Interest Rate Swap Lpu

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Term paper Of Derivatives and risk management
Topic: How an Interest Rate Swap Can Be Constructed To Provide A Company With Additional Cash Flow

Submitted to: ms. Sweta singh

submitted by: raman dhillon(23) gauri gupta(24) saurabh nagpal(25) jatender pal singh(26)

ACKNOWLEDGEMENT

I feel immense pleasure to give the credit of my term paper not only to one individual as this work is integrated effort of all those who concerned with it. I want to owe my thanks to all those group members who guided me to move on the track.

This report entitled (How An Interest Rate Swap Can Be Constructed To Provide A Company With Additional Cash Flow). Critically Review With evidences. I sincerely express my gratitude and lot of thanks to Ms. Sweta Singh (How An Interest Rate Swap Can Be Constructed To Provide A Company With Additional Cash Flow) for guiding me in completing my Term paper and making it a great success. I would like to express my deep sense of gratitude to staff of LOVELY SCHOOL OF BUSINESS who introduced me to the subject and under whose guidance we able to complete my Term Paper.

INTEREST RATE SWAP

Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. Interest rate swaps are very popular and highly liquid instruments.

STRUCTURE
In an interest rate swap, each counterparty agrees to pay either a fixed or floating rate denominated in a particular currency to the other counterparty. The fixed or floating rate is multiplied by a notional principal amount (say, USD 1 million). This notional amount is generally not exchanged between counterparties, but is used only for calculating the size of cash flows to be exchanged.

The most common interest rate swap is one where one counterparty A pays a fixed rate (the swap rate) to counterparty B, while receiving a floating rate (usually pegged to a reference rate such as LIBOR). According to usual market convention, the counterparty paying the fixed rate is called the "payer" (while receiving the floating rate), and the counterparty receiving the fixed rate is called the "receiver" (while paying the floating rate). A pays fixed rate to B (A receives variable rate) B pays variable rate to A (B receives fixed rate). Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of 8.65%, in exchange for periodic variable interest rate payments of LIBOR +

70 bps (0.70%). Note that there is no exchange of the principal amounts and that the interest rates are on a "notional" (i.e. imaginary) principal amount. Also note that the interest payments are settled in net (e.g. Party A pays (LIBOR + 1.50%)+8.65% - (LIBOR+0.70%) = 9.45% net). The fixed rate (8.65% in this example) is referred to as the swap rate At the point of initiation of the swap, the swap is priced so that it has a net present value of zero. If one party wants to pay 50 bps above the par swap rate, the other party has to pay approximately 50 bps over LIBOR to compensate for this.

For example: in the United States, you might have a company called Acme Tool & Die
with a relatively poor credit rating that borrows most of its funds with short maturities. Acme may want to change its exposure to interest rates to more correctly reflect the long-term nature of the projects it is funding. Or, Acme may believe that long-term interest rates are going to rise, causing it to seek protection against the impact of higher interest rates on its balance sheet. One solution is for Acme to enter into an interest rate swap. In exchange for receiving payments tied to the floating rate index Acme uses for borrowing in the short maturities (with payment dates corresponding to the dates Acme must reset its short-term borrowing), Acme would pay a fixed rate index, all on the same notional amount as its total outstanding borrowings. With the swap, the managers of Acme have closed out the company's exposure to changes in short term rates and they have taken on an exposure to long term rates that more closely corresponds to Acme's long term assets. Differences in the credit quality between entities borrowing money motivate the interest rate swap market. Specifically, some agents may have a better borrowing profile in the short maturities than they do in the long maturities. Other agents (with more creditworthy status) have a comparative advantage raising money in the longer maturities. A counter-party's creditworthiness is an assessment of their ability to repay money lent to them over time. If a company has a good credit rating, they are more likely to be able to pay back a loan over time than a company with a poor credit rating. This effect is magnified with time. By making it easier for less creditworthy agents to borrow in the short term than in the long term, lenders make sure that they are less exposed to this risk.

Therefore, we would expect that in fixed-floating interest rate swaps, the entity paying fixed and receiving floating is usually the less creditworthy of the two counterparties. The interest rate swap gives the less creditworthy entity a way of borrowing fixed rate funds for a longer term at a cheaper rate than they could raise such funds in the capital markets by taking advantage of the entity's relative advantage in raising funds in the shorter maturity buckets. As we shall see in a later article, this arbitrage opportunity is expanded when we consider agents who can borrow money in a number of different currencies. In that case, we can think of a matrix of currency and maturity to describe an entity's relative arbitrate opportunities. This can be addressed using currency swaps. Of course, fixed-floating interest rate swaps are not the only kinds of interest rate swaps we can construct. Any kind of interest rate swap is possible, as long as the two counter-parties can come up with differing indices. We could imagine a swap in which there are two different kinds of floating indices or another in which there are two different kinds of fixed indices.

