Copyright 2012 Wintrust Financial Corporation. All Rights Reserved. 2012 WINDY CITY SUMMIT INTEREST RATE SWAPS PRESENTATION

Copyright 2012 Wintrust Financial Corporation. All Rights Reserved.

2 0 1 2 W I N D Y C I T Y S U M M I T

I N T E R E S T R A T E S W A P SP R E S E N T A T I O N

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Table of Contents• Derivatives Overview

– Derivatives and Interest Rate Risk

• The Interest Rate Swap– What is it?– Purpose and Functionality

• Swaps and Me…– Why should today’s borrower consider it?

• Other Types of Protection– Caps and Collars

• Where’s the Crystal Ball?– Historical and expected rates

• Q & A

INTEREST RATE SWAPS

DERIVAT IVES OVERV IEW

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Derivatives—What are They?– Derivatives are financial instruments whose value is derived from another

"underlying" financial security. – An interest rate derivative gains or loses value based on the movements of a

specific interest rate index (U.S. Dollar Prime, LIBOR, Fed Funds, Treasury yields, etc.).

• There are two broad categories of derivative products:

– Exchange-traded products– Often used by traders & speculators (and dealers looking to balance their books)– Standardized contract sizes & terms– Not typically used for customized hedging solutions

– Over-the-counter (OTC) products– Developed to meet hedging demand by companies & investors– Customized contracts between 2 counterparties

INTEREST RATE SWAPS

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INTEREST RATE SWAPS

Derivatives—Growth in the OTC Market

Source: BIS

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INTEREST RATE SWAPS

Derivatives—Why? One word—RISK!

Source: Chatham Financial

10 YEAR UST June 1995 - Current

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

Decrease of $12.1mm in interest cost in four months (148bps * $82k)

Increase of $10.4mm in interest cost in six weeks (127bps * $82k)

10-Year UST

• Example of interest rate exposure on a $100 million, 10-year financing. The present value of every basis point change in interest rates prior to locking the rate is worth about $82,000!

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Term Structure of Interest Rates:

• When you hear “interest rates moved lower today” – which rates are being discussed??

– Short-term deposit rates?– Intermediate maturity rates?– Long-term mortgage rates?

• Interest rates differ across the maturity spectrum due to:– Liquidity– Market expectations

• Concept known as the “Yield Curve”

INTEREST RATE SWAPS

Interest Rate Markets

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INTEREST RATE SWAPS

Source: Wintrust Financial

THE INTERESTRATE SWAP

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What is an OTC Interest Rate Swap?• An agreement between two parties in which one party agrees

to pay a fixed rate of interest and the other agrees to pay a floating rate of interest on an agreed upon notional amount

– No principal changes hands, simply an exchange (“swap”) of interest payments for a set period of time

– Swap rate is derived from market expectations– The FIXED rate is the Present Value of Expected Future FLOATING

rates– LIBOR is the foundation of the swap market

INTEREST RATE SWAPS

Party A Party BLIBOR

Fixed Rate

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How Does an Interest Rate Swap Work?• Overview: Interest rate swaps allow borrowers to effectively

lock-in an interest rate on an existing or future variable rate financing

• Method: Separate contract from the loan that effectively fixes the rate by creating a stream of cash flows that perfectly offsets any rise in rates

• Cost: There are no incremental fees associated with the interest rate swap

INTEREST RATE SWAPS

BorrowerBorrower BankBank

Loan

Floating Rate

Floating Rate

Fixed Rate

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• How does the market demand what the proper fixed rate is for an interest rate swap?

• A swap is simply an exchange of cash flows: therefore, the party paying a fixed rate should demand a rate that is, on a present value basis, the average of the market’s expected floating rate settings over the term of a particular swap contract.

• One mechanism for predicting the future path of rates is by observing the interest rate futures market.

– In general, 3-month LIBOR serves as a baseline rate for calculating an interest rate swap’s fixed rate.

INTEREST RATE SWAPS

How are Swap Rates Determined?

