Chapter 15
Swap Markets
Outline
Background
Use of Swaps for Hedging
Types of Swaps
Plain Vanilla Swaps
Forward Swaps
Risks of Interest Rate Swaps
Basis Risk
Credit Risk
Sovereign Risk
Pricing Interest Rate Swaps
Prevailing Market Interest Rates
Performance of Interest Rate Swaps
Interest Rate Caps, Floors, and Collars
Interest Rate Caps
Credit Default Swaps
Secondary Market for CDS Contracts
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Globalization of Swap Markets
Currency Swaps
Key Concepts
1. Remind students as to how interest rate movements can adversely affect the performance of various
financial institutions.
2. Describe how financial institutions participate in swap markets.
POINT/COUNTER-POINT:
Should Financial Institutions Engage in Interest Rate Swaps for Speculative
Purposes?
COUNTER-POINT: No. They should use their main business to generate gains for their shareholders.
They should serve as intermediaries for swap transactions only to generate transaction fees or take a
position only to hedge their exposure to interest rate risk.
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
Questions
1. Hedging with Interest Rate Swaps. Bowling Green Savings & Loan uses short-term deposits to
fund fixed-rate mortgages. Explain how Bowling Green can use interest rate swaps to hedge its
interest rate risk.
ANSWER: Bowling Green could engage in a fixed-for-floating swap. If interest rates rise, its inflow
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2. Decision to Hedge with Interest Rate Swaps. Explain the types of cash flow characteristics that
would cause a firm to hedge interest rate risk by swapping floating-rate payments for fixed payments.
Why would some firms avoid the use of interest rate swaps, even when they are highly exposed to
interest rate risk?
3. Role of Securities Firms in Swap Market. Describe the possible roles of securities firms in the swap
market.
ANSWER: Securities firms can act as an intermediary by matching up firms that have opposite swap
4. Hedging with Swaps. Chelsea Finance Company receives floating inflow payments from its
provision of floating-rate loans. Its outflow payments are fixed because of its recent issuance of long-
term bonds. Chelsea is concerned that interest rates will decline in the future. Yet, it does not want to
hedge its interest rate risk, because it believes interest rates may increase. Recommend a solution to
Chelsea’s dilemma.
ANSWER: Chelsea could negotiate a putable swap, which represents a floating payment in exchange
5. Basis Risk. Comiskey Savings provides fixed-rate mortgages of various maturities, depending on
what customers want. It obtains most of its funds from issuing certificates of deposit with maturities
ranging from one month to five years. Comiskey has decided to engage in a fixed-for-floating swap to
hedge its interest rate risk. Is Comiskey exposed to basis risk?
ANSWER: Yes. Comiskey’s liabilities are more rate-sensitive than its assets, but it is difficult to
6. Fixed-for-Floating Swaps. Shea Savings negotiates a fixed-for-floating swap with a reputable firm
in South America that has an exceptional credit rating. Shea is very confident that there will not be a
default on inflow payments because of the very low credit risk of the South American firm. Do you
agree? Explain.
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7. Fixed-for-Floating Swaps. North Pier Company entered into a two-year swap agreement, which
would provide fixed-rate payments for floating-rate payments. Over the next two years, interest rates
declined. Based on these conditions, did North Pier Company benefit from the swap?
ANSWER: No. The fixed-rate payments owed by North Pier over the two years would likely have
8. Equity Swap. Explain how an equity swap could allow Marathon Insurance Company to capitalize
on expectations of a strong stock market performance over the next year without altering its existing
portfolio mix of stocks and bonds.
ANSWER: An equity swap involves the exchange of interest payments (based on a specified interest
9. Swap Network. Explain how the failure of a large commercial bank could cause a worldwide swap
credit crisis.
ANSWER: Assume the commercial bank has taken positions in numerous swaps and guaranteed
10. Currency Swaps. Markus Company purchases supplies from France once a year. Would Markus be
favorably affected if it establishes a currency swap arrangement and the dollar strengthens? What if it
establishes a currency swap arrangement and the dollar weakens?
