The following article, written by Evan Wilkoff, originally appeared in the October 2002 issue of Monitor Leasing & Financial Services. It is reprinted here in its entirety:
Although the mechanics of interest rate swap valuation are complex and require dedicated resources to maintain the ability to perform the calculations, it is imperative that every user of this product know the basics of how they work and how they are priced. Armed with this knowledge and the fact that swaps are a negotiable product should provide the user with enough confidence to frequent the market without intimidation.
Since its beginnings in the early 1980s, the interest rate swap market has grown exponentially to become an indispensable tool for most financial institutions and corporations. An interest rate swap is an agreement between two parties to exchange two streams of interest payments, each calculated using a different interest rate index, but applied to a common notional principal amount. When combined with an asset or liability, a swap can change the risk characteristics of that asset or liability by synthetically changing its net cash flow.
Leasing companies utilize interest rate swaps or other related hedging instruments primarily to match the fixed rate nature of their assets (leases) with the floating rate exposure associated with their liabilities (short term financing facilities). Many banks are eager to provide their leasing clients with interest rate hedging products because it is a product in great demand and offers banks (and their capital markets affiliates) the opportunity to generate fee income to complement their traditional financing offerings.
Negotiable Contract
As an aide to standardization and to promote liquidity, the International Swap Dealers Association, Inc. (ISDA) publishes and periodically revises a standard master contract that their members use. This contract is often customized by one or both counterparties for various business, legal, and strategic reasons. An ISDA master contract, once in place between two counterparties, typically absorbs all existing and subsequent swaps between them. The details of new swaps are added to the master contracts as appendices.
Despite these features, the fact is that a swap is a privately negotiated contract. This means that not only are the contractual provisions subject to negotiation, but pricing as well. This feature is often ignored when banks explain the mechanics of swaps to their less experienced customers. Although every leasing company may not experience cut-rate competition for their swap business as a blue chip company enjoys, it does not necessarily mean that they must accept every quote offered them by their bank’s swap provider.
Unlike a typical banking relationship where the bank traditionally benefits when their borrowers do well, trading is a zero-sum game. What one party gains, the other loses. This is why it is so important for buyers of interest rate hedges to understand the product and have market pricing information available prior to purchase. Obtaining market pricing information is difficult and often costly. Unfortunately, one can not just open up the Wall Street Journal and look up the value of an amortizing swap with a specific average life. Even if one could — the data would be as of the prior date — useless unless offered on a real-time basis. In order to obtain appropriate real-time market information that one can use to value swaps, a subscription service must be purchased to obtain up to the minute market data. It would then be up to the user to apply that real-time information in a flexible computer model to obtain accurate pricing as described below.
Companies that do not have the resources in-house to perform this type of analysis often retain the services of a third-party who may act on behalf of the company when dealing with their swap providers.
Pricing Basics
Since a swap is an exchange of two streams of cash flows, the swap can be priced by determining the value of each stream. The value of the swap is simply the difference between the values of the two cash flows.
The value of each stream of cash flows is the net present value (NPV) — the sum of the discounted present values of each cash flow in the stream.
In the absence of transaction costs or dealer profit, the value of a new swap must be zero. The value of each stream of cash flows (also called a leg) must be equal. It may be relatively simple to compute the price of the fixed leg as the cash flows are known. Calculating the NPV of the floating leg is considerably more complex as the cash flows on the floating side are unknown, and discounting both legs adds another layer of complexity.
To calculate the NPV of the floating leg, one needs to calculate each of the unknown floating-rate flows by rates that can be locked in through other hedging transactions. These rates are called forward rates. These rates can be generated using a variety of market data such as cash LIBOR deposit rates, swap spreads, Eurodollar futures prices, and current Treasury yields. Once these implied forward rates are determined, they can be used to generate the rates to obtain its present value. The swap rate, or the rate on the fixed leg, can then be determined by finding that fixed rate which will produce the same discounted present value as the floating leg. This derived rate is called the midpoint or break even rate. See Example 1.
