29a Swaps: Converting interest rate structure

Demonstrate how an interest rate swap can be used to convert a floating-rate (fixed-rate) loan to a
fixed-rate (floating-rate) loan

What do interest rate swaps do?

 They change the nature of interest payments for assets and liabilities.
 Remember when we discussed this in 23f?

No. Anyway, who would want to do that? And how would they do it?

 Companies often borrow at the Prime Rate, which is a floating rate. And they don't like that.
They would prefer to borrow at a fixed rate.

Why do companies prefer borrowing at a fixed rate?

 They just do. It's what the curriculum says, so don't question it. But if you really want to know
why, see 29b.

So what would this interest rate swap look like?

 If a company borrows at LIBOR + 2% but would prefer to borrow at a fixed rate, it can enter a an
interest rate swap to pay a dealer a 5% fixed rate and receive LIBOR in return, the net interest
payments are 5% + 2%.
That's a lot of numbers. What's the net effect?

 Look at what the company pays out: LIBOR plus 2% on its original loan, and another 5% to the

swaps dealer.

Right...

 And the company gets a payment of LIBOR from the swaps dealer.

Right...

 So, LIBOR goes out, but LIBOR comes back in. What's left?

5% to the swaps dealer.

 And...

The "plus 2%" on its original loan.

 Which makes a net interest payment of?

5% plus 2% = 7% fixed interest rate.

 Now you're getting it.

See also: http://qmarks.wordpress.com/2010/03/28/interest-rate-options/

29b Swaps: Interest rate swap duration

Calculate and interpret the duration of an interest rate swap

Interest rate swaps have a duration? I thought only bonds had a duration.

 Think of an interest rate swap's duration as being the net effect of the durations on the
underlying bonds.
 The

duration of an interest rate swap is simply the duration of the asset less the duration of the liability.

 Here's a summary table:

Duration of a Swap Dswap = Dasset − Dliability Value depends on postion

position
Pay-Floating position Dpay floating = Dfixed − Positive number
Dfloating
Pay-Fixed position Dpay fixed = Dfloating − Dfixed Negative number

How am I supposed to remember that a pay-floating position has a positive duration and the pay fixed
position has a negative duration?

 It actually makes a lot of sense if you think about it for a second.

 What does duration measure for a fixed income portfolio?

How sensitive my cash flows are to interest rates, right?

 That's one way of putting it.

 If you take a pay-floating position, then you are receiving fixed payments.
 Which means that you essentially have added a new fixed rate bond to your portfolio.
 And, to get this fixed rate bond, you've traded a floating rate bond.
 Here's a simple example:

Duration of pay-floating swap position = Long fixed rate 0.75 - Short floating rate 0.15 = 0.60

29c Swaps: Cash flow vs. Market value risk

Explain the effect of an interest rate swap on an entity’s cash flow risk
So, a company that has issued floating-rate debt goes to a dealer and gets a pay-fixed interest rate
swap. Everyone's a winner, right?

 Not exactly. It's true that the accountants and people who care about cash flow planning are
happy because now the company's interest payments are locked in.

"Locked in"? As in, they've hedged rid of the company's cash flow risk. So, bonuses for the
accountants?

 Maybe, but you're not looking at risk from a company-wide perspective.

Which is?

 Entering the pay-fixed swap has hedged cash flow risk, sure. But there are other types of risk.

Such as? And anyway, we just hedged one type of risk so quit knocking us.

 But to accomplish that, you've massively increased the duration of a company's liabilities
(see 29a), which is great if interest rates rise...

EXACTLY! If interest rates rise, the hedge is saving the company money that it otherwise would have
been spending on higher interest payments.

 And if interest rates fall?

Then we win again because...

 Think about it: The interest payments are locked in.

Oh, I hadn't thought of that. So all the companies that issued floating rate debt are happy because
their interest payments are lower. And the market value of these companies increases.

 Yes

But not us because we're locked in to a pay-fixed interest rate swap.

