Interest Rate Risk

Prof Mahesh Kumar

Amity Business School
[email protected]
Introduction
 The interest rate risk results from a mismatch
of maturity of assets and liabilities
respectively.
Example:
1. A bank faces interest rate risk if the sources of
funds have shorter term to maturity than of its
advances.
2. A multinational runs an interest rate risk
arising from mismatched timing in re-pricing
those assets & liabilities that are sensitive to
interest rate.
Introduction
3. Risk emanating from a loan contracted at a fixed or
floating rate (linked to the base lending rate) by an
enterprise, a bank or an insurance company is
referred to as interest rate risk. (IRR).
4. Multinationals are subjected to interest rate risk on
their lending/borrowing operations.
 Interest rate risk results into an increase of
financial charge on borrowing or into a capital loss
on bonds.
 Financial markets developed instruments- options,
futures and swaps- on interest to cover these risks.
What is interest?
 Interest is the reward to the investor for
parting with liquidity and undertaking certain
risk towards non-payment by borrowers.
What is interest rate risk?
 Interest rate risk refers to the likely changes in
the cash flows or future value of a firm on
account of changes in the interest rates in the
market.
 The cash flows in connection with a financial
asset or liability may relate to a) interest and
b) principal.
 Based on this interest rate risk is segregated as
i) Income risk
ii) Capital risk
What is income risk?
 There are two types of interest rates- fixed
interest rates and floating interest rates.
 A fixed interest rate remains the same
throughout the duration of contract.
 A floating interest rate is fixed with reference to
a benchmark rate. The effect of floating rate is
to keep the interest rate in line with the current
trends.
 A long term investor can achieve the effect of
floating rate by investing for short term and
rolling over the investment on due dates at the
prevailing rates of interest.
What is income risk?
 A borrower at floating rate runs the risk that at
future revisions the rate of interest may be higher
and thus expenditure turns out to be higher. A
lender at floating rate runs the risk of reduction in
his income if the future interest rate is lower than
the current rate.
 For borrowing and lending at fixed rate, the risk is
measured with respect to the opportunity cost. A
person who has invested or lent at fixed rate loses
opportunity income if the interest rate move up.
 This potential for losing the realized or
opportunity income in the case of investments
and potential for having to pay for higher interest
or losing the opportunity to pay lower interest
constitutes the income risk.
What is Capital Risk?
 Capital risk refers to the reduction in the value
that a long term financial asset may suffer due to
change in interest rate.
 Suppose a bank holds 12% government bond
maturing after 5 years at the rate of Rs. 98/-. If
the government issues a new bond carrying
interest at 14%, the market value of 12% bond
will fall.
12/98*100=12.24
12/X*100=14, X= Rs. 85.6 or Rs.86
It may be noted that the capital risk arises when
long term assets are held for a short time.
Interest Risk Manifestation
 There is a relationship between interest rate risk and
prices of financial securities.
 The price of a financial security is equal to the present
value of cash flows (Ft) that is generated during its
life.
 The price of a fixed rate financial security P,
refundable at the end of the borrowing period
depends upon
1. The coupon amount: Coupon (C) is equal to the
nominal value of the bond and the interest rate.
2. The mode of capital refund: Normally refund R is
done in one lot at the end of the life of a bond, but it
can also be done in installments over a period of a
number of years.
Interest Risk Manifestation
3. Market interest rate (r);
4. Maturity Period (N) of the borrowing.
N
Ft C C CR
P    .......... ..
t 1 1  r  t 1  r (1  r ) 2 (1  r ) n
Where Ft represents the cash flows generated by the
fixed income security.
 When the market interest rate increase, the price of
the fixed income security decreases and conversely
when interest rate decreases, the fixed income
security increases.
Asset Liability Structure and Importance of
Interest Rate Risk
 For financial institutions like banks, there are
additional dimensions to interest rate risk as
both assets and liabilities are interest bearing.
These are known as basis risk and gap exposure
 Basis risk arises when the interest on assets and
liabilities are reckoned on different basis. For
instance, a bank lends six months at LIBOR/PLR
+1% which is funded by the bank accepting six
month term deposits at fixed interest rate. The
bank accepts to roll over both the loan and
deposit at the end of six months. It is possible
that the variation in LIBOR/PLR may not match
with that for term deposits.
Asset Liability Structure and Importance of
Interest Rate Risk
 Gap exposure arises when the assets and
liabilities mature for different periods. For
instance the bank may have committed for two
years lending but the funding in form of fixed
deposits may only be for six months. At the
time of renewal of deposits, the interest rates
may vary which will not be accompanied by
similar changes in interest rates on advances.
Measurement of Interest Rate Risk
Interest rate risk is measured by:
a) Sensitivity
b) Duration
Measurement of Interest Rate Risk
 Sensitivity (S) in the price of a fixed income
financial security indicates the percentage change in
price for each 1% change in the market interest
rate (r)
P N
1 tFt
S P  
r P t 1 (1  r )t 1
 The value of sensitivity depends upon several
factors:
a) Life of the security.
b) Interest rate on the security
c) Market interest rate
Measurement of Interest Rate Risk
 If for example, S=3, it implies that a 1%
(increase from x to x+1%) change in the
market interest rate would result into 3% loss
of capital. Conversely, a 1% decrease in
interest rate will yield capital appreciation of
3%.
 Several principles have been demonstrated by
F.R.Macaulay in a study on interest rates.
1. Bond prices vary in opposite direction to that of
interest rate variation.
