The swap terms available to the insurance company are as follows:
- Every six months the life insurance company will pay LIBOR.
- Every six months the life insurance company will receive 8.40%.
What has this interest-rate contract done for the bank and the life insurance company? Consider first the bank. For every six-month period for the life of the swap agreement, the interest-rate spread will be as follows: Read the rest of this entry »
So far we have merely described an interest-rate swap and looked at its characteristics. Here we illustrate how they can be used in asset/liability management. Other types of interest-rate swaps have been developed that go beyond the generic or “plain vanilla” swap described and we describe these later.
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. The two institutions we use for illustration are a commercial bank and a life insurance company. Read the rest of this entry »
Let’s illustrate the mechanics of a standard single-name credit default swap. Assume that the reference entity is the ABC Corporation and the reference obligation is the ABC Subordinated Debenture due 2110. The swap premium—the payment made by the protection buyer to the protection seller —is 550 basis points. If a credit event occurs, the protection seller pays the protection buyer the notional amount of the contract. In our illustration, we will assume that the notional amount is $10 million.
The notional amount is not the par value of the reference obligation. For example, suppose that a bond issue is trading at 73.53 (par value being 100). If a portfolio manager owns $13.6 million par value of the bond issue and wants to protect the current market value of $10 million (approximately equal to 73.53% of $13.6 million), then the portfolio manager will want a $10 million notional amount. If a credit event occurs, the portfolio manager will deliver the $13.6 million par value of the bond and receive a cash payment of $10 million. Read the rest of this entry »
By far, the most popular type of credit derivative is the credit default swap. It is categorized as one of two credit default products. Not only is this form of credit derivative the most commonly used stand-alone product, but it is also used extensively in structured credit products such as synthetic collateralized debt obligations, which will be discuss later. A credit default swap is probably the simplest form of credit risk transference among all credit derivatives. Because of the popularity of credit default swaps, the other type of credit default product —the credit default option—is rarely used. Hence, we will not discuss that product here.
Credit default swaps are used to shift credit exposure to a credit protection seller. Their primary purpose is to hedge the credit exposure to a particular asset or issuer. In this sense, credit default swaps operate much like a standby letter of credit or insurance policy. In contrast, a total return swap allows an investor to increase exposure to a reference obligation. Read the rest of this entry »
Corporations can customize medium-term notes for institutional investors who want to make a market play on interest rate, currency, and/or stock market movements. That is, the coupon rate on the issue will be based on the movements of these financial variables. A corporation can do so in such a way that it can still synthetically fix the coupon rate. This can be accomplished by issuing an MTN and entering into a swap simultaneously. MTNs created in this way are called structured MTNs. Read the rest of this entry »
Valuing Caps and Floors
The arbitrage-free binomial model can be used to value a cap and a floor. This is because, as previously explained, a cap and a floor are nothing more than a package or strip of options. More specifically, they are a strip of European options on interest rates. Thus to value a cap the value of each period’s cap, called a caplet, is found and all the caplets are then summed. The same can be done for a floor.
To illustrate how this is done, we will once again use the binomial interest-rate tree to value an interest rate option. Consider first a 5.2%, three-year cap with a notional amount of $10 million. The reference rate is the one-year rates in the binomial tree. The payoff for the cap is annual.
Exhibit 25-12 shows how this cap is valued by valuing the three caplets. The value for the caplet for any year, say year X, is found as follows. First, calculate the payoff in year X at each node as either zero if the one-year rate at the node is less than or equal to 5.2%, or the notional principal amount of $10 million times the difference between the one-year rate at the node and 5.2% if the one-year rate at the node is greater than 5.2%
Then, the backward induction method is used to determine the value of the year X caplet. Read the rest of this entry »
An interest-rate agreement is an agreement between two parties whereby one party, for an upfront premium, agrees to compensate the other at specific time periods if a designated interest rate, called the reference rate, is different from a predetermined level. When one party agrees to pay the other when the reference rate exceeds a predetermined level, the agreement is referred to as an interest-rate cap or ceiling. The agreement is referred to as an interest-rate floor when one party agrees to pay the other when the reference rate falls below a predetermined level. The predetermined interest-rate level is called the strike rate.
The terms of an interest-rate agreement include
- The reference rate
- The strike rate that sets the ceiling or floor
- The length of the agreement
- The frequency of settlement
- The notional principal amount
Read the rest of this entry »
Credit default products have a payout that is contingent upon a credit event occurring. The ISDA provides definitions of what credit events are. The 1999 ISDA Credit Derivatives Definitions (referred to as the “1999 Definitions“) provides a list of eight credit events: (1) bankruptcy, (2) credit event upon merger, (3) cross acceleration, (4) cross default, (5) downgrade, (6) failure to pay, (7) repudiation/moratorium, and (8) restructuring. These eight events attempt to capture every type of situation that could cause the credit quality of the reference entity to deteriorate, or cause the value of the reference obligation to decline.
Bankruptcy is defined as a variety of acts that are associated with bankruptcy or insolvency laws. Failure to pay results when a reference entity fails to make one or more required payments when due. When a reference entity breaches a covenant, it has defaulted on its obligation. Read the rest of this entry »
Here we review some of the terminology used in the swaps market and explain how swaps are quoted. 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.
Although our illustrations assume that the timing of the cash flows for both the fixed-rate payer and floating-rate payer will be the same, this is rarely the case in a swap. In fact, an agreement may call for the fixed-rate payer to make payments annually but the floating-rate payer to make payments more frequently (semiannually or quarterly). Also, the way in which interest accrues on each leg of the transaction differs, because there are several day-count conventions in the fixed-income markets. Read the rest of this entry »
There are two ways that a swap position can be interpreted: (1) as a package of forward/ futures contracts, and (2) as a package of cash flows from buying and selling cash market instruments.
