Just what is an interest rate swap?

Aside

One of our team was recently asked to give a simple overview of interest rate swaps and how they work. Below was the explanation we put together, using a comparison between an interest rate swap to a fixed-rate bank loan to illustrate the key characteristics.

We think it is a nice, concise and clear way to explain interest rate swaps so thought we would share it.  Comments welcome.

Bank fixed-rate term loan

Interest rate swap

Bank loan type Separate fixed-rate term loan Borrow floating rate (i.e. 90-day rate resets at market rates plus lending margin). The bank can normally change the lending margin on an annual review of the facilities.
Amount being fixed No flexibility, the full loan amount is fixed. Interest rate swap contract can be entered for any amount, in multiples of $1m. E.g. Borrowing facility of $10m, decide to fix 50% now, therefore enter a $5m swap. Later on the percentage fixed can be increased by doing another swap contract.
Fixing of interest rate Per loan documentation, includes bank lending rate for term (say 5 years) plus bank lending margin = all up fixed interest rate that does not change over the term of the loan Interest rate fixed by entering an “interest rate swap” contract. The borrower pays fixed rate and receives floating rate under the swap contract. The floating interest rate received under the swap for the next 90 days nets off against the 90 day interest rate paid on the physical floating rate loan above. Net result is an all up fixed interest rate, being the fixed swap rate plus the normal bank lending margin on the borrowing facility.
Flexibility Cannot unwind early or unknown penalties applied by the bank for early termination. At any time the swap can be unwound or closed down. If term swap rates subsequently increase, the swap is closed down at a realised cash gain –  being the difference between the contracted swap rate and the higher market swap rate for the term left to run (and vice versa).
Documentation Normal bank loan documents Interest rate swap is a separate legal document under standard “ISDA” bank terms.
Term of fixing Interest rate is fixed for the term of the loan A fixed rate swap can be for any term, does not have to be the same maturity date as the underlying bank loan facility. May be shorter or longer.
Use of bank credit limits Loan principal plus 12 months interest cost usually. Loan principal plus 90 days interest cost, plus credit usage of swap agreement (normally 4% x number of years of swap x principal amount). In addition, if market swap rates subsequently reduce to below the contracted fixed rate of the swap, the bank will add on the unrealised “marked-to-market” revaluation loss onto the total credit usage. The bank normally imposes a a maximum term for swap contracts. They may allow fixing the swap interest rate for 10 years with a “right to break” clause that allows the bank to close down the swap after 5 years if they don’t like the borrower’s credit any more.
Cashflow Interest paid monthly or quarterly. Interest on 90-day physical borrowing paid every 90 days and then the bank calculates the difference between the swap fixed rate and market floating rate every 90 days, with the borrower paying the cash difference between the two interest rates to the bank and vice versa.
Fixing the interest rate in advance of loan drawdown Not really possible. “Forward start” swaps can be entered with the fixed rate commencing from a predetermined date. An option can be purchased to enter a fixed rate swap at a future date as well (“swaption”).

Are interest rate swaps heading the way of the dodo?

Previously I wrote about the bad press interest rate swaps have been receiving and that I felt much of the criticism was unjustified. I firmly believe that a lot of the negativity has been due to people not understanding why swaps are useful and, because of this, they fear their use.

Further muddying the waters has been the recent announcement of new margin requirements for over-the-counter (OTC) swaps. The Commodity Futures Trading Commission (CFTC) has published several important rules for compliance, including a proposed start date of October 12. This has been coming for some time with the Dodd-Frank Act requiring most OTC derivatives to be traded on a Swap Execution Facility (SEF). (A SEF is “a trading system or platform in which multiple participants have the ability to execute or trade swaps”.)

Image courtesy of The Telegraph

This has got everyone excited and even saw Risk Magazine undertake a poll to see what the impact of the proposed margin requirements on uncleared trades would have. The results, while on the face of it are not surprising, could well be mis-leading.

60% of respondents to the survey thought end-users will opt not to use derivatives as a result of initial and variation margins requiring to be posted on uncleared swap trades. When the sort of money being talked about in collateral is in the trillions it is not surprising that there is some concern over this, and questions over the use of swaps in the future.

