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

“Hedge Accounting and Beyond: Currency Volatility and Movements Aren’t Just Treasury’s Problem”

I came across this nice little article today from Jason Busch of Enterprise Irregulars on the need, during such volatile economic times, for a wider understanding of Hedge Accounting and its role in managing an organization’s currency exposure.

As Busch says, management right across businesses with currency exposure (whether through global sourcing or international sales) need to have a much better understanding of the tools at their disposal, and need to stop relying on their treasury team (if they are lucky enough to have one) to manage these “stormy waters”. It takes a collaborative effort between Treasury and “the business” to make sure that a business is qualifying for hedge accounting, and therefore minimising the impact of currency shifts on their profitability.

As Richard Eaddy commented in his latest article, for most businesses hedge accounting need not be the onerous process that it is perceived as and is a vital tool in helping to ensure that the market volatility doesn’t have to flow through to your company’s income statement. But to Jason Busch’s point, it needs to be a team effort.

Five steps to more effective treasury management

I recently read an interesting report in the November 2011 McKinsey Quarterly that highlights the increasing complexities of managing the treasury function of a business and focuses on 5 key areas that should be given attention, no matter what size or type of business you are.

The article delivered a timely reminder that the costs of inadequate focus on this important function can be extremely costly for small and large businesses alike. “Companies pay incremental interest expenses when they overborrow as a result of inaccurate cash flow forecasting and often lose money when they don’t hedge exposures for currencies and for interest rates…”

Now clearly you don’t need to be a McKinsey analyst to work that out, however too many  businesses still take something of a laissez faire approach to the task of managing their currency and interest rate exposure.

The 5 areas the McKinsey report focuses on are:

  • Centralise the treasury function globally
  • Strengthen governance
  • Enhance treasury-management systems
  • Increase the accuracy of cash flow forecasting
  • Manage working capital in developing markets

Points 1 and 5 may only be relevant to organisations with a global footprint, however the other three are extremely pertinent to any business carrying currency and interest rate risk, and can all be improved through the introduction of a tool such as Hedgebook.

Hedgebook’s reporting module allows for stronger governance, enabling the implementation of robust procedures through the provision of good information, while bringing much greater visibility to policy management and adherance.

The same reporting gives decision makers much greater visibility of projected cashflows, while also modeling their sensitivity to market fluctuations, making forecasting much simpler and more accurate.

The McKinsey report was particularly harsh on organisations who still rely on spreadsheets to manage this mission-critical business function.  It found that a staggering number of businesses, including large multinationals, are still relying on error-prone spreadsheets.

“A single error in a single cell can ripple through an entire model, leading managers to borrow instead of invest, to hedge incorrectly, and to forget to fund operating accounts or make debt payments.”

The report identified cost as one of the most-stated barriers to investing in a treasury management solution, but went on to point out that the cost-benefit stacks up every time when you consider the potential cost of a single mistake.

“At one North American utility company a simple spreadsheet error for energy auction bids led managers to enter into nonreversible contracts the company didn’t need – a mistake that cost it half of its operating earning for the quarter.”

This may well be an egregious example, but with many businesses living and dying by their success in navigating a volatile currency market, a subscription to a tool like Hedgebook looks a small price to pay for confidence.

The original McKinsey article can be read here (note you have to register to view)

Interest Rate Swap Tutorial, Part 1 of 5

This is the first in a series of articles that will go from the basics about interest rate swaps, to how to value them and how to build a zero curve.

Introduction to Interest Rate Swaps

An interest rate swap is where one entity exchanges payment(s) in change for a different type of payment(s) from another entity. Typically, one party exchanges a series of fixed coupons for a series of floating coupons based on an index, in what is known as a vanilla interest rate swap.

The components of a typical interest rate swap would be defined in the swap confirmation which is a document that is used to contractually outline the agreement between the two parties. The components defined in this agreement would be:

Notional –  The fixed and floating coupons are paid out based on what is known as the notional principal or just notional. If you were hedging a loan with $1 million principal with a swap, then the swap would have a notional of $1 million as well. Generally the notional is never exchanged and is only used for calculating cashflow amounts.

Fixed Rate – This is the rate that will be used to calculate payments made by the fixed payer. This stream of payments is known as the fixed leg of the swap

Coupon Frequency – This is how often coupons would be exchanged between the two parties, common frequencies are annual, semi-annual, quarterly and monthly though others are used such as based on future expiry dates or every 28 days. In a vanilla swap the floating and fixed coupons would have the same frequency but it is possible for the streams to have different frequencies.

Business Day Convention – This defines how coupon dates are adjusted for weekends and holidays. Typical conventions are Following Business Day and Modified Following. These conventions are described in detail here.

