Swaps

Swaps involve exchange of one set

of financial obligations with another
e.g. fixed rate of interests with
floating rate of interest, one currency
obligation to another, a floating price
of a commodity to fixed price etc.

History of Swaps
First currency swap was engineered in
London in 1979, but the next deal structured by
Salomon Brothers in 1981 in London involving
organizations of the stature of World bank and
IBM, not only ended the 2-year obscurity but
also gave credibility to the instrument, so
necessary for its extremely fast growth.

History of Swaps
First Interest rate swap was engineered
in London in 1981and was introduced in
the US in 1982 by Student Loan
Marketing Association (Sallie Mae).
Commodity swaps were first engineered
in 1986 by Chase Manhattan Bank.

Purpose of a Swap
Reduce

cost of capital
Manage risk
Exploit economies of scale
Arbitrage across capital markets
Enter new markets
Create synthetic instruments

Basic Types of Swap

Interest

Rate Swaps
Currency Swaps
Commodity Swaps
Interest rate swaps and currency swaps
are together known as Rate Swaps.

Rate Conventions
Swaps are most often tied to LIBOR.
It is quoted actual over 360, as though the
year is of 360 days. This raises the effective
rate for a period and has compounding effect.
Bond equivalent yields are quoted on actual
over 365 days.
For comparison, adjustments can be made by
multiplication of a rate differential by 365/360
or by 360/365.

Cash Market Transactions

Swaps are used in conjunction with
following basic cash market transactions:
Obtain

actuals from cash market

Make/receive payments to/from cash
market
Supply actuals to cash market

Initial Exchange of Notionals

(Optional)
.

Notionals

Counterparty A
Notion
al

Notionals

Swap
Dealer

Counterparty B
Notionals

Periodic Usage or Purchase

Payments (Required)
.

Fixed Price

Fixed Price

Swap
Dealer

Counterparty A
Floatin
g Price

Counterparty B
Floatin
g
Price

Re-exchange of Notionals
.

(Optional)

Notionals

Notionals

Swap
Dealer

Counterparty A
Notional
s

Counterparty B
Notional
s

Interest Rate Swap

A, desirous of 10-yr fixed rate debt (available
at 11.25% sa) has access to cheap floating
rate financing (LIBOR + 50bp).
B, desirous of a 10-yr floating rate financing
(available at LIBOR) has access to cheaper
fixed rate financing (10.25% sa).
A dealer available can be a floating rate payer
or receiver at LIBOR and a fixed rate payer at
10.40% sa and receiver at 10.50% sa.

Interest Rate Swap

.

CASH MARKET TRANSACTIONS

Principal

Debt market
(Floating Rate)
Debt Market
(Fixed Rate)

Counterparty A

Swap
Dealer

SWAP

Principal

Counterparty B

Interest Rate Swap

.

CASH MARKET TRANSACTIONS

Debt market
(Floating Rate)
6-M LIBOR +50bps
Debt Market
(Fixed Rate)

10.50% (sa)

Counterparty A

10.25% (sa)

10.40% (sa)

Swap
Dealer

6-M LIBOR

Counterparty B
6-M LIBOR

SWAP

Interest Rate Swap

.

CASH MARKET TRANSACTIONS

Principal

Debt market
(Floating Rate)
Debt Market
(Fixed Rate)

Counterparty A

Swap
Dealer

SWAP

Principal

Counterparty B

Currency Swap
A, needing floating rate dollars, can borrow
euros at 9.0% fixed and dollars at 1-yr LIBOR
floating.
B, needing fixed rate euros, can borrow euros
at 10.1% fixed and dollars at 1-yr LIBOR
floating.
Swap dealer can pay 9.45% fixed on euros
against dollar LIBOR and dollar LIBOR against
9.55% fixed on euros.

Currency Swap
CASH MARKET TRANSACTIONS

Debt market
(Euro)

9%

Debt Market
($)

9.45%

Counterparty A
LIBOR

LIBOR

9.55%

Swap
Dealer

Counterparty B
LIBOR

SWAP

Commodity Swap
A crude oil producer wants to fix a price to be
received for 5 years on production of 8000
barrels p.m. He agrees to pay average of
preceding month price to swap dealer against a
receipt of $68.20/barrel.
An oil refiner wants to fix the price he pays for
oil for 5 years on his average need of 12000
barrels. He agrees to pay $68.40 against market
price of $69.50/barrel for an average price of
preceding month.

Commodity Swap
CASH MARKET TRANSACTIONS

Actuals
Spot Price

Spot
Oil
Market
Spot Price

$68.20/barrel

$68.40/barrel

Swap
Dealer

Counterparty A
Oil Producer

Actuals

Spot Price
(average)

Counterparty B
Spot Price
(average)

Refiner

SWAP

Why a Swap Dealer?

If A and B attempted a swap with each
other directly, it would have failed due
to different requirements. Swap dealer
can be a fixed-rate payer on 4000
barrels and till such time he can hedge
in futures.

Swaption
When a firm doesnt want a swap now
but can lock-in the terms of swap now
by buying an option on swap called
Swaption.

Case Study

B. F. Goodrich - Rabobank

Issues in the case

Why

was the need for swap felt?

How could the rate of borrowing be
reduced for Goodrich?
Describe the structure of the Swap
diagrammatically.
Comment on the role of financial
innovations with reference to the case.

Interest Rate Swap

.

CASH MARKET TRANSACTIONS

US Bond
(Floating Rate)
3-M LIBOR +50bps
Eurobond
(Fixed Rate)

11%

B.F. Goodrich
LIBOR-x

11%(10.7%)

11%

Morgan
Bank

Rabobank
LIBOR-x

SWAP

Calculations
Cost for B.F.Goodrich:
LIBOR + 50bp +11 LIBOR + x = 11.5 +x (i.e. 11.6 to 11.875) as
against 12 to 12.5% (a saving of 40 to 60 bps approx.)
Cost for Rabobank:
8.75 x as against 10.70%
Morgan Bank gets: one time fees ($125000 + annual fees)