Summary
Summary Financial instruments: derivatives
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- Institution
Derivative: If value of financial instrument is based on the value of another financial instrument.
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lOMoARcPSD|837380Financial risk management - swaps - F000738 A - Keuleneer
Valuation and Risk management (Universiteit Gent)
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BUILDING BLOCKS
Interest risk management
SWAP
Exchange something. If we exchange interest payments, then you have an Interest Rate Swap (IRS)
A very simple IRS: Plain Vanilla IRS
What will happen if you buy an IRS? (Payer IRS) → You pay the fixed and you receive the floating
What will happen if you sell an IRS? (Receiver IRS) → You pay the floating and you receive the fixed
Interest rate swap (IRS)
An agreement between two parties (known as counterparties) where one stream of future interest
payments is exchanged for another based on a specified principal amount. Interest rate swaps often
exchange a fixed payment for a floating payment that is linked to an interest rate (most often the
LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations
in interest rates, or to obtain a marginally lower interest rate than it would have been able to get
without the swap.
Plain vanilla IRS
The most basic type of forward claim that is traded in the over-the-counter market between two
private parties, usually firms or financial institutions. The most common and simplest swap is a "plain
vanilla" interest rate swap. In this swap, party A agrees to pay Party B a predetermined, fixed rate of
interest on a notional principal on specific dates for a specified period of time. Concurrently, party B
agrees to make payments based on a floating interest rate to Party A on that same notional principal
on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash
flows are paid in the same currency. The specified payment dates are called settlement dates, and
the time between are called settlement periods. Because swaps are customized contracts, interest
payments may be made annually, quarterly, monthly, or at any other interval determined by the
parties.
For example, on Dec. 31, 2006, Company A and Company B enter into a five-year swap with the
following terms:
• Company A pays Company B an amount equal to 6% per annum on a notional principal of
$20 million.
• Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a
notional principal of $20 million.
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LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits
made by other banks in the eurodollar markets. The market for interest rate swaps frequently (but
not always) uses LIBOR as the base for the floating rate. For simplicity, let's assume the two parties
exchange payments annually on December 31, beginning in 2007 and concluding in 2011.
At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On Dec. 31,
2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000* (5.33% +
1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the
beginning of the settlement period. Normally, swap contracts allow for payments to be netted
against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A
pays nothing. At no point does the principal change hands, which is why it is referred to as a
"notional" amount. Figure 1 shows the cash flows between the parties, which occur annually (in this
example).
➔ You can buy a PV (plain vanilla) IRS: you will receive the floating and pay the fixed
➔ You can sell a PV IRS: you will pay the floating and receive the fixed
➔ Companies prefer having to pay the same amount in every time period, so they will buy a PV
IRS. Banks can sell it.
➔ Payers IRS= I am the buyer, I am the one paying the fixed (you have to look what happens
with the fixed)
➔ Receivers IRS= I am the seller of the PV IRS
Example: in my company, my financing is based on a floating interest rate (1 year EURIBOR + 2%)
(remark: these 2% are a compensation for the credit risk and are only related to funding). We will
look at 4 time periods.
• Spot rate at t0= 7%
• Expected 1 year spot rates = forward rates:
o Year 2: 9%
o Year 3: 13%
o Year 4: 16%
The bank has a 4 years PV IRS with yearly payments. This means that they exchange a floating against
a fixed payment at the end of every year (4 times). The floating is based on 1 year EURIBOR, the fixed
is 8%.
What is the problem? You want certainty, you would like to have the same cost every year. How can
this be realized? Buy IRS from the bank: you pay fixed and receive floating. This results in (expected)
certainty.
Year Expected funding cost Hedge risk using PV IRS Result
Receive Pay
1 -9% +7% -8% -10%
2 -11% +9% -8% -10%
3 -15% +13% -8% -10%
4 -18% +16% -8% -10%
2
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