Introduction to Interest Rate Derivatives

February 2000

Morgan Stanley fixed income research analysts produce proprietary research in conjunction with Morgan Stanley trading desks that
trade as principal in the instruments mentioned in this report. Morgan Stanley fixed income research is therefore not independent
from the proprietary interests of Morgan Stanley, which may conflict with your interests.
Morgan Stanley fixed income research analysts receive compensation based in part on Morgan Stanley’s trading and capital markets
revenues. Morgan Stanley and/or its affiliates may have a position in the debt of the Company or instruments discussed in this report.
Please see additional important disclosures at the end of this report.
 Topics to be Covered

• Section One – What are Interest Rate

Derivatives?

• Section Two – Users of Interest Rate

Derivatives

• Section Three – An Overview of

Recent Market Activity (Why are
Swaps Important?)

• Section Four – The Benchmark Issue

• Section Five – How to Execute and

Unwind a Swap

• Section Six – Examples of Trades

• Section Seven – Following the Market

2
 What are Interest
Rate Derivatives?

3
What Is a Swap?
Spot-Starting 5-Year Fixed/Floating Swap ($100MM Notional)

Fixed Payments
5.44% Semiannually on 30/360 Day Count
Party A Party B
3-Month LIBOR Quarterly on Act/360 Day Count

Floating Payments

• Swap: Contractual agreement to exchange fixed for floating cash flows over a specified
period of time
• Floating rate reference: USD LIBOR
• LIBOR: British Banker Association’s (BBA) fixing of the London Inter-Bank Offered Rate.
A contributor bank contributes the rate at which it could borrow funds, it it were to do so
by asking for and accepting inter-bank offers in reasonable market size just prior to 11 AM
London time. 16 banks contribute, the top and bottom 4 fixings are eliminated, and the
remaining 8 fixings are averaged.

4
A Swap is Different than a AA Bank Bond
An interest rate swap has different characteristics compared to a AA bank bond

• Differences between a swap contract and a AA bank bond

− Swap: No risk of principal loss or default
− Swap: Less risk of downgrade (If a bank is downgraded, it will
be thrown out of the LIBOR panel.)
− Swap: Majority of trades are collateralized, thus reducing
counterparty risk.
• Result: Swap rates trade richer than AA bank credits

5
What is a Swap?
Similar to a leveraged bond transaction
Swap Transaction Is Similar to a Bond Transaction
Combined with 3-Month Financing

Receive Fixed on a Swap

You

Pay LIBOR

UST Rate (buy bonds)

You

Pay Repo

6
What is a Swap?
Swap rate = average of expected LIBOR settings
Suppose You Pay Fixed on a 2-year Swap at a Rate of 4.42%

Floating Leg Fixed Leg

3M LIBOR = 3.65% (Quarterly, Actual/360

3M LIBOR in 3 months 4.42% (Semi, 30/360)

3M LIBOR in 6 months

3M LIBOR in 9 months 4.42% (Semi, 30/360)

3M LIBOR in 1 year

3M LIBOR in 1YR 3M 4.42% (Semi, 30/360)

3M LIBOR in 1YR 6M

3M LIBOR in 1YR 9M 4.42% (Semi, 30/360)

7
What is a Swap?

• How Do We Determine Expectations of Future 3M LIBOR

Settings?
• Out to 5 years, we use Eurodollar contracts:
− Forward contracts on 3M LIBOR
− Liquidity exists out to 5 years
− Convexity issue

• Beyond 5 years, expected 3M LIBOR settings are implied

from the swap rates.

8
U.S. Interest Rate Swap Curve
From the Eurodollar Futures and Market Traded Swap Rates, a Swap Curve
is Generated
6.5

6.1

5.7

5.3

4.9

4.5

4.1

3.7
01Y 07Y 12Y 18Y 24Y 30Y

Swap Curve Treasury Curve

Note: The swap curve is smooth and continuous, with a rate existing at each point.

