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EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term

EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term. Lecture 8: Interest rate derivatives; swaps. LEARNING OUTCOMES. Interest rate and other derivatives Interest rate futures Forward rate agreements (FRA)

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EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term

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  1. EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETSDr Helen Weeds2013-14, Spring Term Lecture 8: Interest rate derivatives; swaps

  2. LEARNING OUTCOMES • Interest rate and other derivatives • Interest rate futures • Forward rate agreements (FRA) • Spread betting and contracts for difference (CFD) • Interest rate caps and floors • Swaps • Interest rate swaps • Credit default swaps (CDS) • CDS in the financial crisis

  3. INTEREST RATE FUTURES • A futures contract in which the underlying asset is an interest-bearing instrument • A contract in which buyer and seller agree to the future delivery of an interest-bearing asset • At a price agreed now • Examples • Treasury bill futures • Treasury bond futures • Eurodollar futures • The underlying is a eurodollartime deposit (i.e. a deposit denominated in US $ held outside the US) • Futures are often cash settled • Parties transfer the associated cash position, rather than delivering the underlying asset itself

  4. Treasury bond futures • Consider a Treasury bond futures contract for a year’s time • Underlying: a bond with face value $100,000 and 6% coupon • Quoted prices are per $1,000 • Current and future prices in June 2013 • Current bond price is 114 • i.e. it costs $114,000 to buy the bond • Bond futures contract for June 2014 delivery is priced at 111.50 • no fee is paid when the contract is taken out • but a (refundable) margin payment of $4,320 must be deposited • Suppose an investor anticipates that bond prices will rise (i.e. interest rate will fall) over the next 12 months • Compare investing in the bond with taking out a futures contract

  5. Treasury bond futures (cont.) • Buy the bond in June 2013 and hold until June 2014 • June 2013: pay $114,000 for the bond • June 2014: bond price has risen 1%, i.e. price is 114 x 1.01 = 115.14 • Investor’s return: $1,140 capital appreciation: 1% x $114,000 + $6,000 interest on the bond (6% coupon on $100,000 face value for 12 months) = $7,140 total profit: 6.3% return on $114,000 initial investment • Buy the futures contract in June 2013 for June 2014 delivery • June 2013: deposit a (refundable) margin payment of $4,320 • June 2014: cash in the bond future at 115.14 • Investor’s return: $3,640 capital appreciation: (115.14 – 111.50) x $1,000  $259.20 forgone interest on $4,320 margin (at 6% for 12 months) = $3,380.80 total profit: 78.3% return on $4,320 initial investment • Leverage: the futures contract amplifies gains (and losses)

  6. Short-term interest rate futures • Notional fixed-term deposits, usually for a three-month period, starting at a specified future date • E.g. in February 2014 an investor arranges a futures contract to ‘deposit’ and ‘receive interest on’ £1m from June to Sept 2014, at a rate agreed when the contract is arranged • Prices are quoted on an index basis P= 100 – i whereP = futures price i = future annual interest rate, in percentage terms • Example • On 15 December 2010, the settlement price for a June three-month sterling future was 98.99 • This implies an annual interest rate of 100 – 98.99 = 1.01%, to be paid for the period June-September 2011

  7. Hedging a deposit • Company expects to receive £100m in Sept 2014 • Anticipates needing the money in Dec 2014, but not before • I.e. will have money to deposit for 3 months from Sept 2014 • Company would like to ensure a good return by taking out a futures contract • Buy 3-month sterling interest rate futures with Sept 2014 expiry • Current price 98.80, implying an (annual) interest rate of 1.20% • By Sept 2014, suppose 3-month interest rates fall to 0.95% • Return at 1.20%: £100m x 0.0120 x 3/12 = £300,000 • Return at 0.95%: £100m x 0.0095 x 3/12 = £237,500 • Difference in return on the deposit: - £62,500 • Now 3-month Sept 2014 futures trade at 100 – 0.95 = 99.05 • Profit on futures: (99.05 – 98.80)/100 x 100m x 3/12 = £62,500 • Exactly offsets the lower return on the deposit

