Global Edition

Chapter 28

Interest-Rate
Swaps, Caps, and
Floors
 Interest-Rate Swaps

 In an interest-rate swap, two parties (called counterparties)

agree to exchange periodic interest payments.
 The dollar amount of the interest payments exchanged is based on a
predetermined dollar principal, which is called the notional
principal amount.
 The dollar amount that each counterparty pays to the other is the
agreed-upon periodic interest rate times the notional principal
amount.
 The only dollars that are exchanged between the parties are the
interest payments, not the notional principal amount.
 This party is referred to as the fixed-rate payer or the floating-
rate receiver.
 The other party, who agrees to make interest rate payments that
float with some reference rate, is referred to as the floating-rate
payer or fixed-rate receiver.
 The frequency with which the interest rate that the floating-rate
payer must pay is called the reset frequency.
 Interest-Rate Swaps (continued)

 Interpreting a Swap Position

 A swap can be interpreted as a package of cash market instruments.

 Consider the following transaction:

● Buy $50 million par of a five-year floating-rate bond that pays
six-month LIBOR every six months; and
● Finance the purchase by borrowing $50 million for five years at 10%
annual interest rate paid every six months.

 The cash flows for this transaction are shown in Exhibit 28-1.
• As the last column indicates, there is no initial cash flow (no cash
inflow or cash outlay).
• In all 10 six-month periods, the net position results in a cash inflow
of LIBOR and a cash outlay of $2.5 million  identical to the position
of a fixed-rate payer.
 Exhibit 28-1 Cash Flow for the Purchase of a Five-Year
Floating-Rate Bond Financed by Borrowing on a
Fixed-Rate Basis
Transaction: Purchase for $50 million a five-year floating-rate bond: floating rate = LIBOR,
semiannual pay; borrow $50 million for five years: fixed rate = 10%, semiannual payments

Cash Flow (millions of dollars) From:

Six-Month Period Floating-Rate Bonda Borrowing Cost Net

0 –$50.0 +$50 $0
1 +(LIBOR1/2)×50 –2.5 + (LIBOR1/2)×50–2.5
2 +(LIBOR2/2)×50 –2.5 + (LIBOR2/2)×50–2.5
3 +(LIBOR3/2)×50 –2.5 + (LIBOR3/2)×50–2.5
4 +(LIBOR4/2)×50 –2.5 + (LIBOR4/2)×50–2.5
5 +(LIBOR5/2)×50 –2.5 + (LIBOR5/2)×50–2.5
6 +(LIBOR6/2)×50 –2.5 + (LIBOR6/2)×50–2.5
7 +(LIBOR7/2)×50 –2.5 + (LIBOR7/2)×50–2.5
8 +(LIBOR8/2)×50 –2.5 + (LIBOR8/2)×50–2.5
9 +(LIBOR9/2)×50 –2.5 + (LIBOR9/2)×50–2.5
10 +(LIBOR10/2)×50+50 –52.5 + (LIBOR10/2)×50–2.5
aThe subscript for LIBOR indicates the six-month LIBOR as per the terms of the floating-rate bond
at time t.
Describing the Counterparties to a
Swap

Fixed-Rate Payer (Receive Floating) Floating-Rate Payer (Receive Fixed)

Pays fixed rate in the swap Pays floating rate in the swap

Receives floating in the swap Receives fixed in the swap

Is short the bond market Is long the bond market

Has bought a swap Has sold a swap

Is long a swap Is short a swap

 Interest-Rate Swaps (continued)

 Terminology, Conventions, and Market Quotes

 The date that the counterparties commit to the swap is
called the trade date.
 The date that the swap begins accruing interest is called the
effective date, and the date that the swap stops accruing
interest is called the maturity date.
 The convention that has evolved for quoting swaps levels is
that a swap dealer sets the floating rate equal to the index
and then quotes the fixed-rate that will apply.
• The offer price that the dealer would quote the
fixed-rate payer would be to pay 8.85% and receive
LIBOR “flat” (“flat” meaning with no spread to LIBOR).
• The bid price that the dealer would quote the fixed-rate
receiver would be to pay LIBOR flat and receive 8.75%.
• The bid-offer spread is 10 basis points.
Exhibit 28-2 Meaning of a “40–50” Quote for
a 10-Year Swap When Treasuries Yield 8.35%
(Bid-Offer Spread of 10 Basis Points)