Floating Index – This defines which index is used for setting the floating coupons. The most common index would be LIBOR. The term of the index will often match the frequency of the coupons. For example, 3 month LIBOR would be paid Quarterly while 6 month LIBOR would be paid Semi-Annually.

Daycount conventions – These are used for calculating the portions of the year when calculating coupon amounts. We’ll explore these in more detail in our discussions on fixed and floating legs. Details of different daycounts can be found here.

Effective Date – This is the start date of a swap and when interest will start accruing on the first coupon.

Maturity Date – The date of the last coupon and when the obligations between the two parties end.

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

Next Article: Constructing fixed legs including calculating coupon amounts.

When to use zero-premium FX collar options as the method of hedging

For importers and exporters managing trade-related transactional FX exposures, the choice of hedging instrument is just as important to overall performance as tactical/strategic risk management decisions to position at the minimum or maximum of hedging policy limits. Increased volatility in many currency pairs over recent years has naturally increased option premium costs, however it is not wise to always hedge via zero-premium collar options and never consider paying premium to buy outright call and put currency options. The choice between these option instruments and straight forward exchange contracts normally comes down to the following considerations:

  • If the home currency spot rate is at an historical low point against the export receipt currency (say based on long-term average rates) and the lead-indicators point to a greater probability of appreciation of the home currency than further depreciation, the choice of hedge instrument is going to be heavily weighted to straight forwards.
  • If the home currency spot rate is at an historical high point against the export receipt currency (based on long-term average rates) and the lead-indicators point to a greater probability of depreciation of the home currency than further appreciation, the choice of hedge instrument is more likely to be buying outright call options on the home currency.
  • When the currency pairs are trading closer to long-term average levels and there is no clear indication on future direction either way, collar options fulfill the objective of being hedged at an acceptable rate (the cap), however leaving some opportunity to participate in favorable market rate movements at least down to the collar floor level.

In some respect, hedging with collars is akin to having permanent orders in the market to deal at more favourable exchange rate levels with protection on the other side along the way. Whilst zero-premium may appear attractive, FX risk managers should always examine the trade-off’s of paying some premium to widen the gap between the floor and cap strike rates to provide greater opportunity of participation in favourable rate movements. In a similar vein, opportunities should be taken to restructure collars over the course of their term by buying back the sold cap or floor, or alternatively converting the collar to a straight forward if original target hedged rates are achievable. An active mixture of hedging instruments within policy limits should provide greater opportunity to beat benchmark and budget exchange rates.

Roger Kerr is widely regarded as one of New Zealand’s leading professional advisers and commentators on local/international financial markets, the New Zealand economy and corporate treasury risk management. Roger has over 30 years merchant and investment banking industry experience, and has been closely associated with the changes and development of New Zealand’s financial markets since 1981. Roger advises many Australian and New Zealand companies in the specialist areas of foreign exchange risk, interest rate and funding risk and treasury management policy/governance matters.

Roger has provided daily market and economic commentary on the 6.40am slot at radio station NewstalkZB since 1994. 

Hedgebook interviewed on Radio New Zealand Business 22.11.11

Hedgebook’s Richard Eaddy is interviewed on Radio New Zealand’s business programme on how Hedgebook can help New Zealand importers and exporters better manage currency volatility.  Click here to listen: Hedgebook interview on Radio New Zealand 22.11.11

Navigating these stormy economic waters

Many exporters confuse foreign exchange management with trying to predict where the currency is going. The reality is that no one knows where the currency is heading today, tomorrow, next week or next year. In the current volatile times it has got a whole lot harder, especially for exporters who are not just grappling with the volatility but also with a currency which against most of our trading partners is close to historical highs.

So if you can’t predict where the currency is going what can you do to better manage your exposure to the daily fluctuations in the currency, which are no doubt seriously impacting on most exporters’’ profitability.

There are certain disciplines that any exporting company needs to know about that is dealing in foreign exchange. For many of these companies it has the biggest impact on the profitability of the organisation. How many times have we heard that if the currency goes above 70 cents or 80 cents or 90 cents I am out of business but how many comapnies also know what their true position is.

The first thing you need to know is what are my exposures, what are my expected foreign denominated cashflows that i can forecast with some certainty over the next month, next year or longer if you can accurately forecast out that far. You then need to think seriously about what exchange rate am I profitable and at what level am I not making any money.

Next you need to think about how am I going to cover these future foreign exchange flows. What are the products that i can use and who is going to provide these products to me?

Most are aware of forward foreign exchange contracts which can be used to lock in an exchange rate for a future date. If you aren’t at least using forward foreign exchange contracts then you should be. Converting the funds when they arrive in your bank account is unlikely to be a long term successful strategy (especially in the current environment) and it is also likely you aren’t getting the best exchange rate on conversion from your bank.

