1 Chapter 15 Interest Rate Derivative Markets Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline  Background  Participation by financial institutions  Types of interest rate swaps  Risks of interest rate swaps  Pricing interest rate swaps  Factors affecting the performance of interest rate swaps  Interest rate caps, floors, and collars  Globalization of swap markets 3 Background  An interest rate swap is an arrangement whereby one party exchanges one set of interest payments for another  e.g., fixed-rate payments are exchanged for floating-rate payments  The provisions of a swap include:  The notional principal  The fixed interest rate  The formula and type of index to determine the floating rate  The frequency of payments  The lifetime of the swap 4 Background (cont’d)  Amounts owed are typically netted out so that only the net payment is made  The market for swaps is facilitated by over-the-counter trading  Swaps are less standardized than other derivatives  Swaps became popular in the early 1980s because of large fluctuations in interest rates  e.g., financial institutions traditionally had more interest rate-sensitive liabilities than assets and were adversely affected by rising interest rates  e.g., some foreign financial institutions had access to long-term fixed rate funding but used funds primarily for floating rate loans  By engaging in an interest rate swap, both institutions can reduce their exposure to interest rate risk (see next slide) 5 Background (cont’d)  A U.S. financial institutions could send fixed-rate payments to a European financial institution in exchange for floating-rate payments  If interest rates rise, the U.S. financial institution receives higher interest payments from the floating-rate portion, which helps to offset the rising cost of obtaining deposits  If interest rates decline, the European institution provides lower interest payments in the swap, which helps to offset the lower interest payments received on its floating-rate loans  The U.S. institution forgoes the potential benefits from a decline in interest rates  The European institution forgoes the potential benefits from an increase in interest rates 6 Background (cont’d)  A primary reason for the popularity of swaps is market imperfections  A lack of information about foreign institutions and convenience encourages individual depositors to place deposits locally  Swaps are sometimes used for speculative purposes  e.g., a firm could engage in a swap to benefit from rising interest rates even if its operations are not exposed to interest rate movements 7 Participation by Financial Institutions  Financial institutions that are exposed to interest rate movements commonly engage in swaps to reduce interest rate risk  Some commercial banks and securities firms serve as intermediaries by matching up firms and facilitating the swap arrangements  Charge fees and may provide credit guarantees  Some institutions act as dealers in swaps  The financial institution takes the counterparty position in order to serve a client 8 Participation by Financial Institutions Financial Institution Participation in Swap Market Commercial banks  Engage in swaps to reduce interest rate risk  Serve as an intermediary by matching up two parties in a swap  Serve as a dealer by taking the counterparty position to accommodate a party the desires to engage in a swap S&Ls and savings banks  Engage in swaps to reduce interest rate risk Finance companies  Engage in swaps to reduce interest rate risk Securities firms  Serve as an intermediary by matching up two parties in a swap  Serve as a dealer by taking the counterparty position to accommodate a party that desires to engage in a swap Insurance companies  Engage in swaps to reduce interest rate risk Pension funds  Engage in swaps to reduce interest rate risk 9 Types of Interest Rate Swaps  Plain vanilla swaps  In a plain vanilla swap (fixed-for-floating swap), fixed-rate payments are periodically exchanged for floating-rate payments  Consider two scenarios:  A consistent rise in market interest rates  A consistent decline in market interest rates 10 Types of Interest Rate Swaps (cont’d)  Plain vanilla swaps (cont’d) Rising Interest Rates Declining Interest Rates Level of Interest Payments End of Year Fixed Outflow Payments Floating Inflow Payments Fixed Outflow Payments Floating Inflow Payments [...]... in year 3: Rising Interest Rates Declining Interest Rates Level of Interest Payments Floating Inflow Payments Fixed Outflow Payments Fixed Outflow Payments Floating Inflow Payments 0 3 End of Year 0 3 15 Types of Interest Rate Swaps (cont’d)  Callable swaps A callable swap provides the party making the fixed payments with the right to terminate the swap prior to its maturity  Allows the fixed-rate . 1 Chapter 15 Interest Rate Derivative Markets Financial Markets and Institutions,. ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline  Background  Participation by financial institutions  Types