Fixed-Rate Fixed-Rate
Receiver Payer

Pay Floating rate of Fixed rate of

six-month 8.85%
LIBOR

Receive Fixed rate of Floating rate of

8.75% six-month
LIBOR
 Interest-Rate Swaps (continued)

 Calculation of the Swap Rate

 At the initiation of an interest-rate swap, the counterparties
are agreeing to exchange future interest-rate payments and
no upfront payments by either party are made.

 While the payments of the fixed-rate payer are known, the

floating-rate payments are not known.

 For a LIBOR-based swap, the Eurodollar futures contract can

be used to establish the forward (or future) rate for
three-month LIBOR.
 Interest-Rate Swaps (continued)

 Calculation of the Swap Rate

 In general, the floating-rate payment is determined as follows:
floating  rate payment 

number of days in period

notional amount  three  month LIBOR 
360

 The fixed-rate payment is determined as follows:

fixed  rate payment 

number of days in period

notional amount  swap rate 
360

 Exhibit 28-4 shows the fixed-rate payments based on an assumed swap

rate of 4.9875%.
 Exhibit 28-4 Fixed-Rate Payments Assuming
a Swap Rate of 4.9875%
Fixed-Rate Payment if Swap
Quarter Days in Period = End Rate Is Assumed to Be
Starts Quarter Ends Quarter of Quarter 4.9875%
Jan 1 year 1 Mar 31 year 1 90 1 1,246,875
Apr 1 year 1 June 30 year 1 91 2 1,260,729
July 1 year 1 Sept 30 year 1 92 3 1,274,583
Oct 1 year 1 Dec 31 year 1 92 4 1,274,583
Jan 1 year 2 Mar 31 year 2 90 5 1,246,875
Apr 1 year 2 June 30 year 2 91 6 1,260,729
July 1 year 2 Sept 30 year 2 92 7 1,274,583
Oct 1 year 2 Dec 31 year 2 92 8 1,274,583
Jan 1 year 3 Mar 31 year 3 90 9 1,246,875
Apr 1 year 3 June 30 year 3 91 10 1,260,729
July 1 year 3 Sept 30 year 3 92 11 1,274,583
Oct 1 year 3 Dec 31 year 3 92 12 1,274,583
 Interest-Rate Swaps (continued)

 Calculation of the Swap Rate

 At the initiation of an interest-rate swap, the counterparties
are agreeing to exchange future payments and no upfront
payments by either party are made.

 This means that the present value of the payments to be

made by the counterparties must be at least equal to the
present value of the payments that will be received.

 The equivalence of the present value of the payments is the

key principle in calculating the swap rate:

PV of floating-rate payments = PV of fixed-rate payments

 Interest-Rate Swaps (continued)

 Calculation of the Swap Rate

 The present value of $1 to be received in period t is the forward
discount factor.
 In calculations involving swaps, we compute the forward discount
factor for a period using the forward rates.
 These are the same forward rates that are used to compute the
floating-rate payments—those obtained from the Eurodollar futures
contract.
● We must adjust the forward rates used in the formula for the
number of days in the period (i.e., the quarter in our
illustrations) in the same way that we made this adjustment to
obtain the payments.
● Specifically, the forward rate for a period (i.e., the period
forward rate) is computed using the following equation:

days in period
period forward rate  annual forward rate 
360
 Interest-Rate Swaps (continued)

 Calculation of the Swap Rate

 The forward discount factor is used to compute the present value of
the both the fixed-rate payments and floating-rate payments.