  8. Hedging a loan • In Dec 2010, Holwell plc plans to borrow £5 million for three months starting in June 2011 • Wants to hedge against a possible rise in short-term interest rates • Sells 10 three-month sterling interest rate futures, notional value £500,000, with June expiry • Price of a futures contract is 98.99: annual interest rate of 1.01%, which is 0.2525% for three months • The cost of borrowing is: £5m × 0.002525 = £12,625 • June 2011: annual interest rate rises to 1.6%, or 0.4% per quarter • The cost of borrowing becomes: £5m × 0.004 = £20,000 • Additional interest paid: £20,000 – £12,625 = £7,375 • Futures position in June 2011 • Close futures position by buying 10 contracts, now priced at 98.40 • Profit on futures: (98.99 – 98.40)/100 x £500,000 x 10 x 3/12 = £7,375

  9. Forward rate agreements (FRA) • An agreement about the future level of interest rates • Used to hedge interest rate risk • Under an FRA, parties agree an interest rate for some future date • If the actual interest rate at that future date is different from the agreed rate, compensation is paid by one party to the other based on the difference in interest rates • E.g.: Company knows that in 6 months’ time it will need to borrow £6m for a period of a year • It arranges this loan with Bank X at a variable rate of interest • Current interest rate (LIBOR) is 7%, but may vary in future • Separately, it takes out an FRA with Bank Y • It ‘purchases’ an FRA at an interest rate of 7% to take effect 6 months from now relating to a 12-month loan • Bank Y does not lend any money to the company, but pays compensation if interest rates (LIBOR) rise above 7%

  10. FRA: outcomes • Suppose in 6 months the spot one-year interest rate is 8.5% • company must pay Bank X: £6 million x 0.085 = £510,000 • this is £90,000 more than if interest rate were 7% • under the FRA, company claims compensation from Bank Y equal to the difference between the rate agreed in the FRA and the spot rate: i.e. (0.085 – 0.07) x £6m = £90,000 • net payment = £510,000 - £90,000 = £420,000 • If interest rate falls below 7%, the company makes a payment to Bank Y: e.g. suppose in 6 months the spot rate is 5% • company benefits because of the lower rate charged by Bank X: interest payment = 0.05 x £6m = £300,000 • but under the FRA the company pays compensation to Bank Y: (0.07 – 0.05) x £6m = £120,000 • NB: sale of the FRA protects Bank Y against a fall in interest rates • However the interest rate moves, the company pays £420,000

  11. FINANCIAL SPREAD BETTING • A way of betting on asset price movements • E.g. Spread betting on shares in Marks & Spencer (M&S): investor punts £10 for every penny rise in M&S share price • if M&Sincreases by 30p the investor wins £300 • but if M&S falls by 30p the investor pays £300 • Spread betting companies quote 2 prices (the spread), e.g. 348p–352p • Investor bets £10 per 1p rise in the price: investor ‘buys’ at 352p • suppose the spread moves up to 375p–379p • investor ‘sells’ to close the position at 375p (the least advantageous price) • gains 23p (375p–352p), i.e. £230 given bet of £10 per penny • Pessimistic investor bets by ‘selling’ at 348p • spread increases to 375p–379p; to close position the investor ‘buys’ at 379p • makes a loss of 31p (379p –348p), i.e. loses £310 at £10 per penny • Spread betting company profits from the 4p spread between prices

  12. Uses of spread betting • Spread betting can be used for insurance • investor holds the underlying share • and wants to protect against possible falls in the share price • Or for speculation: 2 benefits over using the share itself • Leverage • spread betting requires a margin to be deposited (and there may be margin calls if prices move against the investor) • margin is smaller than the size of the bet: a smaller initial outlay than buying the share itself • spread betting allows the investor to leverage its position:i.e. gains / losses are larger percentages of the initial outlay • Gains from falls in share prices • Short selling may not be available to the investor • Spread betting allows investor to gain from price falls, not just rises

  13. Contracts for difference (CFD) • A contract between two parties (‘buyer’ and ‘seller’) stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at the contract time • settled in cash without the need for ownership of the underlying asset • E.g. An investor is pessimistic about Vodafone’s shares • broker quotes Vodafone shares at ‘102p bid’ and ‘103p offer’ • investor sells CFDs for 160,000 shares in Vodafone at a price of 102p • this requires a margin of 10% (say): just over £16,000 • Suppose Vodafone’s share price falls to 92p bid and 93p offer • investor gains 102p − 93p = 9p per share x 160,000 = £14,400 • But if Vodafone’s share price moves to 113p–114p • investor loses 114p − 102p = 12p per share x 160,000 = £19,200