WHAT IS YOUR SWAPS WORTH?
New financial disclosure requirements and new tests for hedge effectiveness make swap valuation a more important topic than ever. In this issue of Derivations we describe how to calculate the market value of a simple interest rate swap and how to measure a swap’s sensitivity to changes in market interest rates. THE CHALLENGE Raising the bar for financial disclosure in the U.S. the Financial Accounting Standards Board (FASB) will introduce a new accounting standard for derivatives, FAS 133 (see Derivations Issue Number 6, entitled “New Accounting Rules For Derivatives and Hedging Activities”). The new American standard brings derivatives’ values onto the balance sheet. It also sets market value-related effectiveness tests for swaps and other derivatives to qualify for hedge accounting. While Canadian standard setters have closely monitored developments in the U.S., current accounting practice in Canada is not expected to change in the near future.

While spread sheets and complex computer pricing models can be relied on to do the analytical and quantitative work in swap valuation, changing reporting and disclosure requirements make it even more important that senior financial managers understand the basic concepts of valuation.

WHAT AFFECTS SWAP VALUE?
From a valuation perspective swaps are not much different from customized notes and bonds. The fixed cash flows in a swap are akin to the interest payments on a high quality fixed rate note, while swap floating cash flows are like the interest payments on a floating rate note. Market variables that affect swap pricing include changes in the level of interest rates, changes in swap spreads, changes in the shape of the yield curve, and FX rates (for currency swaps). Key transaction-specific variables that affect swap valuation include notional principal amount and amortization, time to maturity, swap payment frequency, and floating rate reference index.

MECHANICS OF SWAP PRICING
Measuring the current market value of an interest rate swap involves four distinct elements: Constructing a zero coupon* yield curve Extrapolating a forecast of future interest rates to establish the amount of each future floating rate cash flow Deriving discount factors to value each swap fixed and floating rate cash flow Discounting and present valuing all known (fixed) and forecasted (floating) swap cash flows.

While this may sound complicated, the curve building and discounting techniques are the same techniques used to establish the theoretical market value of any interest bearing security. Constructing a Yield Curve The first step in swap valuation is to build a yield curve from current cash deposit rates, eurodollar futures prices, treasury yields, and interest rate swap spreads. These known market rates are “hooked” together to form today’s coupon yield curve. The coupon curve is the raw material from which a zero coupon yield curve is constructed, usually using a method called “bootstrapping”. This involves deriving each new point on the curve from previously determined zero coupon points (hence the phrase, “bootstrapping”). Zero rates are higher than coupon rates when the yield curve is positively sloped and lower when the curve is inverted. The gap is widest at the far end of the yield curve. When rates are low and the yield curve flat the difference between coupon and zero rates will be minimal, but when rates are high and the curve steep, the difference is significant. Because the cash flow dates of the swap to be valued rarely exactly match the dates for which zero curve points have been developed, interpolation between data points is needed to solve the problem. While this sounds simple, some extremely complicated algorithms have been developed to minimize the errors that can arise from interpolation. Forecasting Future Short-Term Rates One half of the cash flows in a simple swap are floating rate. What makes the floating leg of the swap hard to price is the uncertainty of the forward rates—only today’s floating rate is known for certain. A forecast of future floating rates — a forward yield curve of short term interest rates—is needed before prospective floating rate cash flows can be generated. In fact, the forward curve is just an extension of the zero coupon yield curve; once the zero curve has been developed, it easily transforms into the forward curve needed to generate the swap’s floating rate cash flows. Deriving Discount Factors

Discount factors, used to present value each swap cash flow, are developed as part of the process of bootstrapping the zero coupon yield curve. Like forward interest rates, discount factors are just a transformation of zero coupon rates. In fact, there is a simple formula for converting one to the other. Valuing the Swap With all the calculations concluded, the only step remaining is to apply the discount factors to find the present value of fixed and floating swap cash flows. These values are then netted to determine the swap’s current market value. This value can be positive, zero, or negative, depending on how market interest rates have changed since the swap was created. For a floating to fixed swap, higher market rates will create a gain for the hedger, lower rates a loss. In the example below, a swap with a remaining term of 2 years is valued at a point when market interest rates have risen 1% across the yield curve from the time the swap was put into place.

