CHAPTER 8
INTEREST RATE RISK AND SWAPS
1. Reference Rates. What is an interest “reference rate” and how is it used to set rates
for individual borrowers?
2. My Word is My LIBOR. Why has LIBOR played such a central role in
international business and financial contracts? Why has this been questioned in recent
debates over its value reported?
No single interest rate is more fundamental to the operation of the global financial
markets than the London Interbank Offered Rate (LIBOR). But beginning as early as
2007, a number of participants in the interbank market on both sides of the Atlantic
suspected that there was trouble with LIBOR. The three-month and six-month
maturities are the most significant maturities due to their widespread use in various
Secondly, banks – specifically money-market and derivative traders within the banks
– have a number of interests that may be impacted by borrowing costs reported by the
bank that day. One such example can be found in the concerns of banks in the
interbank market in September 2008, when the credit crisis was in full-bloom. A bank
reporting that other banks were demanding it pay a higher rate that day would, in
3. Credit Risk Premium. What is a credit risk premium?
The cost of debt for any individual borrower will therefore possess two components,
the risk-free rate of interest (
$
US
k
), plus a credit risk premium
$Rating
(RPM )
reflecting
4. Credit and Repricing Risk. From the point of view of a borrowing corporation,
what are credit and repricing risks? Explain steps a company might take to minimize
both.
For a corporate borrower, it is especially important to distinguish between credit risk
and repricing risk. Credit risk, sometimes termed roll-over risk, is the possibility that
a borrower’s creditworthiness at the time of renewing a credit – its credit rating – is
reclassified by the lender. This can result in changing fees, changing interest rates,
5. Credit Spreads. What is a credit spread? What credit rating changes have the most
profound impact on the credit spread paid by corporate borrowers?
The cost of debt changes with credit quality, as a credit spread is added to the basic
6. Investment Grade Versus Speculative Grade. What do the general categories of
investment grade and speculative grade represent?
Although there is obviously a wide spectrum of credit ratings, the designation of
investment grade versus speculative grade is extremely important. An investment
grade borrower (Baa3, BBB-, and above), is considered a high quality borrower that
7. Sovereign Debt. What is sovereign debt? What specific characteristic of sovereign
debt constitutes the greatest risk to a sovereign issuer?
Debt issued by governments – sovereign debt – is historically considered debt of the
highest quality, higher than that of non-government borrowers within that same
country. This quality preference stems from the ability of a government to tax its
8. Floating Rate Loan Risk. Why do borrowers of lower credit quality often find their
access limited to floating-rate loans?
As opposed to fixed rate loans, where the lender accepts both the risk of changing
9. Interest Rate Futures. What is an interest rate future? How can they be used to
reduce interest rate risk by a borrower?
Interest rate futures are relatively widely used by financial managers and treasurers of
nonfinancial companies. Their popularity stems from the high liquidity of the interest
rate futures markets, their simplicity in use, and the rather standardized interest rate
exposures most firms possess.
If a financial manager were interested in hedging a floating-rate interest payment due
at a short-term future date, she would need to sell a future, to take a short position.
This strategy is referred to as a short position because the manager is selling
something she does not own (as in shorting common stock). If interest rates rise by
10. Interest Rate Futures Strategies. What would be the preferred strategy for a
borrower paying interest on a future date if they expected interest rates to rise?
They should sell an interest rate futures – take a short position.
11. Forward Rate Agreement. How can a business firm that has borrowed on a
floating-rate basis use a forward rate agreement to reduce interest rate risk?
A forward rate agreement (FRA) is an interbank-traded contract to buy or sell
interest rate payments on a notional principal. These contracts are settled in cash. The
buyer of an FRA obtains the right to lock in an interest rate for a desired term that
12. Plain Vanilla. What is a plain vanilla interest rate swap? Are swaps a significant
source of capital for multinational firms?
A plain vanilla interest rate swap is a swap to pay fixed/receive floating, or
alternatively, pay floating/receive fixed. The plain vanilla interest rate swap is not a
13. Swaps and Credit Quality. If interest rate swaps are not the cost of government
borrowing, what credit quality do they represent?
14. LIBOR Flat. Why do fixed for floating interest rate swaps never swap the credit
spread component on a floating rate loan?
Interest rate swaps are not sources of capital, and therefore are not intended to price
debt as a market or banker would in assessing a borrower’s credit quality. Instead, the
15. Debt Structure Swap Strategies. How can interest rate swaps be used by a
multinational firm to manage its debt structure?
All companies will pursue a target debt structure which combines maturity, currency
of composition, and fixed/floating pricing. The fixed/floating objective is one of the
most difficult for many companies to determine with any confidence, and they often
just try to replicate industry averages.
16. Cost-Based Swap Strategies. How do corporate borrowers use interest rate or cross
currency swaps to reduce the costs of their debt?
All firms are always interested in opportunities to lower the cost of their debt. The
plain vanilla swap market is one highly accessible and low cost method of doing so.
These lower costs achieved through the plain vanilla swap market may simply reflect
short-term market imperfections and inefficiencies or the comparative advantage
some borrowers have in selected markets via selective financial service providers.
17. Cross-Currency Swaps. Why would one company with interest payments due in
pounds sterling want to swap those payments for interest payments due in U.S.
dollars?
It might be that the company in its continuing business received regular cash inflows
18. Value Swings in Cross-Currency Swaps. Why are there significantly larger swings
in the value of a cross-currency swap than there is in a plain vanilla interest rate
swap?
Cross-currency swaps are subject to both changes in interest rates and changes in
19. Unwinding a Swap. How does a company cancel or unwind a swap?
Unwinding a currency swap requires the discounting of the remaining cash flows
20. Counterparty Risk. How does organized exchange trading in swaps remove any
risk that the counterparty in a swap agreement will not complete the agreement?
Counterparty risk is the potential exposure any individual firm bears that the second
party to any financial contract will be unable to fulfill its obligations under the
contract’s specifications. Concern over counterparty risk has risen in the interest rate
Counterparty risk has long been one of the major factors that favor the use of
exchange-traded rather than over-the-counter derivatives. Most exchanges, like the
Philadelphia Stock Exchange for currency options or the Chicago Mercantile
Exchange for Eurodollar futures, are themselves the counterparty to all transactions.
This allows all firms a high degree of confidence that they can buy or sell exchange-
traded products quickly, and with little concern over the credit quality of the