Hardly any trader will offer swap rates at the break even rate. At a minimum, there must be some spread built in for the provider to allow for risk management, transaction processing, and administration costs. In addition, swap rates are also adjusted for the following factors:
• Current market conditions: This includes the nature and level of competition, if any.
Most swap providers know their clients options, if any.
• Complexity of the swap structure.
• Dealer’s position: If the dealer must enter into an offsetting hedge to ‘zero out’ their position, the costs of doing so will be passed through.
• Credit quality of the counterparty. The default of one counterparty will leave the other exposed to the interest rate risk which was being hedged and an actual cost if that risk is realized. This is typically the greatest factor.
• Client relationship.
• Regulatory constraints: Capital requirements are usually minimal.
• Other profitability concerns.
Characteristics of a Typical Swap
A leasing company that funds themselves through a bank sponsored Commercial Paper (CP) conduit or similar facility typically uses interest rate swaps to attempt to eliminate the interest rate mismatch between their leases (fixed) and CP (floating). In conjunction with a funding, a leasing company will provide their swap provider with the projected cash flows associated with the leases to be funded as well as agreeing to some basic swap terms and conditions.
Typical terms would specify the following:
• Trade Date: Agreement date of swap
• Effective Date: Date swap becomes effective and interest begins to accrue on each leg
• Termination Date: Maturity of swap
• Interest ceases to accrue
• Fixed/Floating Accrual Periods: Interest accrual periods for each leg
• Payment/Settlement Dates: Periodic dates where accruals of each leg are netted and made to the counterparty which is due the net accruals
• Business Day Convention: Usually “Modified Following” which means skips weekends and holidays for rate reset and payment purposes, as long as the payment occurs during the same month
• Fixed Rate Day Count: Usually 30/360 or Actual/360
• Floating Rate Option: Usually 1 month LIBOR
• Floating Rate Day Count: Usually Actual/360 as LIBOR rates are on this basis
Leasing companies utilize interest rate swaps or other related hedging instruments primarily to match the fixed rate nature of their assets (leases) with the floating rate exposure associated with their liabilities.
After the two parties agree on the specifics of the proposed transaction, the swap provider will provide the company with a quote expressed as the swap rate. This swap rate represents the fixed rate that the company must pay on the notional balance(s) specified. Once verbally agreed to, the swap transaction is considered final and the bank will send the company a confirmation letter which will detail all of the terms of the transaction.
Thereafter, on a periodic basis (usually monthly), the bank will compute the interest accrued on each leg of the swap and send the company an invoice (or payment) for the net difference in advance of the payment date.
Termination
Often, companies will refinance their portfolio either in the bond market or with another funding source. If a company has outstanding swaps associated with assets to be refinanced, the may have to terminate or otherwise eliminate their contractual obligations under the term of the swap agreement. This is typically accomplished through a termination. When a swap is terminated, it is valued and a cash payment made between the bank and counterparty on the value of the swap.
Termination Example:
XYZ Leasing Company’s corporate parent has access to a seemingly endless supply of low cost funds and has decided to eliminate their more costly term lines of credit at PigEBank. Interest rates have risen since they entered into their $60 million in swaps and their treasurer values their swaps at $95,000.
The swap trader in PigEBank’s capital markets group gives them a price quote of $55,000. Knowing the current market value of the swap is greater than the quote given, the treasurer speaks to XYZ’s relationship manager for their account, explains their ability to value interest rate swaps through their models and asks the relationship manager to speak with the trader to narrow the differential. After a brief delay, the trader improves the quote to $60,000 which the treasurer accepts.
With their swap pricing tools, the treasurer was able to save XYZ $35,000 in conjunction with the swap termination.
If in advance of the termination the value of the contract cannot be agreed upon by both parties, an assignment of the swap may occur. In other words, a new counterparty (the assignee) substitutes for one of the original counterparties (the assignor). This situation would typically occur if a company knew the approximate market value of their outstanding swaps and received a non-competitive price quote from their original swap provider. They would then have the option to obtain a better value from another qualified counterparty (most major commercial banks have reciprocal credit agreements amongst them- selves) and assign their rights and obligations to the third party — thus effectively removing themselves from the contract.
