Payday loan for anyone

Almost every business borrows money from time to time. A company borrowing at a fixed rate may think it is immune to interest rate risk, but that is not the case. Risk arises from the possibility that interest rates can increase from the time the company decides to take the loan to the time it actually takes the loan. Most companies make plans to borrow based on their cash needs at specific future dates. The rates they pay on these loans are important determinants of their future cash needs, as reflected in their planned interest payments. Exposure to interest rate risk is, therefore, a major concern. Failing to manage interest rate risk can hinder the planning process, as well as result in unexpected demands on cash necessitated by unexpectedly higher interest payments.

In each of the preceding three chapters, we have discussed the role played by the markets represented by the various derivative instruments. The swap market is extremely large, consisting of dealers and end users engaging in customized transactions that involve a series of payments. Swaps can be equivalent to various other derivative instruments. Moreover, we used transactions in assets to replicate swaps. Hence, an obvious question is why swaps exist when the same results can be obtained using other instruments.
First let us ignore the obvious counter-question of why other instruments exist when swaps serve the same purpose. In the race to see which derivative instrument is more popular, swaps have clearly won. We can only surmise the reason why. The tremendous popularity of swaps results largely from the popularity of interest rate swaps. For several reasons, these instruments have been embraced by corporations as tools for managing interest rate risk. One is that interest rate swaps, certainly the plain vanilla type, are simple instruments, rarely requiring technology, computational skills, or financial know-how beyond what exists in most corporate treasury offices. In short, they are easy to understand. In addition, interest rate swaps can easily be viewed as a pair of loans. Borrowing and lending money is second nature to corporations. Corporations view engaging in swaps as nothing more than an extension of their regular practice of borrowing and lending money. Many corporations are restricted in their use of options and futures, but they can usually justify swaps as nothing more than variations of loans. Also, swaps are so easily tailored to alter the interest rate patterns on most corporate loans that they seem to go hand in hand with the typical fixed- and floating-rate loans that corporations take out. Many corporations borrow money and combine the loan with a swap right from the start. Finally, we should note that some dealer firms have exploited the attractions of swaps by aggressive selling. In some cases, corporations entered into ill-advised and occasionally complex, exotic swaps. We do not suggest that most dealers have engaged in unethical actions (although some certainly have) but rather that, as in all sales-oriented activities, customers do not always get impartial advice from sales personnel. In some cases, corporations have used swaps to step over the line from good risk management into speculation on risks they know nothing about. In short, at least part of the success of swaps has probably not been for the right reasons.
But using swaps for the wrong reason does not sufficiently explain the success of these instruments. If it were the primary motivation for their use, swaps would die out as a risk management tool. Instead, swaps have grown in popularity. Swaps provide a mechanism for managing the risks associated with a series of payments. Although forward contracts and other instruments can manage that risk, a swap is more of a portfolio approach to managing risk-a package of risk management tools all rolled up into one. Given that risk often exists in a series, swaps are ideal instruments for managing it. Other instruments may be able to do the job, but they must be carefully constructed with a certain amount of financial ingenuity.

The total risk of an asset or a portfolio can be divided into two types of risk: systematic risk and unsystematic risk. Professor William Sharpe defined systematic risk as the portion of an asset’s variability that can be attributed to a common factor. It is also sometimes called undiversifiable risk or market risk. Systematic risk is the minimum level of risk that can be attained for a portfolio by means of diversification across a large number of randomly chosen assets. As such, systematic risk is that which results from general market and economic conditions that cannot be diversified away.
Sharpe defined the portion of an asset’s variability that can be diversified away as unsystematic risk. It is also sometimes called diversifiable risk, unique risk, residual risk, idiosyncratic risk, or company-specific risk. This is the risk that is unique to a company, such as a strike, the outcome of unfavorable litigation, or a natural catastrophe.
The relationship between the movement in the price of an asset and the market can be estimated statistically. There are two products of the estimated relationship that investors use. The first is the beta of an asset. Beta measures the sensitivity of an asset’s return to changes in the market’s return. Hence, beta is referred to as an index of systematic risk due to general market conditions that cannot be diversified away. For example, if an asset has a beta of 1.5, it means that, on average, if the market’s changes by 1%, the asset’s return changes by 1.5%. The beta for the market is 1. A beta greater than 1 means that the systematic risk is greater than that of the market; a beta less than 1 means that the systematic risk is less than that of the market. Brokerage firms, vendors such as Bloomberg, and online internet services provide information on beta for common stock.
The second product is the ratio of the amount of systematic risk relative to the total risk. This ratio is called the coefficient of determination or R-squared. This ratio varies from 0 to 1. A value of 0.8 for a portfolio means that 80% of the variation in the return of the portfolio is explained by movements in the market. For individual assets, this ratio is typically low because there is a good deal of unsystematic risk. However, through diversification the ratio increases as unsystematic risk is reduced.

