Chapter 07 Swaps

Chapter 7
Swaps
Options, Futures, and Other Derivatives, 8th Edition,

Copyright © John C. Hull 2012 1
Nature of Swaps
A swap is an agreement to exchange
cash flows at specified future times
according to certain specified rules

An Example of a “Plain Vanilla” Interest
Rate Swap
An agreement by Microsoft to receive 6-

month LIBOR & pay a fixed rate of 5% per
annum every 6 months for 3 years on a
notional principal of $100 million
Next slide illustrates cash flows that could
occur (Day count conventions are not
considered)

One Possible Outcome for Cash
Flows to Microsoft (Table 7.1, page 150)
Date LIBOR Floating Cash Fixed Cash Net Cash
Flow Flow Flow
Mar 5, 2012 4.20%
Sep 5, 2012 4.80% +2.10 −2.50 −0.40
Mar 5, 2013 5.30% +2.40 −2.50 −0.10
Sep 5, 2013 5.50% +2.65 −2.50 + 0.15
Mar 5, 2014 5.60% +2.75 −2.50 +0.25
Sep 5, 2014 5.90% +2.80 −2.50 +0.30
Mar 5, 2015 +2.95 −2.50 +0.45

Typical Uses of an Interest Rate
Swap
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

Intel and Microsoft (MS)
Transform a Liability (Figure 7.2, page 151)
5%
5.2%
Intel MS
LIBOR+0.1%
LIBOR

Financial Institution is Involved
(Figure 7.4, page 152)
4.985% 5.015%
5.2%
Intel F.I. MS
LIBOR+0.1
LIBOR LIBOR %
Financial Institution has two offsetting

swaps

Intel and Microsoft (MS) Transform an
Asset (Figure 7.3, page 152)
5%
4.7%
Intel MS
LIBOR-0.2%
LIBOR

Financial Institution is Involved
(See Figure 7.5, page 153)
4.985% 5.015%
4.7%
Intel F.I. MS
LIBOR-0.2%
LIBOR LIBOR

Quotes By a Swap Market Maker
(Table 7.3, page 154)
Maturity Bid (%) Offer (%) Swap Rate (%)

2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850
Day Count
A day count convention is specified for for
fixed and floating payment
For example, LIBOR is likely to be actual/360
in the US because LIBOR is a money market
rate

Confirmations
Confirmations specify the terms of a
transaction
The International Swaps and Derivatives has
developed Master Agreements that can be
used to cover all agreements between two
counterparties
Governments now require central clearing to
be used for most standardized derivatives
The Comparative Advantage Argument
• AAACorp wants to borrow floating

• BBBCorp wants to borrow fixed
Fixed Floating
AAACorp 4.0% 6 month LIBOR − 0.1%
BBBCorp 5.2% 6 month LIBOR + 0.6%

The Swap (Figure 7.6, page 157)
4.35%
4%
AAACorp BBBCorp
LIBOR+0.6%
LIBOR

The Swap when a Financial
Institution is Involved (Figure 7.7, page 157)
4.33% 4.37%
4%
AAACorp F.I BBBCorp
. LIBOR+0.6%
LIBOR LIBOR

Criticism of the Comparative
Advantage Argument
The 4.0% and 5.2% rates available to AAACorp
and BBBCorp in fixed rate markets are 5-year
rates
The LIBOR−0.1% and LIBOR+0.6% rates
available in the floating rate market are six-
month rates
BBBCorp’s fixed rate depends on the spread
above LIBOR it borrows at in the future

The Nature of Swap Rates
Six-month LIBOR is a short-term AA borrowing
rate
The 5-year swap rate has a risk corresponding to
the situation where 10 six-month loans are made
to AA borrowers at LIBOR
This is because the lender can enter into a swap
where income from the LIBOR loans is
exchanged for the 5-year swap rate

Using Swap Rates to Bootstrap the
LIBOR/Swap Zero Curve
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
Example of Bootstrapping the
LIBOR/Swap Curve (Example 7.1, page 160)
6-month, 12-month, and 18-month
LIBOR/swap rates are 4%, 4.5%, and 4.8%
with continuous compounding.
Two-year swap rate is 5% (semiannual)
2.5e −0.04×0.5 + 2.5e −0.045×1.0 + 2.5e −0.048×1.5

−2 R
+ 102.5e = 100
The 2-year LIBOR/swap rate, R, is 4.953%

Valuation of an Interest Rate Swap
Initially interest rate swaps are worth close
to zero
At later times they can be valued as the
difference between the value of a fixed-rate
bond and the value of a floating-rate bond
Alternatively, they can be valued as a
portfolio of forward rate agreements (FRAs)

Valuation in Terms of Bonds
The fixed rate bond is valued in the usual way
The floating rate bond is valued by noting that
it is worth par immediately after the next
payment date

Valution of Floating-Rate Bond
Value = PV
of L+k* at t*
Value = Value = L
L+k*
0 t*
Valuation First Pmt Second

Date Date Pmt Date Maturity
Floating Date
Pmt =k*

Example
Pay six-month LIBOR, receive 8% (s.a.
compounding) on a principal of $100 million
Remaining life 1.25 years
LIBOR rates for 3-months, 9-months and 15-
months are 10%, 10.5%, and 11% (cont
comp)
6-month LIBOR on last payment date was
10.2% (s.a. compounding)
Valuation Using Bonds (page 161)
Time Bfix cash Bfl cash Disc PV PV
flow flow factor Bfix Bfl
0.25 4.0 105.100 0.9753 3.901 102.505
0.75 4.0 0.9243 3.697
1.25 104.0 0.8715 90.640
Total 98.238 102.505
Swap value = 98.238 − 102.505 = −4.267