Measurement of Interest Rate Risk
2. When bonds differ only in terms of market interest
rates one having the lower coupon will vary more
for the same variation of market interest rate.
3. When bonds differ only in terms of their maturity,
the one having longer maturity will vary more for
the same variation of the market interest rate.
4. For every bond, a given increase in the interest rate
results into a smaller variation of price than
identical decrease in the interest rate.
5. For a given percentage increase or decrease of
interest rate (coupon rate), and everything else
being same, the price variation is higher for the
security with the lower coupon.
Measurement of Interest Rate Risk
 Duration: It is an index of time during which an
investor recovers his funds initially invested.
 It is expressed in terms of years
 It enables to compare bonds issued with different
conditions.
 Duration is calculated as:
N
1 Ft
S 
P
t *
t 1 (1  r ) t
 Duration is also equal to the product of sensitivity and
the factor (1+r)
Measurement of Interest Rate Risk
 The securities with longer duration have greater
volatility than those with shorter duration. Thus the
higher duration implies greater risk.
 If the duration of the asset is higher than that of
liability, the financial firm is holding a long position
and then the risk comes from increase in interest
rates as the decrease in the value of assets held will
be higher than the advantage accruing from a
decrease in sum payable.
 On the other hand, if the establishment holds a
short position i.e. the duration of the asset is
smaller than that of liability, the risk emanates from
a decrease in rates.
Managing Interest Rate Risk
The derivatives that are based on interest rate
fall under two categories.
a) Derivatives that reduce the cost of borrowing
e.g. swaps
b) Derivatives meant to ensure that cost of
borrowing does not exceed the pre-determined
level or the income on investment does not go
below the expected level. Forward rate
agreements and interest rate options fall
under this category.
Interest Rate Futures
 An interest rate futures contract is a
commitment to deliver (for the seller of the
contract) or to take delivery of (for the buyer
of the contract) financial securities of a specific
amount, on a predetermined future date.
Interest Rate Futures Market
 Important interest rate future markets are:
1. Chicago Board of Trade (CBOT) at Chicago
2. Chicago Mercantile Exchange (CME) at Chicago
3. London International Financial Future Exchange
LIFFE at London
4. Marche a Terme International de France (MATIF) at
France
5. Deutsche TerminBorse (DTB) at Frankfurt
6. Sydney Futures Exchange (SFE) at Sydney
7. Tokyo Financial Future Exchange (TIFFE) at Tokyo
8. Singapore International Monetary Exchange
(SIMEX) at Singapore
Different Interest Rate Futures
 There exists two types of future contracts:
1. Short term contracts which permit the enterprises to
cover themselves against short term interest rate risks.
2. Long term contracts permitting the enterprises to cover
themselves against long term interest rate risks.
 In short term interest rate futures the underlying
financial instruments are generally short term treasury
bonds or 3 months deposits.
 In long term interest rate future contracts financial
instruments are generally long term treasury bonds.
 Most of the interest rate future contracts do not result
into delivery.
Quotation of Short Term Interest
Rate Futures
 The quotation of short term futures is made in
the form of an index I corresponding to
I=(100-i) where i represents implicit rate at
the date of maturity. Index I is expressed with
two decimal.
 If the implicit interest rate is 9.20%, the
quotation for the contract will be 100-
9.20=90.80. If the implicit rate increases to
12.10% then the quotation will be 100-
12.10=87.90
Quotation of Short Term Interest
Rate Futures
 The minimum fluctuation also known as tick of
a contract is fixed. For example, for a 3
months Euro dollar contract of USD 1000000,
it is equal to 0.01 percent of the contract i.e. it
is equal to 1000000* 0.01/100* 3/12 = USD
25. Thus, a change of 1 percent will bring a
profit or loss of USD 2500 (=25*100) on
above future contract.
 Opening price of a session, settlement price or
closing rate, highest rate, lowest rate, volume
traded is published for each future exchange
Basic Characteristics of Rate Futures
 Basis: The basis, in the context of the futures
market, represents the difference between the
forward rate and spot rate (i.e. spot rate on
settlement date).
 The basis may be positive or negative during the
contract period but however on the maturity date,
there is a convergence of the basis because the
forward rate on that date becomes same as the
spot rate.
 If the duration of a deposit or a loan is not equal to
the duration of the futures contract, the enterprise
or the bank exposes itself to a basis risk.
Basic Characteristics of Rate Futures
 Maturity Date: These are four in number:
March, June, September and December.
 Guarantee Deposits: These are made to
clearing exchanges so as to ensure the
solvability of operators and these margins vary
from 2 to 4 percent.
 Gains and losses are calculated on daily basis.
This is also known as Marking to Market.
Market If the
rates moves unfavorably for the operators he is
called upon to make supplementary payments
(called margins). Conversely, he receives
payments if the rates have moved in his favor.
Covering Risk in the Market of
Interest Rate Futures
 When a futures contract is bought or sold, the price is
fixed but payment is made at a future date.
 When interest rate rise, the price of an interest rate
future comes down. The risk of rise in interest rate is
covered by selling futures contracts. The enterprise that
wants to cover itself against rise of interest rates sells
contracts of amount and duration equivalent to the
position that it wants to cover. If a rise does takes
place, the gain that the enterprise would have by
repurchasing at a lower price the contracts it had sold
compensates the loss resulting from the rise in the rate.
Covering Risk in the Market of
Interest Rate Futures
 When the interest rate falls, the price of an
