CHAPTER 8
INTEREST RATE RISK AND SWAPS
2. My Word is My LIBOR. Why has LIBOR played such a central role in
international business and financial contracts? Why has this been questioned in recent
debates over its value reported?
No single interest rate is more fundamental to the operation of the global financial
markets than the London Interbank Offered Rate (LIBOR). But beginning as early as
2007, a number of participants in the interbank market on both sides of the Atlantic
suspected that there was trouble with LIBOR. The three-month and six-month
maturities are the most significant maturities due to their widespread use in various
loan and derivative agreements, with the dollar and the euro being the most widely
used currencies.
The issues related to LIBOR have been increasingly complicated in recent years –
beginning with the origin of the rates submitted by banks. First, rates are based on
"estimated borrowing rates" to avoid reporting only actual transactions, as many
banks may not conduct actual transactions in all maturities and currencies each day.
As a result, the origin of the rate submitted by each bank becomes, to some degree,
discretionary.
Secondly, banks – specifically money-market and derivative traders within the banks
– have a number of interests that may be impacted by borrowing costs reported by the
bank that day. One such example can be found in the concerns of banks in the
interbank market in September 2008, when the credit crisis was in full-bloom. A bank
reporting that other banks were demanding it pay a higher rate that day would, in
effect, be self-reporting the market's assessment that it was increasingly risky. In the
words of one analyst, akin "to hanging a sign around one's neck that I am carrying a
contagious disease." Market analysts are now estimating that many of the banks in the
LIBOR panel were reporting borrowing rates which were anywhere from 30 to 40
basis points lower than actual rates throughout the financial crisis.
3. Credit Risk Premium. What is a credit risk premium?
The cost of debt for any individual borrower will therefore possess two components,
the risk-free rate of interest ( kUS$ ), plus a credit risk premium (RPM$ Rating ) reflecting
the assessed credit quality of the individual borrower. For an individual borrower in
the United States, the cost of debt ( kDebt $ ) would be:
kDebt $ k US$ RPM$ Rating
The credit risk premium represents the credit risk of the individual borrower. In credit
markets this assignment is typically based on the borrower’s credit rating as
designated by one of the major credit rating agencies, Moody’s, Standard & Poors,
and Fitch. An overview of those credit ratings is presented in Exhibit 8.3. Although
each agency utilizes different methodologies, all include the industry in which the
firm operates, its current level of indebtedness, its past, present, and prospective
operating performance, among a multitude of other factors.
5. Credit Spreads. What is a credit spread? What credit rating changes have the most
profound impact on the credit spread paid by corporate borrowers?
The cost of debt changes with credit quality, as a credit spread is added to the basic
Treasury rate for the maturity in question. The costs of credit quality – credit spreads
– are quite minor for borrowers of investment grade, but rise dramatically for
speculative grade borrowers.
8. Floating Rate Loan Risk. Why do borrowers of lower credit quality often find their
access limited to floating-rate loans?
As opposed to fixed rate loans, where the lender accepts both the risk of changing
interest rates and changing credit quality of the borrower on loan origination, a
floating-rate loan shifts interest rate risk to the borrower. Lenders are not generally
willing to accept both risks when lending to lower credit quality borrowers.
11. Forward Rate Agreement. How can a business firm that has borrowed on a
floating-rate basis use a forward rate agreement to reduce interest rate risk?
A forward rate agreement (FRA) is an interbank-traded contract to buy or sell
interest rate payments on a notional principal. These contracts are settled in cash. The
buyer of an FRA obtains the right to lock in an interest rate for a desired term that
begins at a future date. The contract specifies that the seller of the FRA will pay the
buyer the increased interest expense on a nominal sum (the notional principal) of
money if interest rates rise above the agreed rate, but the buyer will pay the seller the
differential interest expense if interest rates fall below the agreed rate. Maturities
available are typically 1, 3, 6, 9, and 12 months, much like traditional forward
contracts for currencies.
12. Plain Vanilla. What is a plain vanilla interest rate swap? Are swaps a significant
source of capital for multinational firms?
A plain vanilla interest rate swap is a swap to pay fixed/receive floating, or
alternatively, pay floating/receive fixed. The plain vanilla interest rate swap is not a
source of capital; it only alters the interest rate price on repayment of a theoretical –
notional – debt principal.
