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ECN4141 Financial Economics

SWAP AGREEMENT
Swap agreement between two parties, called counterparties, to exchange a stream of cash flows over a fixed time frame in the future. Highly customized private contract Little government regulation Plain vanilla swap basic interest rate or currency swap Interest rate swap (IRS) Plain vanilla IRS - one party agrees to pay a sequence of fixed-rate interest payment and receive a sequence of floating rate interest payment Pay fixed payment swap buyer Pay floating rate payment swap seller Tenor - time period over which the periodic interest payment will be made Notional principal amount used as a basis for computation of net payment to be made by counterparties The floating rate interest payments are determined in advance and paid in arrears
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ECN4141 Financial Economics

Example: Party A has agreed to pay 8.75% of 1 million (the notional principal) or $87,500 each year to party B. Party B will make payment to party A based on the LIBOR. Year LIBOR B pays A A pays B Difference 0 8.5 1 7.5 85,000 87,500 -2,500 2 9.0 75,000 87,500 -12,000 3 7.0 90,000 87,500 +2,500 Remarks A to B A to B B to A

Converting a Floating Rate Obligation to a Fixed Rate Obligation Consider a Financial Institution (FI) that accepts deposits and lends those funds out in the form of long-term loan. Deposits are floating-rate liabilities and loans are fixed-rate assets. The FI can be left at risk should rates on deposit increases. To avoid this risk, FI can enters into swap agreement with Party B on the pay-fixed side. FI pays a fixed rate of 8% (equivalent to rate on loan) to party B and in exchange receives payment based on LIBOR.

The following diagram shows that the FI pays out LIBOR+1% on its deposit. This has eliminated interest rate
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ECN4141 Financial Economics

exposure and locked in a positive cash flow of 100 basis point

FI
Fixed:8%

Fixed:8% LIBOR +2%

Party B

Borrower
LIBOR +1%

Depositor

Swap may be arranged through intermediaries such as swap dealer or swap broker. They not only perform the function of a broker, but also becomes a party to the transaction.

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ECN4141 Financial Economics

The following diagram show the transaction involving broker

FI

Fixed:8%

Broker

Fixed:8%

Party B

LIBOR+2%. Fixed:8%

LIBOR+2.1%.

Borrower
LIBOR +1%

Depositor

Cash Flows based on $1 million notional principal: Year 1 2 3 From FI $80,000 $80,000 $80,000 To FI
LIBOR+2% LIBOR+2% LIBOR+2%

From B
LIBOR+2.1%. LIBOR+2.1%. LIBOR+2.1%.

To B $80,000 $80,000 $80,000

Brokers Cash Flows = (LIBOR+2.1% - LIBOR+2%) x 1 million Year 1 2 3 Net Cash Flows $1,000 $1,000 $1,000

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ECN4141 Financial Economics

Currency Swap (CS) A party holds one currency, but want to hold a different currency Parties exchange equivalent amount denominated in different currencies Interest payment (fixed or floating) are made by each party on the currency it receives Three-step process: 1. Exchange equal initial principal amount of two different currencies at the spot exchange rate at the start of the agreement 2. Pay fixed or floating rate payments over the term of the swap 3. Upon maturity, reswap the principal amount at the predetermined exchange rate Example: The following table shows the comparative advantages in borrowing rates enjoyed by party A and B. Party A B US Dollar Rate 9% 8% UK Pound Rate 6% 7%

Party A has an advantage over Party B in the UK market but wants to hold US dollar
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ECN4141 Financial Economics

Party B has an advantage over Party A in the US market but wants to hold UK pound Party A borrows 10 million and Party B borrows $15 million At the current spot rate of $1.50=1, the amounts are swapped.

The following diagram shows the exchange of notional principal at the inception of swap agreement

Party A

10 m $15 m

Party B

10 m

$15 m

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ECN4141 Financial Economics

UK Bank

US Bank

The following diagram illustrates annual interest payments based on the rate agreed by both parties 8.5% US interest rate and 6.5% UK rate. $1.275 m @8.5% 650,000 @6.5% 600,000 $1.2 m

Party A

Party B

UK Bank

US Bank