Package of Forward Contracts Consider the hypothetical interest-rate swap described earlier to illustrate a swap. Let’s look at party X’s position. Party X has agreed to pay 10% and receive six-month LIBOR. More specifically, assuming a $50 million notional principal amount, X has agreed to buy a commodity called six-month LIBOR for $2.5 million This is effectively a six-month forward contract in which X agrees to pay $2.5 million in exchange for delivery of six-month LIBOR. If interest rates increase to 11%, the price of that commodity (six-month LIBOR) is higher, resulting in a gain for the fixed-rate payer, who is effectively long a six-month forward contract on six-month LIBOR. The floating-rate payer is effectively short a six- month forward contract on six-month LIBOR. There is therefore an implicit forward contract corresponding to each exchange date. Read the rest of this entry »
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. In the most common type of swap, one party agrees to pay the other party fixed-interest payments at designated dates for the life of the contract. This party is referred to as the fixed-rate payer. The other party, who agrees to make interest rate payments that float with some reference rate, is referred to as the floating-rate payer. The frequency with which the interest rate that the floating-rate payer must pay is called the reset frequency. Read the rest of this entry »
Earlier we provided two interpretations of a swap: (1) a package of futures/forward contracts, and (2) a package of cash market instruments. The swap spread is determined by the same factors that influence the spread over Treasuries on financial instruments (futures/forward contracts or cash) that produce a similar return or funding profile. As we explain subsequently, the key determinant of the swap spread for swaps with maturities of five years or less is the cost of hedging in the Eurodollar CD futures market. For longer maturity swaps, the key determinant of the swap spread is the credit spreads in the corporate bond market. Read the rest of this entry »
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. The three-month LIBOR forward rates from the current Eurodollar CD futures contracts are used to (1) calculate the floating-rate payments and (2) determine the discount factors at which to calculate the present value of the payments.
To illustrate this, consider the three-year swap used to demonstrate how to calculate the swap rate. Suppose that one year later, interest rates change as shown in Columns (4) and (6) in Exhibit 25-9. Column (4) shows the current three-month LIBOR. In Column (5) are the Eurodollar CD futures prices for each period. These rates are used to compute the forward rates in Column (6). Note that the interest rates have increased one year later since the rates in Exhibit 25-9 . Read the rest of this entry »
A collateralized debt obligation (CDO) is backed by a diversified pool of one or more types of debt obligations (e.g., U.S. domestic investment-grade corporate bonds, high-yield corporate bonds, emerging market bonds, bank loans, asset-backed securities, and residential and commercial mortgage-backed securities). The funds to purchase the collateral assets are obtained from the issuance of bonds. There is a collateral manager responsible for managing the collateral of assets.
A CDO is classified as a cash CDO or a synthetic CDO. The adjective “cash” means that the collateral manager purchases cash market instruments. A synthetic CDO is so named because the collateral manager does not actually own the pool of assets on which it has the credit risk exposure. Stated differently, a synthetic CDO absorbs the credit risk, but not the legal ownership, of the reference obligations. A credit default swap allows institutions to transfer the credit risk, but not the legal ownership, of the reference obligations it may own. Read the rest of this entry »
A total return swap in the fixed-income market is a swap in which one party makes periodic floating-rate payments to a counterparty in exchange for the total return realized on a reference obligation or a basket of reference obligations. A total return payment includes all cash flows that flow from the reference obligations as well as the capital appreciation or depreciation of those reference obligations. When the reference obligation is a bond market index, the swap is referred to as a total return index swap.
The party that agrees to make the floating payments and receive the total return is referred to as the total return receiver; the party that agrees to receive the floating payments and pay the total return is referred to as the total return payer.
Notice that in a total return swap, the total return receiver is exposed to both credit risk and interest-rate risk. For example, the credit risk spread can decline (resulting in a favorable price movement for the reference obligation), but this gain can be offset by a rise in the level of interest rates. Read the rest of this entry »
The interest-rate swap was developed in late 1981. By 1987, the market had grown to more than $500 billion (in terms of notional principal amount). What is behind this rapid growth? As our asset/liability application earlier demonstrated, an interest-rate swap is a quick way for institutional investors to change the nature of assets and liabilities or to exploit any perceived capital market imperfection. The same applies to borrowers such as corporations, sovereigns, and supranationals.
In fact, the initial motivation for the interest-rate-swap market was borrower exploitation of what were perceived to be “credit arbitrage” opportunities because of differences between the quality spread between lower- and higher-rated credits in the U.S. and Eurodollar bond fixed-rate market and the same spread in these two floating- rate markets. Basically, the argument for swaps was based on a well-known economic principle of comparative advantage in international economics. Read the rest of this entry »
An investor who lends funds by purchasing a bond issue is exposed to three types of credit risk: (1) default risk, (2) credit spread risk, and (3) downgrade risk.
Traditionally, credit risk is defined as the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. This form of credit risk is called default risk. If a default does occur, this does not mean the investor loses the entire amount invested because the investor can expect to recover a portion of the investment. Read the rest of this entry »
One issue that has elicited different responses is the role of currency risk in overall risk and return. Currency risk has been accounted for in all of the evidence presented. So the existence of currency risk will not reduce the benefits of investing in foreign markets. Rather, the question is whether managing currency risk will improve the gains from international investing.
While the reduction of any kind of risk is good, there are two issues that must be considered with regard to currency risk. First, the correlation between currency risk and stock market risk is close to zero. That means that currency changes and stock returns are independent of one another. Though both currency risk and stock market risk contribute to the total risk of a portfolio of foreign stocks, the contribution of currency risk to the total risk is not very large because of the zero correlation. On average, currency risk contributes less than 20 percent of the total risk. Read the rest of this entry »