interest rate future increases. The risk of fall in
interest rates is covered by buying future
contracts. The enterprise that wants to cover
itself against fall of interest rates buys
contracts for an amount and a duration
equivalent to the position that it wants to
cover. If the fall does take place, the gain that
the enterprise would have by reselling at a
higher price the contracts that it had bought
earlier compensates the loss resulting from the
fall of the rate.
Covering Risk in the Market of
Interest Rate Futures
 The number (N) of contracts to be bought or sold is
determined by
MC DC
N   Correlatio nCoefficient
Mc Dc
where MC=Amount to be covered
Mc=Amount of the contract
DC=Duration of the position
Dc=Duration of the contract
Covering Risk in the Market of
Interest Rate Futures
 If the duration of contract and the position of
the contract are identical and the correlation
between the rate to be covered and rate of the
future is perfect i.e.1, then the number of
contracts is equal to
MC
N
Mc
 In practice, N is not always a whole number. In
that case, the number is rounded to the nearest
whole number because one can buy or sell
contracts only in whole numbers.
Risk from the Rise in Interest Rate
 This is the risk to which are exposed:
1. The enterprises which have taken a loan on a
renewable rate or on a roll over basis.
2. The enterprises that have to borrow in future.
Example 1
 In December of the current year, the treasury manager of
a company envisages that he would have to borrow USD
1000000 on 15th March next year. In December, Euro
Dollar futures for March is quoted at 89.50, implying
thereby an interest rate of 10.50%
 The treasury manager knows that his bank will charge an
interest rate of 1% over and above that of LIBOR. He
wishes to cover himself against any rise in interest rate
between December and March.
 He sells in December one futures contract (of USD
1000000 million) of March to cover himself against a
borrowing rate of 11.50% (10.5% LIBOR+1%)
Example 1
 Possible Scenario : A couple of days before 15th March,
LIBOR=11.20%. The treasury manager is to pay the
bank:
1000000*(11.20+1)*3/12=USD 30500
 He repurchases his futures contract at a price of 88.90
(the price quoted on the day the deal is closed), which he
had sold for 89.50 in December. The gain for him is
(89.50-88.90)*100*25=USD 1500
 Thus the net interest paid by the treasury manager is
30500-1500=USD 29500
 So the effective interest rate is
29000/1000000 *12/3 = 11.6%
Example 1
 This difference emanates from the difference
between the LIBOR (11.20%) and the implied
rate by the contract at the time of liquidation
(11.10 percent i.e. 100-88.90)
 This risk is referred to as the risk of basis. It can
be favorable or unfavorable to the treasurer. It
is minimum when the date of borrowing is close
to the date of maturity of the contract.
Example 2
 On 1 March of the current year, an enterprise
knows that it will have to borrow on 15 June a
sum of USD 10 million for 3 months. On 1
March, the 90 days interest rate on Euro dollar
market is 8.5%. But the enterprise anticipates a
rise in interest before June. To cover itself
against this eventuality, the enterprise sells 10
future contract (=10 million/1 million) maturing
in June. The contract price is 91.50
Example 2
 Possible Scenario : On 15 June, when the enterprise
borrows, the interest rate on 90 days borrowing is 13%.
It pays an interest:
10000000*13*90/360= USD 325000
 But at the same time, the enterprise buys back the
futures contracts that it has sold in March. The price on
15 June is 87. In doing so, it makes a gain,
10*(91.50-87)*100*25= USD 112500
 Thus the net payment made by the enterprise is
325000-112500= USD 212500
 This means that the enterprise has paid a net interest
rate of 212500/10000000 *12/3=8.5%
Example 3
 A company is to borrow DM 2.5 million in
December for 3 months. At the moment
(September), the December DM future is quoted
at 92.5. The market rate of Euro DM is 7.5%,
which is likely to go up in months to come.
 What should the company do ? Assume that on
15 December, the DM future has fallen to 91.5
and the Euro DM rate is 8.6%
Example 3
 Since the DM borrowing rate is likely to go up
between September and December, the
company will do well to sell DM future contracts
to cover against interest rate risk.
 The value of one Euro DM contract is DM 1
million while the sum to be hedged is 2.5
million. So the company has to sell either 2
contracts or 3 contracts. Let us say it sells 3
contracts.
Example 3
 On December 15, the company borrows at 8.6%. The sum it
would receive for the face value of DM 2.5 million is found by
the price yield formula
Yield  N
Bond Pr ice  FaceValue [1  ]
360
where N is the borrowing period in days.
 So the sum realized is 2.5[1-0.086*90/360]=DM 2.44625
million
 But the sum that would have been realized at the yield rate of
7.5% is 2.5[1-0.075*90/360]= DM 2.453125 million
 So shortfall = DM 2.453125-DM 2.44625= DM 6875
 Now the company buys back the future contracts. The gain is
equal to 100 ticks (=92.5-91.5). So the gain is 3*100*25= DM
7500. Thus the shortfall is made up through hedging.
Example 4
 A company plans to borrow USD 20 million by
issuing a 90 days commercial paper in August.
The yield rate of the CP is 10.5% at the
moment, i.e. in the month of March. Interest
rates are anticipated to rise. Since no future
contracts are available in CP, the company can
resort to T-bill futures. September T-bill
futures are quoted at 90.20.
Assume that on August 15, the CP yield has
risen to 11 percent and T bill future contract is
quoting at 89.60. What is the company
expected to do?
Solution: Example 4
 In March, at the yield rate of 10.5%, the CP issue will
result into a realization of 20[1-(0.105*90/360)=USD
19.475 million
 But in August the sum realized is going to be 20[1-
(0.11*90/360)]= USD 19.45 million
 The shortfall is equal to USD 0.025 million = USD 25000
 To hedge against the interest rate risk the company sell
20 T-bill September future contracts and repurchases
them on August 15.
 The gain on the future contract is 90.2-89.60 or 60
ticks. This is equal to 20*25*60=USD 30000
 Thus the shortfall is more than compensated by
hedging.
Risk from Fall in Interest Rate
