Risk Latte - LIBOR in Arrears Swap – Again?

LIBOR in Arrears Swap – Again?

Team Latte
Mar 17, 2005

We recently came across a structure offered by a mid-sized European bank to some corporate clients in the emerging markets in Asia. This is the LIBOR in Arrears (LIA) swap that was on sale – or offer – a little more than a year ago. Interestingly, and apparently, a few banks were offering this very same structure to a different set of clients in Asia.

Anyway, here is what the structure more or less looks like:

8 year Callable Cumulative Reverse Floater Swap In-Arrears

Notional Amount: US$50 million

Client pays to the Bank: 6 month USD LIBOR

Client receives from the Bank:

Year 1: 9%
Year 2: Max {(Previous Coupon + 1%) – 6 month LIA, 0}
Year 3: Max {(Previous Coupon + 2%) – 6 month LIA, 0}
Year 4: Max {(Previous Coupon + 3%) – 6 month LIA, 0}
Year 5: Max {(Previous Coupon + 4%) – 6 month LIA, 0}
Year 6: Max {(Previous Coupon + 5%) – 6 month LIA, 0}
Year 7: Max {(Previous Coupon + 6%) – 6 month LIA, 0}
Year 8: Max {(Previous Coupon + 7%) – 6 month LIA, 0}


The bank can cancel the swap anytime after the expiry of six months
from the date of initiation after paying accrued interest to the client.

History & Motivation for the Structure:

LIBOR in Arrears (LIA) notes are generally purchased – as can be intuitively inferred from such a structure – by investors who are directional on the rates. Normally, if the investor, or the corporate borrower in the above case, believes that the rates – USD LIBOR – are not going to rise in future or at least not rise to the levels implied by the forward curve then they have an incentive in buying LIA notes or entering into LIA swaps.

LIBOR in Arrears structures first appeared in the mid 1980s as a simple structure which allowed borrowers to take advantage of expectations of falling interest rates. In an LIA the rate for calculation purposes is always the rate at the end of the interest period and the borrower pays at the end of each interest period; the interest amount which is calculated by reference to the LIBOR rate at the end of the period and not at the beginning of the original interest period – as in a normal LIBOR swap. This is the reason why an investor or a borrower has to be directional on the rates and benefits only if the rates actually fall.

Pricing & Risk Analysis:

One of the biggest attractions in the structure is the carry. A year back, sometimes January 2004, when we first saw this structure in Asia the 10 year swap rate was 4.60% and the 6 month Dollar LIBOR was around 1.22%. Though the structure of the swap was a bit different then the carry was very good and there was good enough motivation and perhaps (misplaced) enthusiasm on part of the borrowers to enter into such a deal.

Given today's 10 year swap rate of 4.926% and the 6 month Dollar LIBOR at 3.30% the carry is still very good. But we believe the risks have increased substantially given the rising interest rate scenario. That is why we are a bit surprised this would be offered now to borrowers and we will be more surprised if the borrowers bite.

All said and done the swap is a reverse floater with an embedded floor and the biggest risk is that if the LIBOR rises significantly then the carry will diminish significantly and the borrower may even experience negative carry. Over and above that it is a cancelable swap and if the bank cancels the swap after six months then the advantage of the carry trade is gone.

Further, this is a cancelable swap and the bank has the right to cancel on a number of different payment dates (six monthly period). This means there is a Bermudan style option embedded in the swap.

In the above structure the client is long a regular LIA swap plus short a swaption (on an offsetting swap). The swaption embedded in the swap - which can cause termination or entering into an offsetting swap - can be valued separately and valuing Bermudan swaptions can be done easily using Hull's method. The above structure can be priced and valued easily using a Monte Carlo simulation approach.

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