  14. INTEREST RATE CAPS • A contract that gives the purchaser the right to set a maximum level for interest rates payable • Compensation is paid to the purchaser if the interest rate rises above an agreed level • Used to hedge longer-term borrowing (usually 2–5 years) • Usually arranged for amounts of £5 million or more • An up-front premium is paid for the contract • Seller of the cap does not need to assess the purchaser’s creditworthiness because it receives the premium in advance • Size of the premium depends on • difference between the current interest rate and the level at which the cap becomes effective • length of time covered • expected volatility of interest rates

  15. Example of an interest rate cap • Oakham plc wishes to borrow £20 million for five years • Obtains a variable rate loan from Bank A based on LIBOR plus 1.5% • The interest rate is reset every quarter based on three-month LIBOR, currently an annual rate of 3% • Oakham is concerned that the interest rate could rise to a high level • Oakham buys an interest rate cap set at LIBOR of 4.5% from Bank B • Oakham pays Bank B an up-front fee of (say) 2.3% of the principal amount, i.e. £20m x 0.023 = £460,000 • If LIBOR rises above 4.5% in any 3-month period, Oakhamreceives compensation from the cap seller to offset the additional interest • E.g. Suppose LIBOR rises to 5.5% for the whole of year 3 • Oakhamwould pay Bank A interest at 5.5% + 1.5% • But would also receive 1% compensation from Bank B • If interest rates instead fell, Oakhambenefits by paying less to Bank A

  16. Floors and collars • Floor • If the interest rate falls below the specified level, the seller (writer) of the floor makes compensatory payments to the buyer • Buyer pays an up-front premium to the seller, determined by the difference between the prevailing interest rate and the floor rate • Collar • Oakham could pay less up-front by selling a floor as well as buying a cap • Buy a cap set at 4.5% LIBOR for a premium of £460,000 • Sell a floor set at 2% LIBOR and receive (say) £200,000 • i.e. net up-front payment of £260,000 • The combination of selling a floor at a low strike rate and buying a cap at a higher strike rate is called a collar

  17. SWAPS • Swap: an exchange of cash payment obligations • Interest-rate swap • one company arranges with a counterparty to exchange interest-rate payments • E.g. • Firm S has a £200m ten-year loan with a fixed interest rate payment of 8% • Firm T has a £200m ten-year loan on which interest is reset every six months at LIBOR + 2% • Swap arrangement • S agrees to pay T’s floating-rate interest on each due date over the next ten years • And T pays S’s 8% interest rate over the ten-year period

  18. Example of an interest rate swap • Cat plc and Dog plc both want to borrow £150m for eight years • Cat would like to borrow on a fixed-rate basis, to match its assets • Dog prefers to borrow at floating rates, because of optimism about future interest-rate falls • Borrowing rates • NB: Dog has a comparative advantagein fixed rate borrowing, while CAT has a comparative advantage in floating rate borrowing • No swap market • Cat would borrow at 10% fixed • Dog would pay LIBOR +1% • A swap agreement gives both firms lower effective interest rates

  19. Interest rate swap • Cat • Pays LIBOR + 2% to Bank A • Pays Fixed 9.5% to Dog • Receives LIBOR + 2% • Net payment: Fixed 9.5% • Dog • Pays Fixed 8% to Bank B • Pays LIBOR + 2% to Cat • Receives Fixed 9.5% • Net payment: LIBOR + 0.5%

  20. Swaps with an intermediary bank • Paris Expori (French property developer) needs to borrow £80m for a six-year period to develop a shopping centre • Borrowing options • Suppose all fixed rate borrowing quotes are over 5.5% • Best floating rate offer is LIBOR + 200 basis points • But company wants to avoid exposure to a rise in interest rate • Solution • Borrow £80m at floating rate • Take out a swap agreement with a bank to swap into a fixed rate • Banks act as market makers in the swaps market • Bank may take out a swap contract with one party without having an offsetting swap with another party (‘warehousing’ swaps) • Hedge position using bonds, interest rate futures or FRAs