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London Inter-Bank Offered Rate:– Rate at which banks lend to one another for various terms– Resets each day at 11:00 a.m. (London time) based on average of

16 contributor banks– 3-Month LIBOR = Fed Funds + 0.25%* (historical avg.)– Prime = 3-Month LIBOR + 2.75%* (historical avg.)– Any variations in OTC structures (1-month LIBOR, Prime, etc.) are

taken into account by calculating a specific spread, or “basis”, to the 3-month LIBOR futures market

INTEREST RATE SWAPS

LIBOR is the Foundation of the Swap Market

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INTEREST RATE SWAPS

• Fixed rates are derived from the present value average of the market’s expectation of future floating

rates over a given term

• If the market’s prediction of rates is CORRECT, there is no difference between paying fixed or

paying floating on the same notional

• If the market’s prediction of rates is NOT CORRECT, the swap will gain or lose value

How is the Fixed Swap Rate Determined?

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• Valuation of an Interest Rate Swap• At inception, the swap has no value because the swap rate

represents the average of what the market believes variable rates will be over the life of the swap

• As rates change, the swap will begin to take on or lose value • If the swap holder needs to break the contract before maturity,

it may be subject to breakage provisions:– Rates Rise: Replacement Swap Rate > Actual Swap Rate, swap is

an asset to the swap holder. The swap holder will receive payment from the Counterparty for the value of the swap.

– Rates Fall: Replacement Swap Rate < Actual Swap Rate, swap is a liability to swap holder. The swap holder will make a payment to the Counterparty for the value of the swap.

INTEREST RATE SWAPS

SWAPS AND ME…

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• What are the Benefits of an Interest Rate Swap?– Flexibility:

• All or a portion of the term• All or a portion of the notional

– Duration:• Longer term financing available

– Certainty:• Known debt service costs

– Bi-lateral Prepayment:• Retain benefit if rates rise• Prepayment often less than traditional yield maintenance if rates fall

– Core-Competency:• Swaps allow borrowers to focus on their “line of business” and not fluctuations in the

interest rate markets

– Current Rate Environment:• Swaps allow borrowers to take advantage of below-market rates when compared to

traditional fixed loan rates

INTEREST RATE SWAPS

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• What Types of Debt can be Hedged?• Over-the-counter Interest Rate hedging products are

customized contracts– Provide great flexibility to borrower– Loan amortization characteristics can be matched in a derivative

hedge contract: • Construction loans• Forward Starting• Irregular/ uncertain draw schedule• Permanent financing• Monthly, quarterly, or semi-annual payments• Mortgage, Hybrid, Straight-line, I/O, Custom amortization

INTEREST RATE SWAPS

OTHER TYPES OF PROTECT ION

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• Other Types of Hedging Products• An interest rate CAP will:

– Guarantee the borrower a maximum fixed rate, yet allow the borrower to retain the properties of a floating rate loan under a specific strike rate

– Cost the borrower a premium to purchase, paid upfront– Be most cost-effective for terms under 5 years and/or when providing

“worst case” disaster protection at a high cap strike rate

• An interest rate COLLAR will:– Guarantee the borrower a maximum fixed rate, yet also require the

borrower to pay a certain minimum rate (even if market rates fall below this pre-determined floor strike rate)

– Help or fully offset the cost of a cap by borrower selling a floor to Bank

INTEREST RATE SWAPS

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• What is an Interest Rate Cap?• Example of a $5MM Cap struck at 1.25%

INTEREST RATE SWAPS

WHERE’S THE CRYSTAL BALL?

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INTEREST RATE SWAPS

Source: WSJ Historical Average (since 1989) = 3.9219%

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INTEREST RATE SWAPS

Source: Wintrust Financial

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INTEREST RATE SWAPS

Source: FRB Historical Average (since 2000) = 3.8737%

QUEST IONS?

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Copyright 2012 Wintrust Financial Corporation. All Rights Reserved. 2012 WINDY CITY SUMMIT INTEREST RATE SWAPS PRESENTATION