125.364 Week 06 Interest Rate Swap

SCHOOL OF ECONOMICS & FINANCE
Hedging Interest Rate Risk:

Swaps, Loan Sales and Securitisation
Textbook Chapter 25 (p. 813-820)
1
Introduction
• A major component of the rapid growth in FI’s off-balance sheet
activities has been in derivative contracts such as futures
contracts, forward contracts, options contracts and swap
agreements.
• FIs of all sizes use these off-balance-sheet instruments to hedge

their asset-liability risk exposures in an attempt to protect an FI's
net worth from adverse events.
• We’ll cover swaps in this topic as they are the most-commonly

used hedge tools in NZ. 2
Introduction (cont.)
• Why do swaps matter for NZ banks?
– Variability in interest rates, which generates uncertainty (and
interest rate risk).
– Customers’ desire to fix the interest rates on their borrowing,
which banks macro-hedge using interest rate swaps.
Macrohedging: hedging the duration gap of the entire balance sheet.
(vs. microhedging: using a derivative contract to hedge a specific
asset or liability risk.)
3
Major Swap Types

• Swap: an agreement between two parties to exchange assets or a series
of cash flows for a specified period of time at a specified interval.
• Swaps are used to restructure the cash flows of assets and/or liabilities
by the transacting parties.
• Generic types of swaps in order of quantitative importance:
– Interest rate swaps
– Currency swaps
– Credit swaps
– Commodity swaps
– Equity swaps
4
Basic Interest Rate Swap

• Basic interest rate swap:
– An agreement between two parties to exchange a series of cash
flows based on a specified notional principal amount.
– Two parties facing different types of interest rate risk can exchange
interest payments.
– A generic (“plain vanilla”) swap is a standard agreement without any
special features.
– Often a swap dealer acting as an intermediary.
• By convention:
– Swap buyer makes the fixed interest payment.
– Swap seller makes the floating interest payment.
5
Basic Interest Rate Swap (cont.)

• Swaps allow FIs to economically convert variable-rate
instruments into fixed-rate (or vice versa) in order to
better match the duration of assets and liabilities.
• Notice that interest rate swaps in themselves have

credit risk. However swap payments are netted and the
notional principal never changes hands, so swaps are
also tools to manage credit risk. (Will discuss it topic 7)
6
Example 1
Insurance Company (IC) Finance Company (FC)
$50million $50millon fixed $50million car $50millon of CD
floating rate rate contract loans @14% @BBR+4%
bonds @ BBR+1% @10%
Bank accepted bill rate
• Negative duration gap • Positive duration gap

• Exposed to falling interest • Exposed to rising interest
rate: (floating) return from rate: (fixed) return from
asset is insufficient to cover asset is insufficient to cover
(fixed) cost of liability. (floating) cost of liability.
• Would want a series of fixed • Would want a series of
payments. floating payments.
7
Example 1 (cont.)
bonds @ BBR+1% @10%
FC receives floating cash flows to

IC receives fixed cash flows to
cover it’s floating payments of
cover it’s fixed payments of
liability.
liability.
• Be a swap buyer: Be a swap seller:

– Make fixed payments Make floating payments
– Receive floating payments Receive fixed payments
8
Example 1 (cont.)
• Let’s assume the swap deal (notional $50million value) is:
– IC pays BBR+2.5% to Finance Company.
– FC pays 12% to Insurance Company.
1) What is the net cash outflow (i.e. net financing cost)?
2) What is the net interest yield on assets?
9

Cash outflows from swap -(BBR+2.5%)×$50m -12%×$50m
+) Cash inflows from swap 12%×$50m (BBR+2.5%)×$50m
+) Cash outflows from liabilities -10%×$50m -(BBR+4%) ×$50m
=) Net financing costs -(BBR+0.5%) -13.5%
(net cash outflows from swap
and liabilities)
The fixed-rate liability is converted into The floating-rate liability is converted

floating-rate liability to better match its into fixed-rate liability to better match
floating-rate nature of asset. its fixed-rate nature of asset.
10
Before Swap
bonds @ BBR+1% @10%
After Swap
$50million $50millon $50million car $50millon of CD
floating rate floating rate loans @14% fixed rate
bonds @ BBR+1% @(BBR+0.5) @13.5%
11

+) Cash inflows from swap 12%×$50m (BBR+2.5%)×$50m
+) Cash outflows from liabilities -10%×$50m -(BBR+4%) ×$50m
=) Net financing costs -(BBR+0.5%) -13.5%
(net cash outflows from swap
and liabilities)
The fixed-rate liability is converted into The floating-rate liability is converted

floating-rate liability to better match its into fixed-rate liability to better match
floating-rate nature of asset. its fixed-rate nature of asset.
(cont.) Insurance Company (IC) Finance Company (FC)

+) Cash inflows from assets BBR + 1% 14%
=) Net interest yield on assets 0.5% 0.5%
12

Cash inflows from swap 12%×$50m (BBR+2.5%)×$50m
Cash outflows from liability side -10%×$50m -(BBR+4%) ×$50m
IC is fully hedged. The 12% payment it received from FC is subject to basic

FC can meet its 10% payments to liability holders. risk.
• Basic risk (residual risk) for FC:

– If FC’s credit risk changes, the premium over the index (bank accepted bill
rate, BBR, in this example) in the cash-market floating-rate liabilities may
change.
– The floating-rate index on the liabilities in the cash market may not match
perfectly the floating-rate index negotiated into the swap agreement. (For
example, if FC’s liability is based on CD rate instead of BBR.)
13
Macroheding with Swaps

• Recall from chapter 6, the change in equity value is:
ΔE = (DA – kDL)×A×(ΔR/(1+R)), while k=L/A
• The change in the value of a swap (ΔS) is:
ΔS = (Dfixed – Dfloat)×NS×(ΔR/(1+R)), while
ΔS = change in the market value of swap contracts,

(Dfixed – Dfloat) = differences in duration between a government bond that has the
same maturity and coupon as the fixed-payment side of the swap, and a government
bond that has the same duration as annual floating payments of the swap,
NS = notional value of swap contracts,
ΔR/(1+R) = shock to interest rates.
14
Macroheding with Swaps (cont.)

• Make ΔE+ΔS = 0, solve for NS:
NS 
DA  kDL  A
D fixed  D float
• Optimal notional value of swap contracts (N S) just

offsets any on-balance sheet loss in net worth.
15
Example 2
An FI has $500 million of assets with a duration of 9 years and $450 million
of liabilities with a duration of 3 years. The FI wants to hedge its duration gap
with a swap that has fixed-rate payment with a duration of 6 years and
floating-rate payments with a payments with a duration of 2 years. What is the
optimal amount of the swap to effectively macrohedge against the adverse
effect of a change in interest rate on the value of the FI’s equity?
NS = [(9 – 450m/500m×3)×500]/(6-2) = $787.5 million
If ΔR/(1+R) = 1%:
ΔE = (9 – 450m/500m×3)×500m×0.01 = $31.5m
ΔS = (6 – 2)×787.5m×0.01 = $31.5m, hedge the loss on equity.
16
Loan Sales
• Loan sales (also called syndications) involve the splitting of
larger loans and loan portfolios (that is, on balance sheet assets)
and selling them to FIs and other investors.
• Used by FI managers to restructure their balance sheet. By
doing this, an FI can change the interest rate sensitivity of the
balance sheet and thus use loan sales to manage interest rate
risk.
• Enable banks to make loans that are too large to hold on their
balance sheet either for lending concentration reasons or for
capital adequacy reasons.
17
Other Reasons for Loan Sales

• Credit risk management
– Loan sales remove assets (and explicit credit risk) from the balance
sheet.
– Loan sales do not completely eliminate the credit risk exposure
because a loan sale contains an implicit quality guarantee by the
lending FI.
• Liquidity risk reduced by loan sales
– The secondary market of loan sales has significantly reduced the
illiquidity of loans.
18
Other Reasons for Loan Sales (cont.)

• Capital ratio requirements
– FIs need to meet capital requirements by maintaining a
minimum capital ratio. Loan sale can boost capital ratio
by reducing the size of assets.
• Fee income
– From arranging a large loan.
19
Securitisation
• Asset securitisation is the packaging and selling of loans and
other assets backed by securities.
• Securitisation was originally used to enhance the liquidity of
the residential mortgage market.
• Now used by FIs to hedge interest rate exposure (and credit
risk).
• Securitisation is possible because of homogeneity of assets.
e.g. good quality, fixed-term, fixed-rate mortgage, which is expected to
provide steady income.
20
Basic Securitisation Process

To enhance Special purpose vehicle: an
marketability off-B/S company/trust. The
profitability of securitised
assets is largely determined by
SPV’s credit rating.
SPV finances the purchase

by using a line of credit
from a FI.
rated by major rating agencies
To protect investors from cash flow
timing mismatches between
To repay any line of credit.
underlying mortgage pool and those
required to be paid on the securitised Investors receive the income and repayment of
assets. principal from the loans (via SPV). 21

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SCHOOL OF ECONOMICS & FINANCE

Hedging Interest Rate Risk:

Textbook Chapter 25 (p. 813-820)

• FIs of all sizes use these off-balance-sheet instruments to hedge

• We’ll cover swaps in this topic as they are the most-commonly

Major Swap Types

Basic Interest Rate Swap

Basic Interest Rate Swap (cont.)

• Notice that interest rate swaps in themselves have

• Negative duration gap • Positive duration gap

FC receives floating cash flows to

• Be a swap buyer: Be a swap seller:

Insurance Company (IC) Finance Company (FC)

The fixed-rate liability is converted into The floating-rate liability is converted

Insurance Company (IC) Finance Company (FC)

The fixed-rate liability is converted into The floating-rate liability is converted

(cont.) Insurance Company (IC) Finance Company (FC)

Insurance Company (IC) Finance Company (FC)

IC is fully hedged. The 12% payment it received from FC is subject to basic

• Basic risk (residual risk) for FC:

Macroheding with Swaps

ΔS = change in the market value of swap contracts,

Macroheding with Swaps (cont.)

• Optimal notional value of swap contracts (N S) just

NS = [(9 – 450m/500m×3)×500]/(6-2) = $787.5 million

Other Reasons for Loan Sales

Other Reasons for Loan Sales (cont.)

Basic Securitisation Process

SPV finances the purchase

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