 Two types of enterprises are exposed to such
risk:
1. The enterprise that have borrowed on a fixed
rate
2. The enterprise that envisages to place their
funds in the future.
Example
 A treasury manager is to receive in three months
i.e. in December of the current year, a sum of
GBP 5 million that he would like to place at 3
month LIBOR rate till April next year. He fears a
fall in the rate of pound sterling.
3 months LIBOR in September is 10 percent;
Price of 3 months sterling futures in September
is 90
 To cover himself against the risk of fall in the
interest rate, he buys 10 (=5/0.5) future
contracts in September.
Example
 Possible Scenario : On maturity in December,
the rate falls to 8 percent. The treasury
manager suffers a loss of opportunity of
5000000*(0.10-0.08)*3/12=GBP 25000
 At the same time, in future market, he sells his
contracts that he had earlier bought whose price
is now 92. So he makes a gain
10*(92-90)*100*12.5 = GBP 25000
 Thus his loss of opportunity is compensated by
the gain on futures market.
Advantages of Interest Rate Futures
 Interest rate future are an efficient means of
reducing the risks of rates and are used widely
for:
1. Reduce the impact of rate fluctuations on
anticipated positions; this in turn ensures the
business unit a more certain borrowing rate or
rate of return on its fixed income securities.
2. Arbitrage between the future market and spot
market.
Limitations of Interest Rate Futures
 Basis risk occurs when the maturity date of
borrowing or lending does not coincide with the
maturity date of a futures contract,
 Risk of correlation is incurred when the rate
covered is not perfectly correlated with the rate
of a futures contract
 Risk of indivisibility is incurred when the number
of contracts bought or sold does not perfectly
correspond to the amount to be covered.
Covering Interest Rate Risk in
Options Market
 Options on interest rate may be used:
1. For covering against interest rate variations; in
effect purchase of option enables the buyer to
ensure that he would not have to pay more than
a certain rate of interest on his borrowing; or
would not receive less than a certain minimum
rate on his lending
2. For speculation
3. For arbitrage operations
Organized Markets of Interest Rate
Options
 Interest rate options were first of all negotiated
on the Stock Exchange of Amsterdam.
 In 1982, an option market developed in Chicago
(CBOT).
 Thereafter, the markets of Sydney, London,
Singapore, Paris, Copenhagen, Montreal etc
were developed.
 Assets traded on interest rate options market
are either fixed rate financial securities or an
interest rate guarantee; 3 month LIBOR, 3
months Euro Dollar, 3 months Euro DM etc.
Mechanism of Interest Rate Options
 Purchase of a call option gives a right to the
holder to buy a financial asset at a fixed price
and purchase of put option gives him a right to
sell a financial asset at a fixed price, called
exercise price, on payment of premium to the
seller of the option.
Mechanism of Interest Rate Options
 Interest rate options have certain characteristics:
1. Contracts are standardized from the viewpoints of
amount, maturity and period (March, June, September,
December)
2. Exercise price are given at intervals of 0.25 dollar for Euro
dollar contracts for example 92.25, 92.50, 92.75 etc.
3. Quotations, for example, for Euro Dollar contracts are
made in index points and 1 index point corresponds to 25
dollars. Thus, if an option on Euro dollar is quoted at
0.30, this means that the option has a price of
0.30*100*25= 750 dollars. Minimum fluctuation is 25
dollars.
4. Contracts are easily negotiable
5. The clearing house ensures the regularity of operations.
Mechanism of Interest Rate Options
Purchase of put option:
 A put option is also called borrowing option.
 It is used to cover against rise in interest rate.
 This option is used by
1. enterprise that has to borrow by issuing bonds
or
2. a portfolio manager who has to shortly liquidate
his bonds.
 Mechanism of Interest Rate Options
 Let us say the treasury manager estimates in January that he
would need to borrow in March. The current interest rate on
bonds is 6%, but it is likely to go up in March. So he buys put
option by paying a price. If in March, the rate goes up he
exercises his put option and sells his bonds at 6%. And if the
rate remains 6% or goes down he abandons his put option.
 Similarly, a portfolio manager knows that he would liquidate
his bonds in 3 months. The bond rate is currently at, say, 93.
But if the interest rate goes up, the bond rate may come
down to say 90 in March. So in order to cover this risk he
buys put options. If the interest rate goes up, he will exercise
his option and liquidate his bonds at the price of Rs.93. On
the other hand, if the rate does go down (or in other words,
the bond price go up to 96), he would abandon his option and
liquidate his bonds at the price of 96.
Mechanism of Interest Rate Options
Purchase of call option:
 A call option is used when one fears a fall in
interest rates.
 For example,
example a treasury manager has to place in
a months’ time dollars for 3 months. He fears
that the interest rate may come down from
current 6 to 5 percent. So he buys a call option.
He will buy this option if the interest goes down
so as to ensure a return of 6 percent or more on
his placement. On a contrary, he will abandon
his option and place his dollars at the prevailing
market rate, say 7.5%, if interest rates rise.
Instruments on Over The Counter Market
Fixed Rate Instruments on OTC
 Forward Forward Operation: This is an operation
that enables an operator to fix immediately
interest rates of a debt or a loan which will be
contracted at a later date.
 For example, an enterprise wants to ascertain
today the interest rate on debt which it will
borrow after 3 months for 6 months. This can be
achieved by:
1. Borrowing for 9 months today
2. Lending for 3 months today.
Example 1
 Company ABC wants to obtain USD 5 million in 3
months for 6 months. It fears a rise in interest rates and
therefore, would like to fix the rate from now itself. The
bank rates at the moment are as follows:
Duration Borrowing Lending
Rates rates
3 Month 3.5 3.6
9-Month 3.75 4