Assignment Example:
XYZ Leasing Company has $200 million of assets financed by the issuance of $200 million of commercial paper provided through their bank’s (PigEBank) capital markets group.
XYZ is refinancing their receivables through a $200 million bond deal, and because interest rates have fallen since they entered into their swaps, is told by PigEBank that they must pay $500,000 to terminate their swap.
Knowing that the break even rate is substantially less that the price quoted, the CFO of XYZ solicits an additional bid from 123Bank and receives a quote of $475,000 (XYZ would have to pay this to terminate the swap through assignment).
The CFO verifies that 123Bank can assume their swap with PigEBank, accepts 123Bank’s bid, pays 123Bank $475,000, and assigns XYZ’s position of the swap to 123Bank. Until the maturity date of the swap, 123Bank and PigEBank will make payments each period just as XYZ and PigEBank did up to the date of the assignment.
The CFO of XYZ just saved $25,000 in conjunction with the refinancing.
Oftentimes, terminations and assignments are performed in conjunction with major refinancings such as issuing term debt. In these cases, notional amounts are typically large and the slightest difference in pricing may translate into thousands of dollars of value. It is yet another reason why users of interest rate swaps should have the resources available to value these products before they contract with their swap provider.
Role of the Third-Party Consultant
Many companies utilize third-party consultants to handle all or part of their interest rate hedging activities. These independent service providers can typically add value for end users depending on the situation in which they are used.
Third-party consultants may have purchased complex pricing models and subscribe to real-time market data in which the costs of these tools and resources can be spread among many clients.
A good third-party consultant will be experienced in dealing with the product, understanding appropriate transaction costs, and have numerous contacts throughout the banking industry to provide greater liquidity and increased price competition for their clients.
A third-party consultant should act independently and not have any undisclosed financial arrangements with swap providers.
Summary
Although the mechanics of interest rate swap valuation are complex and require dedicated resources to maintain the ability to perform the calculations, it is imperative that every user of this product know the basics of how they work and how they are priced. Armed with this knowledge and the fact that swaps are a negotiable product should provide the user with enough confidence to frequent the market without intimidation. It is the uninformed user that should be wary of non-competitive pricing.
Interest Rate Swap Related Definitions
Amortizing Swap: A swap in which the notional principal amount decreases over time.
Asset Swap: A swap which is typically executed in conjunction with an asset purchase.
Breakeven Rate: The rate at which a new swap has a zero value. Also called the midpoint.
Commercial Paper (CP): Short-term obligations with maturities typically ranging from 1 to 270 days issued by banks, corporations, and other borrowers.
Counterparties: The two principal parties involved in a swap trans- action.
Confirm: A letter that lists all of the details of a transaction.
Coupon: The fixed rate of interest in a swap. Also known as the swap rate or swap strike.
Effective Date: The date on which the coupon begins to accrue.
Fixed-Rate Payer: The party that pays the fixed rate in the swap. This party also receives floating-rate cash flows.
Floating-Rate Payer: The party that pays the floating rate in the swap. This party also receives fixed-rate cash flows.
Hedging: A strategy employed to limit risk.
High Coupon Swap: A swap in which the fixed-rate payer agrees to a higher swap rate than market conditions would mandate in exchange for an upfront fee or a positive spread on the floating-leg.
LIBOR Rate: that the most creditworthy international banks dealing in Eurodollars charge each other for large loans.
Maturity Date: The date on which interest ceases to accrue. Also known as the Termination Date.
Notional Amount: The amount used to determine the actual cash flows paid (or received) by applying the corresponding interest rates for the appropriate accrual periods.
Reset Date: The date on which the floating rate is set. The rate set on these dates are usually in effect until the next reset date.
Reset Frequency: How often reset dates occur.
Swap Spread: The difference between the all-in price of a swap and a benchmark yield (usually the yield on a treasury security).
Trade Date: The date on which the counterparties enter into the transaction.
About Evan Wilkoff
Evan Wilkoff is currently a Strategic Consultant for Hembstead Capital, LLC. Evan Wilkoff focuses his consulting practice on providing capital markets and financing expertise to the Specialty Finance industry.
Photography by: Courtesy of Stock Photo
