Transcript Slide 1

Swaps
Chapter 26
Swaps
 CBs and IBs are major participants
– dealers
– traders
– users
 regulatory concerns regarding credit risk exposure
 five generic types of swaps
–
–
–
–
–
interest rate swaps
currency swaps
credit swaps
commodity swaps
equity swaps
Interest Rate Swap
 largest segment of global swap market
 basically a succession of forward contracts
on interest rates arranged by 2 parties
 FIs able to establish long-term hedge with
no need to roll over contracts like with
forwards and futures
 swap buyer
 swap seller
Plain Vanilla Interest Rate Swap
Example
– Consider money center bank that has raised
$100 million by issuing 4-year notes with
10% fixed coupons. On asset side: C&I loans
linked to LIBOR. Duration gap is negative.
DA - kDL < 0
– Second party is savings bank with $100
million in fixed-rate mortgages of long
duration funded with CDs having duration of
1 year.
DA - kDL > 0
Interest Rate Swaps
 We depict this fixed-floating rate swap
transaction in the following
Interest Rate Swaps
 The expected net financing costs for the FIs are
shown below
Interest Rate Swaps
 Assume that the realized path of LIBOR over the 4
year life of the contract would be as follows 9%,
9%, 7%, and 6% at the end of each of the 4 years.
The money center bank’s variable payments to the
thrift are indexed to these rates by the formula:
(LIBOR + 2%) * $100m
 The annual payments made by the thrift were the
same each year
10% * $100m.
End of year
1
2
3
4
One-Year
LIBOR
9%
9%
7%
6%
LIBOR +
2%
11%
11%
9%
8%
TOTAL
Pmt by
MCB
Pmt by thrift
Net Pmt by
MCB
Example 1
 A U.S. insurer has a positive repricing gap of $50
million and is worried that interest rates may fall,
reducing their profitability. A bank with a
considerable amount of mortgage loans has a
negative repricing gap of $50 million. The bank is
concerned that rates may rise, hurting their
profitability. The insurer does not have enough
rate sensitive (variable rate or short maturity)
liabilities, and the bank has too many. How can
risk be reduced to both parties?
Macrohedging with Swaps
 Assume a thrift has positive gap such that
DE = -(DA - kDL)A [DR/(1+R)] >0 if rates rise.
Suppose choose to hedge with 10-year swaps.
Fixed-rate payments are equivalent to
payments on a 10-year T-bond. Floating-rate
payments repriced to LIBOR every year.
Changes in swap value DS, depend on
duration difference (D10 - D1).
DS = -(DFixed - DFloat) × NS × [DR/(1+R)]
Macrohedging (continued)
 Optimal notional value requires
DS = DE
-(DFixed - DFloat) × NS × [DR/(1+R)]
= -(DA - kDL) × A × [DR/(1+R)]
NS = [(DA - kDL) × A]/(DFixed - DFloat)
Example 2
 Suppose DA=5, DL=3, k=.9, and
A=$100,000,000. Also assume the duration
of a current 10-year fixed-rate T-bond with
the same coupon as the fixed rate on the
swap in 7 years and the duration of a
floating-rate bond that reprices annually is 1
year. Solve for NS.
Currency Swaps
 swaps can be used to hedge currency risk similar
to the way they are used to hedge interest rate risk
– immunize FI against exchange rate risk when they
mismatch currencies of assets and liabilities
 Consider FI with all fixed-rate assets denominated
in dollars – financing part of asset portfolio with
50m issue of 4 year medium term British pound
sterling notes that have fixed annual coupon of
10%. There is a UK FI that has all assets
denominated in sterling – partly funding those
assets with $100m issue of 4-year, medium-term
dollar notes with a fixed annual coupon of 10%.
Currency Swaps
 Off the balance sheet, the U.K. and U.S. FIs
can enter into a fixed-fixed currency swap
by which the U.K. FI sends annual
payments in pounds to cover the coupon
and principal repayments of the U.S. FI’s
pound note issue, and the U.S. FI sends
annual dollar payments to the U.K. FI to
cover the interest and principal payments on
its dollar note issue.
Currency Swaps
Currency Swaps
Example 3
 Ohio Bank has all of its assets in dollars but
is financing some of them with an issue of
the equivalent of $75 million of 5 year fixed
rate notes denominated in British pounds.
Bulldog Bank, a British FI, has a net $75
million dollar fixed rate liability exposure.
How should the FIs manage their exposure?
Total Return Swaps
 swap involving an obligation to pay interest
at a specified fixed or floating rate for
payments representing the total return on a
loan or bond (interest and principal value
changes) of a specified amount
Example
 Suppose that an FI lends $100m to a Brazilian manufacturing firm at a
fixed rate of 10%. If the firm’s credit risk increases unexpectedly over
the life of the loan, the market value of the loan and consequently the
FI’s net worth will fall. The FI can hedge an unexpected increase in the
borrower’s credit risk by entering into a total return swap in which it
agrees to pay a total return based on an annual fixed rate plus changes
in the market value of Brazilian government debt (changes in the value
of these bonds reflect the political and economic events in the firm’s
home country and thus will be correlated with the credit risk of the
Brazilian borrowing firm.) Also the bonds are in the same currency (US
dollars) as the loans.
 The FI benefits from the total return swap if the Brazilian bond value
deteriorates as a result of a political or economic shock. Assuming that
the Brazilian firm’s credit risk deteriorates along with the local
economy, the FI will offset some of this loss of the Brazilian loan on its
balance sheet with a gain from the total return swap.
Pure Credit Swaps
 pure credit swap strips interest rate sensitive
element of total return swap – swap by which an
FI receives the par value of the loan on default in
return for paying a periodic swap fee (like an
insurance premium)
– if no default on loan, FI lender receives nothing back
from counterparty
– if loan defaults, FI counterparty will cover default loss by
making a default payment that is often equal to he par
value of the original loan minus the secondary market
value of the defaulted loan (at time of default)
Credit Risk with Swaps
 Credit risk on swaps is however generally much lower than
on loans of equivalent principle amounts because
 1. Only the net payment is due on the swap payment
dates, and this amount will be less than the typical interest
payment on a equivalent principle loan.
 2. Swap payments are often interest only and not
principle, so the notional principle is not at risk.
 3. If a swap partner is worried about the counterparty’s
creditworthiness they may require the counterparty to
obtain a standby letter of credit or to post collateral.