Risk Management Basics

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**Interest Rate Derivatives –**You should be knowing what a derivative security is, if you are reading this material. It is a security that derives its value from an underlying asset. The underlying asset could be anything ranging from a company’s stock, a bond, metals, commodities and several other asset classes. If the underlying is an interest rate then the derivative security becomes an interest rate derivative. The underlying interest rates depend on the contract which is being agreed to by the counter parties and can range from LIBOR, domestic interbank offered rates, Fed Funds Rate etc.

Let us put some effort into understanding the types of interest rate derivatives and the way they function.

## What are Swaps?

This is an important and interesting area under fixed income derivatives. It is an example of a structured transaction to hedge risks in a fixed income investment.

A swap essentially is a contract between counter parties to exchange a series of intermediate cash flows arising throughout the tenor/life of the swap. Almost every swap contract comes under an interest rate swap. Most of them are basically variants of interest rate swaps.

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#### Interest Rate Swaps

**So what is an interest rate swap (IRS)?**

An IRS is a swap contract to exchange a series of intermediate cash flows based on interest rates on a notional amount throughout the tenor of the swap.

In general, they come in the form of exchanging cash flows arising from a fixed interest rate for cash flows arising from a floating interest rate over the tenor of the swap. This type of swap is also known as a fixed for floating swap where on leg of the swap pays/receives a fixed rate and the other leg, a floating rate. It is also called a plain vanilla IRS.

Here’s a simple example to illustrate a fixed for floating swap. We all know that a bank takes deposits and makes loans. Let’s assume that for the deposits Bank A takes, they pay a fixed rate of interest say 5%. For the loans they make let’s assume they charge a floating rate of interest which is the LIBOR (say 3%) plus a spread (3%) over it to account for the riskiness of the borrower. The spread is fixed but the LIBOR keeps changing. If for example LIBOR falls to 1% or below by year end, banks will be paying a constant 5% on deposits but charging lesser on their loans. In order to safeguard against this risk of making a lower interest margin ultimately due to rates falling they enter into an IRS with another Bank B. Take some time to think how the IRS would be structured.

Done? Here it is – Bank A currently pays fixed and receives floating on its deposits and loans respectively. They will enter into an IRS with Bank B to pay floating and receive fixed for a certain time period, say 3 years. Effectively, the structure of the transaction will look like this:

The Swap Rate here is only indicative – a no arbitrage rate has been calculated

By paying floating on the swap, Bank A’s exposure to interest rates falling are benefited. If rates go up above 5%, Bank A still benefits since it pays a lower rate on its deposits and the higher rate will anyway be passed on through the loans it makes which finance the swap’s floating leg. Why does Bank B act as a counter party to Bank A? Simply because they would be having the opposite exposure where they pay floating on their deposits and receive fixed on their loans. As mentioned earlier, the swap payments/cash flows are based on a notional amount.

Hope you got the structure of a swap. Counter parties agree to do a swap since they have either have opposite views or exposures to the underlying.

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#### Currency Swap

These are also called Cross Currency Swaps or Cross Currency Interest Rate Swaps. A good way to refer to it is “Xccy IRS.” As you would guess, this is a variant of an IRS, the difference being two different currencies involved.

A typical transaction would be Bank A (Japanese bank) borrowing say $10m (Notional amount) @ 5% p.a. and lending ¥100m (Notional amount) @ 3% p.a. to Bank B (US bank) for 5 years as part of a Xccy swap. Bank A pays B $500,000 to Bank B while Bank B pays ¥3m to Bank A as swap payments every year throughout the life of the swap. This is a fixed for fixed swap as you can notice.

A fixed for fixed Xccy IRS is simple. A fixed for floating Xccy IRS works similar to that of an equivalent IRS with the exception of two currency legs like the above example where Bank A may borrow $10m at LIBOR + 2% instead of 5%. A fixed for floating IRS though, will have the intermediate cash flows netted against each other depending on a gain or loss. If Bank A’s interest payment at the end of the year is $300,000 and Bank B’s is $500,000 after converting to USD, then Bank B will pay the difference of $200,000 to A. Similar would be the case when A has to pay B the difference.

A floating for floating Xccy IRS (Basis Swap) and normal IRS are also part of the structuring game. Though it is easy we can end this discussion here rather than get deeper and deeper.

#### Difference between a Xccy swap and an IRS

A Xccy swap and an IRS differ apart from the currency legs. The Notional amounts on which the interest payments/cash flows are made are exchanged in the beginning and end in an Xccy swap. The same doesn’t hold for an IRS. In the earlier example the notional principal of $10m and ¥100m are exchanged in the beginning and end. Therefore a Xccy swap eliminates currency risk or exchange rate risk of the notional principal amounts.

#### Other types of Swaps

There are other types of swap derived from interest rate like an Equity swap or a Total Return Swap (TRS) where the swap rate is paid on one leg and the other leg pays equity/equity index related payments like the dividends and capital gains differences; Overnight Indexed Swap (OIS) which is a fixed for floating swap where the floating rate is based on a geometric average of floating rates on an overnight index say LIBOR or Fed Funds.

