capital 46 THEEDGE mal aysia   |  january 17, 2011

derivatives world

Interest Rate Swaps: Pre-2008 crisis

T
he interest rate derivatives market the IRS to Company B would be: [- Libor + 6% • Arbitrage opportunities
is the largest derivatives market in - 8% = - Libor – 2%] So, synthetically the com- The IRS market is closely linked to the in-
the world, and among the oldest. In- by pany has managed to pay on its bond, Libor + terest rate futures and forwards markets.Arbi-
terestingly, the credit crisis of 2008 Jasvin Josen 2%, and can now benefit from further falls in trageurs continuously trade between forwards,
has turned out to be one of the wa- the interest rate. The rate may still seem high futures and swaps resulting in the rates for the
tershed moments for this highly compared with newly issued bonds, but con- different derivatives within the same tenor to
established market. time deposits and receives three-month Libor sidering the issuing cost of bonds, the swap stay in close proximity.
The swap market has undergone an evolu- (London Interbank Offer Rate), for example, + transaction does seem worthwhile.
tion — a change in the motivation of trading, 0.2% on its mortgages. Say the Libor at the first Some important features of
which has brought about new risk that was three-month interval is 5%. The bank makes a Speculation interest rate swaps
considered negligible before the crisis. This margin of 0.2% from its lending business. Say Interest rate swaps are also very often used by Before we go further, it would be useful to un-
article will first brief the reader on the plain-
after three months,Libor falls to 4.8%.The bank’s market participants who want to take profit derstand some important features of the IRS,
vanilla interest rate swap and its prime trad- margins are now being squeezed. from the movement in interest rates.The main such as:
ing motivations before the crisis. Bank A would be interested in entering into speculators in the swap market are the propri- • Reset dates
a fixed-for-floating IRS (see Chart 1) where it etary trading desks of investment banks and These are pre-set dates when the floating
What is an interest rate swap could swap the fixed interest paid on its time hedge funds. rate in the IRS will be reset to
An interest rate swap (IRS) is an agreement be- deposits with a three-month Libor. In this way, Traditionally, an investor the current rate. For exam-
tween two parties to swap interest payments Bank A is not exposed to the changes in Libor who expects interest rates The swap market ple, an IRS that has one float-
on an agreed notional sum of the same cur- as the interest rate risk is hedged with the IRS. to fall would purchase cash has undergone ing leg paying three-month
rency. In the case of a plain-vanilla IRS, par- The IRS will slightly reduce the bank’s overall bonds,whose price increases an evolution Libor (say 5%) will be re-set
ties exchange fixed interest rates with floating margin, but eliminates the bigger downside as interest rates fall. Today, — a change in every three months at pre-de-
interest rates. when Libor moves the other way. investors with a similar view termined dates.At these dates,
The interest rate swap is an important tool could enter a floating-for- the motivation the three-month Libor (which
in hedging for banks and corporations. They Hedging with interest rate swaps — cor- fixed interest rate swap; as of trading, which was 5%) will be changed to the
can also be attractive speculation instruments porations interest rates fall, investors has brought about current rate (say 4.8%).
as we will see later. Say Company B issued a 10-year fixed bond pay a lower floating rate in new risk that • Fixed rate or swap rate
at 8% and it is into its fifth year now. Interest exchange for the same fixed was considered In a previous article, “Finan-
Hedging with interest rate swaps rates have fallen, and the company wishes it rate. negligible before cial Wizardry in Swaps — the
— commercial banks had issued a floating rate bond instead. It is not A speculator can also take the crisis Greek case” ( March 8, 2010),
Commercial banks that are funded on time too late. It can enter into an IRS as in Chart 2. a view of the shape of the the swap rate for a cross cur-
deposits (paying fixed rates) and issue float- Company B pays the floating Libor and receives interest rate curve, an ex- rency swap was discussed. In
ing rate mortgages are exposed to interest rate a fixed rate of 6% from the swap counter-party. ample of which can be seen any fixed-for-floating swap,
risk. For instance, say Bank A pays 5% on its The net effect of the cash flows of the bond and in Chart 3.The speculator may believe that the the fixed rate to be paid by the fixed rate
difference between the six-month Libor rates payer will be such that it makes the swap
will fall further relative to the three-year swap “fair”. In other words, at the inception of