The credit risk in a swap varies during its life. An interest rate or equity swap has no final principal payments. The credit risk in either of these swap types is greater during the middle of its life. This occurs because near the end of the life of the swap, not many payments remain, so there is not much money at risk. And at the beginning of the life of the swap, the credit risk is usually low because the parties would probably not engage in the swap if a great deal of credit risk already were present at the start. Therefore, the greatest potential for credit losses is during the middle of the life of the swap. For currency swaps, in which the notional principals are typically exchanged at the end of the life of the swap, the credit risk is concentrated between the middle and the end of its life.
The parties that engage in swaps are generally of good credit quality, but the fear of default is still a significant concern. Yet, perhaps surprisingly, the rates that all parties pay on swaps are the same, regardless of either party’s credit quality. As we have illustrated here, a plain vanilla swap, in which one party pays a floating rate and the other pays a fixed rate, has the fixed rate determined by the term structure for that underlying rate. Therefore, if a party wanted to engage in a swap to pay LIBOR and receive a fixed rate, it would get the fixed rate based on the LIBOR term structure, regardless of its credit quality or that of the counterparty, provided that the two parties agreed to do the transaction. Implicit in the fixed rate, however, is the spread between LIBOR and the default-free rate. As we described earlier, swap rates are quoted with respect to a spread over the equivalent default-free rate. Thus, a one-year swap rate of 3.68 percent as in our example might be quoted as 50 basis points over the rate on a one-year U.S. Treasury note, implying that the one-year U.S. Treasury note rate was 3.18 percent. This differential is called the swap spread.
It is important to note that the swap spread is not a measure of the credit risk on a given swap but rather a reflection of the general level of credit risk in the global economy. The LIBOR term structure reflects the borrowing rate for London banks, which are generally highly rated but not default free. Whenever a recession approaches or credit concerns arise, this spread widens and fixed-rate payers on swaps end up paying more. Of course, floating-rate payers end up paying more as well, but the additional cost to them is less obvious up front because the floating rates change over the life of the swap.
So all parties pay the same rate, but clearly some parties are better credit risks than others. In addition, virtually no parties are default free, and many are of lower credit quality than the typical London bank on which LIBOR is based. How do parties manage the credit risk in swaps? For right now, however, we cover one such method that we have seen before with respect to forward contracts and that is routinely used in the futures market: marking to market.