 Yes

And that's market value risk?

 Yes

So, entering a pay-fixed swap involves a trade-off between credit risk and market value risk?

 Now you've got it.

29d Swaps: Changing fixed-income portfolio duration

Determine the notional principal value needed on an interest rate swap to achieve a desired level of
duration in a fixed-income portfolio

 Portfolio managers often seek to temporarily alter a fixed-income portfolio's duration

 To decrease your portfolio's duration, buy floating-rate assets and issue fixed-rate
liabilities
 To increase portfolio duration, buy fixed-rate assets and issue floating-rate liabilities
 When doing so, the time horizon of the swap should be the same as the as the amount of time
you want the temporary target duration to be in effect
 What should be the notional principal for the swap?

 Does this formula look familiar?

 Short-maturity swaps will require a huge notional principal to make a significant change to
portfolio duration
 Try a mid-range maturity to bring NP down to a manageable size

Example

NP = $250m

Portfolio's current duration: 5.50

Portfolio's target duration: 4.50

NOTE: Assume that a fixed-rate bond has a duration that is 75% of its maturity (this is a dickish question,
they will almost certainly just give you the swap duration on the exam)

1-year swap with monthly payments: MDUR = (1/12 x 0.5) - (1y fixed x 0.75) = -0.708

2-year swap with semi-annual payments (MDUR = (1/2 x 0.5) - (2y fixed x 0.75) = -1.25
NP required using 1-year swap = (4.50 - 5.50)/(-0.708) x $250m = $353m

NP required using 2-year swap = (4.50 - 5.50)/(-1.25) x $250m = $200m

So, to lower portfolio duration without an insanely high NP, go with 2-year semi-annual pay-fixed,
receive floating interest rate swap.

Just so you know

- Structured rate notes have special leverage-like features that allow its interest rate to move at a
multiple of the market rate

- These go by various names such as leveraged floater or inverse floater

- Insurers and pension funds like these because they have option-like features, but regulators allow
them because they are technically considered fixed-income securities

29e Swaps: Currency swaps

Explain how a company can generate savings by issuing a loan or bond in its own currency and using a
currency swap to convert the obligation into another currency

The borrow domestic plus swap strategy and credit risk

Remind me again why it's cheaper to borrow C$ and covert these into ₩ using a currency swap.

 You remember the part about how Canadian lenders will offer a lower interest rate because
they have better knowledge of and higher trust in a domestic company?

Yes.

 So that explains part of it. Also, by entering a swap, the company is lowering its borrowing cost
by accepting some credit risk.

How so?
  If it simply issues debt, the company is not accepting any credit risk. Rather, its lenders are
accepting credit risk.

Yes.

 But by entering a swap, the company accepts the credit risk posed by the counterparty.

So it the counterparty goes bankrupt and can't make interest payments or return the principal, the
company is in trouble.

 That's right. Which is another reason why the net interest rate on a borrow C$ plus swap
strategy are lower compared to just directly borrowing ₩.

Sure, but if the counterparty is a bank, what are the chances that it's going to go bankrupt?

 You don't pay attention to the news, do you?

If a Canadian company needs 120m Won (₩), why wouldn't it just issue Won-denominated bonds?

 It could, but the interest rate on its Won-denominated bonds would be higher than what it
could borrow at in Canada because Korean investors don't know it as well.

But the company needs ₩120m, so what choice does it have?

 Well, it could start by issuing a bond for C$60m at, say, 7.0%.

But that doesn't get it the ₩120m that it needs.

 Stick with me. To borrow ₩120m directly, Korean investors would charge a interest rate of, say,
7.75%.

Those jerks. That's higher than the 7.0% interest rate that Canadian investors would charge. The
company should just borrow in Canada at 7.0%.

 Tempting, but it still needs to get its hands on ₩120m. So, it starts by issuing C$60m of 7.0%
bonds. Because the exchange rate is C$0.50/₩, this C$60m is equal to ₩120m.

