Presentation on

Swaps

By

Dr B Brahmaiah
 Swaps
A contract between two parties to exchange two
streams of payments for an agreed period of time.
The interest payments are calculated based on the
underlying notionals using applicable rates.
Swaps are arranged in many different currencies
and different periods of time.
US$ swaps are most common followed by
Japanese yen, sterling and
 Swaps
The swaps market has had an exceptional growth
since its inception in 1979.

The swaps volume exceeds $10 trillion today.

Swaps not only often replace other derivative

instruments such as futures and forwards, but also
complement those products.
 Why did swaps emerge?
In the late 1970’s, the first currency swap was
engineered to circumvent the currency control
imposed in the UK.
back-to-back loans were used to exchange debts
in different currencies.
A British company wanting to raise capital in
France with a French company which was in a
reciprocal position.
Back-to-back loans required drafting multiple loan
agreements to state respective loan obligations
with clarity.
 Facilitators
The swaps dealer earns the difference
between the amount received from a
party and the amount paid to the other
party.

The dealer would offset his risks by

matching one swap with another to
streamline his payments.
 Swaps Market Participants

1. Banks
2. Multinational Companies
3. Sovereign and public sector institutions
4. Money Managers
 Interest Rate Swaps
With its absolute advantage in the capital markets,
Deutsche mark was able to receive floating rate
below the London Interbank Offer Rate, (LIBOR.)
Coupon swaps are basically swaps contracts dealing
with an exchange o a fixed rate payment stream for a
floating rate one.

The counterparty who pays the fixed rate is referred to

as the payer or buyer and the counterparty who pays
the floating rate is called the receiver or the seller.
Since the notional principal is an identical amount in the
same currency, the actual principal is not exchanged.
If the payment schedules are identical, only the
difference between the two payments is delivered.
 Currency Swaps
Currency swaps are also used to lower the risk of
currency exposure or to change returns on
investment into another, more favourable currency.
Currency swaps are used to exchange assets or
capital in one currency for another for the purpose
of financial management.
A currency swap transaction involves an exchange
of a major currency against the U.S. dollar.
In order to swap two other non-U.S currencies, a
dealer may need to arrange two separate swaps.
currency swaps involve the exchange of
two or more types of currencies.

The actual excahange of principals

takes place at the commencement and
the termination of the swaps.

Principals and interest payments are

exchanged based on the spot rate
agreed at the inception of the swaps.
The uses of currency swaps are:
1.Lowering funding cost
2.Entering restricted capital markets
3.Reducing currency risk
4.Supply-demand imbalances in the markets

Many variants of the plain vanilla currency

swaps were created to meet some of the
common financial management needs.
 Different kinds of Swaps

1. Amortizing and Accreting Swaps

The notional principals of an amortizing
swap decrease one or more times during
the tenor of the swap.
Accreting swaps are swaps with
increasing notional principals.
2. Forward Swaps
Coupons are set on the transaction date.
However the swap does not start until the given date.

The interest accrual commences on the given date based

on interest rates set on the transaction date.

3. Reversible Swaps
Counterparties of reversible swaps change their roles
one or more times during the duration of the swap.

The payer becomes the receiver and the receiver

becomes the payer
4. Basis Swaps
Basis swaps are swaps on which both
counterparties pay floating rate.

Each counterparty’s interest payments are

tied to different floating rate indices.

Some of the indices are 3 months, 6 months

LIBOR, T-bill rate, and the US commercial
paper rate.
 Non-par swaps : The market value of the
swap at initiation is not zero, and therefore
one party pays the other at the beginning of
the contract.
 Forward or deferred swaps : The exchange
of net interest payments does not begin until
some point in the future.
 Arrears-reset swaps : The floating rate is
set and paid at the end of the period.
5. Amortizing currency swaps
The notional principals of these swaps
are scheduled to decrease over the life
of the swaps.

6. Accreting currency swaps

The notional principals of these swaps
increase periodically. Principals are
exchanged as scheduled.
7. Floating-for-floating rate currency swaps
This swap involves the exchange of a a
floating interest rate payment schedule in
one currency against another floating
interest rate payment schedule in another
currency.
 Example
Consider Company A and Company B who
have entered into a $100-million interest rate
swap in which A commits to pay a fixed rate
and B commits to pay a floating rate for the
next three years (called the “maturity” or
“tenor” of the swap.

Assume that A’s fixed rate is 5% and B’s

floating rate (called the “reference rate”) is the
6-month London Interbank Offered Rate (6-
month LIBOR).
 Every six months, A pays B the fixed 5% rate
(adjusted for semiannual payments) on $100
million (the notional amount), or $2.5 million.
At the same time, B pays to A the then-prevailing
6-month LIBOR rate on $100 million. The two
opposing payments under the swap are netted
so that only the difference between them is
paid semiannually.
In a standard “par swap”, the market value of the
swap at the time of inception is zero, so no cash
is exchanged when the swap is first arranged.
 No principal would be exchanged between
the counterparties either at the initiation or at
the maturity of the swap.
The semiannual cash flows of the above swap
can be represented.
 Swap Cash Flow

1/2 x 5% x $100 mm = $2.5 million

Company A Company B
1/2 x 6 month LIBOR x $100 mm
 Asset Swaps
Assets swaps are used to change the
characteristics of an asset.

