Swaps

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Swaps

• Chapter 26

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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

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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

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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 CI loans linked to
  LIBOR. Duration gap is negative.
• DA - kDL lt 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 gt 0

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Interest Rate Swaps

• We depict this fixed-floating rate swap
  transaction in the following

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Interest Rate Swaps

• The expected net financing costs for the FIs are
  shown below

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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 banks 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.

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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?

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Macrohedging with Swaps

• Assume a thrift has positive gap such that
• DE -(DA - kDL)A DR/(1R) gt0 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/(1R)

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Macrohedging (continued)

• Optimal notional value requires
• DS DE
• -(DFixed - DFloat) NS DR/(1R)
• -(DA - kDL) A DR/(1R)
• NS (DA - kDL) A/(DFixed - DFloat)

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Example 2

• Suppose DA5, DL3, k.9, and A100,000,000.
  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.

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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.

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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. FIs 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.

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Currency Swaps
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Currency Swaps
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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?

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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

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Example

• Suppose that an FI lends 100m to a Brazilian
  manufacturing firm at a fixed rate of 10. If
  the firms credit risk increases unexpectedly
  over the life of the loan, the market value of
  the loan and consequently the FIs net worth will
  fall. The FI can hedge an unexpected increase in
  the borrowers 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 firms 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 firms 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.

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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)

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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
  counterpartys creditworthiness they may require
  the counterparty to obtain a standby letter of
  credit or to post collateral.