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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.
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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
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Background

An interest rate swap is an arrangement whereby one
party exchanges one set of interest payments for another

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)
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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
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Background (cont’d)


in order to serve a client
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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


Floating Inflow
Payments
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Using A Plain Vanilla Swap
Bruny Bank has negotiated a plain vanilla swap in
which it will exchange fixed payments of 8
percent for floating payments equal to LIBOR
plus 1 percent at the end of each of the next
four years. Assume that the notional principal is
$100 million. Fill in the table on the next slide
for the two scenarios of rising and falling
interest rates.
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Scenario 1 Year
 
1 2 3 4
LIBOR 7.0% 7.5% 8.5% 9.5%
Floating rate received
       
Fixed rate paid
       
Swap differential
       
Net dollar amount received
       
Scenario 2 Year
  1 2 3 4
LIBOR 6.5% 6.0% 5.0% 4.5%
Floating rate received
       

interest payments that does not begin until a
specified future point in time

Useful for institutions that expect to be exposed to
interest rate risk at a future point in time

The fixed rate on a forward swap may differ from
the fixed rate on a swap beginning immediately

Institutions may be able to negotiate a fixed rate today
that is less than the expected fixed rate on a swap
negotiated in the future
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Types of Interest Rate Swaps
(cont’d)

A forward swap beginning in year 3:
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
0 3 0 3