Yields, Swaps,

& Corp Fin

Paul Laux

Teaching thoughts

Yields, Swaps, Yield curves

Swap pricing

& Corporate Finance Corporate finance

More teaching
Financing Tactics Teaching with Bloomberg thoughts

In this web version of the

Paul Laux slides, you can click on the
outline at the top right to
Exelon Center Finance Labs Conference navigate. You can zoom in
University of Delaware on any graphic to examine
it in more detail.

August 2013
Gratitude
Yields, Swaps,
& Corp Fin

Paul Laux

Teaching thoughts

Yield curves

Swap pricing

Thanks, Rich, for our Conference. Corporate finance

More teaching
thoughts

Thanks to all of you for the opportunity to

show you some of my teaching ideas.
Stage setting
Yields, Swaps,
& Corp Fin

Paul Laux

Teaching thoughts

Yield curves

The teaching application I have to share is from Swap pricing

Corporate finance
an undergraduate capstone course, “Advanced More teaching
thoughts
Corporate Finance.” As a capstone, the point
is to integrate the students’ prior learning and
send them on their way to apply it. Especially,
the course links financial markets to corporate
finance applications. This application
specifically links yields and interest rates to
swaps to corporate financing opportunities.
Outline
Yields, Swaps,
& Corp Fin

Paul Laux

Teaching thoughts
1 Teaching thoughts Yield curves

Swap pricing
2 Yield curves Corporate finance

More teaching
thoughts
3 Swap pricing
Swap Manager intro
The value of fair value
4 Corporate finance
Benchmarking borrowing costs
Application to fixed rate loans
5 More teaching thoughts
Thoughts on a teaching approach
Yields, Swaps,
& Corp Fin

Paul Laux

Never miss the chance to reinforce and Teaching thoughts

link the basics to practice; “Everything I Yield curves

needed to know I learned in...” Swap pricing

Corporate finance
Example:Yield curves poster—assigned as More teaching
pre-work, review in a prior class or podcast thoughts

Bloomberg analytics apps build finance

concepts into practical form, e.g., as in
Swap Manager for swap pricing
The details can be a bit intense, but also
open doors for extended study later
Markets solve problems...interest rate and
swap markets solve corporate finance
problems
Market information is of practical help even
for those who may never transact in the
specific market
The big picture of yield curves...
Yields, Swaps,
& Corp Fin

Paul Laux
... reinforcing and extending with little pictures: see paper poster
... can’t use swaps unless can use interest rate reasoning Teaching thoughts

Yield curves
The forward curve matrix: Type FWCM <Go>, and specify a
Understanding yield curves, with help from Bloomberg. From spot curves to implied forward rates of interest
curve family, like I23 US Treasury Actives, US Treasury coupon-paying
bonds.
Swap pricing

Bloomberg's
curve finder -- type
Corporate finance
CRVF <Go> -- provides
access to a long list of
yield curves. you can
search by keyword, or

