The Floating Rate Euronote

During the late 1960s, commercial banks in the United States adopted a system of adjusting their prime rate weekly to reflect more closely the increases in their cost of funds. Banks charged a spread above the prime rate, which reflected the creditworthiness of the borrower. Such automatic or floating rate pricing of bank credit shifted the responsibility for increases in lending rates to the monetary authorities. It also shifted the interest rate risk from the bank to the borrower.

Floating rate pricing spread very rapidly to other banking sectors in the early 1970s. Floating rate pricing was adopted in the Eurobond market; the first Eurodollar floating rate note issue occurred in 1970 when the Italian State borrower Ente Nazionale per l’Energia Electtrica (ENEL) issued $150 million Eurodollar floating rate notes. Until the early 1980s, however, the floating rate note was largely dominated by its banking counterpart, the floating rate syndicated loan.

The securitization of international finance, which began in the early 1980s, meant that borrowers shifted to the floating rate note market from the syndicated loan market. In 1983, syndicated loans totaled $67 billion, while only $20 billion of floating rate Euronotes were issued. By 1986, however, floating rate note issues had reached $50 billion, while the volume of international syndicated loan credits had receded to $58 billion. This development was due in large part to the lower borrowing costs in the floating rate note market. New issues of floating rate notes also gained in comparison with fixed rate bonds, and floating rate notes accounted for 38 percent of total volume of fixed rate bonds and floating rate notes in 1985. The floating rate note was permitted for the first time in several non-dollar markets in 1985. Refinancing of high coupon bonds lowered the percentage of floating rate bonds in total fixed and floating rate issues to 25 percent in 1986.

The issuer cost of floating rate notes relative to LIBOR has decreased substantially, especially during 1985–86. Prime sovereign borrowers have been able to undertake large issues at below LIBOR. Second-tier sovereign borrowers and U.S. thrifts and regional banks also have received fine terms. Since 1985, the floating rate note market has introduced a number of innovative coupon reset mechanisms. About 80 percent of floating rate notes guarantee a minimum rate of interest, termed a “floor,” if the index drops below a certain level. Similarly, a significant number of floating rate notes have been issued with an upper limit on the coupon, a “cap.” A mismatched floating rate note has multiple data for selecting interest rates within a single interest payment period; that is, interest payments may be made semiannually, while the interest rate is reset at shorter intervals, for example, monthly. About 20 percent of all floating rate notes were mismatched during 1985.

The most significant innovation in the floating rate note market has been the recent large-scale issue of perpetual floating rate notes by commercial banks, particularly U.K. banks. Through 1986, there had been about 60 issues totaling $20 billion. The incentives for the issue of some types of perpetual floating rate notes were provided by several countries, including the United Kingdom, the United States, Canada, Australia, and France, which regarded such instruments as primary capital, if coupons may not be paid when a dividend payment has been cancelled.

The perpetual floating rate note sector of the Euromarket experienced a major liquidity crisis in December 1986, which marked the end of any expansion in this market in the foreseeable future, and which also affected the dated floating rate note adversely, as discussed in the text.

Currency and Interest Rate Swaps

The basic swap is an exchange of streams of payments over time between two parties. An interest rate swap is an exchange of interest cash flows in the same currency with the principal amounts remaining with the original parties. In currency swaps, the counterparties exchange the interest payments in one currency for interest payments in another currency and the parties also exchange the principal amounts at a negotiated exchange rate. There are three main types of interest rate swaps: coupon swaps (fixed rate against floating rate), basis swaps (e.g., LIBOR against certificates of deposit), and cross-exchange interest rate swaps (swaps of fixed rate flows in one currency to floating rate flows in another). It is estimated that U.S. banks participated as counterparties in $367 billion of interest rate swaps (notional principal) in 1986, compared with $186 billion at the end of 1985. The basic fixed/floating rate swaps make up the great bulk of total swap volume. Financial liberalization and removal of rigid issue calendars in several national markets has presented new opportunities for swap transactions.

The main motivation of the end-users in interest rate swaps is to exploit their comparative advantages and their relative scarcity in the two market segments. Typically, a highly regarded borrower will raise fixed rate funds and swap for floating rate funds raised by a less well-regarded borrower. Frequently, there are other types of swap opportunities. For example, relative risk-premiums for two borrowers may differ in two different markets, creating an arbitrage possibility.

Swaps are also used to transform exposure on the asset side. An institutional investor holding high-grade fixed rate assets can enter the swap market as a fixed rate payer, instead of selling a fixed rate asset and buying a floating rate asset.