  21. Using the interest rate swap market • Swap market deal: pay a fixed rate and receive a floating (LIBOR) rate • Ask rate: the fixed interest rate paid to the bank in return for receiving the LIBOR rate • Bid rate: the fixed rate received from the bank in return for paying LIBOR to it • Suppose the 6-year fixed rate payable (ask rate) is 3.15% p.a. • On each six-monthly rollover date, LIBOR rate is deducted from the agreed fixed rate of 3.15% • Difference is paid by one party to the other • E.g. six months into the contract, LIBOR is set at 1.00% • Paris Expori owes 3.15% to the bank (x 6/12 for 6-month period) • Bank owes 1.00% to Paris Expori(x 6/12 for 6-month period) • The difference changes hands: 2.15% (x 6/12 for 6-month period)

  22. Using a fixed interest swap (cont.) • Paris Expori’sswap flows • Pays LIBOR + 2% to the lending bank • Receives LIBOR from bank in swap market • Pays Fixed 3.15% to bank in swap market • Net payment: Fixed 5.15% (< the 5.5% fixed rate quoted)

  23. Relationship between swaps and forward rate agreements • Recap: a forward rate agreement (FRA) is an agreement about the future level of interest rates • In June, Colston plc borrows £100m for a period of 2 years • Floating interest: set at 3-month LIBOR every three months • In June, Colston could buy an FRA set at LIBOR for Sept-Dec, on notional amount of £100m: suppose this is priced at 5.71% • FRA buyer (Colston) agrees to pay the FRA seller 5.71% • FRA seller agrees to pay Colstonthe spot rate for LIBOR in Sept • Cash settled: e.g. if spot LIBOR in Sept is 6.2%, the FRA seller pays Colston 6.2%-5.71% = 0.49% x £100m × 3/12 = £122,500

  24. Consider a set of FRAs • Colston could take out 7 FRAs to lock in the interest payments on its 2-year loan • One FRA for each future roll-over date, Sept 20x1 to March 20x3

  25. Each FRA is like a one-period swap • and the rest (for Sept 20x2 – March 20x3)

  26. FRAs and swaps • With FRAs, Colston fixes its future interest rate each quarter • June 20x1 to March 20x2: 5.09%, 5.71%, 6.05%, 6.42% • June 20x2 to March 20x3: 6.70%, 6.98%, 7.06%, 7.18% • Alternatively it can take out a swap agreement at a single rate of interest payable in each of the 8 quarters • at, say, 6.39% (approx. average rate)

  27. CREDIT DEFAULT SWAP (CDS) • A swap that transfers credit exposure (default risk) of fixed income products between parties • Also referred to as a credit derivative contract • For the buyer the CDS may represent • Insuranceagainst non-payment of a specified third party bond or loan (‘reference obligation’) which it holds or • Speculation on the possibility that the third party will default, without also holding the reference obligation

  28. CDS payments • Buyer: pays regular fees to the seller, up until the maturity date of the CDS contract • Usually every 3 months over a period of years • Seller: payment is contingent on a defined ‘credit event’ • Seller agrees to pay off the third party debt if this party defaults

  29. Example of a CDS • A pension fund holds £20m (nominal value) of bonds from a software company, Appsoft • Fund manager is concerned about risk of default by Appsoft • Takes out a CDS contract with a CDS dealer (market maker) • CDS ‘spread’ • Pension fund pays 160 basis points, as a percentage of the notional principal per year, i.e. £20m x 0.016 = £320,000 • Usually paid in four quarterly amounts of (approx.) £80,000 each • CDS insurance • In most cases the CDS dealer pays nothing to the pension fund, as the defined credit event does not occur • CDS protection is similar to standard insurance contracts (house, car), except that the buyer does not have to own the asset

  30. CDS dealer as a market maker • CDS dealer may hedge its own position with another party • E.g. suppose that a hedge fund sells protection to the CDS dealer, for a (lower) payment of 155 basis points • CDS dealer makes a margin between the two (160 – 155 bps)

