Swaps

1. Swaps Chapter 26

2. 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

3. 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

4. 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

5. Interest Rate Swaps • We depict this fixed-floating rate swap transaction in the following

6. Interest Rate Swaps • The expected net financing costs for the FIs are shown below

7. 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.

9. 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?

10. 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)]

11. 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)

12. 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.

13. 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%.

14. 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.

15. Currency Swaps

16. Currency Swaps

17. 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?

18. 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

19. 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.

20. 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)

21. 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.