9
Spreadlock Transaction
• Forward contract on a specific swap spread
• “Long” a spreadlock: Investor makes money if swap spread at expiry is higher
than strike
• Suppose you are long a spreadlock at 85 bps on the 10-year swap spread for
expiry 11/8/01
• Suppose on 11/8/01, the 10-year swap spread is at 100 bps

(100-85) x DVO1 of
10-Year Swap x Notional
Investor Dealer

• Spreadlock is cash settled based upon mid-market spread at expiry

• Spreadlocks are usually quoted relative to spot spreads (as a pickup or drop)
• Spreadlocks enable an investor to take a “cleaner” swap spread view
− No accrued interest concerns
− No exposure to initial LIBOR setting
− No roll down effects on curve

10
Other Types of Swaps

• Basis Swaps Enable Investors to Swap a Floating Rate

Index Versus LIBOR:
− Commercial paper,
− Fed Funds,
− T-Bills,
− Prime.

• Basis Swaps Also Exist that Enable Investors to Take

Forward Views on CMT/CMS Rates Versus LIBOR:
− Example: Pay 10-year CMS versus receive LIBOR
• Cross Currency Swaps
− Combining the USD swap market with the swap market in
another currency

11
Volatility Products

• Investors Can Purchase or Sell the Right to Pay or Receive

on a Swap:
− Payor swaption: the right to pay on a swap
− Receiver swaption: the right to receive on a swap

• Investors Can Purchase or Sell Interest Rate Protection on

3M LIBOR and CMS/CMT Rates:
− Cap: Protection against rate increases
− Floor: Protection against rate decreases

• Investors Can Purchase the Right to Buy or Sell Treasuries:

− Put: the right to sell Treasuries
− Call: the right to buy Treasuries

12
Example of a Payor Swaption

• Suppose you want to make money if 5-year rates rise, but

you want limited downside. Therefore, you purchase the
following the following payor swaption:
− You purchase the right to enter the following swap in 3 months
(on 11/8/01):
• Start date: 11/10/01
• End date: 11/10/06
• Investor pays 5.56% versus receiving 3M LIBOR

• This trade is comparable to buying a 3M put on the current

5-year note. In both cases, you make money if rates rise
beyond the strike levels at expiry.

13
Example of a Payor Swaption

• Suppose it is now 11/8/01, and the 5-year swap rate is 5.70%.

You are in-the-money by 14 basis points.

Current Market Exercise the Payor Swaption

Receive 5.7% for 5 Years Pay 5.56% for 5 Years

You

Pay LIBOR Receive LIBOR

• Net gain on the option settlement: 14 bps per annum for 5 years

14
 Users of Interest
Rate Derivatives

15
Major Players in the Swap Market
Web of Interdependence
New Issue Asset/Liability Loan Originations Asset Swaps
Asset Swaps
Hedging Management Hedging (Prepays)

Eurodollar Exchange
OAS
Corporates ABS/CMBS

Volatility

Global
Rate/FX/Credit Mortgages Asset
Arbitrage Swap Market (Residential) Swaps

Convexity
Hedging

Discount
Repo Treasuries Agencies Notes

Specials Mortgage
On-the-Run Off-the-Run Bullets Callables
GC Market

16
Corporate Hedging
Rate Lock New Issuance Asset/Liability Management Swap

UST + Swap Spread UST + Swap Spread

Swap Swap
Corporate Corporate
Dealer Dealer
LIBOR + X LIBOR + X

UST +
Credit Spread
Investor

Swap Spreads Widen Swap Spreads Tighten

• Corporates pay fixed to hedge • Corporates receive fixed to achieve

future debt issuance floating rate exposure

17
Investor Asset Swap

UST + Swap Spread

Investor Swap Dealer
LIBOR + X

Fixed-Rate Asset

Issuer Swap Spreads Widen

• Active users: Hedge funds, pension funds, banks, and insurance

companies
• Asset swap strategy: Valuing fixed rate assets relative to
LIBOR curve

