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- Political Risk
- Factors Affecting Balance of Payments
- Franchising and Leasing
- Operating Exposure
- Options Strategies
- Translation Exposure
- Why are Firms Using Interest Rate Swaps to Time the
- Forex Exposure
- Transaction Exposure
- Financial Leasing
- IFM1 Basics
- Credit Rating 1
- Options - Valuation
- Venture Capital
- Factoring
- Financial System and Market
- Real Options LBSIM
- Structured Notes Cms
- Housing Finance
- Lease

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called counter parties, to trade cash flows

over a period of time.

Swap is the exchange of one security for

another to change the maturity (bonds),

quality of issues (stocks or bonds), or

investment objectives.

Recently, swaps have grown to include

currency swaps and interest rate swaps.

Popular form of Swaps

• Currency swap involves an exchange of cash

payments in one currency for cash payments in

another currency.

• Interest rate swap allows a company to borrow

capital at fixed (or floating rate) and exchange its

interest payments with interest payments at

floating rate (or fixed rate).

Structure of Swaps

Swaps are over-the-counter (OTC) derivatives.

They are negotiated outside exchanges. They

cannot be bought and sold like securities or futures

contracts, but are all unique.

As each swap is a unique contract, the only way to

get out of it is by either mutually agreeing to tear

it up, or by reassigning the swap to a third party.

This latter option is only possible with the consent

of the counter party.

Interest Rate Swaps

An interest rate swap (IRS) is a contractual

arrangement between two counter-parties

who agree to exchange interest payments on

a defined principal amount for a fixed period

of time.

In an IRS, the principal amount is never

exchanged and therefore is referred to as a

“notional” principal amount.

Interest Rate Swaps contd…

rather, they convert one interest rate

basis to a different rate basis (e.g., from

floating to fixed, or from fixed to

floating). Cash Flows on IRS are a

function of the notional principal

amount, interest rates, and time.

Interest Rate Swaps contd…

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

Interest Rate Swaps contd…

exchange interest payments on specific

dates, according to a predetermined

formula. Exchanges typically cover

periods ending on the payment date

and reflect differences between the

fixed rate and the floating rate at the

beginning of the period.

Interest Rate Swaps contd…

against each other to prevent redundant

transfers of cash between counter

parties; a net settlement is the only

transfer of cash, made by the owing

party on the payment date.

Comparative Advantage Argument

AAACorp BBBCorp

LIBOR

Deal through intermediary

Currency Swaps

Currency Swaps generally involve exchange of

Principals and fixed coupon payments in one

currency with the equivalent Principals and fixed

coupon payments in other currency. Currency

Swaps helps firms to transform liability in one

currency to a liability in another currency and

also, convert from an investment in one currency

to an investment in another currency

Comparative Advantage

Argument

Can$ Sterling £

Company B 9.80% 11.0% *

while Company B has comparative advantage in sterling

market.

11% £

9% Can $ 11% £

Company A Company B

9% Can $

Deal through intermediary

9% Can $ 11.0% £

9% Can $ 11% £

A F.I. B

10.4% £ 9.7% Can $

0.1% and to the financial institution 0.1% (ignoring

exchange risk). The swap deal is equally attractive to

all the parties.

Mechanics of Swap Pricing

• Constructing a zero coupon* yield curve

• Extrapolating a forecast of future interest

rates to establish the amount of each future

floating rate cash flow

• Deriving discount factors to value each swap

fixed and floating rate cash flow

• Discounting and present valuing all known

(fixed) and forecasted (floating) swap cash

flows.

Constructing a Yield Curve

• Build a yield curve from current cash deposit

rates, eurodollar futures prices, treasury

yields, and interest rate swap spreads. These

known market rates are “hooked” together to

form today’s coupon yield curve.

• The coupon curve is the raw material from

which a zero coupon yield curve is

constructed, usually using a method called

“bootstrapping”. This involves deriving each

new point on the curve from previously

determined zero coupon points (hence the

phrase, “bootstrapping”).

Constructing a Yield Curve

contd..

• Zero rates are higher than coupon rates when

the yield curve is positively sloped and lower

when the curve is inverted. The gap is widest

at the far end of the yield curve.

• When rates are low and the yield curve is flat,

the difference between coupon and zero

rates will be minimal, but when rates are high

and the curve steep, the difference is

significant.

Constructing a Yield Curve

contd..

• Because the cash flow dates of the swap to

be valued rarely exactly match the dates for

which zero curve points have been

developed, interpolation between data points

is needed to solve the problem.

• While this sounds simple, some extremely

complicated algorithms have been developed

to minimize the errors that can arise from

interpolation

Forecasting Future Short-

Term Rates

swap are floating rate. What makes the

floating leg of the swap hard to price is

the uncertainty of the forward rates—

only today’s floating rate is known for

certain.