ANSWER: Markus could engage in a currency swap arrangement in which it agrees to swap dollars
11. Basis Risk. Explain basis risk as it relates to a currency swap.
ANSWER: Basis risk would reflect the hedging of a position in a foreign currency with a swap in a
12. Sovereign Risk. Give an example of how sovereign risk is related to currency swaps.
ANSWER: An example of sovereign risk is that the government of a country could suspend the
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13. Use of Interest Rate Swaps. Explain why some companies that issue bonds engage in interest rate
swaps in financial markets. Why do they not simply issue bonds that require the type of payments
(fixed or variable) that they prefer to make?
ANSWER: In some cases, the premium paid by a risky firm when issuing fixed-rate bonds may be
higher than if it issues variable-rate bonds. Thus, it may prefer to issue variable-rate bonds even if it
14. Use of Currency Swaps. Explain why some companies that issue bonds engage in currency swaps.
Why do they not simply issue bonds in the currency that they would prefer to use for making payments?
ANSWER: Companies may not be well known in the country where the bonds denominated in a
Advanced Questions
15. Rate-Capped Swaps. Bull and Finch Company wants a fixed-for-floating swap. It expects interest
rates to rise far above the fixed rate that it would pay and remain very high until the swap maturity
date. Should it consider negotiating for a rate-capped swap with the cap set at two percentage points
above the fixed rate? Explain.
16. Forward Swaps. Rider Company negotiates a forward swap to begin two years from now, in which it
will swap fixed payments for floating-rate payments. What will be the effect on Rider if interest rates
rise substantially over the next two years? That is, would Rider be better off by using this forward
swap than if it had simply waited two years before negotiating the swap? Explain.
ANSWER: Rider would have been better off with the forward swap, because the fixed rate specified
17. Swap Options. Explain the advantage of a swap option to a financial institution that wants to swap
fixed payments for floating payments.
ANSWER: A swap option would allow the financial institution to terminate the swap arrangement
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18. Callable Swaps. Back Bay Insurance Company negotiated a callable swap involving fixed payments
in exchange for floating payments. Assume that interest rates decline consistently up until the swap
maturity date. Do you think Back Bay might terminate the swap prior to maturity? Explain.
19. Credit Default Swaps. Credit default swaps were once viewed as a great innovation could make
mortgage markets more stable. However, the swaps were sometimes criticized for making the credit
crisis worse. Why?
ANSWER: Credit default swaps protect securities against default, but the protection is only as strong
20. Credit Default Swap Prices. Explain why the failures of Lehman Brothers caused prices
on credit default swap contracts to increase.
ANSWER: The credit crisis illustrated how protection provided to buyers of a CDS is only as good as
21. Reform of CDS Contracts. Explain how the Financial Reform Act of 2010 and the rules issued to
implement it attempted to reduce the risk in the financial system resulting from the use of credit
default swaps.
ANSWER: As a result of the Financial Reform Act of 2010, derivative securities such as swaps are to
be traded on an exchange or clearinghouse. One obvious result of having derivatives traded on an
CRITICAL THINKING QUESTION
Credit Default Swaps and the Credit Crisis A critic recently mentioned that the creation of credit
default swaps caused the credit crisis in the 2008-2009 period. Write a short essay that supports or refutes
this statement.
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ANSWER
Credit default swaps allowed investors to bet that valuations of mortgages and MBS would decline. This
might have expedited the correction of the housing bubble because it allowed some investors to capitalize
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “The swaps market is another Wall Street-developed house of cards.”
There is a concern that the swaps market could overexpose some banks so if swap arrangements
b. “As a dealer in interest rate swaps, our bank takes various steps to limit our exposure.”
Any provisions that could force clients to meet their swap obligations would help protect banks.
c. “The regulation of commercial banks, securities firms, and other financial institutions that
participate in the swaps market could create a regulatory war.”
Managing in Financial Markets
As a manager of a commercial bank, you have just purchased a three-year interest rate collar, with
LIBOR as the interest rate index. The interest rate cap specifies a fee of 2 percent of notional principal
a. Determine the net fees paid, as well as the expected net payments to be received as a result of
purchasing the interest rate collar.