18
Dealer Inventory Hedging

UST + Swap Spread

Bond Trading Desk/
Swap Trading Desk
Syndicate Desk
LIBOR + X

UST + Credit Spread

Corporate Bond Swap Spreads Widen

19
Mortgage Convexity Hedging
Duration Profile Interest Rate Scenario

New
Swap
Mortgage
Mortgage Swap Portfolio Swap
Portfolio Hedge Hedge

– OR –

Unwind
Mortgage Swap Swap
Portfolio Hedge Mortgage Swap
Portfolio Hedge

• Because of prepayment characteristics, a pool of mortgages has negative convexity

• Interest rate swaps are actively used to dynamically manage the convexity exposure as
interest rates change

20
Mortgage Convexity Hedging

Market Sells Off Market Rallies

UST + Swap Spread UST + Swap Spread

Mortgage Swap Mortgage Swap
Holder Dealer Holder LIBOR + X
Dealer
LIBOR + X

Swap Spreads Widen Swap Spreads Tighten

21
Money Mangers Managing Portfolio Exposure

Treasury Bonds

Agency Bonds
Money Manager Swap Market
Mortgages
Pay or receive fixed in the swap market
Corporate Bonds

• Money Manager Transacts with the Swap Market to:

− Increase and reduce spread exposure
− Lengthen or shorten duration

22
Investors Taking Long/Short Market Positions
Short the Market Long the Market

UST + Swap Spread UST + Swap Spread

Swap Swap
Investor Investor
Dealer Dealer
LIBOR + X LIBOR + X

Investor

Swap Spreads Widen Swap Spreads Tighten

• Investors pay fixed in expectation of • Investors receive fixed in expectation

higher rates of lower rates.

23
 An Overview of
Recent Market
Activity

24
Three Wake Up Calls...

• Three wake up calls of the past three years:

• Russia/Hedge fund crisis of 1998,

• Y2K fears, and

• Reduction of Treasury supply.

25
The Market Effects...
Primary effects on the swap and Treasury markets:

• Wider swap spreads,

• Technically driven Treasury curve,
• Increase in swap spread (credit spread) volatility,
• New users in the swap market,
• Increasing interest to use alternative products (swaps, Agencies)
as a method of hedging and valuation,
• Increasing correlation between swap spreads and credit spreads,
and
• The increasing development of the U.S. swap market trading on
an outright rate basis rather than as a spread to Treasuries.

26
Budget Surplus and Treasury Supply
• The recent emergence of a budget surplus has led to a sharp drop in Treasury
supply in the U.S.
Budget Surplus/Deficit (-) Supply of Outstanding Treasuries1
$ Billions % of GDP

250 45
40
150
35
50 30
25
-50
20
-150 15
10
-250
5
-350 0
1981 1985 1989 1993 1997 2001E 1981 1985 1989 1993 1997 2001E

1
Excludes Federal Reserve holdings

27
Change in the Treasury Supply
Relationship Between Swap Spreads and Change in Treasury Borrowing
$ Billions bps
200 187 120
169 158 113.1
150
100 100
50 21 83.7 86.4
80
0
-50 63.4
60
-100
-109 -100 -113
-150 40.7 40
-200 36.8 38.4 36.0
-250 -213 20
1994 1995 1996 1997 1998 1999 2000 2001

Change in Treasury Borrowing Average 10-Year Swap Spread

Notes: Change in Treasury borrowing is for the fiscal year (ended September). Change in borrowing includes change in total
public marketable debt outstanding.
Swap spread calculation is the unweighted average of daily swap spread closes on each business day of the calendar.
Source: MSDW, Bloomberg, U.S. Treasury