Forecasting Future Short-

Term Rates contd..

A forecast of future floating rates — a

forward yield curve of short term interest

rates—is needed before prospective

floating rate cash flows can be

generated. In fact, the forward curve is

just an extension of the zero coupon

yield curve; once the zero curve has

been developed, it easily transforms

into the forward curve needed to

generate the swap’s floating rate cash

flows.

Deriving Discount Factors

each swap cash flow, are developed as

part of the process of bootstrapping the

zero coupon yield curve. Like forward

interest rates, discount factors are just a

transformation of zero coupon rates. In

fact, there is a simple formula for

converting one to the other.

Valuing the Swap

• With all the calculations concluded, the only

step remaining is to apply the discount factors

to find the present value of fixed and floating

swap cash flows. These values are then

netted to determine the swap’s current

market value.

• This value can be positive, zero, or negative,

depending on how market interest rates have

changed since the swap was created. For a

floating to fixed swap, higher market rates will

create a gain for the hedger, lower rates a

loss.

Valuation of Interest Rate Swaps

Forward Curve for LIBOR

• Assume the following LIBOR interest rates:

Spot (0f3) 5.42%

Forward Curve for LIBOR contd.

LIBOR yield curve

5.62

5.57 0 x 12

0x9

5.50

0x6

5.42

spot

0 6 9 12 Months

Implied Forward Rates

• We can use these LIBOR rates to solve for the

implied forward rates

– The rate expected to prevail in three months, 3f6

– The rate expected to prevail in six months, 6f9

– The rate expected to prevail in nine months, 9f12

rates is called bootstrapping

Implied Forward Rates

• An investor can

– Invest in six-month LIBOR and earn 5.50%

– Invest in spot, three-month LIBOR at 5.42% and re-

invest for another three months at maturity

the same return, then we can solve for the

implied forward rate on the 3 x 6 FRA

Implied Forward Rates

(cont’d)

• The following relationship is true if both

alternatives are expected to provide the

same return:

2

0 f 3 3 f 6 0 f 6

1 + 1 + = 1 +

4 4 4

Implied Forward Rates

(cont’d)

• Using the available data:

2

.0542 3 f 6 .0550

1 + 1 + = 1 +

4 4 4

3 f 6 = 5.58%

Implied Forward Rates

(cont’d)

• Applying bootstrapping to obtain the

other implied forward rates:

– 6f9 = 5.71%

– 9f12 = 5.77%

Implied Forward Rates

(cont’d)

LIBOR forward rate curve

5.77

5.71 9 x 12

6x9

5.58

3x6

5.42

spot

0 3 6 9 12 Months

Valuation of Currency Swaps

In a currency swap the principal is exchanged at

the beginning and the end of the swap. Therefore,

currency swaps can be valued either as the

difference between 2 bonds or as a portfolio of

forward contracts

• Value of Swap (Vs) = Value of the debt security

in foreign currency (Bf) X Spot Exchange rate (S)

- - Value of the debt security in home currency

(Bh)

Illustration

The following information is taken from the books of

a bank relating to an interest rate swap

Remaining term to maturity 3 years

Fixed rate paid by bank 10%

Floating rate received by bank 6m LIBOR

Current 6m LIBOR 9%

Market quote for 3 year swap 10.5% semi-annual vs.

LIBOR

Find out the value of the swap, if bank has received

the latest interest payment.

Risk Behind Swaps

The time horizon for the floating as well as fixed

rates may be different from that comprised in the

swap deal

The lender (outside parties) can enter into swaps

themselves if they find spread attractive, which

finally reduces the attractiveness of swaps to the

parties.

Engineering Swaps

Illustration

Following are the rate of borrowing of companies A & B:

Currency A B

$ LIBOR+0.50% LIBOR+0.70%

DEM 5.35% 6.75%

The company B borrows dollars at a floating rate of

interest and the company A borrows DEM at a fixed rate

of interest. A financial institution is planning to arrange a

swap deal between the two companies and requires a

minimum of 50 basis points spread. If the swap is to

appear equally attractive to A and B, what rate of interest

will A and B end up paying? Ignore exchange risk.

Illustration

Three companies X, Y and Z have come together to reduce their interest cost.

Following are the requirement of those companies and interest rates offered to

them in different markets:

Company Requirement Fixed$ $ Floating Fixed Euro

X Fixed $ funds 5.75% LIBOR + 0.90% 6.00%

Y Floating $ funds 5.25% LIBOR + 0.75% 6.50%

Z Fixed Euro Funds 6.00% LIBOR + 0.60% 6.25%

The amounts required by the companies are equal and are for three years on

bullet payment basis. You are required to arrange a swap between three

parties in such a way so swap benefit is equally divided among the three

companies.

