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Swap is an agreement between two parties, 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…
**

IRS’s do not generate new funding; 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…
**

Interest rate Swaps can be used to 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…
**

The counter parties to the IRS agree to 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…
**

Fixed and floating payments are netted 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

4.00%

AAACorp

3.95%

LIBOR

BBBCorp

LIBOR+1%

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 A Company B

9.00% 9.80%

*

10.5% 11.0% *

**Company A has a comparative advantage in Can $ market while Company B has comparative advantage in sterling market.
**

11% £ 9% Can $

Company A

9% Can $

Company B

11% £

**Deal through intermediary
**

9% Can $ 11.0% £

9% Can $

A

10.4% £

F.I.

9.7% Can $

B

11% £

Advantage to A vis-à-vis market is 0.1% and to B is 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 ShortTerm Rates
**

One half of the cash flows in a simple 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 ShortTerm 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
**

Discount factors, used to present value 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) Six Month (0f6) Nine Month (0f9) Twelve Month (0f12) 5.42% 5.50% 5.57% 5.62%

**Forward Curve for LIBOR contd.
**

LIBOR yield curve % 5.62 5.57 0x9 5.50 5.42 spot 0 6 9 12 Months 0x6 0 x 12

**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

• The technique to obtain the implied forward 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 reinvest for another three months at maturity

• If the market expects both choices to provide 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:

0 f 3 3 f 6 0 f 6 1 + 1 + = 1 + 4 4 4

2

**Implied Forward Rates (cont’d)
**

• Using the available data:

.0542 3 f 6 .0550 = 1 + 1 + 1 + 4 4 4 3 f 6 = 5.58%

2

**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 6x9 5.58 5.42 spot 0 3 6 9 12 Months 3x6 9 x 12

**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 Fixed rate paid by bank Floating rate received by bank Current 6m LIBOR Market quote for 3 year swap 3 years 10% 6m LIBOR 9% 10.5% semi-annual vs. LIBOR

Find out the value of the swap, if bank has received the latest interest payment.

**Risk Behind Swaps
**

Floating Rates are Short Term Rates 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 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

**Total Return Swaps
**

A Total Return Swap (TRS) is a 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…
**

A TRS is similar to a plain vanilla swap 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
**

Cross currency swaps are instruments 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

• Delayed Start Swap 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…
**

• Indexed Principal Swap 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
**

The buyer and seller of the swaption agree 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

• Total return on an equity index is 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..
**

An investor believes that LIBOR will stay 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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