28
Fed is Preparing to Adapt

• Decline in Treasury debt presents a challenge to

implementation of monetary policy
• Fed will need acceptable substitutes if Treasury supply
continues to decline
• Results of recent study:
− Will expand collateral accepted on repo trades
− Will be buying GNMAs for open market operations in the near
future
− Consider changing the Federal Reserve Act to expand further
in the future

29
Corporate Supply Increasing
$ Billions bps
600 120
511 524
498
500 113.1 457 100
400 366 83.7 86.4
80
293
300 253
224 63.4
60
200
40.7 40
100
36.8 38.4 36.0
0 20
1994 1995 1996 1997 1998 1999 2000 2001

Corporate Issuance 10-Year Swap Spread

Notes: Corporate debt includes all investment grade public & 144A debt (excludes private placement, convertible, ABS, MBS,
high yield, municipals, CDs, and MTNs under $50mm.
Swap spread calculation is the unweighted average of daily swap spread closes on each business day of the calendar.
Source: MSDW, Bloomberg, U.S. Treasury

30
Increase in Credit Spread Volatility
10 Year Swap Spreads
(bp)
Volatility: 2.21 bps/day
140

120

100
Volatility: 0.85 bps/day
80

60

40

20
May-94 Feb-96 Nov-97 Aug-99 May-01

Source: MSDW, Bloomberg

31
Swap Spreads: A Benchmark for Credit Spreads
Swap spreads serve as an indicator of the general level of credit spreads
Historical 10-Year Spread Data
(1/2/98 to 5/10/01)
230

180

130

80

30
Jan-98 Nov-98 Sep-99 Jul-00 May-01

10-Yr Swap Spread 10-Yr AA2 Credit Spread

10-Yr A2 Credit Spread 10-Yr BBB1 Credit Spread

Source: MS, Bloomberg

32
New Swap Market Participants
We have observed increasing interest in the swap market by:

• Internal credit trading desks, and

• The account base, including
− Money managers,
− Insurance companies and banks,
− Corporations, and
− Hedge funds.

• As a result of the increased interest in the swap market by

typical participants in the credit markets (as these
participants search for an alternative method of hedging,
valuation, and speculation), correlations between swap
spreads and credit spreads are increasing.

33
Dramatic Growth in Derivatives Usage
OTC Derivative Contracts
• Since the first wake-up call of 1998, the use of interest rate derivatives has increased
dramatically
Outstanding at Fiscal Year End – Notional Amounts
$ Trillion
80.0

62.4

52.3 9.4
8.0 2.4
2.3
29.0
25.5
4.7 4.9 50.6
17.7 1.8 42.0
1.6
3.7
1.2 19.2 22.3
12.8

1995 1996 1997 1998 1999 2000E

Interest Rate Swaps Cross Currency Swaps Interest Rate Options
Note: 2000 total value is an estimate of MS Swap’s trading desk
Source: ISDA, BIS, Morgan Stanley

34
OAS Mortgage Spreads1 vs. 5-Yr Swap Spreads
Strong correlation with other markets
bp
Correlation = 90%
120

100

80

60

40

20
Jan-97 Feb-98 Mar-99 Apr-00 May-01

Treas OAS Mortgage Spread 5-Year Swap Spread

Note: (1) OAS Mortgage Spreads = A representative basket of Government/Agency Mortgages that are individually option
adjusted and weighted by their total outstanding amounts
Source: Morgan Stanley

35
Swap Spreads Versus FHLMC Credit Spreads

bp
Correlation = 99%
140

120

100

80

60

40

20
May-98 Feb-99 Nov-99 Aug-00 May-01

10-Year Swap Spread 10-Year Agency Credit Spreads

Source: Morgan Stanley

36
MSDW Industrial1 Spreads and Swap Spreads

bp
Correlation = 88%
140 230

120 200

100 170

80 140

60 110

40 80
May-98 Feb-99 Nov-99 Aug-00 May-01

10-Year Swap Spread MSDW Industrial

Note: MSDW Industrials - A representative basket of investment grade bullets marked by our trading desk with an average
duration of 10 years.
Source: Morgan Stanley

