Quick Study... A Gold Fixed/Floating Interest Rate Swap

A central bank may need to retain the liquidity of its gold; therefore, it places deposits for three or six months and often rolls forward with the same counterpart. An interest rate swap offers the opportunity for it to take advantage of positive yield curves and convert the short-term lending rates from one bullion bank into long-term rates through another, without having to transfer its gold reserves from that short-term investments.

Definition

An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another with different characteristics but in the same currency. Usually, the cash flows are linked to interest payments on a regular frequency, with her monthly, quarterly, semi-annually or annually and can be different on the pay and receive side.

One party pays a fixed interest rate at specified intervals over an agreed period and the other party pays a floating rate set for each of the periods, calculated on a notional principal amount.

Because the parties exchange only the interest payments without exchanging the underlying debt (asset), interest rate swaps do not appear on the balance sheets of the participants, although the cash flows from the swap transaction show up on the profit & loss accounts (income statements).

If' payment days coincide then only a net payment is made representing the difference between the fixed and floating rates.

Hypothesis

A central bank prefers to place gold on deposit in the market for a six -month period, rolling it forward for a further period at maturity. However, it holds the view that gold interest rates will fall. It enters into an interest rate swap with a bullion bank whereby it receives a fixed rate of interest on the notional principal value. They pay interest on the same notional principal, calculated on a floating reference rate derived from the mean London Inter-bank Forward Gold Lending rate (GOFO) and the London Inter-bank Offered Rate for dollars (LIBO R). The central bank thereby converts its floating rate lending into a fixed rate and thus minimises its exposure to falling short-term interest rates.

Terms

• Notional Principal per Calculation Period: 32,000 troy ounces (Total Notional Principal: 128,000 troy ounces)
• Effective Date: 2 March 1998
• Termination Date: 29 February 2000
• Period End Date: Semi-annually, commencing 28 August 1998 to, and including the Termination Date

Fixed Amount Details

• Fixed Rate Payer: The bullion bank
• Fixed Rate Payer Payment Dates: Two Business Days immediately following each Period End Date
• Fixed Rate: 2.05% p.a. paid semi-annually

Floating Amount Details

• Floating Rate Payer: The central bank
• Floating Rate Payer
• Payment Dates: Two Business Days immediately following each Period End Date
• Floating Reference Rate: Six months dollar LIBOR less six­ month GOFO mean (LIBOR - GOFO)
• Pricing Dates: Each London Business Day during the Calculation Period
• Documentation: The central bank 1992 ISDA Master Agreements

How is it priced?

A swap contract is nothing more than a strip of forwarding contracts. The market prices swap according to supply and demand; bullion banks raise or lower rates depending on whetl1er they wish to pay or receive fixed.

It is possible to simulate the pay-off profile by using a strip of gold interest rate forwards or futures. However, these must be priced to accommodate the costs of meeting margin calls as well as managing several deals and cash flows, instead of a single one as in the case of a swap.

There are also additional factors that must be taken into account when pricing or using commodity swaps. In the case of a gold fixed floating swap, the holders of the underlying asset derive value from having the gold available for use. This influences the pricing of the swap and can make it deviate from its simple theoretical value.

Why would a bullion bank benefit by arranging such a swap? It bridges a gap between two sets of customers: central banks with the short-term maturity preferences and gold producers which generally prefer to borrow longer term to match their maturity profile.