 The present value of the fixed-rate payment for period t:

present value of the fixed-rate payment for period t 
days in period t
notional amount  swap rate   forward discount factor for period t
360

 Summing up the present value of the fixed-rate payment for each

period gives the present value of the fixed-rate payments:

present value of the fixed-rate payment 

days in period t
swap rate   notional amount   forward discount factor for period t
360
 Interest-Rate Swaps (continued)

 Calculation of the Swap Rate

 Solving for the swap rate:

swap rate =
present value of floating-rate payments
N days in period t
 notional amount   forward discount factor for period t
t 1 360
 Interest-Rate Swaps (continued)

 Valuing a Swap
 Once the swap transaction is completed, changes in market
interest rates will change the payments of the floating-rate
side of the swap.

 The value of an interest-rate swap is the difference

between the present value of the payments of the two
sides of the swap.
 Interest-Rate Swaps (continued)

 Duration of a Swap
 From the perspective of a fixed-rate receiver, the
interest-rate swap position can be viewed as follows:
long a fixed-rate bond + short a floating-rate bond

 the dollar duration of such a position is simply the

difference between the dollar duration of the two bond
positions that make up the swap:

dollar duration of a swap = dollar duration of a fixed-

rate bond – dollar duration of a floating-rate bond
 Interest-Rate Swaps (continued)

 Application of a Swap to Asset/Liability Management

 An interest-rate swap can be used to alter the cash flow
characteristics of an institution’s assets so as to provide
a better match between assets and liabilities.

 An interest-rate swap allows each party to accomplish its

asset/liability objective of locking in a spread.

 An asset swap permits the two financial institutions to

alter the cash flow characteristics of its assets: from
fixed to floating or from floating to fixed.

 A liability swap permits two institutions to change the

cash flow nature of their liabilities.
 Hedging against Interest Rate Risk

• Banks lend long term (income) and borrow short term (cost)

• Short term interest rates rise  spread income declines

• Use IRS to lock in a spread over the cost of funds

• E.g. a bank funds its 5-year loan portfolio earning fixed

interest of 8% by borrowing at 6m LIBOR
 By a 5-year IRS: pay fixed 5.5%
receive 6m LIBOR
 Outcome: spread income locked at 250 bps
 Liability (Liability-Based) Swap

• Companies issuing FRNs are exposed to interest rate risk

• Short term interest rates rise  higher interest expenses

• Use IRS to fix the financing costs

• E.g. a company has issued a FRN paying 6m LIBOR+100 bps

with 3 years to maturity
 By a 3-year IRS: pay fixed 6.75%
receive 6m LIBOR
 Outcome: borrowing cost fixed at 7.75%
 Lower Borrowing Costs

• AAA Corp wants to borrow floating

• BBB Corp wants to borrow fixed

• The credit spread between AAA and BBB is higher for

fixed (200 bps) than for floating (80 bps)  a credit
spread differential of 120 bps

Borrow Borrow
Fixed Floating

AAA Corp 5.00% 6-month LIBOR + 0.20%

BBB Corp 7.00% 6-month LIBOR + 1.00%

 Lower Borrowing Costs (cont’d)

 AAA Corp issues fixed-rate bond

 BBB Corp issues FRN

 Use IRS to share the credit spread differential

Scenario I – Without Intermediary (or Intermediary as Broker)

BBB pays fixed 5.50%

AAA Corp BBB Corp

BBB receives LIBOR
AAA pays fixed 5.00% BBB pays LIBOR
+1.00%

Before: LIBOR + Before: 7.00%

0.20% After: 5.50% + 1.00% = 6.50%
After: LIBOR – 0.50% Saving = 0.50%
Saving = 0.70%
 Lower Borrowing Costs (cont’d)

Scenario II – With Intermediary as Dealer (e.g. UBS)

UBS pays fixed 5.40% UBS receives fixed 5.60%

UBS

LIBOR LIBOR

AAA Corp BBB Corp

AAA pays fixed 5.00% BBB pays LIBOR

+1.00%

Before: LIBOR + 0.20% Before: 7.00%

After: LIBOR – 0.40% After: 5.60% + 1.00% = 6.60%
Saving = 0.60% Saving = 0.40%
 Asset (Asset-Based) Swap