Okay. So then it exchanges the C$60m for ₩120m?

 Yes. The company enters something called a Currency Swap. The counterparty is usually a bank
- probably even a bank that it has an ongoing business relationship with, so there's a lot more
there's a higher level of trust compared to borrowing directly from Korean investors.

And it avoids having to borrow at 7.75% from those jerky Korean investors.
  Yes, although the Canadian bankers are probably also jerks. But anyway, the company takes the
C$60m that it has just raised at 7.0% from Canadian investors and gives it to the currency swap
counterparty.

That's stupid. The company raises C$60m and just gives it away?

 Not exactly. In exchange, the swap countrparty gives it ₩120m.

Okay. So everyone's happy now.

 Sort of. The next part of the currency swap involves exchanging interest payments. The
company agrees to pay a rate of 7.25% on its ₩120m to the bank, which agrees to pay a back a
rate of 6.85% on the C$60m.

Wait, they pay 7.25% and get back 6.85%. This sounds like a bad deal.

 Think about the overall cash flows. Here's what happens every time an interest payment is due
(say once a year):
 The company pays C$4.2m to its bondholders (C$60m x 7.0%) and ₩8.7m to the swap
counterparty (₩120m x 7.25%)
 But it gets C$4.11m from its swap counterparty (C$60m x 6.85%)
 So the net payment is ₩8.7m plus C$0.09m, which is the equivalent of paying 7.25% +
0.15%, or 7.4%

Just so you know

Q: What does a company do if it has converted the nature of its interest payments from floating to fixed
by entering a pay-fixed currency swap, but believes that interest rates are going to drop?

A: The company can accomplish this by entering a separate pay-floating swap contract. The
counterparty to this new contract can be another swaps dealer or it could even enter into a second
swap contract with its current counterparty.

I get that they pay 7.25% to the swap counterparty for the ₩120m, but where does the extra 0.15%
come from?

 They are borrowing C$60m at 7.0%, but only getting paid 6.85% from their swap counterparty.

Okay, that makes sense, but isn't this a bad deal?

 With a swap, the company can borrow ₩120m at 7.4%, right?

Yes.

 And the alternative was to borrow ₩120m directly at 7.75%, right?

Yes.

 So this was a good deal, right?

I guess. Hey, one more question. Why are North Korean investors such jerks?

 You really don't get it, do you?

29f Swaps: Repatriating foreign earnings

Demonstrate how a firm can use a currency swap to convert a series of foreign cash receipts into
domestic cash receipts

Related LOSs

See 19b and 27f

 Companies regularly repatriate cash flows generated in by foreign subsidiaries

 Of course, these cash flows are denominated in FC and need to be converted into the parent's
DC
 A given exchange rate can be locked in using a currency swap (another way of accomplishing
this is to use a forward contract - see 27f)

To accomplish this with a currency swap, do the following:

1. Determine NP in FC by dividing the amount of the payment to be received by the foreign

country's swap rate
2. Determine NP in DC using the current exchange rate
3. When foreign currency is repatriated, pay counterparty interest in FC based on NP in FC at
foreign country's swap rate
4. At the same time, receive interest payment in DC based on NP in DC at the domestic swap rate

NOTE: Unlike other swaps, the counterparties do NOT exchange notional principal in this type of
transaction.

NP = Notional Principal

FC = Foreign Currency

DC = Domestic Currency
29g Swaps: Portfolio diversificaion using equity swaps

Explain how equity swaps can be used to diversify a concentrated equity portfolio, provide international
diversification to a domestic portfolio, and alter portfolio allocations to stocks and bonds

What are equity swaps?

 Like all swaps, equity swaps involve counterparties trading returns on an agreed notional
principal
 What makes them equity swaps is that at least one of these returns is linked to equity (either an
individual stock or an index)
 Equity swaps provide a low-cost way for investors to temporarily adjust their equity exposure
without having to sell any assets
 But remember, if you want your exposure adjusted beyond the swap's expiry date, you'll need
to enter into a new one (and terms offered at that time might not be as attractive)

How can equity swaps help diversify a portfolio with a concentrated position?

