could help to offset the higher cost of the debt financing. d. What is a possible disadvantage of Carson using the interest cap hedge as opposed to no hedge? If interest rates decline, Carson would still incur a cost from the interest rate cap, but would not receive any benefits. The reduction in debt financing costs would be partially offset by the cost of an interest rate cap. Explain the tradeoff from using an interest rate swap versus an interest rate cap. The profit from an interest rate swap would be more closely matched to the increase in debt financing costs from the use of a floating-rate loan. Conversely, the cap does not offset any increase in debt financing costs until the interest rates exceed a specific level. However, if interest rates decline, the interest rate swap used by Carson would require net outflow payments, while the interest rate cap would not require additional payments. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