Asset swaps are not only used by investors to

change the characteristics of their investments, but
also by banks to create synthetic investment
packages for their clients.

A bank purchases a bond which can be converted

into a more desirable asset. Then the bank
arranges a currency swap with the purchased
bond and puts together an investment package.
 6M US$ LIBOR
Investor Dealer
FF 6.50%

FF 6.45%

FF 7.00%
6M US$ LIBOR

Potential
Bond
Counterparty
 Commodity Swaps
A corn producer wanting to receive fixed unit
price payments for a given amount of corn
produced may enter into a swap to receive
payments from a counterparty who wants to
pay a fixed unit price for a given amount of
corn bought.
Dealers involve multiple counterparties to
complete their books as well as use futures to
hedge their open position.

Swaps are arranged with swaps dealers to

arrive at a desired outcome, but the
transactions of the actual goods are
performed in the cash markets.
 Equity Swaps
Equity swaps are used to hedge the downside risk
of the market.
Equity swaps involve a counterparty exchanging
scheduled payments based on the total return,
including the capital appreciation and dividend, of a
market index for fixed rate payments.
The notional principal, tenor and payment schedule
are specified.
For instance a NIFTY Index correlated portfolio
holder can make periodical payments based on the
NIFTY Index return to receive fixed rate payments.
 Swap Documentation
Swaps agreements are usually initiated over the phone.
The phone agreement is confirmed, usually within 24
hrs., by a telex, fax or letter.

The agreement is not final until proper documentation

covering all the relative issues are exchanged and
signed by counterparties.
The documentation of swaps was standardized by new
York based International Swap and Derivatives
Association (ISDA), British Bankers’ Association (BBA)
and Australian Bankers’ Association (ABA) code 1987,
standard forms of agreements.
 The documentation covers the following issues.
1. Payments : Payment terms specifies payment
dates, currency, interest rates, and the amount of
notional principals.
2. Representations: Each party provides
representations to each other by validating that
they have the authority to enter into the swap
agreement and that they are free of certain events
such as being in default or in a litigation suit.
3. Agreements : This section is supplemental to
the master agreement and provides for the
furnishing of financial statements.
 Risks Associated With Swaps

1. Interest rate risk

2. Exchange rate risk
3. Default risk
4. Sovereign risk
5. Mismatch risk
6. Basis risk
7. Capital requirement
Under the Basle Accord, dealers of swaps and
other off-balance sheet instruments are imposed
risk-adjusted capital requirements.

Capital requirements for swaps are ascertained

according to the following steps.

The add-on-amount is calculated by multiplying

the notional amount by the add-on-factor.
 Sassy 6M US$ LIBOR
Dealer
Threads
Fixed Rate 7.0%

Fixed Fixed
Rate 7.0% Rate 7.3%
Sassy
1Y US$ Dealer 6M US$ Counterparty
Threads
LIBOR LIBOR

1Y US$
LIBOR 6M US$
LIBOR

Treasury
 Fixed Fixed
Japanese Yen Yen
Dealer Counterparty A
Co. Fixed 6M US$
DM LIBOR

Fixed
DM
6M US$
LIBOR

Counterparty B
1. Interest Payment Flow

Fixed EUP 6.35%

Kithirst Fesserus
6M US$ LIBOR Bank

2. Principal exchange at the maturity date

EUP 12,000,000 Fesserus

Kithirst Bank
US$ 18,000,000
Investor LIBOR+20% 7.07% s.a. Eurobond

LIBOR
6.50% s.a.

Potential
Counterparty
 LIBOR
Investor Bank
Fixed 6.5% s.a

LIBOR

6.45% s.a
7.07% s.a.

Potential
Eurobond Counterparty
Typical Uses of an
Interest Rate Swap
 Converting a liability from
– fixed rate to floating rate
– floating rate to fixed rate

 Converting an investment from

– fixed rate to floating rate
– floating rate to fixed rate
The Comparative Advantage
Argument (Table 7.4, page 157)

 AAACorp wants to borrow floating

 BBBCorp wants to borrow fixed

Fixed Floating

AAACorp 4.0% 6-month LIBOR + 0.30%

BBBCorp 5.20% 6-month LIBOR + 1.00%
The Nature of Swap Rates
 Six-month LIBOR is a short-term AA
borrowing rate
 The 5-year swap rate has a risk
corresponding to the situation where 10 six-
month loans are made to AA borrowers at
LIBOR
 This is because the lender can enter into a
swap where income from the LIBOR loans is
exchanged for the 5-year swap rate
Using Swap Rates to Bootstrap
the LIBOR/Swap Zero Curve
 Consider a new swap where the fixed rate is
the swap rate
 When principals are added to both sides on the
final payment date the swap is the exchange of
a fixed rate bond for a floating rate bond
 The floating-rate rate bond is worth par. The
swap is worth zero. The fixed-rate bond must
therefore also be worth par
 This shows that swap rates define par yield
bonds that can be used to bootstrap the LIBOR
(or LIBOR/swap) zero curve
Valuation of an Interest Rate
Swap that is not New
 Interest rate swaps can be valued
as the difference between the value
of a fixed-rate bond and the value of
a floating-rate bond
 Alternatively, they can be valued as
a portfolio of forward rate
agreements (FRAs)
Valuation in Terms of Bonds
 The fixed rate bond is valued in the
usual way
 The floating rate bond is valued by
noting that it is worth par immediately
after the next payment date
Valuation in Terms of FRAs