More teaching
lookup by country.
Bloomberg refers to
the curves by ID
number. Prominent
curves are the I25 US
Treasury yield curve,
and the S23 US dollar
denominated swaps
curve (of which more
thoughts
elsewhere on this
page). When you know
the curve you want,
one way to get started
with it is to type GC
<Go>, for "Graph Note that the implied
curves." You can then forward curves are all
enter the ID number of
upward sloping. That
the curve that
interests you, and suggests that, at each
obtain a chart. The
The chart shows
date, the economy has
rest of this page is to expected interest rates for
several snapshots of
help you understand
some of the key yield
the "forward curve." In specific periods farther
order, from top to into the future to be
curves you will want to
bottom, they are from
use.
10 years ago (white), 5
higher than for periods
years ago (green), 1 closer to the present. Of
year ago (blue, barely course, the succession of
visible) and Mar 2013
curves (each one lower
(now or 'spot'--meaning
the spot time not spot than the previous one)
curve). Interest rates says it has not turned out
have been falling all that way. If the Fed
decade long!
controls rates with
monetary policy and QE,
this suggests their
actions have been
unanticipated. Or perhaps
market forces, which are
harder to anticipate, have
been more important.
Swap curves: Plain vanilla interest rate swaps promise the periodic payout (or receipt) of a floating rate cash flow (often at
a LIBOR rate) in return for the periodic receipt (or payout) of a fixed rate cash flow. The fixed interest rate used to compute the
The green lower fixed rate receipt is called the "swap rate." The swap rate is what market participants bargain about, as it sets the present
value of the swap. Eyes-wide-open bargaining will lead to a swap with zero NPV at the start. Later, as interest rates change,
curve is the I25
one party will tend to win or lose as the NPV rises or falls, and the swap becomes "off market" rate.
Treasury actives
coupon paying
curve. The blue The curves below are swap curves, showing swap rates for plain vanilla swaps of different tenors (or lengths of agreement). In
these swaps, the exchanges happen semi-annually. Two swap curves are shown--one relative to EUR LIBOR (with payments in
upper curve is
the I39 US Strips EUR), and one relative to USD LIBOR (with payments in USD). The Treasury curve is shown for comparison.
curve.
Swap curves depend on both spot and forward curves. They depend on spot curves because future cash flows must be
The green top discounted to determined their value---a job for which spot curve rates are well suited. They depend on forward curves
This GC graph curve is the S23 because the future payments on the floating leg depend on future interest rates---and forward curves give us a sense for
USD swap curve. expected future interest rates.
shows the I25
Treasury "actives" The red curve
yield curve, which has usually in the
coupon-paying T bond The bottom panel shows middle is the I25
YTMs. The chart also the spread between the Strips coupon Treasury
shows the yield curve curve and the Treasury actives curve. The blue
for Treasury Strips. A curve. The spread is always curve at the
Treasury Strip is a positive. This will always be bottom is the S45
pure-discount (zero- the case for an upsloped EUR swap curve.
coupon) bond version coupon curve. The reason is
of a TBond, with only that the coupon curve is really
one cash flow, at an average of the spot curve
elements for all dates up to the The bottom panel shows interest rate
maturity time. The
maturity, since the coupon differential between the various
Strips curve is one
bonds has cash flows at all curves. In this picture, the US swap
case of a spot curve.
those dates. The near-in dates curve is subtracted from each of the
One way to think
have spot curve yields that are other curves. S23 - I25 would be
about a coupon bond
lower than the ones that are called the "swap spread," so
is that it is really a
further out in maturity. Bloomberg's red curve (shown by
collection of strips or
default--I made no special choices
zeros, engineered to
on this GC screen) is the negative of
have just the right
the swap spread. (Also note that red
payouts at each time.
and blue have different meanings in
the top panel vs. the bottom.) Details of the recent
shape and changes in
The snapshots
Swaps are usually quoted for a AA the USD swap curve (at
on this page
credit situation. Thus it may seem left) and EUR swap
What are spot curves useful for? When you know the yield off the spot curve, you were taken in
natural that USD swap rates are curve (above). The long
know how to form the present value of a dollar received at that date. Just form the discount March 2013.
higher than Treasuries. But it needn't end of the USD swap
factor (i.e., (1+SpotYield)^-N). If the curve is for riskless bonds, the PV is for a risk free dollar. If be like that, as there are additional curve has been
the curve is for, e.g., AA bonds, then the PV is for a dollar with that riskiness. considerations. For example, at the steepening slightly
long end of the curve, the USD swap lately, suggesting that
What else are spot curves useful for? They are the observed rates from which forward rates of rate is lower (the swap spread is The EUR swap rate is generally lower than the USD swap long term fixed
interest can be calculated. Forward rates give insight into the future rates of interest that negative). Since the swap rate is paid rate, suggesting that payments at that fixed rate in EUR payments are being
market participants expect. See the next section for more on this (up and to the right). in return for a floating rate, that are regarded as quite desirable. One possible reason, just seen as somewhat less
suggests that market participants as an example, would be if the USD floating rate is valuable relative to
expect the floating rate to be quite expected to track higher more than the EUR floating rate, floating rate payment
low, or else that there is low liquidity making it more attractive (higher demand) to fix payments (i.e., so the market
Questions or comments? Paul Laux, on the fixed pay side of the market at in EUR terms. requires larger fixed
Department of Finance, laux@udel.edu the long end (allowing fixed rate payments to make a fair
payers to get a better deal). deal).
Next: Bloomberg Swap Manager
Yields, Swaps,
& Corp Fin