 Individuals or Institutions with concentrated portfolios may want to diversify, but still wish to
retain control of their shares
 In an equity swap, the counterparties agree on a notional principal and trade the returns on
their holdings
 Swap example: A has a concentrated position in XYZ, so it enters a swap B in exchange for the
return on the S&P 500 for the same period
 If XYZ return < S&P 500 return, A "wins" because its cash flow from the swap are net positive
 If XYZ return > S&P 500 return, A "loses" because its cash flows from the swap are net negative
 But whether A "wins" or "loses" on their swap in a given period
 1) Its portfolio is more diversified than it was without the swap, and
 2) It did not have to sell its position in the stock of its benefactor's company

When would an investor want to use a equity swap? What are the potential drawbacks in each
situation?

 An investor can gain exposure a foreign market by entering a swap of the return on the
domestic index for the return on the foreign market's index
 DRAWBACK: The investor must accept currency risk
 DRAWBACK: If your portfolio doesn't perfectly match the domestic index, the investor is
exposed to tracking error
 An endowment with investments that are heavily concentrated in the stock of its benefactor's
company can change its risk profile to that of a diversified portfolio
 DRAWBACK: If the foundation must pay return that is significantly higher than the one it
receives, it may need to sell some of its portfolio, which is exactly what it was trying to
avoid in the first place (see 14i)
 A portfolio manager can alter its relative exposure to equities compared to bonds by swapping
the S&P 500 return for LIBOR
  DRAWBACKS: Cash flow risk & Tracking error (as described above)
 An entrepreneur (see 12d) or employee (see 8c) with high concentrations of wealth in own
company stock can diversify their portfolio
 DRAWBACK: Executive's control may become disproportionately large compared to
his/her share of cash flows
 DRAWBACK: There may be tax consequences for an entrepreneur seeking to diversify a
concentrated position in low basis stock if authorities consider a transaction to be an
effective sale

29h Swaps: Interest rate swaptions

Demonstrate the use of an interest rate swaption 1) to change the payment pattern of an anticipated
future loan and 2) to terminate a swap.

What are interest rate swaptions?

 Just so you know: Section 5.3

 The call feature of a callable bond can be synthetically removed by selling a receiver
swaption (net effect is receiving cash for giving up call option)
 Similarly, a call feature can be synthetically added to non-callable debt by purchasing a
receiver swaption
 Note that callable bonds (of the non-synthetic variety) are not as common as they used
to be (see 22b)

Recall that a swap is composed of a series of forward contracts, so its payoffs are symmetric

 Therefore, parties to swap contracts assume a higher level of risk compared to holders
of options contracts (which have asymmetric payoffs)
 Interest rate swaptions are named with respect to the fixed-rate:
 The buyer of a payer swaption receives the right enter an interest rate swap as the
fixed-rate payer
 The buyer of a receiver swaption receives the right to enter an interest rate swap as
fixed-rate receiver
 An investor considering a interest rate swap can reduce his/her risk exposure by purchasing an
interest rate swaption, which provides the right to enter a swap if the conditions are right at the
time of exercis, but not the obligation to do so if the conditions are not right
 Of course, as with options, the buyer of an interest rate swap must pay a premium for
this asymmetric payoff (ie. the right to walk away)

Why would an investor use an interest rate swaption?

The motivations for using interest rate swaption are no different than for using an interest rate swap -
there is just an extra charge for optionality

1) To change the pattern of payments on an upcoming fixed-income obligation

 Payer swaptions protect the buyer against an interest rate increase

 If the market rate at option expiry is below the rate in the swaption contract, the buyer can walk
away and pay the lower market rate

2) To terminate a swap position

 If a company enters a swap, it can also enter a swaption contract as an insurance policy that can
be used if its position in the original swap goes horribly wrong