 Each exchange of payments in an

interest rate swap is an FRA
 The FRAs can be valued on the
assumption that today’s forward rates
are realized
An Example of a Currency Swap

An agreement to pay 11% on a

sterling principal of £10,000,000 &
receive 8% on a US$ principal of
$15,000,000 every year for 5 years
 Exchange of Principal

 In an interest rate swap the

principal is not exchanged
 In a currency swap the principal is
usually exchanged at the
beginning and the end of the
swap’s life
The Cash Flows (Table 7.7, page 166)
Dollars Pounds
$ £
Year ------millions------
2004 –15.00 +10.00
2005 +0.60 –0.70
2006 +0.60 –0.70
2007 +0.60 –0.70
2008 +0.60 –0.70
2009 +15.60 −10.70
Typical Uses of a
Currency Swap

 Conversion from a liability in one currency to a

liability in another currency

 Conversion from an investment in one

currency to an investment in another currency
Comparative Advantage Arguments
for Currency Swaps (Table 7.8, page 167)
General Motors wants to borrow AUD
Qantas wants to borrow USD

USD AUD
General Motors 5.0% 12.6%
Qantas 7.0% 13.0%
Valuation of Currency Swaps

Like interest rate swaps, currency

swaps can be valued either as the
difference between 2 bonds or as a
portfolio of forward contracts
Swaps & Forwards
 A swap can be regarded as a convenient
way of packaging forward contracts
 The “plain vanilla” interest rate swap in our
example (slide 7.4) consisted of 6 FRAs
 The “fixed for fixed” currency swap in our
example (slide 7.22) consisted of a cash
transaction & 5 forward contracts
Swaps & Forwards
(continued)

 The value of the swap is the sum of the

values of the forward contracts underlying
the swap
 Swaps are normally “at the money” initially
– This means that it costs nothing to
enter into a swap
– It does not mean that each forward
contract underlying a swap is “at the
money” initially
Credit Risk

 A swap is worth zero to a company

initially
 At a future time its value is liable to be
either positive or negative
 The company has credit risk exposure
only when its value is positive
Other Types of Swaps

Floating-for-floating interest rate swaps,

amortizing swaps, step up swaps,
forward swaps, constant maturity
swaps, compounding swaps, LIBOR-in-
arrears swaps, accrual swaps, diff
swaps, cross currency interest rate
swaps, equity swaps, extendable
swaps, puttable swaps, swaptions,
commodity swaps, volatility swaps……..
Valuation of Swaps
 The standard approach is to assume
that forward rates will be realized
 This works for plain vanilla interest rate
and plain vanilla currency swaps, but
does not necessarily work for non-
standard swaps
Variations on Vanilla Interest
Rate Swaps
 Principal different on two sides
 Payment frequency different on two sides
 Can be floating-for-floating instead of floating-
for-fixed
 It is still correct to assume that forward rates
are realized
 How should a swap exchanging the 3-month
LIBOR for 3-month CP rate be valued?
Compounding Swaps (Business
Snapshot 30.2, page 699)

 Interest is compounded instead of being paid

 Example: the fixed side is 6% compounded
forward at 6.3% while the floating side is LIBOR
plus 20 bps compounded forward at LIBOR plus
10 bps.
 This type of compounding swap can be valued
using the “assume forward rates are realized”
rule. This is because we can enter into a series
of forward contracts that have the effect of
exchanging cash flows for their values when
forward rates are realized.
Currency Swaps
 Standard currency swaps can be valued
using the “assume forward LIBOR rate
are realized” rule.
 Sometimes banks make a small
adjustment because LIBOR in currency
A is exchanged for LIBOR plus a spread
in currency B
More Complex Swaps
– LIBOR-in-arrears swaps
– CMS and CMT swaps
– Differential swaps
These cannot be accurately valued by
assuming that forward rates will be
realized
LIBOR-in Arrears Swap (Equation
30.1, page 701)

 Rate is observed at time ti and paid at time ti rather than

time ti+1
 It is necessary to make a convexity adjustment to each
forward rate underlying the swap
 Suppose that Fi is the forward rate between time ti and
ti+1 and i is its volatility
We should increase Fi by i i (ti 1  ti )ti
2 2
 F
1  Fi i

when valuing a LIBOR-in-arrears swap

CMS swaps
 Swap rate observed at time ti is paid at
time ti+1
 We must
– make a convexity adjustment because
payments are swap rates (= yield on a par
yield bond)
– Make a timing adjustment because
payments are made at time ti+1 not ti
 See equation 30.2 on page 702