#### Uses of Swaps

Just like any other derivative contract, swaps are used as a tool to hedge risk. The examples mentioned till now emphasized swaps as a tool to hedge risk. Meanwhile, they can also be used as a tool to speculate on interest rates where a counter party may not be having an original exposure. Thirdly, they can be used to make arbitrage gains if the swap rates are slightly mispriced – here the mispricing difference gets quickly noticed whereby multiple entities would like to make a riskless profit ultimately making this demand and supply lead to an equilibrium rate which cannot be arbitraged away.

## Interest Rate Options (Interest Rate Derivatives)

Given that we’re on the topic of swaps, it would be right to introduce this type of interest rate derivative.

#### Swaption

This is an option on swap – a double derivative. It isn’t difficult though. An option gives the buyer of the option, the right but not the obligation to buy or sell the underlying at a predetermined strike price on a future date (at expiration in the case of European Options; before or at expiration in the case of American Options). You can google up for more on options.

In the case of a Swaption, the strike price is replaced by a strike rate, an interest rate based on which the buyer can choose to exercise the option and the underlying is a swap. More theory will only complicate things, so here’s a simple example.

ABC buys a 3 year Swaption where they pay fixed and receive floating (they buy a payer Swaption) at a strike rate of 2% exercisable at the end of one year. At expiration, if the reference rate is greater than 2%, ABC will exercise the option following which the swap takes effect for 3 years. If the reference rate is less than 2% the option will not be exercised.

#### Caps and Floors

As the terms should indicate, a Cap caps one’s risk and a Floor floors one’s risk. Caps and Floors are options on interest rates i.e. the underlying is an interest rate and the strike rate is the rate at which the buyer exercises the option. They are generally issued with Floating Rate Bonds/Notes (FRNs).

Caps consist of a series of ‘Caplets’ and Floors of ‘Floorlets’. Caplets and Floorlets are essentially caps and floors but with short time frames. A one year Cap may consist of a series of four Caplets which have a tenor/expiration of 3 months each.

Generally a Cap transaction goes like this: ABC Corporation issues a floating rate bond at LIBOR+2% where LIBOR may be at 3%. The risk for ABC is if interest rates or LIBOR rise quickly say in a year, where they have to pay higher rates. So, along with the bond they buy a Cap from a bank at a strike of 3.5% so that if LIBOR goes above 3.5%, ABC exercises the Cap. Exercising it makes ABC pay only 3.5% and they make the profit which is the difference between LIBOR or the reference rate and 3.5% over that time period. The profit helps repay the increase in LIBOR and thus ABC is effectively capped in his payments.

In the worst case scenario ABC ends up paying only 5.5%. If ‘minus (-)’ indicates outflows and ‘plus (+)’ inflows, here is how it would look for ABC Corp if the payments were agreed on an annual basis:

FRN payments: ‒ (LIBOR + 2%)

Cap related payment: +LIBOR – 3.5%

Combining both would give: – 3.5% – 2% = –5.5% thus limiting the borrower’s exposure to interest rate changes.

A floor similarly would be combined with an FRN but by lenders. So the lender of ABC Corp’s bond would buy a floor to limit their exposure to interest rate changes. This time, you should be able to structure the transaction without my giving you an example.

There are variants of caps and floors one of them being ‘interest rate collars’ which are a combination of buying a cap and selling a floor but let’s not get into that.

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## Forward Rate Agreements (FRAs)

These are forward contracts on interest rates between counterparties. FRAs are contracts to borrow or lend money at a predetermined rate on a notional principal at future point in time.

ABC may enter into a FRA to borrow @ 5% on a notional amount for 3 months, starting after 6 months (a 6X9 FRA – a FRA expiring after 6 months to borrow money for 3 months). This helps ABC in the event of 3 month interest rates going up at the end of 6 months from today.

ABC could also enter into a FRA to lend @ 5% on a notional amount for 3 months, starting after 6 months (a 6X9 FRA – a FRA expiring after 6 months to borrow money for 3 months). This helps ABC in the event of 3 month interest rates going down at the end of 6 months from today.

## Conclusion

The examples given might be overly simplistic practically of Interest Rate Derivatives. The concepts are quite simple, but we have not gone into the nitty-gritties of the workings. The calculations are a bit complex in nature but it is fair if we understood the concepts for now. Sometimes being the jack of all might be worth it – the world lacks good generalists. Go over the concepts explained, try getting a hang of it and try answering the open ended questions under each concept because it ultimately helps strengthen your understanding and makes you think. As regards practical examples there are loads of examples on swaps, lesser known ones on interest rate options and FRAs although they are done very regularly. Google those once you get a hang of these concepts to understand them better.

Mac Ginley says

I really enjoy reading your blogs because you come up with great work which is very useful and helpful to readers.

Dheeraj Vaidya says

thanks Mac!

Firmin Poly says

Thanks for explaining interest rate derivatives in clear way with examples.. this has helped me a lot to understand about the derivatives. i had a small question can you explain me What exactly are Swaps in Finance.

Dheeraj Vaidya says

my pleasure to hear that this has helped u! Thanks and in finance Swaps are nothing but the exchange of cash flow. If you want to know more about Swaps In Finance then you can read this article – Swaps in Finance in which I have explained nuts and bolts of swaps.