A Simple Rule of Thumb for Estimating the Sensitivity of a Swap’s Value to Changes in Market Interest Rates Change in Value

While understanding the basics of swap valuation should make senior financial officers more comfortable with the balance sheet implications of the firm’s hedging activity, a quick and dirty way to estimate a hedge’s value and rate sensitivity can also prove useful. A Simple Rule of Thumb for Estimating the Sensitivity of a Swap’s Value to Changes in Market Interest Rates While understanding the basics of swap valuation should make senior financial officers more comfortable with the balance sheet implications of the firm’s hedging activity, a quick and dirty way to estimate a hedge’s value and rate sensitivity can also prove useful. DV ’01—the change in dollar value of a swap for a one basis point change in market interest rates— is a simple measure for benchmarking how the value of an interest rate swap changes as interest rates change. However, because the DV ’01 changes as market rates go up and down and the shape of the yield curve changes, it can only be used to estimate the change in a swap’s value for small shifts in rates. The chart below describes the DV ’01 for a $25 million interest rate swap with maturity between 2 and 10 years. These values are based on today’s yield curve (May, 1999). The values needed to estimate the potential gain or loss on a hedge include the actual fixed rate on the swap, the market fixed rate for a swap of equal remaining life, and the DV ’01 of the swap.

For example, Company ABC has a two month window in which to execute a five-year swap program covering $25 million of its bank debt. The company could hedge the debt today at a fixed swap rate of 5.90%, but it hopes that the market will improve over the next few weeks.

Using the DV ’01 value, the company can estimate how much it stands to gain or lose from delaying the hedge. From the chart, the DV ’01 of a 5 year $25 million swap is $9,375. A 25 basis point change in rates (a not uncommon occurrence over a two month period), would trigger an opportunity gain or loss around $234,375 ($9,375 X 25 basis points). With an available estimate now of how much is at risk, the company can decide how confident it is in its interest rate forecast.

AN INTEREST RATE SWAP IS THE EXCHANGE OF A STREAM OF CASH FLOWS BASED ON A FIXED INTEREST RATE IN EXCHANGE FOR A STREAM OF CASH FLOWS BASED ON A FLOATING INTEREST RATE
For example, Party A is currently paying a floating rate of interest but wishes to convert that to a fixed rate of interest. Party B is currently paying a fixed rate of interest but wishes to pay a floating rate. The two parties can enter into an interest rate swap whereby Party A pays a fixed rate to B in exchange for a floating rate of interest. The net result (as shown in the example below) is that Party A ends up paying a floating rate of interest and Party B ends up with a fixed rate of interest.

EXAMPLE - OF INTEREST RATE SWAP

Bank A is AAA-rated bank in U.K., and needs $10m cash inflow to finance floating-rate, 5year Eurodollar term loans to its commercial clients. To minimize (eliminate) interest rate risk, bank would prefer to match floating-rate debt (CDs or notes) with its expected floatingrate assets (Eurodollar loans). It has two sources of debt available: a) 5-YR FIXED-RATE BONDS @ 10% or b) 5-YR FLOATING-RATE NOTES (FRNs) @ LIBOR With floating rate loans and fixed rate debt, there is interest rate risk. Worried about? Therefore, bank prefers floating-rate debt, to match the floating rate loan (asset). Company B is a BBB rated MNC in U.S., needs $10m for 5 years to finance a capital expenditure (new project, investment in property/plant, replace worn out equipment, etc.). It has two sources of debt available: a)5-YR FIXED-RATE BONDS @ 11.75% b) 5-YR FLOATING-RATE NOTES (FRNs) @ LIBOR + .50% With FRNs there is interest rate risk if interest rates . Therefore, MNC prefers fixed-rate debt to guarantee a fixed, stable interest expense. Swap Bank can broker an interest rate swap deal (for a fee) with Bank A and Company B that will benefit both counterparties. When structured properly all three parties will benefit (Bank A, Company B, and the swap bank). "Risky" BBB Fixed-Rate Floating-Rate "Safe" AAA Company B 11.75% LIBOR +.5% Bank A 10% LIBOR Difference (11.75 - 10%) Risk Premium 1.75% .50%

(LIBOR + .5%) - LIBOR QSD 1.25%

The key to an interest-rate swap is the QSD (Quality Spread Differential), the difference or spread between fixed interest rates (Risky - Safe), and variable interest rate (Risky - Safe).