Paul Laux
Start with 5-year plain-vanilla interest rate swap.
Teaching thoughts
Type SWPM <Go> to enter Bloomberg's "Swap Manager" facility. Pricing rooted in present values of Yield curves
cash flows forecasted using OIS swap rates as the basis for discount rates and forecasting cash
flows based on cash/futures interest rates and yield curves. Three screen regions (red boxes) show Swap pricing
each counterparty (leg) details and market pricing. Swap Manager intro
The value of fair value

Corporate finance

More teaching
thoughts

Zero premium indicates

semiannual USD fixed coupon at
1.778% pa over 5 years is market-
value-equivalent to quarterly USD
LIBOR floating (recently at
0.263% pa)
Cross-currency basis swaps
Yields, Swaps,
& Corp Fin

Paul Laux
A basis for making cost of finance comparisons across currencies
Teaching thoughts
SWPM can also value cross-currency basis swaps (float-float swaps across Yield curves
two currencies). Use PRODUCTS pull-down menu to chose this swap.
Swap pricing
Quarterly- reset quarterly-pay 5-year x-crncy basis swap across Swap Manager intro
USD-EUR has zero premium for deal to receive USD LIBOR and The value of fair value
pay EUR LIBOR minus a 23 b spread. Market conditions are
Corporate finance
USD LIBOR at 26.310 bp and EUR LIBOR at 22.6bp pa.
More teaching
thoughts
This is useful info...and not only for
Yields, Swaps,
& Corp Fin

Paul Laux

swap counterparties Teaching thoughts

Yield curves

• Usefulness: If I’m a treasurer with a Swap pricing

Swap Manager intro
The value of fair value
borrowing need, this analysis tells me what Corporate finance

interest rate in someone else’s currency is a More teaching

thoughts
good deal in my currency
• Claim: Borrowing five years floating at
semiannual USD LIBOR is the same as cost of
financing as borrowing five years floating at
quarterly EUR LIBOR minus 23 bp
• Evidence for claim: One can be swapped into
the other, with zero premium paid/received...a
zero NPV trade
Swap manager is flexible...
Yields, Swaps,
& Corp Fin

Paul Laux
... to deal with various deals. Here is an annual pay swap.
Teaching thoughts
Use pull-downs to change reset and pay At annual reset and pay frequency, the -23 bp spread
freq to "Annual". results in an "off-market" premium swap, with a Yield curves
positive market value of 0.5955 bp, i.e. $5954 per $10
million of notional principal. Swap pricing
Swap Manager intro
The value of fair value

Corporate finance

More teaching
thoughts
The fair-value annual swap
Yields, Swaps,
& Corp Fin

Paul Laux

Ask SWPM to calculate EUR LIBOR spread for zero premium. The at-market swap has a spread
Teaching thoughts
of -21.81 bp pa. Comparing to the quarterly EUR LIBOR case, increasing the rate paid to the
EUR LIBOR leg a little reduces the PV of the deal to the USD LIBOR paying leg, so it is no Yield curves
longer positive.
Swap pricing
Swap Manager intro
The value of fair value

Corporate finance

More teaching
thoughts
Behind the scenes...
Yields, Swaps,
& Corp Fin

Paul Laux
Curves, cash flows, and valuation scenarios are on the SWPM tabs
Teaching thoughts

Yield curves

Swap pricing
Swap Manager intro
The value of fair value

Corporate finance

More teaching
thoughts
BB help docs provide pricing and
Yields, Swaps,
& Corp Fin

Paul Laux

key-punch details Teaching thoughts

... green help key explains a lot of the finance I am skipping over Yield curves

Swap pricing
Swap Manager intro
The value of fair value

Corporate finance

More teaching
thoughts
What’s it got to do with corp fin?
Yields, Swaps,
& Corp Fin

