Amortizing Swaps

Calculating the All-In Cost

When you first learnt about interest rate swaps, the periodic exchange of interest rate

payments was assumed to be based on a constant underlying notional principal

amount (typically a Eurobond against a loan, each requiring a single repayment of

principal at maturity). In reality, for a lender, this is far from the case.

More likely, in structuring a loan, real estate financing, or private placement, the periodic

exchanges of interest on the swap are not based on cash flows with a constant notional

principal but rather one that is either decreasing (an amortizing structure) or increasing (a

zero-or deep-discount structure). Once considered “high tech”, these deals have gone the

way of plain vanilla swaps and have become “commodisized”. Bankers must understand

how these swaps are structured, priced, and utilized as important rate risk management

tools.

Here we analyze amortizing swaps. To structure and price an amortizing swap, you must

first identify the liability structure you want to protect and decide what type of swap will

best hedge the interest paid on the loan. You also must look at projected loan outstandings

and the amortization schedule to identify the notional principal amounts you need in the

swap.

After that, you must strip the projected outstandings into separate swaps of various tenors

fitting the amortization schedule and price each swap separately. You can blend the separate

fixed rates that your customer will pay to you into one fixed rate applicable to the entire

structure. This is accomplished by looking at the fixed-rate cash flows you would receive in
the swap from your floating-rate borrower if you actually did separate swaps with him or

her.

Calculating the IRR (Internal Rate of Return) that these cash flow receipts would represent

will give you the single blended fixed rate your customer would be asked to pay in the

swap. Finally, you can calculate the all-in fixed rate achieved by your customer through the

swap by calculating the IRR of his or her total cash flows in and out over the life of the loan

and the swap.

Loan Proposal

Borrower: Prime Borrower, Inc.

Facility: $ 500,000,000 7-Year Step-Down Revolving Credit

Purpose: To replace existing revolving credit

Pricing: Prime plus 1,5 % payable monthly

Amortization: $ 200,000,000 at the end of year 3

$ 100,000,000 at the end of year 5

$ 200,000,000 at the end of year 7

Utilization: 80 %
Structuring Interest Rate Risk Protection

Coupon Swap

Prime Borrower is to pay a floating rate of prime + 1.5 % on its bank debt. As protection

from rising rates, Prime Borrower wants to convert all or part of this floating-rate payment

to a fixed rate.

Money Market Swap

Normal coupon swaps convert floating-rate payments based on six-month LIBOR to fixed

rates based on semiannual U.S. Treasuries. In this case, you need the bank to pay

Prime Borrower a floating-rate payment based on monthly prime, not six-month

LIBOR. You must, therefore, structure this deal using two swaps: a normal coupon

swap and a money market swap that will exchange payments of six-month LIBOR

for payments based on monthly prime.

Application

Complete this swap diagram showing the effect of the two swaps.

Bank  Prime Borrower Fixed Rate  Bank

  LIBOR

Floating-Rate Bank Loans
Prime + 1,5 %
Structuring the Amortizing Swap

This structure leaves Prime Borrower receiving a floating- rate payment based on monthly

prime and making fixed-rate payment based on semiannual U.S. Treasuries.

When you quote the fixed-rate cost the Prime Borrower, ignore the LIBOR payments

altogether and simply quote a fixed rate against prime. The only problem here is that the

amount of outstandings varies over the life of the deal. To choose the right notional

principal amounts for the swap, you need to study the projected outstandings.

Choosing Notional Principal Amounts

To cover the projected outstandings in this deal, Prime Borrower will need three swaps.

Application

Assign a dollar value to each swap to fit the projected outstandings.

3 year $ ___________

5 year $ ___________

7 year $ ___________

Pricing the Amortizing Swap

You need to give Prime Borrower a single fixed rate for the amortizing structure over the

whole seven-year period, but each swap must be priced separately, because the rates for

different tenors vary according to the yield curve.

You may assume that the following rates are valid for these swaps.
Naturally, the bank wants to buy low and sell high, which means, in the case of swaps, pay

the lower rate and receive the higher rate. Therefore, the bank wants to receive the offer

rate in the coupon swap and pay the bid rate in the money market swap.

Swap Rates

Tenor U.S. Coupon Swap Money

Treasuries Bid/Offer Market Swap
Bid/Offer

3 years 7,67 % T + 82/87 P-120/P-110

5 years 8,01 % T + 87/94 P-120/P-110

7 years 8,29 % T + 85/92 P-120/P-110

Credit Fee and Exposure

Before you can calculate the all-in fixed rate Prime Borrower will pay, you must calculate

an appropriate credit fee. To do that, you must calculate the fractional credit exposure

represented by each swap.