Co. B would have to pay 1.75% more than Bank A for fixed rate debt, but only .5% more for variable rate. The QSD is 1.25% , reflecting the difference, or additional default risk premium on fixed rate debt. The yield curve (fixed rate) for risky debt is much steeper than for safe debt, since lenders will: 1) Not have an opportunity to adjust (raise) the rate, and 2) Not have the opportunity to cancel the debt if the company gets in trouble, and 3) Not be able to change the terms of the loan. All of these would be possible under floating-rate agreements, and lenders therefore have to "lock-in" a high default risk premium for fixed-rate debt at the beginning of the loan. When a QSD exists, it represents the potential gains from trade if both parties get together, through the swap bank. Here is an example of how the 1.25% QSD can be split up as follows: .5% for each party (bank and MNC) in the form of interest rate savings and .25% profit for the bank to arrange the deal. For $10m, each party (Bank A and Co. B) can save $50,000/year for 5 years, and the bank will make $25,000/yr for 5 years (total of $625,000 to split). Without the swap, Bank A will pay variable-rate @ LIBOR, and Co. B will pay fixed-rate @ 11.75%. With the swap, each party will save .5%, as follows: Bank A will paya all-incost (interest expense, transactions cost, service charges) interest expense of LIBOR - .5% (saving .50%) and Co. B will pay all-in-cost interest expense of 11.25% (saving .50%). Here is how: Instead of actually issuing the type of debt they really want, each party issues the opposite of what they want, and then they swap CFs. Instead of variable debt at LIBOR, Bank A issues fixed-rate bonds at 10%. Instead of issuing fixed rate at 11.75%, Co. B issues variable-rate debt at LIBOR + .5%. The parties issue the debt that they don't want, and make interest payments directly to the bondholders for 5 years. The swap bank then arranges the following CF payments: 1. Co. B pays 10.50% fixed-rate interest (on $10m) to the Swap Bank, and the bank passes on 10.375% interest payment to Bank A in U.K. (Swap bank makes the difference = 10.50% 10.375% = .125%). 2. Bank A pays LIBOR - .125% on $10m to the Swap Bank and they pass on LIBOR - .25% to Company B.

As a result, here is the net position of each party: Bank A Pays -10% Fixed-rate interest (on $10m) to bondholders

Receives +10.375% fixed rate interest from Swap Bank (Net on fixed rate debt = +.375%) Pays variable -(LIBOR -.125%) rate to Swap Bank (Reduced by +.375% on fixed rate debt) NET INTEREST = LIBOR - .50% variable rate (w/swap), vs. LIBOR (w/o swap) Company B Pays Pays -10.50% Variable-rate Fixed-rate LIBOR + to .5% Swap to Bank bondholders

Receives LIBOR - .25% from Swap Bank (Net on variable-rate debt = -.75%) NET INTEREST = 11.25% Fixed Rate (w/swap), vs. 11.75% (w/o swap) Swap Bank Receives Pays Pays 10.375% LIBOR Receives 10.50% to -.25% Bank to Co. A B LIBOR fixed-rate (Net -.125% (Net of of from +.125% from +.125% on on Co. fixed-rate Bank variable-rate B debt) A debt)

NET INCOME = .25% (on $10m)

Net result: Bank A borrows at LIBOR - .5% instead of LIBOR, gets a variable-rate, and saves 0.50%. Co. B borrows at 11.25% instead of 11.75%, gets a fixed rate, and saves .50%. Swap Bank makes .25% to arrange the deal. Note: All interest payments/CFs are in USD. Actually, only the net difference in dollar CFs actually needs to be exchanged, NOT the gross amount. Example: Suppose that when the first payment is due LIBOR is 8%. CFs for Co. B: Pay $1.050m to Swap Bank (10.50% x $10m)

Receive $775,000 from Swap Bank (7.75% x $10m), (LIBOR - .25% = 7.75%) Net PMT to SWAP BANK = $275,000 Pay $850,000 to bondholders (LIBOR + .5%) x $10m. Total interest expense = $275k + $850k = $1.125m (or 11.25% of $10m), vs. $1.175m @ 11.75%, or a savings of $50,000 per year. CFs for Bank A: Receive Pay $1.0375m $787,500 to from Swap Swap Bank Bank (10.375% (7.875% of of $10m) $10m)

Net RECEIPT from SWAP BANK = $250,00 Pay $1m to bondholders ($10m x 10%)

Total Interest Expense = $1m - $250,000 = $750,000 (7.5% of $10m, @LIBOR -.50%), vs. $800,000 @ LIBOR, or a savings of $50,000. Swap Bank Receives $275,000 from Co. B, and pays $250,000 to Bank A, profit of $25,000/year. Regardless of what happens to LIBOR, the Swap Bank will always receive $25,000 profit/year. HOW DO WE VALUE SWAPS? There are several steps: 1. Identify the cash flows. To simplify things, many people draw diagrams with inflows and outflows of funds over time. 2. Construct the swap curve, obtained from the government yield curve and the swap spread curve. 3. Construct a zero-coupon curve from the swap curve. (See the Fixed Income section). 4. Present value the cash flows using the zero-coupon rates.

