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
Notional

Swap Dealer

Notionals

Counterparty B
Notionals

Periodic Usage or Purchase Payments (Required)

.

Fixed Price

Counterparty A
Floating Price

Swap Dealer

Fixed Price

Counterparty B
Floating Price

Re-exchange of Notionals
(Optional)
.

Notionals

Counterparty A
Notionals

Swap Dealer

Notionals

Counterparty B
Notionals

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)

Principal

Counterparty A

Swap Dealer

Counterparty B

SWAP

Interest Rate Swap

.

CASH MARKET TRANSACTIONS

Debt market (Floating Rate) 6-M LIBOR +50bps Debt Market (Fixed Rate)
10.25% (sa)

10.50% (sa)

Counterparty A
6-M LIBOR

Swap Dealer

10.40% (sa)

Counterparty B
6-M LIBOR

SWAP

Interest Rate Swap

.

CASH MARKET TRANSACTIONS Principal

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

Principal

Counterparty A

Swap Dealer

Counterparty B

SWAP

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

9%

Debt market (Euro) Debt Market ($)

LIBOR

9.45%

Counterparty A
LIBOR

Swap Dealer

9.55%

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

Spot Oil Market
Spot Price

Actuals
Spot Price

Actuals

$68.20/barrel

Counterparty A
Oil Producer
Spot Price (average)

Swap Dealer

$68.40/barrel

Counterparty B
Spot Price (average)

SWAP

Refiner

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%(10.7%)

11%

B.F. Goodrich
LIBOR-x

Morgan Bank

11%

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)