  31. CDS and bond yields • Suppose an investor does the following • Buys a corporate bond yielding 7% p.a. on its face value • Buys a 5-year CDS to protect against the risk of default • Suppose the CDS spread is 200 basis points (i.e. 2%) p.a. • CDS converts the corporate bond into a risk-free bond (approx.) • Investor makes a risk-free return of 7% – 2% = 5% • This should equal the risk-free interest rate (e.g. gilts, LIBOR) • Relationship between CDS spread and bond yields n-year CDS spread n-year bond yield – risk-free rate

  32. Credit events Types of credit eventtriggering payment by the CDS seller (depending on CDS contract terms) • Insolvency of the third party borrower (‘reference entity’) • Failure to pay principal and/or interest • Debt restructuring • Borrower renegotiates the terms of its debt (in its own favour) • E.g. extend maturity, defer interest, reduce principal, swap debt for equity • Obligation acceleration • Default on another debt triggers an earlier payment • Repudiation/moratorium • Borrower renounces its debt obligation and refuses to pay

  33. Settlement • CDSs may be physically settled or cash settled • Physical settlement • CDS buyer delivers the reference obligation (or debt assets of the reference entity) to the CDS seller • CDS seller pays buyer the face value of the reference obligation • e.g. £20m in the Appsoft example • Cash settlement • Credit event triggers a cash payment by the CDS seller to the buyer • Amount paid = face value minus recovery value of the debt • e.g. recovery rate of 40% of the face value of the debt • secondary market in defaulted bonds, or use an auction process • ‘Naked CDS’ • CDS buyer or seller holds no debt in the reference entity • Most CDS trades are of this type

  34. CDS IN THE FINANCIAL CRISIS • Credit default swaps outstanding, 2001-08 (US $ trillion)(Source: International Swaps and Derivatives Association) • Note: these are gross notional amounts, not a measure of risk • Netting of offsetting obligations reduces amounts considerably • 31 Dec 2010: gross notional amount $25.5 trillion; net $2.3 trillion • Even for the net notional amount to be paid out would require • every reference entity to experience a credit event • with zero recovery rate

  35. Lehman Brothers failure • Lehman Brothers declared bankruptcy on 15 September 2008 • Other parties had sold CDSs on Lehman Brothers debt • An auction of Lehman Brothers’ debt held on 10 October 2008 set a price of 8.625 cents on the dollar (for Lehman’s senior bonds) • I.e. CDS sellers had to pay 100 – 8.625 = 91.375 cents per dollar of face value of Lehman Brothers’ bonds to CDS buyers • Lehman Brothers was itself a major CDS dealer (selling CDS contracts on other parties’ debt) • Its CDS counterparties were forced to replace lost protection • Lehmans’ default caused credit spreads to widen • Hence counterparties had to take out CDS contracts elsewhere at much higher prices

  36. American International Group (AIG) • AIG • Was the world’s largest insurance company • Its derivatives-trading subsidiary, AIG Financial Products (AIG FP), wrote CDS on mortgage securities (CDOs) • AIG did not hedge its position • It ran a ‘one-way book’: i.e. it was mainly a seller of protection • It did not operate a ‘matched book’, i.e. balance the protection it was selling by buying protection to reduce its net exposure • AIG did not have to maintain capital reserves or post collateral • CDSs are OTC derivatives, not insurance contracts, and as such were largely unregulated • AIG did not have to maintain capital reserves against swaps • While it had a AAA credit rating AIG was not required to put up any collateral against its swaps

  37. Failure of AIG • Fall in US house prices • Default rates on mortgage securities underwritten by AIG turned out to be much higher than expected • AIG stopped underwriting multi-sector CDOs in early 2006 • 2007: AIG FP lost more than $10 billion, and raised more capital • First half of 2008: AIG FP lost $14.7 bn • Counterparties (investment banks) began demanding collateral from AIG • 15 September 2008 (day of Lehman’s bankruptcy) • The major credit rating agencies downgraded AIG • CDS contracts then required AIG to hand over $13-18 bn in additional collateral to buyers of swaps • AIG was effectively bankrupt • US Federal Reserve lent AIG $85 bn to facilitate an orderly sale of its assets, in return for a 79.9% equity stake • This protected AIG’s counterparties: ‘too interconnected to fail’

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