4. Interest Rate Risk

InterestRateRiskChapter41TheSwapBankAswapbankisagenerictermtodescribeafinancialinstitutionthatfacilitatesswapsbetweencounterparties.Theswapbankcanserveaseitherabrokeroradealer.Asabroker,theswapbankmatchescounterpartiesbutdoesnotassumeanyoftherisksoftheswap.Asadealer,theswapbankstandsreadytoaccepteithersideofacurrencyswap,andthenlaterlayofftheirrisk,ormatchitwithacounterparty.InterestrateswapsThemostcommontypeofswapisa“plainVanilla”interestrateswap.Itistheexchangeofafixedrateloantoafloatingrateloan.Takebenefitfromcomparativeadvantage.Somecompaniesmayhavecomparativeadvantageinfixedratemarkets,whileothercompanieshaveacomparativeadvantageinfloatingratemarkets.Whencompanieswanttoborrow,theylookforcheapborrowing,However,thismayleadtoacompanyborrowingfixedwhenitwantsfloatingorborrowingfloatingwhenitwantsfixed.Thisiswhereaswapcomesin.Aswaphastheeffectoftransformingafixedrateloanintoafloatingrateloanorviceversa.AnExampleofanInterestRateSwapConsiderthisexampleofa“plainvanilla”interestrateswap.BankAisaAAA-ratedinternationalbanklocatedintheU.K.andwishestoraise$10,000,000tofinancefloating-rateEurodollarloans.BankAisconsideringissuing5-yearfixed-rateEurodollarbondsat10percent.Itwouldmakemoresenseforthebanktoissuefloating-ratenotesatLIBORtofinancefloating-rateEurodollarloans.AnExampleofanInterestRateSwapFirmBisaAA-ratedU.S.company.Itneeds$10,000,000tofinanceaninvestmentwithafive-yeareconomiclife.FirmBisconsideringissuing5-yearfixed-rateEurodollarbondsat11.75percent.Alternatively,firmBcanraisethemoneybyissuing5-yearfloating-ratenotesatLIBOR+½percent.FirmBwouldprefertoborrowatafixedrate.AnExampleofanInterestRateSwapTheborrowingopportunitiesofthetwofirmsare:COMPANYBBANKAFixedrate11.75%10%FloatingrateLIBOR+.5%LIBORAnExampleofanInterestRateSwapTheswapbankmakesthisoffertoBankA:YoupayLIBOR–1/8%peryearon$10millionfor5yearsandwewillpayyou103/8%on$10millionfor5yearsCOMPANYBBANKAFixedrate11.75%10%FloatingrateLIBOR+.5%LIBORSwapBankLIBOR–1/8%103/8%BankAAnExampleofanInterestRateSwapHere’swhat’sinitforBankA:Theycanborrowexternallyat10%fixedandhaveanetborrowingpositionof-103/8+10+(LIBOR–1/8)=LIBOR–½%whichis½%betterthantheycanborrowfloatingwithoutaswap.10%½%of$10,000,000=$50,000.That’squiteacostsavingsperyearfor5years.SwapBankLIBOR–1/8%103/8%BankACOMPANYBBANKAFixedrate11.75%10%FloatingrateLIBOR+.5%LIBORAnExampleofanInterestRateSwapTheswapbankmakesthisoffertocompanyB:Youpayus10½%peryearon$10millionfor5yearsandwewillpayyouLIBOR–¼%peryearon$10millionfor5years.COMPANYBBANKAFixedrate11.75%10%FloatingrateLIBOR+.5%LIBORCompanyBSwapBank10½%LIBOR–¼%AnExampleofanInterestRateSwapAnExampleofanInterestRateSwap:TheycanborrowexternallyatLIBOR+½%andhaveanetborrowingpositionof10½+(LIBOR+½)-(LIBOR-¼)=11.25%whichis½%betterthantheycanborrowfloating.COMPANYBBANKAFixedrate11.75%10%FloatingrateLIBOR+.5%LIBORLIBOR+½%½%of$10,000,000=$50,000that’squiteacostsavingsperyearfor5years.SwapBankCompanyB10½%LIBOR–¼%AnExampleofanInterestRateSwapTheswapbankmakesmoneytoo.LIBOR–1/8–[LIBOR–¼]=1/810½-103/8=1/8¼SwapBankCompanyB10½%LIBOR–¼%LIBOR–1/8%103/8%BankACOMPANYBBANKAFixedrate11.75%10%FloatingrateLIBOR+.5%LIBORAnExampleofanInterestRateSwapTheswapbankmakes¼%SwapBankCompanyB10½%LIBOR–¼%LIBOR–1/8%103/8%BankABsaves½%Asaves½%COMPANYBBANKAFixedrate11.75%10%FloatingrateLIBOR+.5%LIBORInterestrateriskismoredifficulttomanageTherearemanydifferentinterestratesinanygivencurrency(Treasuryrates,interbankborrowingandlendingrates,swaprate,mortgagerates…)Althoughthesetendtomovetogether,theyarenotperfectlycorrelated.Termstructure:afunctiondescribethevariationoftheratewithdifferentmaturity.Thisisknownasthetermstructureofinterestratesoryieldcurve.4.1ManagementofNetInterestIncome(Table8.1,page160)Supposethatthemarket’sbestguessisthatfutureshorttermrateswillequaltoday’sratesWhatwouldhappenifabankpostedthefollowingrates?Howcanthebankmanageitsrisks?Maturity(yrs)DepositRateMortgageRate13%6%53%6%ManagementofNetInterestIncome(Table8.2,page161)Theasset-liabilitymanagementgroupshouldtrytoensurethattheinterestrateriskisminimizedIncreasethefive-yearrateonbothdepositsandmortgages.Thismakesfive-yeardepositsrelativelymoreattractiveandone-yearmortgagesrelativelymoreattractive.Ifthereisstillanimbalancewithdepositorsandborrowers,five-yeardepositandmortgageratescouldbeincreasedevenfurther.“Liquiditypreferencetheory”leadstolong-termratesbeinghigherthanshort-termratesmostofthetime.Maturity(yrs)DepositRateMortgageRate13%6%54%7%4.2LIBORandSwapRatesLIBOR(Londoninterbankofferedrates)are1-,3-,6-,and12-monthborrowingratesforcompaniesthathaveaAA-rating.LIBORprovidedbytheBritishBankersAssociation(BBA)istheaverageoftheresponsesfromcertainbanksaftertheratesinthelowestquartileandhighestquartilehavebeendiscarded.SwapRatesarethefixedratesexchangedforfloatinginaninterestrateswapagreement.UnderstandingSwapRatesAbankcan1.LendacertainprincipalforsixmonthstoaAAborrowerandrelenditforninesuccessivesix-monthperiods.2.EnterintoaswaptoexchangetheLIBORforthefive-yearswaprate.Thisshowsthattheswaprater