U.S. money center banks and U.K. investment and merchant banks, as well as Japanese securities houses, are the main intermediaries in the swap market. For those institutions, swaps have developed into an important source of off-balance sheet earnings and an important vehicle to generate underwriting businesses. With the growth in volume of swap transactions, an active market between swap dealers has developed. Such dealers, frequently banks, enter swaps with counterparties for which they have arranged a bond issue and then enter into an offsetting swap with a second dealer, who in turn enters into another offsetting swap with another dealer, who offsets his swap with an end-user. It is estimated that the interdealer share of the swap market exceeds 50 percent. A secondary market for swaps has benefited from increased standardization of swap contracts under the auspices of the International Swap Dealers Association (ISDA).

There are three types of secondary market transactions: swap sales or assignments to a new counterparty, swap terminations, and reverse swaps. Swap sales and swap terminations extinguish the seller’s obligations, while reverse swaps are written to offset the effects of an existing swap.

Counterparties in swap transactions assume credit risk arising from the possibility that the counterparty does not perform under the swap contract and exposes the other counterparty to unexpected mismatch and losses if interest or currency rates have moved adversely. The swap technique has been one of the most successful of the recent financial innovations; 40 percent of all new international bond issues now involve a swap of one form or another.

A recent development in swap markets has been the growth of asset swaps; that is, the use of an interest or currency swap to transform an asset rather than a liability. The transactions mostly have involved the transformation of fixed rate assets into floating rate assets, through the creation of “synthetic floaters.” The asset holder, who receives a fixed rate coupon from his asset, agrees to a fixed rate payment on a fixed/floating interest rate swap in return for a floating rate payment. The swap counterparty thus receives fixed payments and pays floating without necessarily possessing floating rate assets; hence the term “synthetic floats.”

Exchange-Traded Financial Futures and Options Contracts

A futures contract is a standardized forward contract that is traded on an exchange. Financial futures markets date to the mid-1970s when the Chicago Board of Trade (CBOT) began trading in a futures contract based on Government National Mortgage Association (GNMA) instruments. This was followed with futures contracts for 90-day U.S. Treasury bills and a treasury bond contract. The trading volume in these futures contracts grew quickly, and by 1979 the daily volume of futures trading in the treasury bill market had exceeded the volume of trading in the underlying securities.

An important reason for the ready acceptance and continued popularity of the markets for interest rate futures has been the establishment of exchange clearinghouses that become the counterparty in every transaction. Thus, it is the soundness of the exchange, rather than the creditworthiness of the original issuer, that is of concern to the holder of the contract. Without the clearinghouse, the market would become much less liquid as the product would lose its homogeneity and trading volume would be smaller.

The second major advance in futures markets was the introduction of cash settlement rather than settlement in kind. Cash settlement allows the writer of a contract to use market prices at the closing of the contract to determine the gain or loss on the contract and settle in cash rather than deliver the physical commodity. This development has made it possible to write futures contracts on such synthetic securities as ocean freight, consumer price index, and others.

The development of futures markets paralleled the development of options contracts. In a futures contract, the holder has the right and the obligation to buy and sell the underlying security at a specified price during a specified period; in an option contract, the holder of the option has the right but not the obligation to buy (call option) or sell (put option) the security at the agreed price. Thus the risk of options contracts is asymmetrically distributed: the holder only risks losing the price (premium) paid for the options contracts, while the writer is liable for the full price movement in an adverse direction. The most successful options contracts have been those on foreign exchange.

In addition to the explicitly traded options contract, there has been a significant expansion in the use of options and forward contracts that are embedded in bonds. In this case, the bond’s principal at redemption has been linked to an index or price of another instrument or currency, or the yield movements have been restricted through caps or collars. Finally, the maturity of bonds has been subject to call and put provisions. The use of equity warrants has been particularly successful in the light of rising stock indices.

Financial futures and options can be regarded, together with interest rate and currency swaps, as the most successful of the recent financial innovations. The growth in the diversity of contracts traded, in the volume of some of the major contracts, and in the number of exchanges, has been rapid in recent years (Table 47). The trading volume of currency options doubled to 6 million contracts (with an average contract rise of $100,000) from 1985 to 1986; the total financial futures trading volume of all U.S. exchanges grew by 22 percent in 1986 to 120 million contracts (with an average contract size of $1 million), and the trading volume of financial options of all U.S. futures exchanges grew by 64 percent in 1986 to 27 million contracts (with an average contract size of $1 million).