Floating-rate cash flows

Naturally, this presupposes the reference rate used for the floating-rate cash flows is EURIBOR. Furthermore, part of swap spread is attributable simply to the fact that EURIBOR for a given maturity is higher than the rate on a comparable maturity benchmark government. 

Investors can also use interest rate swaps for a similar purpose. These contracts exchange fixed-rate cash flows for floating-rate cash flows based on LIBOR/EURIBOR. Investors on the paying (fixed) leg of the swap reduce the duration of their portfolio, while those on the receiving (fixed) leg increase the duration of the portfolio. Since interest rate swaps are extremely liquid contracts, they are an efficient way of expressing a short-term view on interest rates. 

The asset swap is an agreement that allows investors to exchange or swap future cash flows generated by an asset, usually fixed rates to floating rates. It is essentially a combination of a fixed coupon bond and an IRS. We define it thus ... 

We illustrate with an example. Consider a floating-floating cross-currency swap between EUR and GBP. The latter currency has higher forward rates. If the discount rate falls in both currencies, the EUR leg value will decrease by more than the GBP side. This is because a higher value of the EUR cash flows than the GBP cash flows is paid at maturity on the reexchange of principal. 

In contrast to a conpon rate that remains unchanged for the bond s entire life, a floating-rate security or floater is a debt instrument whose coupon rate is reset at designated dates based on the value of some reference rate. Thus, the coupon rate will vary over the instrument s life. The coupon rate is almost always determined by a coupon formula. For example, a floater issued by Aareal Bank AG in Denmark (due in May 2007) has a coupon formula equal to three month EURIBOR plus 20 basis points and delivers cash flows quarterly. 

An index-linked bond has its coupon or maturity value or sometimes both linked to a specific index. When governments issue index-linked bonds, the cash flows are linked to a price index such as consumer or commodity prices. Corporations have also issued index-linked bonds that are connected to either an inflation index or a stock market index. For example, Kredit Fuer Wiederaufbau, a special purpose bank in Denmark, issued a floating-rate note in March 2003 whose coupon rate will be linked to the Eurozone CPI (excluding tobacco) beginning in September 2004. Inflation-indexed bonds are detailed in Chapter 8. 

Under the secured loan structure, the trustee might find it necessary under certain circumstances to enforce the fixed and floating charges. Such circumstances could include unremedied events of default under the issuer-borrower loan, or if third-party creditors were to attempt to put the company into administration. In this case, the trustee would seek to have an administrative receiver appointed on behalf of the secured creditors. However, the process could disrupt the receipt and payment of cash flows. The ratings of the notes are based on timely payment of interest (and sometimes principal) so the transaction will include some form of liquidity support, which is typically sized to enable the issuer to cover one year s debt service. 

The cash flows for this transaction are set forth in Exhibit 19.1. The second column of the exhibit shows the cash flows from purchasing the 5-year floating-rate bond. There is a 50 million cash outlay and then 10 cash inflows. The amount of the cash inflows is uncertain because they depend on future levels of 6-month EURIBOR. The next column shows the cash flows from borrowing 50 million on a fixed-rate basis. The last column shows the net cash flows from the entire transaction. As the last column indicates, there is no initial cash flow (no cash inflow or cash outlay). In all 10 6-month periods, the net position results in a cash... 

EXHBIT 19.1 Cash Flows for the Purchase of a 5-Year Floating-Rate Bond... 

It can be seen from the net cash flow in Exhibit 19.1 that a fixed-rate payer has a cash market position that is equivalent to a long position in a floating-rate bond and a short position in a fixed-rate bond— the short position being the equivalent of borrowing by issuing a fixed-rate bond. 

While our illustrations assume that the timing of the cash flows for both the fixed-rate payer and floating-rate payer will be the same, this is rarely the case in a swap. An agreement may call for the fixed-rate payer to make payments annually but the floating-rate payer to make payments more frequently (semi-annually or quarterly). Also, the way in which interest accrues on each leg of the transaction differs, because there are several day count conventions in the fixed-income markets as discussed in Chapter 3. 

The long end of the swap curve is derived directly from observable coupon swap rates. These are generic plain vanilla interest rate swaps with fixed rates exchanged for floating interest rates. The fixed swap rates are quoted as par rates and are usually compounded semiannually (see Exhibit 20.2). The bootstrap method is used to derive zero-coupon interest rates from the swap par rates. Starting from the first swap rate, given all the continuously compounded zero rates for the coupon cash flows prior to maturity, the continuously compounded zero rate for the term of the swap is bootstrapped as follows ... 

There is no net outflow or inflow at the start of these trades, because the 100 million spent on the purchase of the FRN is netted with the receipt of 100 million from the sale of the Treasury. The subsequent net cash flows over the three-year period are shown in the last column. As at the start of the trade, there is no cash inflow or outflow on maturity. The net position is exactly the same as that of a fixed-rate payer in an interest rate swap. For a floating-rate payer, the cash flow would mirror exactly that of a long position in a fixed-rate bond and a short position in an FRN. Therefore, the fixed-rate payer in a swap is said to be short in the bond market—that is, a borrower of funds—and the floating-rate payer is said to be long the bond market. 

Current pt. Current-pay bonds have been issued in Turkey. They are similar to interest-indexed bonds in that their redemption payments at maturity are not adjusted for inflation. They differ, however, in their term cash flows. Current-pay bonds pay an inflation-adjusted coupon plus an indexed amount that is related to the principal. In effect, they are inflation-indexed floating-rate notes. 

Notes issued in synthetic structures are organized by tranche. With the proceeds from the notes it issues to investors, the SPV purchases high-quality (AAA) liquid securities—for example, U.S. Treasuries, bank asset-backed paper such as credit card ABS, and German bonds, such as Pfandbriefe —to serve as collateral. This collateral will generate LIBOR-related interest and principal cash flows that the SPV passes on to the investors together with the swap premium, which creates an additional credit spread on the notes. The cash flows from the collateral may not match the payments due on the issued notes—for example, the bonds used as collateral may pay a flxed rate and the issued notes a floating one. To remedy this, the... 

It was suggested earlier that a swap be seen as a bundle of cash flows arising from the sale and purchase of two cash-market instruments a fixed-rate bond with a coupon equal to the swap rate and a floating-rate bond with the same maturity and paying the same rate as the floating leg of the swap. Considering a swap in this way, equation (7.23) can be rewritten as (7.24). 

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