Paul Laux
If I’m a treasurer with a borrowing need, this analysis can tell us what
interest rate in someone else’s currency is a good deal in my currency. Teaching thoughts

Yield curves
hhType XCF, for pictorial cross-currency basis swap premium analysis. Choose single currency analysis
from Views pulldown, EUR (vs USD LIBOR) and 5 year term. Note results show spreads for a zero premium Swap pricing
at various dates (including Today). Note this is bid view, i.e., the leg receives USD LIBOR.
Corporate finance
Benchmarking
borrowing costs
Application to fixed
rate loans

More teaching
thoughts

Recall -23 bp is same

spread we say with
quarterly reset in earlier
detailed analysis---numbers
here are result of same
analysis.
USD vs EUR LIBOR floating rates
Yields, Swaps,
& Corp Fin

Paul Laux
A lower EUR rate is PV-equivalent to a higher USD rate. Di↵erential
level at 22-23 bp for maturities of 2+ years; was 45-ish bp last year. Teaching thoughts

Same analysis (XCF <Go>), but now choose more maturities and mid-point quotes. We are moving
Yield curves
toward a full comparison of financing opportunities in dollars and euros, from the point of view of
a US based treasurer. The x-crncy basis swap market tells us what spread (EUR LIBOR differential
Swap pricing
vs USD LIBOR) would make for an at-market swap today---thereby telling us what would be an at-
market deal comparison on floating rate loans.
Corporate finance
Benchmarking
borrowing costs
Application to fixed
rate loans

More teaching
thoughts

Today's market, for

various maturities

Today's market is the rightmost set of bars,

with history to the left.
Can view info in various formats...
Yields, Swaps,
& Corp Fin

Paul Laux
... to answer various questions; e.g., a yield curve view helps
treasurer evaluate floating rate loan comparisons of various terms Teaching thoughts

Yield curves

Swap pricing

Corporate finance
Benchmarking
borrowing costs
Application to fixed
rate loans

More teaching
thoughts
Analyze x-crncy fixed rates too
Yields, Swaps,
& Corp Fin

Paul Laux
... by snapping on same-currency fixed-for-floating swap to each leg
... remember, swap manager prices those too Teaching thoughts

Yield curves

Swap pricing

Corporate finance
Here is the USD side of the analysis. We have seen both these SWPM screens before. On left is a USD Benchmarking
fixed-for-floating swap. On right is a USD-EUR LIBOR floating-floating swap (cross-currency basis borrowing costs
swap).
Application to fixed
rate loans

More teaching
thoughts

1.78% fixed is PV-equivalent to

USD LIBOR floating (i.e., with And USD LIBOR floating is PV-equivalent to EUR LIBOR - 23
timing details as shown). bp. So if treasurer with a 1.77% fixed USD borrowing
opportunity can beat EUR LIBOR - 23 bp, it is a good deal (in
PV terms; appropriate-for-the-use is a different question). To
compare to a fixed rate EUR loan, snap a EUR fixed-for-floating
swap onto this analysis.
Not a fantasy
Yields, Swaps,
& Corp Fin

Paul Laux
... research has established that searching for good funding
opportunities this way is profitable for AA-rated credits Teaching thoughts

... Journal of Financial Economics 86 (2007), 145-177 Yield curves

Swap pricing

Corporate finance
Benchmarking
borrowing costs
Application to fixed
rate loans

More teaching
thoughts
Teaching tactics
Yields, Swaps,
& Corp Fin

Paul Laux

• This sort of thing works best hands-on—but Teaching thoughts

Yield curves
pound the points, as students will want to lose Swap pricing

the forest for the trees Corporate finance

• My favorite routine: See one, do one, teach More teaching

thoughts

one
• Force more than is comfortable: Detailed,
graphical briefing books; recordings; class lab
exercises
• Better for depth than breadth; takes a lot of
time
The end. Thank you for your time
Yields, Swaps,
& Corp Fin

Paul Laux

and e↵ort! Teaching thoughts

Yield curves

Swap pricing

Corporate finance

That’s all I know about Bloomberg and most More teaching

thoughts

of what I know about fixed income.

Questions?