Financial Risk Management

Zvi Wiener
Following
P. Jorion, Financial Risk Manager Handbook
http://pluto.huji.ac.il/~mswiener/zvi.html FRM 972-2-588-3049
 Swaps
Zvi Wiener
02-588-3049
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
http://pluto.huji.ac.il/~mswiener/zvi.html FRM 972-2-588-3049
 Interest Rate Swaps: Concept
An agreement between 2 parties to exchange
periodic payments calculated on the basis of
specified interest rates and a notional amount.

Plain Vanilla Swap

Fixed rate
A B
Floating rate
Based on a presentation of Global Risk Strategy Group of Deutsche Bank
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 IRS
In a standard IRS, one leg consists of fixed
rate payments and the other depends on the
evolution of a floating rate.
Typically long dated contracts: 2-30 years
Sometimes includes options, amortization,
etc.
Interest compounded according to different
conventions (eg 30/360, Act/Act. Act/360, etc.)

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 IRS Origins
AAA wants to borrow in floating and BBB
wants to borrow in fixed.
Fixed Floating
AAA 7.00% LIBOR+5bps
BBB 8.50% LIBOR+85bps
difference 1.5% 0.8%
Net differential 70bps = 0.7%

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 Comparative Advantage
7.4%
7.0% Libor+85bp
AAA Libor BBB

Cost of funds for AAA=Libor - 40bp (45bps saved)

Cost of funds for BBB=8.25% (25bps saved)
Swap rate = 7.40%
Swap rate is the fixed rate which is paid against
receiving Libor.

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 Basic terms of IRS
Notional amount
Fixed rate leg
Floating rate leg
Calculated period
Day count fraction

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 Basic terms of IRS
Payer and receiver - quoted relative to fixed
interest (i.e. payer = payer of fixed rate)
buyer = payer, seller =receiver
Short party = payer of fixed, (buyer)
Long party = receiver of fixed, (seller)
Valuation = net value NOT notional!!

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 Various swaps
Coupon swaps - fixed against floating.
Basis or Index swaps - exchange of two
streams both are computed using floating IR.
Currency swap - interest payments are
denominated in different currencies.
Asset swap - to exchange interest received
on specific assets.
Term swap maturity more then 2 years.
Money Market swap - less then 2 years.
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 Payments
Fixed payment =
(notional)(Fixed rate)(fixed rate day count convention)

Floating payment =
(notional)(Float. rate)(float. rate day count convention)

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 Time Value of Money
present value PV = CFt/(1+r)t

Future value FV = CFt(1+r)t

Net present value NPV = sum of all PV

-PV 5 5 5 5 105
4
5 105
PV
t 1 (1 rt ) t
(1 r5 ) 5

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 Swap Pricing
A swap is a series of cash flows.
An on-market swap has a Net Present Value of
zero!
PV(Fixed leg) + PV(Floating leg) = 0

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 Pricing
Floating leg is equal to notional amount at
each day of interest rate settlement (by
definition of LIBOR).
Fixed leg can be valued by standard NPV,
since the paid amount is known.

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 Forward starting swaps
interest starts accruing at some date in the
future.
Valuation is similar to a long swap long and
a short swap short.

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 Zero coupon swap (reinvested payments)
Amortizing swap (decreasing notional)
Accreting swap (increasing notional)
Rollercoaster (variable notional)

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 Amortizing swap

Decreasing notional affects coupon payments

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 Unwinding an existing swap
Enter into an offsetting swap at the
prevailing market rate.
If we are between two reset dates the
offsetting swap will have a short first period
to account for accrued interest.
It is important that floating payment dates
match!!

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 Unwinding
8%
A LIBOR B

6%
A LIBOR C

Net of the two offsetting swaps is 2% for the

life of the contract. (sometimes novation)

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 Risks of Swaps
Interest rate risk - value of fixed side may
change
Credit risk - default or change of rating of
counterparty
Mismatch risk - payment dates of fixed and
floating side are not necessarily the same
Basis risk and Settlement risk

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 Credit risk of a swap contract
Default of counterparty (change of rating).
Exists when the value of swap is positive
Frequency of payments reduces the credit risk,
similar to mark to market.
Netting agreements.
Credit exposure changes during the life of a
swap.

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 Duration of a swap

Fixed leg has a long duration (approximately).

Short leg has duration about time to reset.

Duration is a measure of price sencitivity to

interest rate changes (approximately is equal to
average time to payment).

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 IRS Markets
Daily average volume of trade (notional)
1995 1998 2001
$63B $155B $331B

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 Mark to market
daily repricing
collateral
adjustments
reduces credit exposure

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 Reasons to use swaps by firms
Lower cost of funds
Home market effects
Comparative advantage of highly rated firms

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 Global Derivatives Markets 1999
Exchange traded $13.5T OTC Instruments $88T
IR contracts 11,669 IR contracts 60,091
Futures 7,914 FRAs 6,775
Options 3,756 Swaps 43,936
FX contracts 59 Options 9,380
Futures 37 FX contracts 14,344
Options 22 Forwards 9,593
Stock-index contr. 1,793 Swaps 2,444
Futures 334 Options 2,307
Options 1,459 Equity-linked contr. 1,809
World GDP in 99 = 30,000 Forw. and swaps 283
All stocks and bonds = 70,000 Options 1,527
Liquidation value = 2,800 Commodity contr. 548
Others 11,408
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Source BIS slide 31
 FRM-GARP 00:47
Which one of the following deals has the
largest credit exposure for a $1,000,000 deal
size. Assume that the counterparty in each
deal is a AAA-rated bank and there is no
settlement risk.
A. Pay fixed in an interest rate swap for 1 year
B. Sell USD against DEM in a 1 year forward
contract.
C. Sell a 1-year DEM Cap
D. Purchase a 1-year Certificate of Deposit

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 FRM-GARP 00:47
Which one of the following deals has the
largest credit exposure for a $1,000,000 deal
size. Assume that the counterparty in each
deal is a AAA-rated bank and there is no
settlement risk.
A. Pay fixed in an interest rate swap for 1 year
B. Sell USD against DEM in a 1 year forward
contract.
C. Sell a 1-year DEM Cap
D. Purchase a 1-year Certificate of Deposit

Swaps Zvi Wiener slide 33