• FRN investors finding good bargains in fixed-rate corporates

• Use IRS to convert fixed-rate income to floating-rate

• E.g. an investor has bought a fixed-rate bond yielding

7.25% with 5 years to maturity
 By a 5-year IRS: pay fixed 5%
receive 6m LIBOR
 Outcome: a synthetic FRN paying 6m LIBOR + 225 bps
 Speculation

• Expecting interest rates to rise  Pay fixed/Receive

float

• Expecting interest rates to drop  Pay float/Receive

fixed

• Advantages:
 Cheaper to execute
 Less risky than bond purchase
 Leverage – increasing notional principal
 Swap Rate Yield Curve

 Dealers in the swap market quote swap rates for different

maturities. The relationship between the swap rate and
maturity of a swap is called the swap rate yield curve or, more
commonly, the swap curve.

 Because the reference rate is typically LIBOR, the swap curve is

also called the LIBOR curve.

 The swap curve is used as a benchmark in many countries

outside the U.S.

 Unlike a country’s government bond yield curve, the swap curve

is not a default-free yield curve but reflects the credit risk of the
counterparty to an interest rate swap.
 Swap Rate Yield Curve (continued)

 There are three advantages of using a swap curve over a

country’s government securities yield curve.
i. There may be technical reasons why within a government
bond market some of the interest rates may not be
representative of the true interest rate but instead be
biased by some technical or regulatory factor unique to that
market.

ii. To create a representative government bond yield curve, a

large number of maturities must be available.

iii. The ability to compare government yields across countries

is difficult because there are differences in the credit risk
for every country.
 Non-Generic Swaps

 Varying Notional Principal Amount Swaps

 In a generic or plain vanilla swap, the notional principal amount
does not vary over the life of the swap  bullet swap.

 Amortizing swap: the notional principal amount decreases in

a predetermined way over the life of the swap.
• Such a swap would be used where the principal of the
asset that is being hedged with the swap amortizes over
time.

 Accreting swap: the notional principal amount increases in a

predetermined way over time.

 Roller coaster swap: the notional principal amount can rise

or fall from period to period.
 Non-Generic Swaps (continued)

 Basis Swap and Constant Maturity Swap

 Basis rate swap: both parties exchange floating-
rate payments based on a different reference rate.
• For a bank, the risk is that the spread between
the prime rate and LIBOR will change  basis
risk.

 Constant maturity swap: one of the floating legs

tied to a longer-term rate such as the two-year
Treasury note and another floating leg tied to a
money market rate.
 Non-Generic Swaps (continued)

 Forward Start Swap

 Forward start swap: the swap does not begin
until some future date that is specified in the
swap agreement.

 A forward start swap will also specify the swap

rate at which the counterparties agree to
exchange payments commencing at the start
date.
 Non-Generic Swaps (continued)

 Swaptions
 There are options on interest-rate swaps.

• Swaptions grant the option buyer the right to enter into an

interest-rate swap at a future date.

i. Payer swaption: the option buyer has the right to enter into an
interest-rate swap that requires paying a fixed-rate and receiving
a floating rate.

ii. Receiver swaption: the option buyer has the right to enter into
an interest-rate swap that requires paying a floating rate and
receiving a fixed-rate.
 Example of a Swaption

• A company anticipates entering into a three-year, pay-

fixed/receive-floating swap one year from now.

• It is concerned about interest rates rising by the time

it enters into the swap.

• It buys a payer swaption, expiring in one year, where

the underlying swap has a three-year maturity.
 The strike rate is 7.00%.
 The notional principal is $100 million.
 Example of a Swaption (cont’d)

• At expiration, suppose the market swap rate is

8.50% but the Company has an option to enter into a
swap paying 7.00%.
 So it exercises the swaption.

• By exercising the swaption, it enters into a swap,

paying 7.00% and receiving LIBOR.

• It can then enter into a swap at the market rate of

8.50%, receiving 8.50% and paying LIBOR.

• Such transactions save 8.50% - 7.00% = 1.50% per

annum (or $1,500,000 per annum)