We have mentioned on a few occasions that swaps are subject to credit risk. Indeed, as we have emphasized throughout the blog, all over-the-counter derivatives are subject to credit risk. In this section, we examine some of the issues involved in the credit risk of swaps.
Recall that a swap has zero market value at the start. It starts off as neither an asset nor a liability. Once the swap is engaged and market conditions change, the market value becomes positive for one party and negative for the other. The party holding the positive value swap effectively owns an asset, which represents a claim against the counterparty. This claim is a netting of the amount owed by the counterparty and the amount that the party owes, with the former exceeding the latter. The party holding the positive-value swap thus assumes credit risk. The counterparty could declare bankruptcy, leaving the party holding the positive-value swap with a claim that is subject to the legal process of bankruptcy. In most swap arrangements, netting is legally recognized, so the claim has a value based on the net amount.
The party to which the swap has a negative value is not subject to credit risk. It owes more than is owed to it, so the other party faces the risk.
During the life of the swap, however, the market value to a given party can change from positive to negative or vice versa. Hence, the party not facing credit risk at a given moment is not entirely free of risk, because the swap value could turn positive for it later.
The timing of credit risk is in the form of immediate or current credit risk and deferred or potential credit risk. The former arises when a payment is immediately due and cannot be made by one party. The latter reflects the ever-present possibility that, although a counterparty may currently be able to make payments, it may be unable to make future payments.
Let us work through an example illustrating these points. Consider two parties A and B who are engaged in a swap. At a given payment date, the payment of Party A to Party B is $100,000 and the payment of Party B to Party A is $35,000. As is customarily the case, Party A must pay $65,000 to Party B. Once the payment is made, we shall assume that the market value of the swap is $1,250,000, which is an asset to A and a liability to B.
Suppose Party A is unable to pay and declares bankruptcy. Then Party B does not make any payment to Party A. Party A is bankrupt, but the swap is an asset to A. Given the $65,000 owed by A to B, the claim of A against B is $1,250,000 – $65,000 = $1,185,000. We emphasize in this example that A is the bankrupt party, but the swap is an asset to A, representing its claim against B. If B were holding the positive market value of the swap, it would have a claim of $1,250,000 + $65,000 = $1,3 15,000 on A as A enters into the bankruptcy process.
Let us change the example a little by having A not be bankrupt on the payment date. It makes its payment of $65,000 to B and moves forward. But a few months later, before the next payment, A declares bankruptcy. Its payment is not immediately due, but it has essentially stated that it will not make its next payment or any payments thereafter. To determine the financial implications of the event, the two parties must compute the market value of the swap. Suppose the value is now $1,100,000 and is positive to A. Then A, the bankrupt party, holds a claim against B of $1,100,000. The fact that A is bankrupt does not mean that it cannot have a claim against someone else, just as a bankrupt corporation can be owed money for inventory it has sold but on which it has not yet collected payment.
Of course, A could be bankrupt and B’s claim against A could be the greater. In fact, with A bankrupt, there is a very good possibility that this scenario would be the case. Then, of course, B would simply be another of A’s many creditors.
Exactly what happens to resolve these claims in each of these situations is a complex legal issue and is beyond the scope of our level of treatment. In addition, the bankruptcy laws vary somewhat around the world, so the potential exists for different treatments of the same situation. Most countries do recognize the legality of netting, however, so it would be rare that a party would be able to claim the full amount owed it without netting out the amount it owes.

Insurance companies are financial intermediaries that, for a price, will make a payment if a certain event occurs. They function as risk bearers. There are two types of insurance companies: life insurance companies (“life companies”) and property and casualty insurance companies (“P&C companies”). The principal event that the former insures against is death. Upon the death of a policyholder, a life insurance company agrees to make either a lump sum payment or a series of payments to the beneficiary of the policy. Life insurance protection is not the only financial product sold by these companies; a major portion of the business of life companies is in the area of providing retirement benefits. In contrast, P&C companies insure against a wide variety of occurrences. Two examples are automobile insurance and home insurance.
The key distinction between life and P&C companies lies in the difficulty of projecting whether a policyholder will be paid off and, if so, how much the payment will be. While this is no simple task for either type of insurance company, from an actuarial perspective it is easier for a life company. The amount and timing of claims on P&C companies are more difficult to predict because of the randomness of natural catastrophes and the unpredictability of court awards in liability cases. This uncertainty about the timing and amount of cash outlays to satisfy claims affects the investment strategies used by the managers of P&C companies’ funds.

We have seen in this blog that options represent rights and forward contracts represent commitments. Just as there are options to enter swaps, there are also forward contracts to enter into swaps, called forward swaps. They are not as widely used as swaptions but do offer the advantage, as is always the case with forwards, that one does not have to pay any cash up front as with an option premium. Forward swaps are priced by pricing the swap off of the forward term structure instead of the spot term structure.