37
 The Benchmark
Issue

38
Treasury Market

• Advantages:
− Historical benchmark
− Large, liquid, transparent market
− Availability of research and analysis
− Comfort level

• Disadvantages:
− Technicals / Fundamental analysis put in question
− Scarcity premium
− On-the-run vs. off-the-run
− Repo discrepancies

39
Swap Market

• Advantages:
− Can value almost any security
− Smooth, continuous curve
− Common hedging tool by the street
− Large, liquid market

• Disadvantages:
− Transparency
− Lack of market information and research
− Systems requirements
− Credit / Documentation

40
Agency Market

• Advantages:
− Effort by Agencies to become the benchmark
− Liquid, transparent market
− Accepted globally
− Existence of repo and futures market

• Disadvantages:
− Dependent upon ability to grow
− On-the-run vs. off-the-run
− Repo discrepancies

41
Greenspan’s Comments
Monetary Policy Report to Congress (February 13, 2001)

• “In the corporate bond market, yield spreads on high-yield and

lower rated investment-grade bonds, measured relative to the ten-
year swap rate, began rising sharply in September and by year-
end were at levels well above those seen in the fall of 1998.”

• “Given the possibility that liquidity could deteriorate further as the

Treasury continues to pay down its debt, market participants
reportedly increased their reliance on alternative investments -
including interest rate swaps and debt securities issued by
government-sponsored housing agencies and other corporations -
for some of the hedging and pricing functions historically provided
by Treasury securities.”

42
 How to Execute and
Unwind a Swap

43
Long 10-Year Swap Spread Trade
Suppose you go long 10-year swap spreads at 80 bps

• Steps:
− 1. Buy 10-year notes
− 2. Pay fixed on a 10-year swap
− 3. Duration weight the notionals
− 4. Set initial LIBOR
− 5. Handle the repo

44
Unwind 10-Year Swap

• 3 Components of an Unwind Value:

− 1. Gain/loss on the fixed leg of the swap
− 2. Accrued interest
− 3. Gain/loss on the LIBOR setting

45
 Example Trades

46
Forward Curve View
As of August 2, 2001 Years Forward

Swap Tenor Spot 0.5 1 2 3 4 5 7 10 15 20

2y 4.415 4.922 5.433 6.093 6.369 6.460 6.589 6.610 6.854 6.831 6.610
5y 5.426 5.712 5.979 6.342 6.489 6.563 6.682 6.733 6.928 6.846 6.538
10y 5.936 6.113 6.282 6.506 6.621 6.693 6.755 6.815 6.894 6.717 6.486
30y 6.296 6.391 6.480 6.591 6.639 6.657 6.665 6.657 6.621 6.419 6.182
Spreads (bps)
2-5 101.1 79.0 54.5 24.9 12.0 10.4 4.3 12.2 7.5 1.5 -7.2
2-10 152.1 119.1 84.9 41.3 25.2 23.3 16.6 20.5 4.0 -11.4 -12.4
2-30 188.1 146.9 104.7 49.9 26.9 19.7 7.6 4.7 -23.3 -41.2 -42.8
5-10 51.0 40.1 30.3 16.4 13.2 12.9 124 8.2 -3.4 -12.9 -5.2
5-30 87 67.9 50.2 24.9 14.9 9.4 3.4 -7.5 -30.7 -42.7 -35.6
10-30 36.1 27.8 19.8 8.5 1.8 -3.6 -9.0 -15.8 -27.3 -29.8 -30.4

%
7.0
6.5
6.0
5.5
5.0
4.5
4.0
3.5
1y 2y 3y 4y 5y 7y 10y 15y 30y

Spot Curve 1-Year Forward Curve

47
Forward Curve View
As of close 2/1/00
Swap Curve
Spot 1 Year Forward
2yr Rate 4.415% 5.433%
10yr Rate 5.936% 6.282%
Differential 152.1 bps 84.9 bps

