How are Swaps Caps and Collars Priced?

All these financial instruments are known as derivative instruments, which mean they are derived from an underlying physical financial instrument, such as treasury bonds or deposits.

Each is calculated differently and some are more complex than others are. In respect of the above instruments, an explanation of how they are calculated is given below.

Swap.

As explained in “derivatives in Plain English ” a swap is the exchange of a floating rate interest obligation for a fixed rate obligation. In essence,when one enters a swap one normally is fixing an interest rate on a loan or a deposit. The price of the fixed rate, is calculated from the equivalent rate for either a fixed deposit or a fixed loan for the term in question. Other factors which influence the rates are, the starting date of the swap and the amortization schedule.

Caps and Collars.

These are more complex derivative instruments. They are also called interest rate options. As such the pricing components of a Cap or Collar, include those mentioned above, and also include the rate at which the instruments to be priced (the strike rate), the volatility of markets at the time of pricing and the duration the contract is valid (usually the longer time remaining the more expensive they should be). The pricing methodology uses either of two well-established Option pricing models called Black-Scholes or Garmen Kollhagen. The mathematics in these models is very complex, and pricing of these is normally done using a software program. The pricing models should take in all the pertinent criteria and create a Premium value on the structure.

Cost of Canceling or breaking a swap contract .

An interest rate swap is a stand-alone financial instrument that is mostly used to fix the interest rate on a loan or indeed an investment. When a customer enters into a swap they are entering into an obligation to either pay or receive a certain fixed rate of interest on an agreed nominal amount for an agreed term. In the event the client wishes to break or collapse a swap, it may be because the nature of the underlying loan or investment has changed.

During its life a swap will always have a value. This value is the difference between the existing rate of the swap and the prevailing rate for the remaining term at the time it is collapsed. This value may be positive or negative depending on the rates at that time.

When it is collapsed the party with the positive value receives this from the other party.

Example:

ABC Inc has 3 years left on a swap for $5mil. At a fixed rate of 5%. They wish to collapse the swap as the underlying loan has been repaid. The current 3 year fixed rate is 4.50%.

In essence the client has borrowed at a 5% fixed rate and to dispose of this they must now lend back to AIB at the current 3-yr.rate of 4.50%. Thus there is a negative 50bp carry on that transaction for the remaining 3-year term.The client owes AIB the present value of the 50bps for 3 years. This is due the day the swap is collapsed.

In the event that the rate is at 5.50% when the swap is collapsed, then AIB will pay the client the present value of the 50bps.

Duration of Swaps

The swaps market in general goes out as far as 30 years; however the vast majority of swaps transacted are only out as far as 10 years. Although credit issues often restrict swaps to 5 year terms, it is possible to go as far as 10 years in the right circumstances. Such circumstances would be, for example, agreeing and implementing a “credit put” at 5 years, where the swap provider has the right to cancel the swap at that time. Another method is for the swap user to collateralize the deemed credit exposure. These are common conditions used in the market to enable unrated entities hedge interest rate risk with swaps and they are also used by Banks to manage counterparty credit risk.

Forward swaps

Forward swaps are quite simply swaps that begin on a specific agreed date in the future. An example of how this would be used is where a borrower has a construction loan for 2 years where they drawdown the funds piecemeal until the facility is fully drawn.

The pricing on forward swaps differs from swaps that start immediately. The difference will depend on the shape of the yield curve at the time of pricing. In the current interest rate environment, a 5-year Libor swap starting today is 5.12. A 5-year swap starting in 1 year ’s time is 5.92. This is a reflection of the current difference between floating rates of 1.80% and fixed rates at 5.12%.

Interest rate risk for conventional term loan financing and tax exempt bonds. Benefit of Swaps in a low and high interest rate environment .

In essence the risk is similar as there is and always has been a correlation between taxable and tax exempt interest rates. As a rule of thumb, tax exempt rates are 70% of the equivalent taxable rate *

When a client is considering taking on either taxable or tax exempt term debt they should consider the impact of interest rate moves in their decision making. Their decision to hedge or not will be determined by market conditions and the outlook at the time they take on the debt. They should look at how various interest rate levels could affect their cash flows over the life of their debt or over their budget or planning cycle (normally 5 years)

Rather than using a floating rate for forecasting, they should use the pertinent fixed rate at that time and also consider how it compares to the historic averages.

Once such sensitivity analysis has been carried out the client will have a much clearer picture of what risk they have to interest rate movements.

If the client wishes to remove all risk or mitigate a portion of it, they can utilize any of the financial instruments available such as swaps, caps and collars. The benefit of these instruments is that they are very flexible and can be tailored specifically to suit a client’s individual need. In addition, depending on the interest rate environment, the comfort clients have using these instruments and their ability to manage their exposures actively,they can use a mixture of these instruments to manage their interest rate risk.

* Tax exempt interest rates have in the past few years been between 68% and 78% of the equivalent taxable rate. In general this is a reflection of Corporate tax rates.(approx.30%). This relationship does move around depending on market conditions and any pending or potential changes in tax legislation.

If our company has a forward contract due in one-month ’s time and we realize we don ’t need this contract, what do we do?

The most prudent course of action is to cancel unneeded contracts immediately you realize the contract will not be utilized. When you cancel the contract you have a potential for profit or loss on this cancellation, depending on the current forward /spot rate of the currency mix.

Example:

You have a forward contract to buy EUR100,000 against the US dollar at EUR/USD 0.9150 in 30 days. To cancel the contract, you will need to sell EUR100,000 vs.USD to the bank. The forward rate to sell EUR100k in 30 days is EUR/USD 0.9090. Once you have booked this deal, the two deals are netted and you will owe the bank USD600.00 (i.e.you will owe the bank USD91,500 for contract A ,offset by the bank owing you USD90,900 in contract B )

Alternatively, if you have continuing exposure in the currency you may decide to swap this contract to a future requirement date, on maturity of the deal.

It is now May, I need to book a forward contract for goods due in August, but I am not sure exactly what date they will arrive?

Forward contracts can be booked either to a specific date or with a ‘window ’ period. The window refers to the start and end date of the contract.

In the case above your company need to book a ‘window ’ forward contract with a start date on 01AUG and an end date on 30AUG. A window forward will be priced slightly differently to a conventional forward, as the bank has to ensure the currency is available to you on call between the specified dates. The window forwards are very useful for shipped goods that have unsure import dates.

What is the normal period for booking future receivables /payables in foreign currency?

This period can change from industry to industry, but generally companies do not book contracts greater then 12 months forward. This is mainly due to the of future currency needs, also the forward market over 12 months is very illiquid and prices are subsequently unpredictable.

A popular strategy in booking forward 12 months is to cover your exposure quarter-by-quarter. Therefore for the 1 st quarter you would cover 100% exposure, 75% in the second, 50% in the third and 25% in the final quarter. As the quarters mature, you would ‘top up ’ on the forthcoming quarters to keep the 100--75-50-25 pattern repeating (see below)in the next four quarters.

	Q1	Q2	Q3	Q4	Q1	Q2
Q1 ‘02	100%	75%	50%	25%
Q2 ‘02		100%	75%	50%	25%
Q3 ‘02			100%	75%	50%	25%
Q4 ‘02				100%	75%	50%
Q1 ‘03					100%	75%
Q2 ‘03						100%

Example:
In Quarter 2 ’02, you should have 100% booked for that quarter, 75% booked for Quarter 3,50% covered for the final quarter of the year, with 25% hedged for Q1 of the next year. If the FX rate goes in your company ’s favor you might cover a higher percentage of future transactions. This policy does not achieve the best rate, but will give you a good average rate hedge.