Wednesday, February 6, 2013

LIBOR and Derivatives – how close are they?

LIBOR and Derivatives – how close are they?
By Jasvin Josen
This article appeared in The Edge on Dec 3, 2012

We are quite familiar with the recent LIBOR (London Interbank Offered Rate) scandal in the financial markets. The obvious effect of the manipulation of the LIBOR is to mortgage loans and corporate loans. However, there was a bigger concern that LIBOR was integrated into approximately USD350 trillion worth of derivative contracts globally.
LIBOR affects derivatives in more that one way. Firstly, interest rate derivatives use LIBOR to determine their payoffs at certain dates. Secondly, all derivative positions are priced using LIBOR, where LIBOR is used as the discounting rate.

Interest rate Derivatives
Interest rate derivatives have payoffs depending on interest rate levels. For example if an investor buys the CME Eurodollar Future, his profit from this derivative will depend on what level the 3-month USD LIBOR is.

Other common interest rate derivatives are interest rate forwards (also known as forward rate agreements or FRAs), interest rate swaps, interest rate options and structured rate products. In this 2-part article series, I demonstrate how LIBOR can affect interest rate swaps, interest rate options and structured rate products.

(i) Interest rate swaps
Let us say that Company BIG issued a $100m 5% fixed coupon bond to its investors when interest rates in the market were generally high. After a few years, the general interest rates have dropped. To benefit from the lower interest rates, BIG enters into an interest rate swap with its investment bank with the following terms:

Fixed rate payer:             Investment Bank
Fixed rate:                        5 percent p.a.
Floating rate payer:         Company BIG
Floating rate:                   6-month Libor, paid semi-annually
Notional amount:             $ 100 million
Maturity:                          5 years

The swap is shown in Chart 1

Chart 1: Interest rate swap

The investment bank agrees to pay 5.0% of $100 million on an annual basis for the next five years. So, it will pay 5% of $100 million, or $5 million, once a year.

Company BIG agrees to pay the 6-month Libor on $100 million on a semi annual basis to the Investment Bank for the next five years. That is, the bank will pay the 6-month Libor rate, divided by two and multiplied by the notional amount, two times per year. For example, if the 6-month Libor is 4.2% on a reset date, BIG will be obligated to pay 4.2%/2 = 2.4% of the notional amount, or $2,400,000. (To keep it simple, day count conventions are excluded).

The idea is that BIG gets the fixed rate of 5% from the bank and passes it on to its bondholders annually. Then at every 6-month intervals BIG will make floating interest payments to the bank. In this way, on a net basis, BIG is paying floating interest payment on this $100m bond liability and gets to take advantage of the falling interest rates in future.

The reader may now wonder about the investment bank. Surely it will make losses as interest rates come down in the market. Well, the bank works it out like this. At the initial of the swap, the banker looks at the forward interest rate curve, to estimate the future 6-month LIBOR it could receive from BIG. Now, there are many ways in which the bank can structure the swap.

In the first scenario, let us say that BIG is determined to receive a rate of exactly 5% payment from the swap every year. The bank will analyse the future cash flows where it makes a 5% fixed payment and receives floating interest payments in the five years.  In a low interest rate forward environment, the net cash flows could very well prove negative for the bank. The bank will have to charge an upfront fee to BIG, as compensation for taking on the interest rate risk.

In the second scenario, let us say that BIG is not too keen in paying any upfront fees. The bank analyses its future cash flows again but this time, plays around with the fixed rate until the present value of the net cash flows is almost zero. In a low interest rate forward environment, the fixed rate is likely to be lower than the original 5%. Under this arrangement, BIG will probably only receive, perhaps a fixed rate of 4% and can only partially benefit from the low interest rates in future.

So how does LIBOR affect this swap?

Well, at an obvious level, every six months re-set dates, both parties will look at the LIBOR rate that morning to determine the rate that BIG will pay the investment bank for a six- month period. Readers may recall the Barclays case, where the corporate deals side of the bank allegedly asked their money market traders to set the LIBOR rate at a certain date to be not higher (or lower) than a certain rate, for its own benefit. Applying this case to our example, let us assume that BIG’s investment bank also contributes to the setting of LIBOR every morning. BIG’s investment bank, being a floating rate receiver in the swap deal, could be tempted to submit a higher LIBOR rate, hoping that a higher LIBOR setting that morning will result in the bank receiving a higher floating rate payment from BIG. Every basis point matters – for this deal, one basis point will results in an additional $10,000 (0.01% * $100million). And the bank has thousand of such deals every day.

At a less obvious level, is the pricing of the swap in both counterparties’ books. The bank and BIG will have to record the fair value of the swap in their books. The fair value of the swap is simply the present value of the total cash flows (or payoffs) in the future. For example, let us say that BIG is into the 2nd year of the swap. The fair value of the swap will the be the future fixed $5 million received from the bank at end of Year 2,3,4, and 5, netted with the future semi-annual floating payments to be paid out to the bank in Year 2 to 5. To obtain the present value of these payments, they have to be discounted by a risk-free interest rate. Market players globally have been comfortable with using the LIBOR rate as the discount rate.

If LIBOR is artificially higher than it really should be, BIG may have valued its net cash flows lower than it should and could be showing a lower asset or liability in its books.

There are millions of interest rate swaps globally, with counterparties wanting to hedge against interest rates such as industries, financial institutions, pension funds, mutual funds, insurance companies, etc. Other than the plain vanilla interest rate swap in the above example, many other popular variations of the interest rate swap like collars, caps, floors, range accruals, etc will be affected by LIBOR in the same way.

In the next article, I will illustrate how LIBOR affects the payoffs and pricing of an options and structured rate products.

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