The swap spread is obtained from market makers. It is the market-determined additional yield that compensates counter-parties who receive fixed payments in a swap for the credit risk involved in the swap. The swap spread will differ with the creditworthiness of the counterparty. Just like an option, a swap can be at-the-money, in-the-money or out-of-the-money. Most swaps are priced to be at-the-money at inception meaning that the value of the floating rate cash flows is exactly the same as the value of the fixed rate cash flows at the inception of the deal. Naturally, as interest rates change, the relative value may shift. Receiving the fixed rate flow will become more valuable than receiving the floating rate flow if interest rates drop or if credit spreads tighten. Investment banks and commercial banks are the market makers for most of these swaps. Most of them warehouse the risk in portfolios, managing the residual interest rate risk of the cash flows. As you can imagine, the management of these risks can be very complex with swaps maturing on a daily basis and the difficulties of managing a variety of similar but not identically matched products.

USERS AND USES OF INTEREST RATE SWAPS
Interest rate swaps are used by a wide range of commercial banks, investment banks, nonfinancial operating companies, insurance companies, mortgage companies, investment vehicles and trusts, government agencies and sovereign states for one or more of the following reasons: 1. To obtain lower cost funding 2. To hedge interest rate exposure 3. To obtain higher yielding investment assets 4. To create types of investment asset not otherwise obtainable 5. To implement overall asset or liability management strategies 6. To take speculative positions in relation to future movements in interest rates.

ADVANTAGES OF INTEREST RATE SWAPS 1. A floating-to-fixed swap increases the certainty of an issuer's future obligations. 2. Swapping from fixed-to-floating rate may save the issuer money if interest rates decline. 3. Swapping allows issuers to revise their debt profile to take advantage of current or expected future market conditions. 4. Interest rate swaps are a financial tool that potentially can help issuers lower the amount of debt service. RISKS FOR THE SWAP BANK IN THE SWAP MARKET 1. Interest rate risk, from a change in interest rates before the bank finds an opposing counterparty for the other side of an interest rate swap. Swap banks that are traders stand ready to take just one side of the swap now, then later find a client for the other side. Example from beginning of chapter: Suppose swap bank makes deal with company B, where bank will receive 10.50% from Co. B. They hope to find a customer like Bank A, and make fixed rate pmts of 10.375%, and the swap bank makes 12.5 bp or .125%. If rates rise by only .5% before they finalize deal with Bank A, they would have to pay out 10.875% to Bank A (instead of 10.375%), and the swap bank would lose money. 2. Basis risk, when the floating rates are NOT pegged to the same index. Example: One counterparty's payments are pegged to LIBOR and the other to U.S. T-Bill rate. When the two indexes do not move perfectly together, the swap could periodically be unprofitable for the bank. 3. Ex-rate risk, like int. rate risk, from changes in ex-rates during the time it takes to offset the position with an opposing counterparty. 4. Mismatch risk, from a mismatch with respect to the size of the principal sums of the two counterparties, the maturity date or the debt service dates. In Example 10.5, we assumed that both the German and U.S. MNCs wanted 5-year debt for $36m (�40m), and payments made on the same date.

5. Political risk, from foreign exchange controls or taxes on capital flows, other political problems that affect the swap, resulting in loss of profits for the bank. To facilitate trading and make the swap market more efficient, there is an intl. swap organization, International Swaps and Derivatives Association (ISDA) that acts to coordinate swap activities, disseminate information, etc. The ISDA has developed two standard swap agreements/contracts, one for int. rate swaps and one for currency swaps, that outline the terms and conditions of a standard swap, address issues like default, early termination, etc.

REFERENCES

http://en.wikipedia.org/wiki/Interest_rate_swap http://victoryrisk.com/interest_rate_swaps.htm http://www.investopedia.com/articles/optioninvestor/07/swaps.asp http://www.derivativepricing.com/resolution-swaps/ http://www.scribd.com/doc/52571347/52/The-principle-features-of-an-interest-rate-swap-are http://home.earthlink.net/~green/whatisan.htm http://www.scribd.com/doc/17641520/Interest-Rate-Swap-Diagram http://www.treasurer.ca.gov/cdiac/publications/math.pdf http://www.derivativesone.com/interest-rate-swap-example/ http://spruce.flint.umich.edu/~mjperry/466-10.htm http://victoryrisk.com/interest_rate_swaps.htm

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