If you are still dealing with the local branch of your bank you should talk to your Relationship Manager about dealing directly with the banks fx dealers to ensure you are getting the best pricing possible. Remember you can negotiate both the margin the bank is charging you and the ultimate price the fx dealer is quoting. This is especially important when transacting fx contracts out into the future. If you are dealing with more than one provider then even better as this puts some competitive tension into the pricing.

You might want to also consider fx options. Options are like an insurance premium on your future fx receivables. An option gives you the right, but not the obligation, to transact at an agreed rate. Whilst often deemed to be expensive they should be a consideration as part of your overall fx management. In the current environment with the kiwi having been in an uptrend for some time forward exchange contracts has been the best strategy, however at some stage in the future the kiwi will be in a downtrend and when this is well established options would be a worthwhile consideration.

Banks are the obvious ones to sell you fx and options but there are also numerous reputable fx brokers around who provide good rates and good service. In days gone by the banks have not serviced small to medium sized businesses as well as they could but in recent times this has changed and they are generally very focused on servicing this sector much better.

Consideration should also be given to having some sensible parameters around how much cover is appropriate to have in place given the accuracy of your cashflows, competitive situation and other relevant factors. You may need some outside expertise to provide this and there are a number of independent advisors who will put together an appropriate treasury risk policy.

The last piece in the puzzle is being able to record, report and value your fx transactions. Most still use spreadsheets to do this but we all know the downside of using them. It is a well documented fact that most financial spreadsheets have at least one error in them and the risk of not recording a deal correctly is too big to take for most organisations. More and more Directors of companies are looking to move away from the reliance on spreadsheets where possible as the risks associated with fx are too high to take the risk of missing a deal and the potential cost.

But it isn’t just the risk of using spreadsheets it is also having access to the best possible information to make the best possible decisions. Spreadsheets will tell you where you are now but they won’t tell you where you are heading. It is always important to know what your current position is based on the cover you have in place but what about your total position based on the cover you are still to take. Are you still profitable at this level? Or what happens if the currency goes up another 10%, what does that mean for the profitability of the company? Should you lock in everything now because you can’t live with the currency moving higher?

These systems exist and they are inexpensive, especially if compared to the risk of missing a deal or not knowing what your true position is. Like any business decision, the better the information the better the outcome.

For most exporters fluctuations in the currency is a daily topic of conversation and many are grappling with the historical highs we are currently facing. There is no crystal ball to tell you where the rates are going from here but there are some common sense measures that in the medium to longer term can be put in place to ensure the ongoing viability of your business.

Richard Eaddy – CEO, Hedgebook.

– A related article by NTZE can be found on the NZTE website (http://j.mp/s68o7k)


Making business easier…

Well Hedgebook is officially underway. That feels good.

Isn’t it great when a good idea comes to fruition. Heaven knows most of them don’t…And as they say, its often the simple ideas that turn out to the the best ones. Hedgebook certainly fits that mold.

We’re about making it easier for organisations to manage their treasury function.

For those of you who, like me, aren’t an accountant, treasury is a catch-all term for the tasks that combine to “maximise a firm’s liquidity and mitigating its operational, financial and reputational risk”.

More specifically, we help organisations manage their foreign exchange contracts and interest rate swaps to ensure you are able to make sound, timely financial decisions. That sounds a like worthy goal.

For years we’ve all been relying on ‘that spreadsheet’ locked away on someone’s hard drive, never really sure whether it is up to date or whether we are looking at the right version. As Kiwi’s we tend to be a bit “she’ll be right” about things like this. Perhaps we’ve not really thought about it, or perhaps there just hasn’t been a decent alternative.

But as a country of exporters and importers, for whom navigating the stormy waters of currency fluctuations can mean life or death for some businesses it really is time we took this a bit more seriously.

Enter Hedgebook. Finally, an easier and more secure alternative to spreadsheets.

The truth is, we’ve actually been around for a while. At least the stuff under Hedgebook’s bonnet has been. The engine that powers Hedgebook has was developed by some very clever people a few years back and in various incarnations it has been put through its paces by numerous customers around the world.

So why has it taken so long to get Hedgebook to market? That’s where the “cloud” comes in. The cloud is having a profoundly positive impact on businesses in so many ways. In our case it is allowing us to bring “enterprise-level” software to the market at a price that makes it a viable option for all sizes of business. Now the rest of us can afford the powerful tools that large corporates have been using for years.

So here we are. Hedgebook. Treasury management in the cloud. In the small but important world of treasury management it’s a big deal. We’d like to think it’s a game changer.

That’s not to say we are finished. Far from it. Hedgebook is a constant work in progress and we already have big plans for improvement and the first people we will be taking guidance from is our users.

It is going to be an exciting ride.

Richard Penny is the Market Development Director for Hedgebook.