However I think we need to “back the truck up” a bit here. These new regulations do not relate to non-financial entities. The new proposals state “the margin requirements need not apply to non-centrally-cleared derivatives to which non-financial entities that are not systematically-important are a party.”

So corporations are exempt and therefore can continue to use swaps as they have done before – as a risk management tool to hedge future movements in interest rate risks. Interest rate swaps have got organisations into trouble in the past and no doubt will do so in the future, but almost without exception the reason that the deals have gone sour is because the people entering into them in the first case did not understand them. Sure the sales people have been gung-ho in some cases and they may or may not have been the best tool to use at the time, but again if the organisations entering into the swaps had a clear understanding of their use, most of these problems would be averted.

It is timely to remind ourselves of what needs to be in place to confidently enter into derivative deals. Firstly, make sure you have an exposure that the derivative will accurately hedge.  If as a borrower you have floating rate debt then an interest rate swap whereby you swap your floating interest payments for fixed interest payments would be appropriate. If you have floating rate debt and you sell an option to receive a premium to offset your interest payments, then this is speculation and is not managing your interest rate risk as you still have unlimited risk on the top side.

Secondly, understand the product itself well enough so you know the risks you are taking on board. If you are unsure DO NOT ENTER THE TRANSACTION. Normally plain vanilla deals will suffice, if you move away from the plain vanilla again you need to understand intimately what you are getting into. If interest rates go up what is the impact on your portfolio? Likewise if interest rates go down, what does that mean to you?

Finally you need to be able to record, report and value these transactions so that at all times you have a good handle on your current position and what might happen in the future if interest rates change. If you can’t capture your deals appropriately and value them then this is when unpleasant surprises can happen. You need to know your position at all times.

So changes are on their way, but as a business there is no cause for concern that instruments like swaps will no longer be able to be used as a risk management tool. If you follow the common sense rules then they are still an important way to manage your risks – despite what the regulators may seem to be saying.

Richard Eaddy is the CEO and founder of Hedgebook and the Managing Director of ETOS Ltd, specialists in treasury outsourcing services. Richard has worked in the corporate treasury risk management industry for more than 20 years. He has held senior roles in large corporate treasury departments in both New Zealand and Europe, provided treasury risk management advice to major corporations and for the last ten years has headed up the largest treasury outsourcing company in Australasia. Richard can be contacted at richard.eaddy@myhedgebook.com.

Interest Rate Swap Tutorial, Part 3 of 5, Floating Legs

Interest Rate Swap Example

For our example swap we will be using the following inputs:

  • Notional: $1,000,000 USD
  • Coupon Frequency: Semi-Annual
  • Fixed Coupon Amount: 1.24%
  • Floating Coupon Index: 6 month USD LIBOR
  • Business Day Convention: Modified Following
  • Fixed Coupon Daycount: 30/360
  • Floating Coupon Daycount: Actual/360
  • Effective Date: Nov 14, 2011
  • Termination Date: Nov 14, 2016
  • We will be valuing our swap as of November 10, 2011.
In the previous article we generated our schedule of coupon dates and calculated our fixed coupon amounts.

Calculating Forward Rates

To calculate the amount for each floating coupon we do the following calculation:

Floating Coupon = Forward Rate x Time x Swap Notional Amount

Where:

Forward Rate = The floating rate determined from our zero curve (swap curve)
Time = Year portion that is calculated by the floating coupons daycount method.
Swap Notional = The notional amount set in the swap confirmation.

In the next couple articles we will go through the process of building our zero curve that will be used for the swap pricing. In the meantime we will use the following curve to calculate our forward rates and discount our cashflows.

swap zero curve

The numbers at each date reflect the time value of money principle and reflect what $1 in the future is worth today for each given date.

Let’s look at our first coupon period from Nov 14, 2011 to May 14, 2012. To calculate the forward rate which is expressed as a simple interest rate we use the following formula:
simple interest formula
where:

forward rate discount factor

Solving for R
forward rate formula

In our example we divide the discount factor for May 14, 2012 by the discount factor for Nov 14, 2011 to calculate DF.

