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• A swap is an agreement between counter-parties to exchange cash flows at specified future times according to pre-specified conditions. • A swap is equivalent to a coupon-bearing asset plus a coupon-bearing liability. The coupons might be fixed or floating. • A swap is equivalent to a portfolio, or strip, of forward contracts--each with a different maturity date, and each with the same forward price.

**A “Plain Vanilla” Interest Rate Swap, I.
**

• Party B agrees to pay a fixed payment and receive a floating payment, from counter-party A. • Party B is the fixed rate payer-floating rate receiver (the “pay-fixed” party). • Party A is the fixed rate receiver-floating rate payer (the “receive-fixed” party). • Typically, there is no initial exchange of principal (i.e., no cash flow at the initiation of the swap).

based on 6-mo LIBOR. every six months. a payment on a notional principal of $100 million. II.A “Plain Vanilla” Interest Rate Swap.20%. company B receives from company A. • The next two slides illustrate the cash flows. . • Note that 6-month LIBOR at origination is R0 = 4. • Define NP as the notional principal. • Define R as the fixed rate. ~ • Define R as the variable (floating) rate. an agreement is struck wherein for the next 3 years. Company B makes a fixed payment on the same notional principal to company A. based on a rate of 5% per annum. • On 3/1/02.

the first floating cash flow. . based on the rate. R0.20%. is known: it is 4. The time t variable cash flow is typically based on the time t-1 floating interest rate. or #days/365. Thus. All subsequent floating cash flows are random variables as of time zero (but always known one period in advance).~ ~ ~ R 0 R1 R 2 R 3 0 Multiply each “R” by NP times #days between payments over 360 R R R R (or use a 365-day year) • • • • Each actual payment (“difference check”) equals the difference between the interest rates times NP times #days between payments over 360.

9% 4.0.25 +0. 2004 Mar. 1.5% 5.75 +2. 2003 Mar.1.55 +2.50 –2.20 +0.50 –2.50 –2. 2003 Sept.05 +0.50 –2.The Cash Flows to Company B ---------Millions of Dollars--------LIBOR FLOATING Date Mar.2% 4.45 –2.05 FIXED Net Cash Flow Cash Flow Cash Flow .1.80 +2.6% 5.50 –2.6% 4.30 +2.40 –0. 1.10 +2.1% 5.4% +2.1. 2002 Sept.1.30 . 2004 Sept.50 –0. 1. 2005 Rate 4. 2002 Mar.

20%. .000.000)(0.000.000. • Net Cash Flow: -$400.500.A Closer Look at the Cash Flows on September 1.042)(1/2) = +$2.100. • Fixed Payment: – Based on 5% rate.000. 2002: 4. 2002 • Floating Payment: – Based on the 6-month LIBOR rate that existed on March 1. – ($100. – ($100.05)(1/2) = -$2.000.000)(0.

40%.g. a dealer might quote 20 (bid) and 24 (asked).Quoting Plain Vanilla Swaps • Typically.64%. . the pay-fixed party will pay 5.” • If you buy LIBOR (pay-fixed). – Suppose the yield midpoint of the most recently issued 5-year T-note is 5. you pay a spread over the most recently issued Treasury with the same maturity as the swap (the asked swap spread). • Example: – For a 5-year swap. LIBOR. the floating index. is bought or sold “flat. and receive LIBOR. e. • If you receive fixed (sell LIBOR) then you receive the Treasury rate plus the bid swap spread. which is smaller than the asked swap spread. – Then.

– a floating rate to fixed rate. . • To convert an investment (asset) from: – a fixed rate to floating rate.Typical Uses of an Interest Rate Swap • To convert a liability from: – a fixed rate to floating rate. – a floating rate to fixed rate.

or 2-year Treasury rate and 10-year Treasury rate). varies according to some randomly changing interest rate index. LIBOR and the prime rate. . • Amortizing swap: varying NP according to a predetermined schedule. an initial payment will have to be negotiated.. • Forward swap: The first cash flow takes place in the “far” future. • Index amortizing swap: The NP. or term of the swap. “long” after the terms of the swap have been negotiated.Other Interest Rate Swap Structures • Off market swaps: The fixed rate may be away from the market. • Basis swap: The two interest rates both float (e.g.

: It is the interest rates that are fixed or floating. • N. the NP is exchanged at the swap’s initiation and termination dates. floating for fixed.B.Currency Swaps • There are four types of basic currency swaps: – – – – fixed for fixed. . fixed for floating. floating for floating. • Typically.

• To convert an investment (asset) in one currency to an investment in another currency.Typical Uses of a Currency Swap • To convert a liability in one currency into a liability in another currency. .