 The manager wants to ensure the rate that he would

have to pay on his borrowings. What should he do and
what is the rate he can lock in.
Solution: Example 1
 The ABC Company borrows for 9 months at a rate of 4%
and immediately lends for 3 months at a rate of 3.5%
 Thus after 3 months for 1 dollar the company will have
(1+0.035*3/12)
 But the bank should receive after 9 months
(1+0.04*9/12)
 So the effective rate, say i, to be paid by the company is
worked out by equality
(1+0.035*3/12)(1+i/100*6/12)= (1+0.04*9/12)
i=4.213%
 This is the forward rate for the company for borrowing
after 3 months for a period of 6 months.
Example 2
 A treasury manager after 5 months will need to borrow
Rs.300000 for 3 month. The current rates are as follows
Duration Borrowing Lending
Rates rates
3 Month 9.5 10.0
5 Month 9.8 10.2
8 Month 10.0 10.5
9-Month 10.2 10.8

The manager wants to ensure the rate that would have

to pay on his borrowings. What should he do and what
is the rate he can lock in.
Solution: Example 2
 Since he has to borrow after 5 months for a period of 3
months, the rates that concern him are those
corresponding to 5 months and 8 months.
 He should borrow at 10.5% and lend this sum
immediately for 5 months at 9.8% Let us say the effective
rate is i. Then,
[1+(0.098*5/12)] [1+(i/100*3/12)] = [1+0.105*8/12)]
i=11.2%
 Thus the treasury manager has been able to lock in an
effective rate of 11.2%. The interest on borrowing would
amount to:
300000*0.112*3/12 =Rs.8400
Instruments on Over The Counter Market
Fixed Rate Instruments on OTC
 Forward Rate Agreement (FRA): It is a tailor
made futures contract.
 Unlike normal future contracts which are
standardized, a forward rate agreement is for
pre-decided maturity date, for a pre-decided
amount and at a pre-decided rate, as may be
agreed between the borrower and the lender.
Instruments on Over The Counter Market
 Example, an enterprise knows that after 6 months, its
need is for a 3 month loan. The enterprise can lock in the
interest rate on this loan by buying a FRA from a bank.
 The bank may offer to sell 6 month forward rate
agreement on a 3 months LIBOR at 6%.
 If at the end of 6 months, the 3 months LIBOR rate is
greater than 6%, the bank will pay the difference to the
enterprise.
 But if the 3 months LIBOR rate is less than 6%, the
enterprise would pay the difference to the bank.
 Settlements of FRAs are done on the notional value.
Instruments on Over The Counter Market
 Example, a company buys a 5/11 (borrowed for
6 months after 5 months from today) FRA at 6%
for a notional principal of 1 million.
 If after 5 months, LIBOR stands at 6.40%, the
counterparty will pay the company the
difference- 40 points or $2000 (=1000000*
0.40/100*6/12)
 If LIBOR goes down, say to 5.5%, the company
will pay the difference ($2500).
Instruments on Over The Counter Market
 The FRA may, prima facie, sound more
attractive than futures. However, banks usually
charge a higher rate if an enterprise wants to
borrow odd amounts for odd periods.
 If the manager of the enterprise changes his
mind and wants to sell his forward contract, he
must negotiate afresh with the bank.
Example 1
 A company will need to buy after 4 months a
forward rate agreement (FRA) from a bank to
borrow for 3 months. The 4/7 FRA is quotes at
6.5. What will the company do if after 4 months,
the rate
a) Rises to 7%
b) Falls to 6%
c) Remains at 6.5%
Example 1
a) Since the rate has risen, the bank has to pay the
difference to the company. Say, the borrowing is
planned for $ 1 million. Then the bank has to pay
(0.07-0.065)* 1000000* 3/12= $ 1250.
b) Since the rate has fallen to 6%, the company will
have to pay the bank, an amount (0.065-
0.06)*100000*3/12= $1250
c) Since there has been no change in the rate,
neither the bank nor the company pays or
receives.
Swap Introduction- Definition and Uses
 A swap is an arrangement between two
companies to exchange cash flows at one or
more future dates.
 Swaps are used:
1. To reduce the cost of capital
2. Manage risk (interest rate, exchange rate,
commodity price movement)
3. Exploit economies of scale
4. Enter new markets
5. Create synthetic instruments
Financial Swaps
Financial swaps have three variants:

a) Currency Swap
b) Interest Rate Swap
c) Combined Interest Rate and Currency Swap
(CIRCUS)
Introduction-Swap Variants
 ‘Vanilla Swaps’ can be used in three different
settings:
1. An interest rate swap to convert a fixed rate
obligation to a floating rate obligation
2. A currency swap to convert an obligation in
one currency to an obligation in another
currency
3. A commodity swap to convert a floating price
to fixed price
Introduction
 A forward contract can be viewed as simple
example of swap.
 A forward contract leads to the exchange of
cash flows on just one future date, swaps
typically lead to cash flow exchanges taking
place on several future dates.
 Interest rate and currency swaps are often
discussed together and are collectively called
rate swaps.
Introduction-LIBOR
 The floating side has most often been tied to the
London Inter bank Offer Rate abbreviated as LIBOR.
 LIBOR is the rate of interest offered by the banks
on deposits of other banks in Eurocurrency
markets.
 One month LIBOR is the rate offered on one month
deposit, three month LIBOR is the rate offered on three
month deposit and so on.
 LIBOR rates are determined by trading between banks
and change frequently so that the supply of funds in
inter bank market equals the demand for funds in that
market.
Introduction-LIBOR
 A five year loan with a rate of interest specified as
6 month LIBOR plus 0.5% p.a. In this life of loan
is divided into ten periods each six months in
length. For each period the rate of interest is set
at 0.5% p.a. above the six month LIBOR rate at
the beginning of the period. Interest is paid at the
end of the period.
 LIBOR rates are quoted on annual basis and by
convention is stated as though year has 360 days,
but the interest is actually paid everyday. This
results in increase in effective rate of interest.
Structure of Swap
 All swaps have basically the same structure.
 Two parties, called counterparties, agree to one
or more exchanges of specified quantities of
underlying assets.
 These underlying assets are known as notional.
 A swap may involve one exchange of notional,
two exchange of notional, a series of exchange
of notional or no exchange of notional.
 The notional exchanged in the swap may be
same or different.
Interest Rate Swap
 In interest swap the loan liability is not
exchanged; only periodical payment of interest is
exchanged. The loan amount becomes the
notional value on which the interest is calculated.
 An interest rate swap is also known as the coupon
swap where the liabilities exchanged are of fixed
and floating interest rates. In a basis swap, the
interest rate involved are both floating, but on
different basis for instance one may be pegged to
LIBOR and other to treasury bill rate.
Interest Rate Swap
 A zero coupon swap is a special type of swap
where one counterparty makes lump sum
payment of interest instead of periodical
payments. The lump sum payment can occur
at any time, up-front, at maturity or during
the life of the swap.
Structure of Swap
 Between the exchange of notional counter party make
payments to each other for using the underlying
assets. The first counterparty makes periodic payment
at a fixed price for using second counterparty’s assets.
The fixed price is the swap coupon. At the same time,
the second counter party makes periodic payment at a
floating rate for using the first counterparty’s assets.
 Usually we have an intermediary that serves as a
counterparty to both end user and is called swap
dealer or market maker or swap bank. The swap
dealer profits from bid-ask spread it imposes on the
swap coupon.
Interest Rate Swap
 A standardized fixed-to-floating interest rate swap,
known in the market jargon as plain vanilla coupon
swap (also referred to as ‘exchange of borrowings’) is
an agreement between two parties in which each
contracts to make payment to the other on a particular
dates in the future till a specified termination date.
 The party which makes fixed payments and which are
fixed at outset are known as fixed rate payer.
 The party which makes payments the size of which
depends upon the future evolution of a specified
interest rate index e.g. LIBOR is known as floating rate
payer.
Interest Rate Swap
 Interest rate swaps are used to reduce the cost
of financing.
 In these cases, one party has access to
comparatively cheap fixed rate funding but
desires floating rate of interest while another
party has access to comparatively cheap
floating rate funding but desires fixed rate of
funding.
Interest Rate Swap-Example
 Consider a three year swap initiated on March 15,2005,
between Infosys and Wipro. We assume Infosys agrees
to pay to Wipro an interest rate of 5% p.a. on a notional
principal of 100 crores and in return Wipro agrees to pay
Infosys six month LIBOR rate on the same notional
principal. We assume that agreement specifies that
payments are exchanged every six months, and the 5%
rate is quoted with semi annual compounding.
The swap can be diagrammatically depicted as:
5%
Wipro Infosys
LIBOR
Interest Rate Swap-Example
Cash flows to Infosys in a Rs100 cr three year interest rate swap
when a fixed rate is paid and LIBOR is received
Date 6 mth LIBOR Floating cash Fixed cash Net cash flow
rate (%) flow rcvd flow paid
Mar 15,’05 4.20
Sep 15,’05 4.80 +2.10 -2.50 -0.40
Mar 15,’06 5.30 +2.40 -2.50 -0.10
Sep 15,’06 5.50 +2.65 -2.50 +0.15
Mar 15,’07 5.60 +2.75 -2.50 +0.25
Sep 15,’07 5.90 +2.80 -2.50 +0.30
Mar 15,’08 6.40 +2.95 -2.50 +0.45
Interest Rate Swap-Example
 From above table we can enunciate the cash flows
in the third column of the table are the cash flows
from a long position in a floating rate bond. The
cash flows in the fourth column of the table are
the cash flows from the short position in a fixed
rate bond. The exchange can be regarded as the
exchange of fixed rate bond for a floating rate
bond. Infosys whose position is described in the
table is long a floating rate bond and short a fixed
rate bond. Wipro is similarly long a fixed rate
bond and short a floating rate bond.
Using the Swap to Transform a Liability
 The swap could be used to transform a floating rate loan
into a fixed rate loan. Suppose that Infosys arranged to
borrow Rs.100 cr at LIBOR plus 10 basis points and
Wipro has a three year Rs.100 cr loan outstanding on
which it pay 5.2%. The swap between two companies
can be shown as
5.2% 5%
Wipro Infosys
LIBOR LIBOR+0.1%
Using the Swap to Transform a Liability
 After Infosys has entered into the swap it has three
cash flows:
1. It pays LIBOR plus 0.10 to its outside lenders.
2. It receives LIBOR under the terms of the swap.
3. It pays 5% under the term of the swap.
 These three sets of cash flows net out to an interest
rate payment of 5.1%. Thus for Infosys the swap could
have the effect of transforming borrowings at a floating
rate of LIBOR plus 10 basis point into a borrowings at a
fixed rate of 5.1%
Using the Swap to Transform a Liability
 For WIPRO the swap has following three set of cash
flows:
1. It pays 5.2% to its outside lenders
2. It pays LIBOR under the terms of the swap.
3. It receives 5% under the terms of the swap.
 These three cash flows net out to an interest payment
of LIBOR plus 0.2% . Thus for WIPRO the swap has the
effect of transforming borrowings at a fixed rate of
5.2% into a borrowings at a floating rate of LIBOR plus
20 basis points.
Using the Swap to Transform an Asset
 Swaps can be used to transform the nature of an asset.
Suppose that Infosys owns Rs.100cr in bonds which
provide an interest of 4.7% over next three year and
Wipro has an investment of similar amount that yields
LIBOR minus 25 basis points. The swap between two
companies can be shown as
LIBOR-0.25% 5%
Wipro Infosys
LIBOR 4.7%
Using the Swap to Transform an Asset
 After Infosys has entered into the swap it has three
cash flows:
1. It receives 4.7% on the bonds.
2. It receives LIBOR under the terms of the swap.
3. It pays 5% under the terms of the swap.
 These three sets of cash flows net out to an interest
rate inflow of LIBOR minus 30 basis points. Thus
Infosys has transformed an asset earning 4.7% into an
asset earning LIBOR minus 30 basis points.
Using the Swap to Transform an Asset
 After Wipro has entered into the swap it has three set
of cash flows:
1. It receives LIBOR minus 25 basis points on investment.
2. It pays LIBOR under the terms of the swap.
3. It receives 5% under the terms of the swap.
 These three cash flows net out to an interest rate inflow
of 4.75%. Thus Wipro has transformed an asset earning
LIBOR minus 25 basis points into an asset earning
4.75%
Role of a Swap Dealer
 Usually two non-financial companies such as
Infosys and Wipro do not get in touch directly
to arrange a swap. They each deal with a
financial intermediary such as bank or other
financial institutions.
 ‘Plain vanilla’ fixed for floating swaps are
usually structures so that financial institution
earns 3-4 basis points on the pair of offsetting
transactions.
Role of a Swap Dealer