0.9966889 / 0.9999843 = 0.9967046

T is calculated using Actual/360. The number of days in our coupon period is 182. 182/360 = 0.505556

R = (1 – 0.9967046) / (0.9967046 x 0.505556) = 0.654%

Our first coupon amount therefore is:

Floating Coupon = Forward Rate x Time x Swap Notional Amount

$ 3,306.33 = 0.654% x 0.505556 x $1,000,000

Below is a table with our forward rate calculations & floating coupon amounts for the rest of our coupons.

swap forward rates

The final step to calculate a fair value for our complete swap is to present value each floating coupon amount and fixed coupon amount using the discount factor for the coupon date.

Present Value of Net Coupon is
(Floating Coupon Amount – Fixed Coupon Amount) x Discount Factor

interest rate swap

Our net fair value of this swap is $ 0.00 as of November 10, 2011.

So far in this tutorial we have gone through basic swap terminology, fixed leg coupon calculations, calculating forward rates for floating leg coupon calculations and discounted our cashflows to value a swap.

Thanks to our sister company Resolution for providing us with this series of posts.

Next Article: Present value of money & bootstrapping a swap curve

The GFC, Corporate Governance and Hedgebook…

In the wake of the Global Financial Crisis (GFC), Corporate Governance has become a key focus, not just for large organisations but for small to medium sized entities as well.

Corporate Governance relates to the rules around how a company is controlled, whether it is by processes, policies, laws or customs.

Two of the key areas of Corporate Governance are reporting & disclosure, and risk management.

Reporting and disclosure means demanding integrity both in financial reporting and in the timeliness and balance of disclosures relating to the entity’s affairs. Risk management is regularly verifying that the entity has appropriate processes in place to identify and manage potential and relevant risks.

Hedgebook is ideally suited to assist in both these areas of Corporate Governance and is designed specifically to help any business better manage its foreign exchange and interest rate risks. From a reporting and disclosure point of view, it enhances the reporting around treasury giving more visibility to “what if” scenarios as well as better defining an organisation’s current position

For risk management, Hedgebook assists with not only the areas mentioned above but also in compliance with treasury policies, which is a key plank of any organisation’s risk management process. With having online access to valuations for financial instruments, Hedgebook gives greater transparency over risk management issues as well as assisting in making better business decisions. Hedgebook also tells an organisation not only what their risk position is today, but given current market conditions, what their position is in the future.

As we see increased awareness of corporate governance amongst small to medium sized companies, a tool like Hedgebook is putting information in the hands of these organisations at an affordable price.

This not only makes better corporate governance possible for these organisations, while at the same time enabling better decision making in a crucial area of business.

Look out for our next article on better Reporting and Disclosure coming soon.

Interest Rate Swap Tutorial, Part 2 of 5, Fixed Legs

Interest Rate Swap Fixed Legs

Now that we know the basic terminology and structure of a vanilla interest rate swap we can now look at constructing our fixed leg of our swap by first building our date schedule, then calculating the fixed coupon amounts.

For our example swap we will be using the following inputs:

  • Notional: $1,000,000 USD
  • Coupon Frequency: Semi-Annual
  • Fixed Coupon Amount: 1.24%
  • Floating Coupon Index: 6 month USD LIBOR
  • Business Day Convention: Modified Following
  • Fixed Coupon Daycount: 30/360
  • Floating Coupon Daycount: Actual/360
  • Effective Date: Nov 14, 2011
  • Termination Date: Nov 14, 2016
  • We will be valuing our swap as of November 10, 2011.

Swap Coupon Schedule

First we need to create our schedule of swap coupon dates. We will start from our maturity date and step backwards in semi-annual increments. The first step is to generate our schedule of non-adjusted dates.

swap coupon dates unadjusted

Then we adjust our dates using the modified following business day convention.

swap coupon dates adjusted

Note that all the weekend coupon dates have been brought forward to the next Monday.

Swap Fixed Coupon Amounts

To calculate the amount for each fixed coupon we do the following calculation:

Fixed Coupon = Fixed Rate x Time x Swap Notional Amount

Where:

Fixed Rate = The fixed coupon amount set in the swap confirmation.

Time = Year portion that is calculated by the fixed coupons daycount method.

Swap Notional = The notional amount set in the swap confirmation.

