Structuring interest rate derivatives I: Swaps

Escrito el 12 septiembre 2010 por Antonio Rivela Rodríguez en Uncategorized

This is the first one of a sequence of blogs where I will try to analyze and explain real derivatives used by firms in order to reduce their cost of funding. The purpose of this blog is to explain concepts that are not clarified by theoretical books.

This is so because derivatives structuring is a combination of art and science.

You need creativity to come up with brand new concepts, then solid technical skills together with computer modeling skills are a must, and finally commercial skills in order to convince the world to use your products.

Exotics are the products beyond the easy/simple ones or “plain vanilla”. We called them plain vanilla making an analogy with vanilla ice-cream: as simple as you can get it. Let´s bear in mind that today´s plain vanilla products used to be exotics 5/10 years ago because innovation drives this business at the speed of light.

Lets take a look at swaps first:

A swap is an OTC derivative which involves the exchange of cash payment streams between two counterparties on an agreed amount for a fixed time period. Each payment stream is known as a leg of the swap.

Swaps are designed to manage exposure to risk, such as index values or interest rates and for speculation purposes. Swaps are available across the asset classes.

Interest rate swaps are the most common type of swap.

A interest rate swap is an exchange of payment streams (usually in cash) between two counterparties on an agreed amount of debt (the notional) for a fixed time period.

The payments streams exchanged can be either fixed or floating as follows:

Fixed and floating
Floating and fixed
Floating and floating
Fixed and fixed

The floating rate is set according to the chosen reference rate. Usually the rate is set at the start of each payment period and paid at the end of that payment period (in advance). However, the floating rate can also be set at the end of the period (in arrears).

What interest rate swaps are available?
Available interest rate swaps include the following but there are many others:

Callable swap
Cancelable swap
CMS swap
CMS spread swap
Cross-currency swap
Forward rate agreement (FRA)
Inverse floater
Knock in swap
Quanto swap
Range accrual swap
Vanilla swap
Zero coupon swap

Note Many (but not all) of these swaps can be an:
Amortizing swap.
Accreting swap

In this sequence of blogs I will explain each of the concepts to make your life easier.

See you next!

Antonio Rivela
IE Business School Finance Professor
Managing Director netvalue consultores


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Robert Sabo (www.hedgewerks.com) 8 octubre 2010 - 23:04

Most hedgers must bare this information in mind – there is more to derivatives and hedging than the technical “science” side. In fact, the simpler the hedge, the more “art” is involved when it comes to pricing, timing, and advice.
Many times, an alternative hedge is superior to a plain vanilla hedge, but these are not sold to hedgers as the marketing desks of many commercial banks are not experienced enough to delivery the service required. Oftentimes, a hedgers primary need is not the hedge itself but the ability to exit the hedge at the lowest cost possible when current financial circumstances change. So the applications of options is often appropriate in some or various forms, but again is rarely discussed or sold.
The interest rate hedging market is becoming more transparent all the time, with the advent of free websites such as http://www.swapdesk.com, but valuable guidance and advise is still in short supply.

Howard Lothrop 9 octubre 2010 - 22:04

I’ll disagree, at least regarding using derivatives in a business line process, for example to hedge a loan at a bank. Plain vanilla and conservative really should (and does) rule the day. That’s because the goal is risk reduction. The borrower wants a long term fixed while the bank wants to offload the excess rate risk. Plain vanilla OTC pay fixed, rcv float is the answer, particularly when a repeatable business line process is the goal.

Why? Because the bank is looking to reduce the risk and earn higher risk adjusted returns. If they were simply trying to maximize income without considering risk, sure they should look at more exotic hedges, but that’s crossing the line from hedging (pure risk reduction) into speculation (try to pick up higher earnings at expense of a little more risk).. Also, no other hedge has a tighter bid/ask spread than a plain vanilla swap. Tighter spreads = easier exit if needed.

Howard Lothrop

Robert Sabo (www.hedgewerks.com) 12 octubre 2010 - 18:46

Howard, my comments were really meant for the corporate hedger, not so much the bank looking to hedge its balance sheet exposure or providing hedges for its borrowers. I have been in this market for over 15 years and the lack of creativity, transparency, and quality advice has always been frustrating to me as a practitioner. Poor assessment and advice upfront often leaves hedgers with very bad tastes in their mouths and completely turned off to anything that falls into the “derivatives” solution. Plain vanilla is often the best solution, but other ideas and strategies need to be explored and alternative solutions at least presented. There is a never one perfectly best solution known upfront. Even a plain vanilla swap will not do a hedger any good if it needs to be broken mid way through its tenor and rates have moved significantly since the onset of the the hedge – but this is exactly where so many hedgers find themselves. With good advice upfront, many unfortunate hedging war stories can be mitigated if not avoided.

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Darren 15 abril 2012 - 03:34

Often a good investment, Interest Rate Derivatives are at least a guide to feel out the market.

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