Using Swap Rates to Bootstrap the LIBOR/Swap

Zero Curves

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

Total Return Swaps

bilateral financial transaction where the

counter parties swap the total return of

a single asset or basket of assets in

exchange for periodic cash flows,

typically a floating rate such as LIBOR

+/- a basis point spread and a

guarantee against any capital losses.

Total Return Swaps contd…

except the deal is structured such that

the total return (cash flows plus capital

appreciation /depreciation) is

exchanged, rather than just the cash

flows.

Total Return Swaps contd…

A key feature of a TRS is that the parties do

not transfer actual ownership of the assets,

as occurs in a repo transaction. This allows

greater flexibility and reduced up-front capital

to execute a valuable trade. This also means

Total Return Swaps can be more highly

leveraged, making them a favorite of hedge

funds. Total Return Swaps (TRS) are also

known as Total Rate of Return Swaps

(TROR).

Cross Currency Basis Swaps

to transfer assets or liabilities from one

currency into another. The market

charges for this a liquidity premium, the

cross currency basis spread, which

should be taken into account by the

valuation methodology.

Cross Currency Basis Swaps

contd…

Cross currency swaps differ from single currency

swaps by the fact that the interests rate payments on

the two legs are in different currencies. So on one leg

interest rate payments are in currency 1 on a notional

amount N1 and on the other leg interest rate

payments are in currency 2 calculated on a notional

amount N2 in that currency. At inception of the trade

the notional principal amounts in the two currencies

are usually set to be fair given the spot foreign

exchange rate X, i.e. N1 = X·N2, i.e., the current spot

foreign exchange rate is used for the relationship of

the notional amounts for all future exchanges.

Cross Currency Basis Swaps

contd…

Exotic Swaps

The delayed start swap is a regular plain

vanilla swap exchanging cash flows in one

index against cash flows in another index

with the exception that the start date of the

swap is not immediate.

Exotic Swaps contd..

• The Collapsible Swap

A combination of a plain vanilla swap with a

swaption (~ an option on the swap) on that swap.

Swaption gives us the right but not the obligation

to enter into a swap with the same terms except

that we will be buying fixed rates and receiving

floating rates.

The cash flows will offset and the swap will be

deemed to be closed out since the swaption is with

the same financial institution with whom we have

contracted the swap.

Exotic Swaps contd…

The indexed principal swap is a variant in

which the principal is not fixed for the life

of the option but tied to the level of interest

rates.

Interest rate swaptions

An interest rate swaption is simply an option on an

interest rate swap. It gives the holder the right but

not the obligation to enter into an interest rate

swap at a specific date in the future, at a particular

fixed rate and for a specified term. For an up-front

fee (premium), the buyer selects the strike rate

(the level at which it enters the interest rate swap

agreement), the length of the option period, the

floating rate index (e.g. LIBOR) and tenor.

Interest rate swaptions

on the strike rate, length of the option

period (which usually ends on the starting

date of the swap if swaption is exercised),

the term of the swap, notional amount,

amortization, and frequency of settlement.

Types of Interest rate swaptions

European Swaptions give the buyer the right to

exercise only on the maturity date of the option.

American Swaptions, on the other hand, give the

buyer the right to exercise at any time during the

option period.

Bermudan Swaptions give the buyer the right to

exercise on specific dates during the option period.

Equity Swaps

exchanged periodically for a fixed or

floating return

• When the return on an equity index is

exchanged for LIBOR the value of the swap

is always zero immediately after a payment.

This can be used to value the swap at other

times.

LIBOR-in-arrears Swaps

Under a LIBOR Set In Arrears Swap, the fixed

side of the swap is the same, but the floating side

is different. Instead of setting the LIBOR at the

beginning of the rollover or reset period, we set it

at the END of the period. The payment is made as

normal at the end of the period, which in this case

is the same as the setting date.

– Normal: LIBOR set in advance, paid in arrears.

– LIBOR in Arrears: LIBOR set in arrears and paid in

arrears.

LIBOR-in-arrears Swaps contd..

at the same level or fall over the next three

years. In this scenario, LIBOR will be

lower at the END of each reset period, than

at the BEGINNING. We could enter a Swap

where we RECEIVE 6 month LIBOR for 2

years and PAY 6 month LIBOR Set In

Arrears for 2 years.

Constant Maturity Swap

• CMS is a variation of the regular interest rate

swap. In a constant maturity swap, the floating

interest portion is reset periodically according to a

fixed maturity market rate of a product with a

duration extending beyond that of the swap's reset

period.

• CMS are exposed to changes in long-term interest

rate movements. They are initially priced to reflect

fixed-rate products with maturities between two

and five years in duration, but adjust with each

reset period.

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