Below is our date schedule with the Time portion calculated using the 30/360 daycount convention. More on daycounts can be found in this document titled Accrual and Daycount conventions.

Note the coupons which are not exactly a half-year due to the business day convention. If our business day convention was no-adjustment all the time periods would have been 0.5. This is a difference between swaps and bonds, as bonds will generally not adjust the coupon amounts for business day conventions, they will simply be 1/(# coupon periods per year) x coupon rate x principal.

swap schedule with daycount

The coupon amount for our first coupon will be 1.24% x 1,000,000 x 0.50 = $6,200.00. Below are the coupon amounts for all of the coupons.

swap coupon schedule

Now that we know our coupon amounts, to find the current fair value of the fixed leg we would present value each coupon and sum them to find the total present value of our fixed leg. To do this we calculate the discount factor for each coupon payment using a discount factor curve which represents our swap curve. We will build our discount factor curve later in this tutorial series.

Thanks to our sister company Resolution for providing us with this series of posts.

Next Article: Swap floating legs including calculating forward rates

Are interest rate swaps really that bad?

Interest rate swaps have been getting a bit of a bad rap lately. First it was the UK banks selling them to unsuspecting customers and now Goldman Sachs in the US is in a tangle with the City of Oakland over a swap they sold them fourteen years ago. A swap that has, not surprisingly, gone bad.

For those of us old enough to remember, none of this is very new. Back in 1988 the London Borough of Hammersmith and Fulham got itself caught up in an interest rate saga that continues be taught to first year law students but probably should also be taught to first year swaps traders. The London borough entered into a massive amount of interest rate swaps, totalling US $6 billion to manage debt of just US $350 million. The swaps were obviously speculative in the hope interest rates would go down and when they didn’t Hammersmith and Fulham were looking down the barrel of some enormous losses. The case went to the High Court and it was ruled that local governments could use interest rate swaps but not for speculative purposes and therefore the banks who sold them the swaps lost millions as they had to tear up the contracts. For those with a legal bent the contracts were deemed to be ultra vires or outside of the borough’s legal authority to enter into and hence is still studied as a landmark case today.

Whether the High Court got it right or not in terms of voiding the swap contracts is up for debate, caveat emptor or “let the buyer beware”, springs to mind, but the court did get it right by allowing British local authorities to enter into interest rate swap agreements for the purpose of limiting interest rate risk.

Interest rate swaps are a risk management tool and should be used as such. The basis of financial risk management is to smooth out volatility in financial markets so that organisations are not exposed to shock movements, whether it is interest rates, foreign exchange rates or commodity prices. The alternative is to remain unhedged and be at the mercy of financial markets. Good risk management should be coupled with a board-approved Treasury Policy which outlines the risks an organisation is prepared to take, including how much or how little hedging needs to be undertaken. Organisations should also have robust systems in place to record, report and value these instruments so that risk management decisions can be made with confidence. It is all very well to enter into these transactions but if you are not tracking them properly then this can open you up to even more risks.

The authorities haven’t been ignoring this issue either. The international accounting standards recognise the difference between speculative and non-speculative transactions through hedge accounting. If you can’t prove a deal is hedging an underlying exposure, such as floating rate debt, then any change in value is recognised in earnings.

Interest rate swaps should be used for what they are intended, to manage risk. They are not negating that risk, but they are giving certainty of interest rate cost and limiting any potential downside.

Banks should be obligated to make sure their customers understand the risks of what they are doing, but equally so the customer should not be entering into a financial transaction they don’t fully understand. There is a lot of talk about the negative side of interest rate swaps but used correctly they are a powerful risk management tool for the purpose of limiting interest rate risk, as the High Court in London all those years ago so rightly ruled.

Richard Eaddy is the CEO and founder of Hedgebook and the Managing Director of ETOS Ltd, specialists in treasury outsourcing services. Richard has worked in the corporate treasury risk management industry for more than 20 years. He has held senior roles in large corporate treasury departments in both New Zealand and Europe, provided treasury risk management advice to major corporations and for the last ten years has headed up the largest treasury outsourcing company in Australasia. Richard can be contacted at richard.eaddy@myhedgebook.com.