040. unlike in an interest rate swap. • Note that in currency swaps.An Example of a Fixed for Fixed Currency Swap • An agreement to pay 1% on a Japanese Yen principal of ¥1. .000 every year for 3 years. • In a currency swap.000.000.000 and receive 5% on a US dollar principal of $10. the direction of the cash flows at time zero is the opposite of the direction of the subsequent cash flows in the swap (see the next slide). the principal is exchanged at the beginning and at the end of the swap.

000.000 .000 ¥10.000 Party B ¥1.000.000 Party B At maturity: Party A $10.000.040.Cash Flows in a Fixed-for-Fixed Currency Swap At origination: $10.400.040.000.000 Party B At each annual settlement date: Party A $500.000 Party A ¥1.

000 to the fixed rate payer.000.000. Fixed rate payer (Floating rate Receiver) $10.040.000 Fixed rate Receiver (Floating Rate Payer) ¥1.000.040. – The fixed rate receiver pays ¥1.Cash Flows in a Fixed-for-Floating Currency Swap • On the origination date: – The fixed rate payer pays $10.000 to the fixed rate receiver.000.000 .

00% 6.25% 5.5 6 mo.20% 6. • On the origination date. NP1 = ¥1.000. LIBOR is: Time 0. Settlement dates are every 6 months. 6 month LIBOR is 5.000.5%. and r2 = 6 month $-LIBOR (floating).000 yen. 6 mo. • Assume that subsequently. NP2 = $10. LIBOR 5.Calculating Subsequent Cash Flows for this Fixed-for-Floating Currency Swap • Tenor is three years.040.5 1.50% 6.0 2. and r1 = 1% fixed in yen.44% .0 1.5 2.000. beginning 6 months hence.

000 $262.0 LIBOR 5.All Cash Flows for this Fixed-forFloating Currency Swap 6-mo.2MM ¥5. time 0.000 $310.5 2.44% ---Fixed rate Payment $10MM ¥5.2MM ¥5. .5001 $275.2MM ¥5.000 $10MM N.000 $300. 1 Time 1.0 2.20% 6.50% 6.000 $322.000.2MM ¥1. The time t floating cash flow is determined using the time t-1 floating rate.5 1.2MM ¥5.0 0.2MM ¥5.B.0 1.040MM Floating rate Payment ¥1.5 3.0525/2)($10.50% 5.000) = $262.0 floating rate payment is (0.040MM $275.500.00% 6.25% 5.

. giving one of the counter-parties (the one who is losing) the incentive to default. • This means that there is a higher probability of a large buildup in value.Credit Risk: Currency Swaps • Note that there is greater credit risk with a currency swap when there will be a final exchange of principal.

This risk is the risk that the counter-party will default. • Only the winning party (for whom the swap is an asset) faces credit risk. • The credit risk in a swap is greater when there is an exchange of principal amounts at termination. • Many vehicles exist to manage credit risk: – – – – Collateral (or collateral triggers) Netting agreements Credit derivatives Marking to market .Credit Risk • No credit risk exists when a swap is first created.

• Index differential swaps. on a NP of $20MM. but they are applied to the NP of one of the currencies. and receive $-based LIBOR. . or “diff” swaps: – The cash flows are based on two floating rates in different countries. pay €-based LIBOR. They all apply to currency swaps. too. – For example.Other Currency Swap Structures • See the different interest rate swap structures presented earlier. All payments are in $.

. The NP is not exchanged.Commodity Swaps • • • • • Equivalent to a strip of forward contracts on a commodity.000 oz. 10. e. of gold.. Define NP in terms of the commodity. Define Pfixed as the fixed price. or the actual price one period earlier) to the fixed price. Payments are made by comparing the actual price of the commodity on the settlement date (or an average price over the period.g.

• Pfixed = $320/oz. • NP = 10.Commodity Swaps: an Example. I. • A gold mining firm wants to fix the price it will receive for the gold it will mine over the next 3 years. based on average price of gold during the past six months. • Settlement is semi-annual. • A gold user wants to fix the price it will have to pay for the gold it needs for the next 3 years.000 oz. .

II.000 +$200. $305 $330 $368 $402 $348 $300 Producer pays (-) or receives (+) +$150.0 2.0 1.000 -$820.5 3. gold price during past pd.000 -$100.5 1.0 .000 -$480.Commodity Swaps: an Example. Subsequently: Avg.000 Time 0.5 2.000 -$280.

23 Thomas W. . Miller.©David Dubofsky and 11. Jr.

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