5.2% 4.985% 5.015%

Swap Infosys
Wipro
Dealer

LIBOR LIBOR LIBOR+0.1%

Role of a Swap Dealer

4.985% 5.015% 4.7%

Swap Infosys
Wipro
Dealer

LIBOR LIBOR LIBOR

-0.25%
Role of a Swap Dealer
 Swaps as financial instruments have gained popularity
with transformation of swap brokers into swap dealers.
 The swap dealer stands ready to enter a swap as a
counterparty and with equal willingness to play the role
of fixed rate payer or fixed rate receiver.
 Unlike direct swap between two end users, the swap
dealer does not need to match all the terms of the first
swap with Counterparty A to the second swap with
Counterparty B.
 The swap dealer does not need to have an immediately
available counterparty B into order to enter a swap with
counterparty A.
Role of a Swap Dealer
 Swap dealers warehouse swaps and run a swap book.
They seek to match their swap book in order to remove
the risk associated with unmatched swaps. Thus swap
dealer strives to have balanced book and any
unbalances which exist are hedged by the swap dealer.
4.985%
Wipro Swap Dealer
6m LIBOR

4.985% 5-yr T-note (long position)

Wipro Swap Dealer G Sec Market
6 m LIBOR 6 m T-bill (short position)
The Comparative Advantage Argument
 The popularity of swaps concerns comparative
advantages. Some companies have
comparative advantage when borrowing in
fixed rates whereas others have a comparative
advantage in floating rate markets.
 To obtain a new loan, it makes sense for a
company to go to the market it has a
comparative advantage.
The Comparative Advantage Argument

 AAACorp wants to borrow floating

 BBBCorp wants to borrow fixed

Fixed Floating

AAACorp 4.00% 6-month LIBOR + 0.30%

BBBCorp 5.20% 6-month LIBOR + 1.00%
The Comparative Advantage Argument
 A key feature of the rates offered by AAACorp
and BBBCorp is that difference between the
two fixed rates is greater than the difference
between the two floating rates.
 BBBCorp pay 1.2% more than AAACorp in fixed
rate and 0.7% more than AAACorp in floating
rate markets.
 Thus BBBCorp appears to have a comparative
advantage in floating rate markets whereas
AAACorp has comparative advantage in fixed
rates markets. It is this anomaly that can lead
to a swap being negotiated.
The Swap

3.95%

4%
AAA BBB
LIBOR+1%

LIBOR
The Comparative Advantage Argument
 The swap arrangement appears to improve the
position of AAACorp and BBBCorp by 0.25%
each. The total gain from deal is 0.5%.
 The total apparent gain from this type of
interest rate arrangement is always a-b, where
a is the difference between the interest rates
facing the two companies in fixed rate market,
b is the difference between the interest rates
facing the two companies in floating rate
markets. In this case a=1.2% and b=0.70%
The Swap when a Financial Institution is
Involved