The Fed (Federal Reserve) has suggested that exposure for U.S. dollar interest rate swaps

be calculated at 0,5 % to 1,0 % of the notional principal multiplied by the number of years.

Because Prime Borrower is not the strongest credit, we will conservatively utilize the high

end of this range: 1,0 %.

Application

Calculate the fractional exposure for each swap.

credit fee x 3 years x $ amount = $ ___ ______ (A)

credit fee x 5 years x $ amount = $ _________ (B)

credit fee x 7 years x $ amount = $ _________ (C)

Total Exposure = $ _________

In keeping with the Fed’s proposal on exposure and capital adequacy requirements, you

will price these swaps so they return the same earnings per dollar of exposure as loans to

the same company. If you assume that P + 1.5 % represents a lending margin of 2.5 %, you

can apply this margin to the exposure amounts calculated above to determine the amount of

annual credit fee Prime Borrower should pay. This annual credit fee will be expressed as a

percent of the notional principal, as it will be collected by increasing the fixed rate paid by

Prime Borrower in the swap.

Application

Calculate the credit fee for each swap.

0.025 x $ ____(A)_____ = $ _________ / $ amount = ____ %

0.025 x $ _____(B)____ = $ _________ / $ amount = ____ %

0.025 x $ _____(C)____ = $ _________ / $ amount = ____ %

Application

Now that you know the credit fee and the correct swap spread to quote, you are ready to

calculate the total fixed rate you want to receive from Prime Borrower for each of the three

swaps.

Swap Tenor 3 5 7

Treasury Rate

Swap Spread

Credit Fee

Total Fixed Rate

To blend these three fixed rates, you must use the concept of internal rate of return,

calculating a constant interest rate equivalent to the three. Because interest payments make

sense only when applied to principal amounts, you will have to use the three rates just

calculated with the notional principal amounts and reductions as if they were principal

borrowed and partly repaid each year.

Application

Use the following table to calculate the fixed-rate payments you would receive from Prime

Borrower if you actually did three separate swaps. Remember to divide the fixed rates by 2,

because you have semiannual periods.

Time 3-year 5-year 7-year Total Loan Total
Fixed Fixed Fixed Fixed Principal Cash
Payments Payments Payments Payments Payments Flows

0 ($400,000) ($400,000)

1 ____ ____ ____ ____ 0 ____

2 ____ ____ ____ ____ 0 ____

3 ____ ____ ____ ____ 0 ____

4 ____ ____ ____ ____ 0 ____

5 ____ ____ ____ ____ 0 ____

6 ____ ____ ____ ____ $160,000 ____

7 ____ ____ ____ 0 ____

8 ____ ____ ____ 0 ____

9 ____ ____ ____ 0 ____

10 ____ ____ ____ $80,000 ____

11 ____ ____ 0 ____

12 ____ ____ 0 ____

13 ____ ____ 0 ____

14 ____ ____ $160,000 ____

Application

Now calculate the IRR of the previous cash flows. The answer will be the semiannual fixed

rate Prime Borrower will pay you in the swap in exchange for receiving floating-rate from
you. This fixed rate includes a credit spreads and is expressed on a semiannual bond

equivalent yield basis.

Answer: _____________

Calculating the All-In Fixed-Rate Cost to Prime Borrower

To calculate the true all-in fixed-rate cost to Prime Borrower, you must calculate the IRR of

the cash flows it will pay and receive, including the principal amount received and then

repaid on the loan. In this case, there are seven years of monthly flows, or 84 total cash

flows, plus the initial disbursement on the loan at time 0.

(Remember that you have principal repayments of $ 160 million at the end of year 3, $ 80

million at the end of the year 5, and $ 160 million at the end of year 7).

Application

Calculate Prime Borrower’s total cash flows over the life of the deal

Funding Swap Swap Principal Total

Cost Receipts Payments Payments Flows
Month

…….

84

The monthly IRR of these cash flows is _______ %.

Conclusion

You have given Prime Borrower a synthetic fixed rate of ______ % on its amortizing loan.

You have achieved this rate while earning a credit fee equivalent to a lending margin of

_____, with credit exposure (using the Fed’s most conservative fractional credit exposure

estimate of 1,00 %) of $ ________ at the outset, and this number will reduce the loan

amortizes. For the first year, your credit fee on the swap will be $ ______ .