rate. The Libor only has maturities of up to 12 the swap, the price of the swap should
Chart 1 – Hedging with interest rate swaps   months. He enters into a constant maturity ideally be zero. Now, the price of the swap
swap paying the six-month Libor rate and re- is simply the present value of its floating
(commercial banks) ceiving the three-year swap rate (which is pe- and fixed cash flows. To make the price
riodically set to the market swap rate). zero, the fixed rate is adjusted to make the
present value zero. This fixed rate is also
The interest rate swap market known as the swap rate or the at-market
The interest rate swap market flourishes not swap rate.
only for the reasons of hedging and specula-
Speculation
tion, but also because of two more important New developments
features:rate swaps are also very often used by Now
Interest market that we have a reasonable
participants who want level of under-
to take a view
• Quality spread differential between standing of the plain-vanilla interest rate swap,
andfirms
profit from the movement in interest rates.inThe main speculators in the swap market
the next article, we will study how the swap
areDue
proprietary tradinglevels
to the varying desk of investment banks
of counter-party and hedge
market funds.
changed after the 2008 crisis, bring-
risk of companies, there is often a “quality ing about “basis risk” which was considered
Traditionally, an investor
spread differential”, whoallows
which expectedbothinterest rates to fall would
par- insignificant beforepurchase cashafford
but cannot bonds,
to be
Hedging with the IRS – The example of the corporation ties to
whose benefit
price will from an interest
increase as the rate swap.rates
interest Say fall.
sidelined
Today,now.
investors with a similar view could
Bank
enter A (rated AAA) is able
a floating-for-fixed to borrow
interest fundsas interest rates fall, investors would pay a
rate swap;
Say Company B issued a 10 year fixed bond at 8% and it is into its 5th year now. Interest at Libor + 2% while Bank B (rated BBB) will Jasvin Josen is a specialist in developing
lower
havefloating rateatin
to borrow exchange
Libor forcould
+ 3%.They the same
enterfixed rate.
methodologies for valuation of various
rates have fallen and the company wished it issued a floating rate bond instead. It isAnot intotooan IRScan
speculator where
alsoBank
take aB view
pays Libor
of the+shape
2.5% ofderivative products.
the interest She has
rate curve, over 10 of
an example
late. It can enter into an IRS as in Chart 2. Company B pays the floating LIBOR and receives and receives a fixed rate from Bank A. This years’ experience in investment banking
which is aChart 3.
is beneficial forThe
Bankspeculator may believe
B as it is cheaper than that
andthe
thedifference
financialbetween
industry the six-month
in Europe and
fixed rate of 6% from the swap counterparty. The net effect of the cash flows of theLIBOR bond
financing from
rates will fallthe market.
further As for
relative toBank A, Asia. Comments:
the three-year jasvin@gmail.com.
swap rate. The LIBOR only has
and the IRS to Company B would be: [- LIBOR +6% - 8% = - LIBOR – 2%] So, synthetically thethefixedofrate
maturities up negotiated
to 12 months.is often into aReaders
also better
He enters constantmay also follow
maturity her at http://
swap paying the six-
than borrowing on the market. derivativetimes.blogspot.com.
company has managed to pay on its bond, LIBOR + 2% and can now benefit from further month LIBOR rate and receiving the three-year swap rate (which is periodically set to the
Cusatis, Thomas: Hedging instruments and risk management
falls in the interest rate. The rate may still seem high compared to newly issued bonds, market
butswap rate).
Hedging with the IRS – The example of the corporation
considering the issuing cost of bonds, the swap transaction does seem worthwhile. Chart 3 – An example of an Interest Rate (Yield) Curve
Chart 2 – Hedging with interest rate swaps (corporations) Chart 3 – An example of an interest rate (yield) curve
Say Company
Chart 2B–issued a 10
Interest year
Rate fixed(Hedging
Swap 8% and it2)is into its 5th year now. Interest
bond atexample
rates have fallen and the company wished it issued a floating rate bond instead. It is not too
late. It can enter into an IRS as in Chart 2. Company B pays the floating LIBOR and receives a
fixed rate of 6% from the swap counterparty. The net effect of the cash flows of the bond
and the IRS to Company B would be: [- LIBOR +6% - 8% = - LIBOR – 2%] So, synthetically the
company has managed to pay on its bond, LIBOR + 2% and can now benefit from further
falls in the interest rate. The rate may still seem high compared to newly issued bonds, but
considering the issuing cost of bonds, the swap transaction does seem worthwhile.
Chart 2 – Interest Rate Swap (Hedging example 2)

Source: Cusatis, Thomas: Hedging Instruments and Risk Management

The IRS market