A major defence industry supplier, Death Mines plc, wishes to borrow £1 million for twelve years at a fixed interest rate to finance a new investment project. It could do so by issuing a straight eurobond but, as it is not well known in the market and does not have a high credit risk rating, would have to pay a coupon of 8 per cent which it regards as too high. The firm’s own bank is willing to lend Death Mines the required amount via a one-year floating rate note at a rate of 2 per cent over LIBOR, currently at 3.6 per cent.

Clearly, the floating rate loan is much cheaper at the moment, but LIBOR could easily rise over the period of the loan to such a level that Death Mines would finish up losing on the project. Thus, it enters into a contract with a swap bank, Border International, to pay to it 5 per cent on the principal, receiving in exchange LIBOR.

The position of Death Mines now is:

Pays to its own bank LIBOR + 2 per cent

Pays to Border 5 per cent

Receives from Border LIBOR

Net position — fixed rate loan at 7 per cent

But what of Border International? It appears to be running a serious risk here. However, it would have entered into the above contract only if it were at the same time entering into another contract with a counterparty which we shall assume to be a large US multinational, GM Foods Inc. GM Foods is a prime borrower and so can borrow on the eurobond market on the finest terms, but prefers a floating rate loan as it is willing to gamble on interest rates falling in the future. Thus, it issues a straight £500,000 eurobond with a coupon of 4.375 per cent. Then it enters into a contract with Border International to pay Border LIBOR in exchange for a fixed return of 4.75 per cent.

The position of GM Foods now is:Funds

Pays on its straight eurobond 4.375 per cent

Receives from Border 4.75 per cent

Pays to Border LIBOR

Net position - floating rate loan at LIBOR - 0.375 per cent

Border International’s position now is:

Receives from Death Mines 5 per cent

Pays to Death Mines LIBOR

Receives from GM Foods LIBOR

Pays to GM Foods 4.75 per cent

Net position - profit of 0.25 per cent

(Interest rate differentials such as this are often referred to in the market in terms of basis points where 1 basis point = 0.01 per cent. Thus, 0.25 per cent is 25 basis points.)

Failed speculation with interest rate swaps

In the 1980s the Hammersmith and Fulham local authority in London, seeking to maximise its income to counter the effects of restrictions imposed by the central government, attempted to profit by speculation in interest rate swaps but ran up huge losses instead. It entered the sterling interest rate swaps market on 1 December 1983. Council officers had visited the London International Financial Futures Exchange (LIFFE), where the idea of using swaps to reduce the sensitivity of the council’s borrowings to interest rate fluctuations was explained to them. An independent inquiry in 1991, however, showed that such was the level of the user’s understanding, that the leader of the council and the finance department were not clear whether they were interested in futures or options transactions. The council’s activities in the money markets intensified in May 1987 when it began to become involved in swaptions and other complex transactions, eventually totalling 550 transactions.

At the time, interest rates were falling and the local authorities gambled on their continued fall. Thus, in 1988 when the base rate of interest in the UK was 7.5 per cent, local authorities swapped fixed interest rate for floating interest rate loans of the same value with hedging banks. The only payments made were for the net liabilities on whichever was the higher - the fixed or the floating rate. Thus if interest rates had continued to fall the local authorities would have profited. Their aim was to pick correctly the trough in interest rates and at that stage to reverse the swap, moving back to a fixed interest rate, probably at a lower rate than their original interest payments.

However, the local authorities were taken unawares by the sharp jump in interest rates, which saw the base rate of interest rise to 15 per cent in 1989. They were then, under the terms of the contract, required to pay large amounts to the banks - the difference between the now very high floating rates and the fixed rate on their original loans. Despite the volume of contracts and the size of the risk, there was never any monitoring system established to track the performance and possible dangers of their derivatives business. Happily for them, the ratepayers of the most indebted local authorities were rescued by the courts, which ruled that it had been illegal for the local authorities to use their funds in this way and therefore that the contracts were unenforceable. The banks could be said to have exposed themselves to legal risk - the risk of losing through a decision of the courts.

Possibly related posts: (automatically generated)
An interest rate swap & Failed speculation