3.93% 3.97%
4%
AAA F.I. BBB
LIBOR+1%
LIBOR LIBOR
The Comparative Advantage Argument
 Why are spreads between the rates offered to AAACorp
and BBBCorp be different in fixed and floating market?
We expect these differences to be arbitraged away.
 The reason for spread differentials is due to the nature
of contracts available to companies in fixed and floating
markets.
 The 4% and 5.2% rates available to AAACorp and
BBBCorp in fixed rate markets are five year rates (the
rates at which companies can issue five year fixed rate
bonds). The LIBOR+0.3% and LIBOR+1% rates
available to AAACorp and BBBCorp in floating rate
markets are six month rates.
The Comparative Advantage Argument
 In floating rate market , the lender usually has the
opportunity to receive floating rates every six months (in
extreme cases can even refuse rollover of the loan),
while the fixed rate financing do not have the option to
change the terms of the loan.
 The spreads between the rates offered to AAACorp are
the reflection of the extent to which BBBCorp is more
likely to default than AAACorp. During the next six
months there is a little chance that either AAACorp or
BBBCorp will default. As we look further ahead, default
stastics show that the probability of default by a
company with low credit rating (such as BBBCorp)
increases faster then the probability of default by
company with relatively higher credit rating (such as
AAACorp). This is why spread in five year loan is greater
than the spread of the six month rate.
Quotes By a Swap Market Maker
Maturity Bid (%) Offer (%) Swap Rate (%)
2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850
Quotes By a Swap Market Maker
 Financial institutions are merchant makers and
they give quotes for a number of different
maturities and number of different currencies.
 The bid is the fixed price in a contract where
market maker will pay the fixed and receive
floating; the offer is the fixed rate in a swap
where the market maker will receive fixed and
pay floating.
 The average bid and offer fixed rates is known
as the swap rate.
Currency Swap
 In simplest form currency swap involves
exchanging principal and interest payment in
one currency for principal and interest
payments in another currency.
 A currency swap agreement requires the
principal to be specified in each of the two
currencies and they are exchanged at the
beginning and at the end of the life of the
swap. The principal amounts are chosen to be
approximately equivalent using the exchange
rate at the swap’s initiation.
Currency Swap- Example
 Consider a hypothetical five year currency swap between
IBM (a US based Co) and British Petroleum (a UK based
Co) into on Feb 1, 2002. Suppose IBM pays a fixed rate
of interest of 11% in sterling and receives a fixed rate of
interest of 8% in dollars from British Petroleum. Interest
payments are made once a year and principal amounts
are $15 million and GBP 10 million. The swap for this
deal can be depicted as :
11%
IBM British Petroleum
8%
Currency Swap- Example
 This type of swap is known as fixed currency swap
because interest rates in both the currencies are fixed.
 Initially the principal amounts flow in opposite direction
to the arrows.
 Thus at the outset IBM receives GBP 10 million and pays
$15 million.
 Each year during the life of the swap contract , IBM
receives $ 1.20 million (8% of $15million) and pays GBP
1.10 million ( 11% of GBP 10 million)
 At the end of the life of the swap, it pays a principal of
GBP 10 million and receives a principal of $15 million.
The Cash Flows
Dollars Pounds
$ £
Year ------millions------
2001 –15.00 +10.00
2002 +1.20 -1.10
2003 +1.20 –1.10
2004 +1.20 –1.10
2005 +16.20 –11.10
Currency Swap
 A currency swap can transform borrowings in
one currency to borrowings in another
currency.
 The swap can also be used to transform the
nature of asset. Suppose that IBM can invest
GBP10 million in UK to yield 11% pa for the
next five years, but feels that US dollar will
strengthen against sterling and prefers US
denominated investment. The swap has the
effect of transforming the UK investment into a
$15 million investment in the US yielding 8%.
Comparative Advantage
 Currency swap can be motivated by comparative
advantage.
 Suppose the five year fixed rate borrowing cost to
General Motors and Jet Airways in USD and INR is given
below:
USD INR
General Motors 5.0% 12.6%
Jet Airways 7.0% 13%
1. INR rates are higher than US interest rates.
2. General motors is more creditworthy than Jet Airways
because it is offered a more favorable rate of interest in
both the currencies.
3. Since spreads are different in different currencies, swaps
can be negotiated.
Comparative Advantage
 Here a=2, b=0.4. This may be on account of
comparative tax advantage of two companies.
General Motors position might be such that
USD borrowing lead to lower taxes on its
worldwide income than INR borrowings and
may be vice versa for Jet Airways.
 We now suppose that General Motors wants to
borrow in INR and Jet Airways in USD.
 Total gain to all parties on account of this swap
deal is 2-0.4=1.6% pa
 The deal can be depicted as;
Comparative Advantage
USD 5.0% USD 6.3%
GM Swap Dealer Jet Airways
USD 5.0% INR 11.9% INR 13% INR 13%

USD 5.0% USD 5.2%

GM Swap Dealer Quantas Air
USD 5.0% INR 11.9% INR 11.9% INR 13%
Jet Airways some foreign risk

USD 6.1% USD 6.3%

GM Swap Dealer Quantas Air
USD 5.0% INR 13% INR 13% INR 13%
GM bears some foreign risk
Cross Currency Interest Rate Swap
 This is a combination of currency swap and
interest rate swap. For instance a US firm
which can borrow cheap dollar funds at floating
rate may exchange the liability with UK firm
which borrows sterling at cheaper rates with
fixed interest. This type of swap is known as
CIRCUS acronym standing for Combined
Interest Rate and Currency Swap.
Credit Risk in Swaps
 Since swaps are tailor made private arrangement between two
parties, therefore they entail credit risk.
 If neither party defaults, the financial institution remains fully
hedged.
 A financial institution has credit exposure from a swap only
when the value of swap to the financial institution is positive
and there will be no effect on the financial institution’s position
if the value of swap is negative.
 Potential losses from default on a swap are much less than the
potential losses from default on loan with the same principal.
This is because the value of the swap is usually only a small
fraction of the value of the loan.
 Potential losses from defaults on a currency swap are greater
than on an interest rate swap. The reason being principal
amount in two different currencies are exchanged at the end of
the life of a currency swap, a currency swap has greater value
than an interest rate swap.