• Suppose you believe the 2s-10s swap curve will not flatten as much as implied by forward
swap curve
• You can enter into a 2s-10s steepener 1 year forward at flat (notionals are DV01 weighted)
• In 1-Year:
6.282% (10-Years)

LIBOR
Investor Dealer
5.433% (2-Years)

LIBOR

48
Hedging a Bond with Swaps
Suppose you buy $100mm FHLMC 7.0% 3/15/10 and we want to hedge this
position with swaps:

• Hedge: Pay fixed on a swap to 3/15/10

• DV01 of FHLMC 3/10: 7.04
• DV01 of swap: 6.80
• Hedge ratio: $103.5mm swaps

49
Hedging a Bond with Swaps

Pay Fixed: 5.836%

(Semiannual, 30/360)
Investor Swap Dealer
3M LIBOR
(Quarterly, Actual/360)

Yield: 5.783%

FHLMC 3/10

• Yield/yield swap spread: -5.3 bps (5.783% - 5.836%)

50
Hedging the Optionality in a Callable Bond

• Suppose you are long $100mm of FHLMC 7.625% 9/9/09

callable in 9/9/02 and you want to hedge out the optionality.

• You have sold the right to buy the bonds, so you need to
buy the right to be long the market. This requires buying an
American receiver swaption.

• In essence, you are buying the call back embedded in the

bond through the swaption market. The effectiveness of the
trade is dependent upon the correlation between swap rates
and the yield on the bond as well as the correlation between
swap vol and vol on the bond.

51
Accessing the Credit Markets in Other Countries

• Suppose a corporation based in the USD needs 10-year

dollar funding.

• However, US investors are full on the name and are not

eager to further invest in this corporation. The corporation
locates an opportunity in Japan, as Japanese investors are
very keen to buy this corporation’s paper.

• Solution: Corporation can issue in JPY and swap the

issuance back to USD through the use of a cross-currency
swap.

52
 Following the
Market

53
Sources of Information

• Derivatives Strategy and Marketing Online

• Telerate: 19901
• Reuters: ICAP1
• Bloomberg:
− Current levels and historical data
• $$SWAP10 Index <GO>
• USSWAP5 Index <GO>
• IRSB <GO>
− Pricing:
• BCSW <GO>
• SWPL <GO>

• LIBOR Settings: Telerate 3750

54
Sources of Information
• Interest Rate Strategy Online
− Trade ideas / Market commentary
− Real time swap rates and swap spreads
− Historical data
• Telerate: 19901 and 19902
• Reuters: ICAP1
• Bloomberg:
− Current levels and historical data
• $$SWAP10 Index <GO>
• USSWAP5 Index <GO>
• IRSB <GO>
− Pricing:
• BCSW <GO>
• SWPL <GO>

• LIBOR Settings: Telerate 3750

55
Interest Rate Derivative Products Online

56
Interest Rate Derivative Products Online

Click

57
Telerate 19901

58
Bloomberg Historical Data
Swap Rate

59
Bloomberg Historical Data
Swap Spread

60
Bloomberg Swap Model

61
Disclaimer

This memorandum is based on information generally available to the public from sources believed to be reliable. No
Representation is made that it is accurate or complete. Certain assumptions may have been made in this analysis which have
resulted in any returns detailed herein. No representation is made that any returns indicated will be achieved. Changes to the
assumptions may have a material impact on any returns detailed. Past performance is not necessarily indicative of future returns.
Price and availability are subject to change without notice. The forgoing has been prepared solely for informational purposes and
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NOT FOR DISTRIBUTION TO PRIVATE CUSTOMERS AS DEFINED BY THE U.K. SECURITIES AND FUTURES
AUTHORITY.

62