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