MECHANICS OF AN INTEREST RATE SWAP

Ahmad Sharif Pour

Date: June 1, 2011

AGENDA

Overview of Interest Rate Swap Valuing Interest Rate Swap Risks Associated with Interest Rate Swap Reasons for the Rapid Growth of Interest Rate

Swap Market.

INTEREST RATE SWAP

Interest rate swap transactions began in 1981 Eurobond as principal security

The largest component of the OTC interests rate derivatives market As of December 2010, national amount

outstanding ($364 trillion) Gross market value ($13 trillion)

AN OVERVIEW OF INTEREST RATE SWAPS

An agreement between two counterparties Exchange periodic interest payments based on

predetermined principal value Time frame Notional principal amount Fixed interest rate (Fixed-rate payer) Floating interest rate (Floating-rate payer)

Treasury bills, LIBOR (London Interbank Offered Rate), commercial paper, bankers acceptance, certificates of deposit, federal funds rate, and prime rate

Payment dates

Firm A (Payer) Firm B (Receiver)

Floating Rate

Fixed Rate

Time Frame: 5 yearsNotional principal amount: $50 MillionFixed rate: 10%Floating rate: six-month LIBORPayment dates: Every six months

HOW INTEREST RATE SWAPS ARE USED

Applications of Interest Rate Swaps Alter Cash flow of asset to provide a better

match between assets and liabilities Asset Swap

Alter cash flow of assets from fixed to floating or from floating to fixed without affecting the underlying assets.

Liability Swap Alter cash flow of liabilities from fixed to floating

or from floating to fixed without affecting the underlying assets

ASSET SWAP

Firm AFinancial

IntermediaryLIBOR + 40 bps

10%

Firm B

LIBOR + 150 bps

Bond Bond

9.5%10%

LIBOR + 60 bps

Net = [(LIBOR + 150 bps + 10%) - LIBOR + 60bps] = 10.9%

Net = [(10%+ LIBOR + 40bps) – 9.5%] = LIBOR + 90bps

Financial Intermediary Net: .7%

INTEREST RATE SWAP VALUATION

Summing the present value of cash flow

1st step: calculate the present value of floating rate payments

2nd step: calculate the present value of the notional principal. Then, multiply it by the days in the period LIBOR futures rate as discount rate

3rd step: calculate the swap rate Divide the results from step 1 by results from step 2

Result is the fixed rate that the party is willing to pay in return for receiving the 6-month LIBOR

INTEREST RATE SWAP RISKS

Interest rates increase

Interest rates decrease

Fixed-rate payer Gain Loss

Floating-rate payer Loss Gain

Interest Risk

INTEREST RATE SWAP RISKS-CONT. Credit risk

Occurs when counterparties default on the swap agreement

Only one party at a time will be subject to credit risk

Example Suppose company A pays 8% and company B pays 6-

month LIBOR Now, if market rate on swaps falls below 8%, company

B benefits and company A may default. Company B suffers a credit loss if company A goes

bankrupt What happens if the interest rate increase to

9%?

REASONS FOR THE RAPID GROWTH OF INTEREST RATE SWAP MARKET

Ability of institutional investors and corporate borrowers to changes the nature of their assets and liabilities Credit arbitrage opportunities Comparative advantage

Increased volatility of interest rates Caused borrowers and lenders to hedge or

manage their risk exposure Interest rate swap is more liquid than forward

rate contract

TAKE-AWAY

Interest rate swap is an agreement between two counterparties to exchange periodic interest payment Notional principal amount is not exchanged. Rather

the interest rate times notional principal amount is exchanged.

Alter cash flow of assets from fixed to floating or from floating to fixed without affecting the underlying assets.

Interest rate valuation methods: Summing present value of cash flows YTM and zero coupon method

Interest rate swaps risks Interest risk Credit risk

QUESTIONS

REFERENCES 5/24/2011, Amounts outstanding of over-the-counter (OTC)

derivatives, http://www.bis.org/statistics/otcder/dt1920a.pdf

Fabozzi, Frank. Modigliani, Franco. and Jones, Frank. 2010, Foundations of Financial Markets and Institutions(Pearson Prentice Hall)  

5/24/2011, Understanding Interest Rate Swap Math and Pricing, http://www.treasurer.ca.gov/cdiac/publications/math.pdf 

Beidleman, Carl R. I991, Interest Rate Swaps (Richard D. Irwin, INC.)