When a swaption is exercised, it effectively creates a stream of equivalent payments, commonly referred to in the financial world as an annuity. This stream is a series of interest payments equal to the difference between the exercise rate and the market rate on the underlying swap when the swaption is exercised. Consider a European payer swaption that expires in two years and is exercisable into a one-year swap with quarterly payments, using 901360 as the day-count adjustment. The exercise rate is 3.60 percent. The notional principal is $20 million. Now, suppose we are at the swaption expiration and the term structure is the one we obtained when pricing the interest rate swap earlier in this series of posts.
Under these conditions, we found that the swap fixed payment is 0.0092, equating to an annual fixed rate of 3.68 percent.
The holder of the swaption has the right to enter into a swap to pay 3.60 percent, whereas in the market such a swap would require payment at a rate of 3.68 percent. Therefore, here at expiration this swaption does appear to offer an advantage over the market rate. Let us consider the three possible ways to exercise this swaption.
The holder can exercise the swaption, thereby entering into a swap to pay 3.60percent.
The quarterly payment at the rate of 3.60 percent would be $20,000,000(0.0360)(901360=) $180,000. The swaption holder would then be engaged in a swap to pay $180,000 quarterly and receive LIBOR. The first floating payment would be at 3.45 percent25and would be $20,000,000(0.0345)(901360) = $172,500. The remaining floating payments would, of course, be determined later.
Alternatively, the holder can exercise the swaption, thereby entering into a swap to pay 3.60 percent, and then enter into a swap in the market to receive fixed and pay floating. The fixed rate the holder would receive is 3.68 percent, the market-determined fixed rate at the time the swaption expires. The quarterly fixed payment at 3.68 percent would be $20,000,000(0.0368)(90/360) = $184,000. Technically, the LIBOR payments are still made, but the same amount is paid and received. Hence, they effectively offset. Panel B illustrates this payment stream. This arrangement would be common if the counterparty to the second swap is not the same as the counterparty to the swaption.
The holder can arrange to receive a net payment stream of $184,000 – $180,000 = $4,000. Panel C illustrates this payment stream. In this case, the counterparty to the second swap is probably the same as the counterparty to the swap created by exercising the swaption, who would be the counterparty to the swaption. Because the floating payments are eliminated, the amount of cash passing between the parties is reduced, which mitigates the credit risk.

Swaptions have a variety of purposes, which we shall cover in more detail in the near future when we discuss swap applications and strategies. For right now, however, we take a brief glance at why swaptions exist.
Swaptions are used by parties who anticipate the need for a swap at a later date but would like to establish the fixed rate today, while providing the flexibility to not engage in the swap later or engage in the swap at a more favorable rate in the market. These parties are often corporations that expect to need a swap later and would like to hedge against unfavorable interest rate moves while preserving the flexibility to gain from favorable moves.
Swaptions are used by parties entering into a swap to give them the Jexibility to terminate the swap. Suppose the party in a swap is paying fixed and receiving floating. If it owned a receiver swaption, it could exercise the swaption, thereby entering into a swap to receive a fixed rate and pay a floating rate. It would then have offset the floating parts of the swap, effectively removing any randomness from the position.24But the only way the party could do so would require having previously purchased a swaption. Similarly, parties engaged in a receive-fixed, pay-floating swap can effectively offset it by exercising a payer swaption.
Swaptions are used by parties to speculate on interest rates. As with any interest rate sensitive instrument, swaptions can be used to speculate. Their prices move with interest rates and, like all options, they contain significant leverage. Thus, they are appropriate instruments for interest rate speculators.

The two types of swaptions are a payer swaption and a receiver swaption. A payer swaption allows the holder to enter into a swap as the fixed-rate payer and floating-rate receiver. A receiver swaption allows the holder to enter into a swap as the fixed-rate receiver and floating-rate payer. Therefore, these terms refer to the fixed rate and are comparable to the terms call and put used for other types of options. Although it is not apparent at this point, a payer swaption is a put and a receiver swaption is a call.
Swaptions have specific expiration dates. Like ordinary options, swaptions can be European style (exercisable only at expiration) or American style (exercisable at any time prior to expiration). A swaption is based on a specific underlying swap. For example, consider a European payer swaption that expires in two years and allows the holder to enter into a three-year swap with semiannual payments every 15 January and 15 July. The payments will be made at the rate of 6.25 percent and will be computed using the 301360 adjustment. The underlying swap is based on LIBOR, and the notional principal is $10 million. Of course, a swaption has a price or premium, which is an amount paid by the buyer to the seller up front.
Note that this swaption expires in two years and the underlying swap expires three years after that. This arrangement is called a 2 X 5 swaption, a terminology we used in explaining FRAs. The underlying can be viewed as a five-year swap at the time the swaption is initiated and will be a three-year swap when the swaption expires.
Finally, there are a number of ways to settle a swaption at expiration. Recall that ordinary options can allow for either physical delivery or cash settlement.