DERIVATIVES R US/V1N16/Interest Rate Swaps
VOLUME 1, NUMBER 16/June 19, 1995
This issue deals with the topic of interest rate swaps. If you've been with me from the start, I discussed swaps in general in Volume 1, Number 2, February 27 (If you don't have this one and want it, skip to the end of this issue for information on how to retrieve it). The largest volume of swaps is in the interest rate area and are, accordingly, called "interest rate swaps."
An interest rate swap is a contract between two parties in which each party agrees to make a series of interest payments to the other on scheduled dates in the future. Each interest payment is computed using a different formula.
For example, let's take the simplest interest swap, called the "plain vanilla" or "fixed for floating rate swap." Let's say that today, June 19, let XYZ corporation agree to make payments to a swap dealer, which we'll call ABC Bank, each December 19 and June 19 for the next three years. The interest payments will be based on a dollar principal amount of $20 million, which is called the Notional Principal. The payment dates are called "settlement dates." Let XYZ promise to pay ABC interest at a fixed rate of 9 percent. ABC promises to pay XYZ interest at the LIBOR (Eurodollar) rate in effect exactly six months prior to each settlement payment date.
Thus, today we observe LIBOR and consequently XYZ and ABC know what the first payment will be on December 19. Normally only the net payment (i. e., the net amount that one party owes the other) is made. On December 19, we'll observe LIBOR and that will determine the payment on the following June 19. Thus, while the first LIBOR-based or floating payment is known, all of the remaining floating payments are not yet known. Thus, you can see that XYZ in effect buys a claim on a series of interest payments at LIBOR by agreeing to make interest payments at 9 percent. The actual payments are computed as (LIBOR - 9) X (Notional Principal) X (# of days in the six month period /360)/100 although there are some slight variations.
Some people find it a bit confusing that LIBOR at the beginning of the period sets the rate paid at the end of the period. To see this, let us consider why XYZ may have entered into the swap. Suppose XYZ was currently engaged in a loan with three years left with payments reset every six months on June 19 and December 19 according to LIBOR. XYZ will probably pay LIBOR plus so many basis points. Thus, at the beginning of each six month period XYZ finds out its new interest rate and makes its interest payment six months later. Thus, XYZ is highly exposed to interest rate risk. By entering into the swap, XYZ's exposure is eliminated. Any increase in the interest it owes is offset by an increase in the interest it receives on the swap. In effect, XYZ has converted a floating rate loan to a fixed rate loan at 9 percent plus the spread over LIBOR.
Why did XYZ do this? Perhaps it could have gotten a fixed rate loan in the first place. But that is not always possible. Perhaps XYZ sees this as a more attractive deal. That is possible but if XYZ did not do the swap, it would be a debtor and face no credit risk. With the swap, it assumes the risk that ABC will default. So maybe it saves a little for taking on the risk that the bank will default. Perhaps XYZ took out the floating rate loan awhile back, thinking rates would fall. Now it thinks rates will rise. The swap allows it to change the loan to a fixed rate loan. Moreover, the swap is a very efficient instrument. It can be constructed at extremely low cost and is probably cheaper than taking out a new fixed rate loan and using the proceeds to buy an offsetting floating rate security paying LIBOR. Technically this would accomplish the same thing but it would surely be much more costly and time consuming to set up.
The term structure of interest rates and the forward rates implied by the relationship between short and long term rates is critical to the evaluation of a swap. When initiated the swap has no value to either party. It is neither an asset nor a liability. The present value of the fixed payments equals the present value of the floating payments that are implied by the forward rates in the current term structure of interest rates. If the term structure does not change, neither party will gain or lose at the expense of the other on the swap. However, if interest rates rise, XYZ will gain on ABC because XYZ pays fixed and receives floating. The swap will have positive (negative) value to XYZ (ABC) and can then be thought of as an asset (liability). The actual numerical value is computed by determining the present value of the floating payments implied by the new term structure minus the present value of the fixed payments.
The bank, acting as a dealer in interest rate swaps, determines the fixed rate that he is willing to pay against LIBOR. This rate, as noted above, equates the present value of the fixed payments to the present value of the floating payments, given that the floating payments are set at the forward rates implied in the current term structure. Then the dealer adds and subtracts so many basis points so that he quotes a higher rate that he will accept if he pays LIBOR and a lower rate that he will pay if he receives LIBOR. The actual quote is stated in terms of so many basis points over the rate on the U. S. Treasury note whose maturity is closest to the swap maturity. This protects the dealer in the event that he makes a quote just before interest rates make a sharp move.
The dealer will, of course, do numerous derivative transactions, including interest rate options and various other options, forward contracts, futures and swaps. The dealer will attempt to hedge his overall position, thereby earning the bid-ask spread.
The interest rate swap described here is the most elementary swap of them all. There are numerous variations and from time to time, I'll cover some of them.
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