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Chapter 7: Problem 14

"Companies with high credit risks are the ones that cannot access fixed-rate markets directly. They are the companies that are most likely to be paying fixed and receiving floating in an interest rate swap." Assume that this statement is true. Do you think it increases or decreases the risk of a financial institution's swap portfolio? Assume that companies are most likely to default when interest rates are high.

Short Answer

Expert verified
It increases the risk of the swap portfolio due to the higher likelihood of default when interest rates rise.

Step by step solution

01

Analyze Companies' Actions

High credit risk companies typically participate in swaps where they pay fixed rates and receive floating rates. This is because they cannot access fixed-rate markets directly and thus use swaps to convert their floating-rate debt into fixed-rate debt.
02

Understand Interest Rate Environment

Since these companies are more likely to default when interest rates are high, the financial institution faces increased risk if interest rates rise. In this scenario, the companies would struggle to meet their obligations, especially paying the fixed rate, as they do not benefit from rising floating rates.
03

Evaluate Impact on Financial Institution

The financial institution, which is essentially receiving fixed payments from these high credit risk companies, would face greater risk exposure. This is because the likelihood of default increases, threatening the payment inflows that typically balance the swap portfolio.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Credit Risk
Credit risk is essentially the risk that a borrower will not be able to fulfill their obligation to repay a debt. In the context of interest rate swaps, companies with high credit risks are often unable to access traditional fixed-rate loan markets due to their likelihood of default.

This is why they may choose to engage in interest rate swaps. By doing so, they pay a fixed rate and receive a floating rate, effectively converting their existing floating-rate debt into more predictable fixed-rate debt. This can be beneficial for their financial management, but it transfers some risk to the financial institution involved in the swap.
Floating Rate
The floating rate in a swap is a variable interest rate that can change with market conditions, typically linked to benchmarks like the London Interbank Offered Rate (LIBOR) or the federal funds rate.

Companies engaging in swaps to manage their debts often receive the floating rate in exchange for paying a fixed rate. This allows them to potentially benefit from falling interest rates. However, when interest rates rise, their financial situation can become strained, particularly if their revenues are insufficient to cover rising interest costs.
  • Allows flexibility with market changes
  • Beneficial in declining rate environments
  • Risky if rates increase and cash flow is limited
Financial Institutions
Financial institutions play a critical role in swap markets. They act as intermediaries, entering into contracts with companies that may have differing risk profiles.

In this capacity, they manage portfolios that include diverse interest rate swap agreements. However, swaps involving high credit risk entities pose a significant challenge. When the counterparty defaults, the institution loses the expected inflows, potentially destabilizing its financial stability. To mitigate this risk, financial institutions frequently perform rigorous assessments of creditworthiness before entering into such agreements.
Default Risk
Default risk refers to the probability that a borrower, like a company in a swap agreement, will fail to meet its debt obligations. This risk is inherently high when dealing with entities already classified as having elevated credit risk.

Given that these companies often participate in swaps during periods of high interest rates, the risk of default increases since they might struggle with their fixed payments.

Financial institutions, therefore, need to be acutely aware of default risk and maintain strategies to mitigate its impact on their portfolios, possibly through diversification or credit derivatives to hedge against potential defaults.

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Most popular questions from this chapter

Companies \(\mathrm{A}\) and \(\mathrm{B}\) have been offered the following rates per annum on a $$\$ 20$$ million 5-year loan: $$ \begin{array}{lcc} \hline & \text { Fixed rate } & \text { Floating rate } \\ \hline \text { Company A: } & 5.0 \% & \text { LIBOR }+0.1 \% \\ \text { Company B: } & 6.4 \% & \text { LIBOR }+0.6 \% \\ \hline \end{array} $$ Company A requires a floating-rate loan; company B requires a fixed-rate loan. Design a swap that will net a bank, acting as intermediary, \(0.1 \%\) per annum and that will appear equally attractive to both companies.

Company X wishes to borrow US dollars at a fixed rate of interest. Company \(Y\) wishes to borrow Japanese yen at a fixed rate of interest. The amounts required by the two companies are roughly the same at the current exchange rate. The companies are subject to the following interest rates, which have been adjusted to reflect the impact of taxes: $$ \begin{array}{lrr} \hline & \text { Yen } & \text { Dollars } \\ \hline \text { Company X: } & 5.0 \% & 9.6 \% \\ \text { Company Y: } & 6.5 \% & 10.0 \% \\ \hline \end{array} $$ Design a swap that will net a bank, acting as intermediary, 50 basis points per annum. Make the swap equally attractive to the two companies and ensure that all foreign exchange risk is assumed by the bank.

Company \(X\) is based in the United Kingdom and would like to borrow \(\$ 50\) million at a fixed rate of interest for 5 years in US funds, Because the company is not well known in the United States, this has proved to be impossible. However, the company has been guoted \(12 \%\) per annum on fixed- rate 5 -year sterling funds, Company \(Y\) is based in the United States and would like to borrow the equivalent of \(\$ 50\) million in sterling funds for 5 years at a fixed rate of interest. It has been unable to get a quote but has been offered US dollar funds at \(10.5 \%\) per annum. Five-year government bonds currently yield \(9.5 \%\) per annum in the United States and \(10.5 \%\) in the United Kingdom. Suggest an appropriate currency swap that will net the financial intermediary \(0.5 \%\) per annum.

A corporate treasurer tells you that he has just negotiated a S-year loan at a competitive fixed rate of interest of \(5.2 \%\). The treasurer explains that he achieved the \(5.2 \%\) rate by borrowing at 6-month LIBOR plus 150 basis points and swapping LIBOR for \(3.7 \%\). He goes on to say that this was possible because his company has a comparative advantage in the floating-rate market. What has the treasurer overlooked?

Explain what a swap rate is. What is the relationship between swap rates and par yields?
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