Stern Brothers University - Hedging and Derivatives
| What is an interest rate swap? An interest rate swap is a contractual agreement between two parties under which each agrees to make periodic payments to the other based upon a notional amount of principal for an agreed upon period of time. Four (4) Basic Characteristics of an Interest Rate Swap |
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Notional Amount
The size of an interest rate swap is referred to as the notional amount, which is the amount used to calculate the actual cash amounts that will be periodically exchanged. Neither party assumes the credit risk of the “counterparty”. Since there is no exchange of principal, swaps are generally viewed as cash instruments, and are treated as off-balance sheet transactions. Netting of Actual Payments Both the Fixed-Rate Payer and the Counterparty make payments on a predetermined date. At that time, the two amounts are netted against each other with one party paying the other the difference (rather than each party making its full payment). Swaps Can Create a Synthetic Fixed Rate An organization having variable-rate bonds can frequently create a lower synthetic fixed-rate for a period of time by entering into a swap. In doing so, it becomes the Fixed-Rate Payer by agreeing to pay a fixed rate (determined at the time of the “rate lock”), and in turn receives a variable-rate payment from the Swap Provider. The variable-rate payment can be based upon either the tax-exempt BMA index, or a percent of LIBOR (e.g. 67%). For the variable-rate borrower, the primary benefit of entering into a floating-to-fixed rate swap is to hedge interest rate exposure. Assuming that short term interest rates increase over the term of the agreement, the Fixed-Payer will receive a corresponding (and offsetting) variable rate payment while paying a predetermined fixed rate of interest. Fixed Rate Debt and Embedded Options Fixed rate bonds typically include a call provision for the bondholder (e.g. 10 years of call protection). In theory, this right represents an option that becomes more valuable to the bondholder the further interest rates decline (or less valuable as rates increase). Although swap agreements do not contain a prepayment option, early termination of a contract is permitted and will involve the payment (or receipt) of the value of the remaining contract period to maturity. If interest rates increase, the swap will become “in the money” representing a gain for the Fixed-Payer assuming it elects to terminate the arrangement prior to the term of the swap agreement. Conversely, if rates decline and the Fixed-Rate Payer is forced to terminate the swap, it will be required to make a payment to the Swap Provider based upon the change in rates and the remaining term of the swap agreement. BMA Versus LIBOR BMA is a Bond Market Association index generally consisting of over 250 tax-exempt issues that reset weekly, which have similar characteristics to the Borrower’s issue (e.g. over $10 million, pays interest monthly, has the highest short term rating, and is not subject to AMT). As such, the rate received from the Swap Provider will closely match the rate paid by the Fixed-Payor to Bond Holders. Since there is a tax risk inherent in the ownership of tax-exempt securities (the value will change somewhat as tax rates change), the tax risk is retained by the Swap Provider resulting in a somewhat higher fixed rate paid by the Fixed-Payor. An alternative to receiving BMA from the Swap Provider would be to receive a percent of LIBOR generally equal to the tax equivalent yield of a tax exempt bond. A conservative number to assume is for the Fixed-Payor to receive 70% of LIBOR. Doing so effectively shifts the tax liability from the Swap Provider to the Fixed-Payor and results in a lower fixed rate (e.g. 30 basis points). Risks in Swap Transactions - There are four (4) fundamental risks in a swap transaction: Basis Risk – Since the borrower will pay the actual rate on its variable-rate bonds and receive either the BMA rate or a percent of LIBOR, basis risk represents the degree to which these two rates vary. Receiving the BMA rate can mitigate basis Risk. Counterparty Risk – This is the risk that the party on the other side of a swap transaction does not fulfill its obligation under the agreement. To the extent that any interest rate swap involves mutual obligations to exchange cash flows, a degree of credit risk is implicit in the arrangement. Note however, that because a swap is a notional principal contract, no credit risk arises with respect to the amount of principal advanced by a lender to a borrower as in the case of a loan. Further, because the cash flows to be exchanged under an interest rate swap are typically "netted" (or offset), what is paid or received represents simply the difference between fixed and floating rates of interest. Tax Risk – This is the risk that a change in federal or state tax law impacts the Fixed-Payer’s borrowing cost. Since BMA is a tax-exempt index, there is no tax risk for the Fixed-Rate Payer in a BMA swap. Conversely, a percent of LIBOR swap by definition assumes a certain level of taxation. To the extent that tax law changes impact the rates paid to the variable-rate bondholder (either positively or negatively), the variable-rate received from the Swap Provider under a LIBOR based swap may not match that payment. Early Termination Risk - The net present value of the aggregate cashflows that comprise an interest rate swap will be zero. As time passes, however, this will cease to be the case, the reason being that the shape of the yield curves used to price the swap initially will change over time. If, for example, shortly after an interest rate swap has been completed there is an increase in forward interest rates: the forward yield curve steepens, the benefit will accrue to the Fixed-Payor under the swap and will represent a cost to the floating rate payor (from Fixed-Payor’s perspective the swap will be “in the money”). In the event that it elects to terminate the swap at that point, the Fixed-Payor will receive a cash payment equal to the present value of the increase in value. Alternatively, if the floating rate payer wishes to cancel the swap by entering into a reverse swap with a new counterparty for the remaining term of the original swap, the net present value figure represents the payment that the floating rate payer will have to make to the new counterparty in order for him to enter into a swap which precisely mirrors the terms and conditions of the original swap. As a general rule the decision to terminate a swap early is a voluntary one. There may, however, be instances when it is imposed upon the Borrower. In rare instances an organization may be required to redeem the proceeds of a bond issue for reasons such as the change of use or ownership of a facility financed with tax-exempt bonds or the inability to renew or replace the Letter of Credit. |
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Factors Influencing the fixed-rate payment Some of the factors that will impact the rate paid by the Fixed-Rate Payer include: |
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| In general, the highest fixed rate paid by the Fixed-Payor will be from a Swap Agreement that has a longer maturity, includes a variable-rate payment from the Swap Provider based upon BMA, without a Periodic Reversion provision. Assuming that the Borrower has a specific “target” fixed-rate that it wants to pay, this can be accomplished by: |
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Forward-Starting Swap
If interest rates are projected to increase in the relative near future, it is possible to continue to benefit by the lower rates and lock in a fixed-rate in a favorable interest rate environment by using a forward-starting swap. Since a forward rate, by definition, includes a measure of uncertainty, the rate will almost certainly be higher than the rate for a current swap, and the longer the period of time until it actually takes effect – the greater the forward-starting fixed-rate. A “rule of thumb” in estimating the impact of a forward-starting swap is that the fixed-rate paid by the borrower will increase approximately 2 basis points for each month until the swap actually takes effect. |
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Documentation
There are basically three documents that are used in a swap: |
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Timing
Assuming that there are no major credit concerns or issues with respect to the borrower, a swap transaction can generally be completed within a two-three week period. Prior to the actual execution of the agreement, the borrower can lock in a fixed-rate. Costs In general, there are minimal out-of-pocket expenses associated with a swap, because they are generally embedded within the rate paid by the organization. The one exception would be any legal fees or other expenses incurred by the borrower in reviewing the documents. |