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The net payments are derived as follows:
0
1
2
3
LIBOR
6%
10%
11%
Interest Rate
Ceiling
Payments
Received
(Based on
$100 Million
of Notional
Principal)
$0
$1,000,000
$2,000,000
Fee Paid
$2,000,000
Points Below
the Floor
Fee Received $3,000,000
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b. Assuming you are very confident that interest rates will rise, should you consider purchasing a
callable swap instead of the collar? Explain.
The interest collar is most appropriate if you are confident that interest rates will rise. The
c. Explain the conditions under which your purchase of an interest rate collar could backfire.
If interest rates decline rather than rise, you will not receive any payments on the interest rate
Problems
1. Vanilla Swaps. Cleveland Insurance Company has just negotiated a three-year plain vanilla swap in
which it will exchange fixed payments of 8 percent for floating payments of LIBOR + 1 percent. The
notional principal is $50 million. LIBOR is expected to 7 percent, 9 percent, and 10 percent,
respectively, at the end of each of the next three years.
a. Determine the net dollar amount to be received (or paid) by Cleveland each year.
ANSWER:
End of Year:
1
2
3
LIBOR
7%
9%
10%
Floating Rate Received
8%
10%
11%
Fixed Rate Paid
8%
8%
8%
of $50 Million)
b. Determine the dollar amount to be received (or paid) by the counterparty on this interest rate
swap each year based on the assumed forecasts of LIBOR.
2. Interest Rate Caps. Northbrook Bank purchases a four-year cap for a fee of 3 percent of notional
principal valued at $100 million, with an interest rate ceiling of 9 percent, and LIBOR as the index
representing the market interest rate. Assume that LIBOR is expected to be 8 percent, 10 percent, 12
percent, and 13 percent, respectively, at the end of each of the next four years.
a. Determine the initial fee paid, as well as the expected payments to be received by Northbrook if
LIBOR moves as forecasted.
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ANSWER:
End of Year:
0
1
2
3
4
LIBOR
8%
10%
12%
13%
Interest Rate Ceiling
9%
9%
9%
9%
0%
1%
3%
4%
$3,000,000
b. Determine the dollar amount to be received (or paid) by the seller of the interest rate cap based on
the assumed forecasts of LIBOR.
ANSWER:
End of
Year 0 = $3,000,000 received
3. Interest Rate Floors. Iowa City Bank purchases a three-year interest rate floor for a fee of 2 percent
of notional principal valued at $80 million, with an interest rate floor of 6 percent, and LIBOR
representing the interest rate index. The bank expects LIBOR to be 6 percent, 5 percent, and 4 percent
respectively at the end of each of the next three years.
a. Determine the initial fee paid, as well as the expected payments to be received by Iowa City if
LIBOR moves as forecasted.
ANSWER:
End of Year:
0
1
2
3
LIBOR
6%
5%
4%
Interest Rate Floor
6%
6%
6%
Floor
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b. Determine the dollar amounts to be received (or paid) by the seller of the interest rate floor based
on the assumed forecasts of LIBOR.
ANSWER:
End of
Flow of Funds Exercise
Hedging with Interest Rate Derivatives
Recall that if the economy continues to be strong, Carson Company may need to increase its production
capacity by approximately 50 percent over the next few years to satisfy demand. It would need financing
a. How could Carson use interest rate swaps to reduce the exposure of its cost of debt to interest rate
movements?
Carson could engage in a swap of fixed interest rates in exchange for floating interest rates. If
b. What is a possible disadvantage of Carson using the interest rate swap hedge as opposed to no
hedge?
If interest rates decline, Carson would incur lower debt financing costs on its floating-rate loans.
c. How could Carson use an interest rate cap to reduce the exposure of its cost of debt to interest
rate movements?
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Carson could purchase an interest rate cap, in which it would receive payments if market interest
d. What is a possible disadvantage of Carson using the interest cap hedge as opposed to no hedge?
If interest rates decline, Carson would still incur a cost from the interest rate cap but would not
e. Explain the tradeoff from using an interest rate swap versus an interest rate cap.
The profit from an interest rate swap would be more closely matched to the increase in debt