AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E3. The use of financial derivatives to hedge against interest rate risk

E3a. Interest Options and Swaps 7 / 13

Syllabus E3a)

a) Evaluate, for a given hedging requirement, which of the following is the most appropriate given the nature of the underlying position and the risk exposure:

iii) Interest rate swaps
iv) Interest rate options.

Interest Rate Options



Grants the buyer the right (no obligation) to deal at a specific interest rate at a future date. 

At that date the buyer decides whether to go ahead or not

These protect against adverse movements in the actual interest rate but allow favourable ones!

Clearly, because of this, the option involves buying at a premium.

Interest rate Swaps

2 companies agree to exchange interest rate payments on different terms (eg fixed and variable).

For example one interest rate payment as a fixed rate and the other at a floating rate.

Interest rate swaps can act as a means of switching from paying one type of interest to another, allowing an organisation to obtain less expensive loans and securing better deposit rates.

Advantages

  1. Easy

  2. Low transaction costs (compared to getting a different loan)

In the simplest form of interest rate swap

Party A agrees to pay the interest on party B's loan, while party B reciprocates by paying the interest on A's loan. 

If the swap is to make sense, the two parties must swap interest which has different characteristics. 

Assuming that the interest swapped is in the same currency, the most common motivation for the swap is to switch from paying floating rate interest to fixed interest or vice versa. 

This type of swap is known as a 'plain vanilla' or generic swap.

Illustration 1

Company A 
- has a loan at FLOATING rate (LIBOR + 0.8%) from Bank A
- thinks that the interest rates go up so wants FIXED rate

Company B
- has a loan at FIXED rate (8%) from Bank B
- thinks that the interest rates go down so wants FLOATING rate

Solution

  • Company A can use a swap to change from paying interest at a floating rate of LIBOR + 0.8% to one of paying fixed interest of 8%.

    So the Company A will pay:
    8% to Company B
    Libor + 0.8% to Bank A

    And will receive LIBOR + 0.8% form Company B.

    Therefore will effectively pay (8% FIXED + (LIBOR + 0.8%) - (LIBOR + 0.8%)) = 8% (FIXED).

  • Company B will pay:
    8% to Bank B
    Libor + 0.8% to Company A

    And will receive 8% form Company A.

    Therefore will effectively pay (8% FIXED + (LIBOR + 0.8%) - 8% FIXED)  = LIBOR + 0.8% (FLOATING)

LIBOR or the London Inter-Bank Offered Rate is the rate of interest at which banks borrow from each other in the London inter-bank market.

A swap may be arranged with a bank, or a counterparty may be found through a bank or other financial intermediary.

Fees will be payable if a bank is used.

However a bank may be able to find a counterparty more easily, and may have access to more counterparties in more markets than if the company seeking the swap tried to find the counterparty itself.

Swaps are generally terminated by agreeing a settlement interest rate, generally the current market rate.