Valuation in Terms of FRAs
Each exchange of payments in an interest
rate swap is an FRA
The FRAs can be valued on the
assumption that today’s forward rates are
realized

Valuation of Example Using FRAs
(page 163)
Time Fixed Floating Net Cash Disc PV

cash flow cash flow Flow factor Bfl
0.25 4.0 -5.100 -1.100 0.9753 -1.073
0.75 4.0 -5.522 -1.522 0.9243 -1.407
1.25 4.0 -6.051 -2.051 0.8715 -1.787
Total -4.267

Overnight Indexed Swaps
Fixed rate for a period is exchanged for the
geometric average of the overnight rates
Should OIS rate equal the LIBOR rate? A
bank can
Borrow $100 million in the overnight market,
rolling forward for 3 months
Enter into an OIS swap to convert this to the 3-
month OIS rate
Lend the funds to another bank at LIBOR for 3
months
Overnight Indexed Swaps continued
...but it bears the credit risk of another bank in
this arrangement
The OIS rate is now regarded as a better proxy
for the short-term risk-free rate than LIBOR
The excess of LIBOR over the OIS rate is the
LIBOR-OIS spread. It is usually about 10 basis
points but spiked at an all time high of 364 basis
points in October 2008

An Example of a Currency Swap
An agreement to pay 5% on a sterling
principal of £10,000,000 & receive 6% on
a US$ principal of $18,000,000 every year
for 5 years

Exchange of Principal
In an interest rate swap the principal is not
exchanged
In a currency swap the principal is usually
exchanged at the beginning and the end of
the swap’s life

The Cash Flows (Table 7.7, page 166)
Date Dollar Cash Flows Sterling cash flow

(millions) (millions)
Feb 1, 2011 -18.0 +10.0
Feb 1, 2012 +1.08 −0.50
Feb 1, 2012 +1.08 −0.50
Feb 1, 2014 +1.08 −0.50
Feb 1, 2015 +1.08 −0.50
Feb 1, 2016 +19.08 −10.50

Typical Uses of a
Currency Swap
Convert a liability in one currency to a

liability in another currency
Convert an investment in one currency to
an investment in another currency

Comparative Advantage May Be
Real Because of Taxes
General Electric wants to borrow AUD
Quantas wants to borrow USD
Cost after adjusting for the differential impact
of taxes
USD AUD
General Electric 5.0% 7.6%
Quantas 7.0% 8.0%

Valuation of Currency Swaps
Like interest rate swaps, currency swaps can
be valued either as the difference between 2
bonds or as a portfolio of forward contracts

Example
All Japanese LIBOR/swap rates are 4%
All USD LIBOR/swap rates are 9%
5% is received in yen; 8% is paid in dollars.
Payments are made annually
Principals are $10 million and 1,200 million
yen
Swap will last for 3 more years
Current exchange rate is 110 yen per dollar
Valuation in Terms of Bonds (Table 7.9,
page 169)
Time Cash Flows ($) PV ($) Cash flows (yen) PV (yen)

1 0.8 0.7311 60 57.65
2 0.8 0.6682 60 55.39
3 0.8 0.6107 60 53.22
3 10.0 7.6338 1,200 1,064.30
Total 9.6439 1,230.55
Value of Swap = 1230.55/110 − 9.6439 = 1.5430

Valuation in Terms of Forwards
Time $ cash Yen cash Forward Yen cash Net Present

flow flow Exch rate flow in $ Cash value
Flow
1 -0.8 60 0.009557 0.5734 -0.2266 -0.2071
2 -0.8 60 0.010047 0.6028 -0.1972 -0.1647
3 -0.8 60 0.010562 0.6337 -0.1663 -0.1269
3 -10.0 1200 0.010562 12.6746 +2.6746 2.0417
Total 1.5430

Swaps & Forwards
A swap can be regarded as a convenient
way of packaging forward contracts
Although the swap contract is usually
worth close to zero at the outset, each of
the underlying forward contracts are not
worth zero

Credit Risk
A swap is worth zero to a company initially
At a future time its value is liable to be either positive or
negative
The company has credit risk exposure only when its
value is positive
Some swaps are more likely to lead to credit risk
exposure than others
What is the situation if early forward rates have a
positive value?
What is the situation when the early forward rates have
a negative value?
Other Types of Swaps
Floating-for-floating interest rate swaps,
amortizing swaps, step up swaps, forward
swaps, constant maturity swaps,
compounding swaps, LIBOR-in-arrears
swaps, accrual swaps, diff swaps, cross
currency interest rate swaps, equity swaps,
extendable swaps, puttable swaps,
swaptions, commodity swaps, volatility
swaps……..


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Chapter 7

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

An agreement by Microsoft to receive 6-

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Converting an investment from

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Financial Institution has two offsetting

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Maturity Bid (%) Offer (%) Swap Rate (%)

Options, Futures, and Other Derivatives, 8th Edition,

• AAACorp wants to borrow floating

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

2.5e −0.04×0.5 + 2.5e −0.045×1.0 + 2.5e −0.048×1.5

The 2-year LIBOR/swap rate, R, is 4.953%

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Valuation First Pmt Second

Options, Futures, and Other Derivatives, 8th Edition,

Swap value = 98.238 − 102.505 = −4.267

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Time Fixed Floating Net Cash Disc PV

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Date Dollar Cash Flows Sterling cash flow

Options, Futures, and Other Derivatives, 8th Edition,

Convert a liability in one currency to a

Options, Futures, and Other Derivatives, 8th Edition,

General Electric 5.0% 7.6%

Quantas 7.0% 8.0%

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Time Cash Flows ($) PV ($) Cash flows (yen) PV (yen)

Value of Swap = 1230.55/110 − 9.6439 = 1.5430

Options, Futures, and Other Derivatives, 8th Edition,

Time $ cash Yen cash Forward Yen cash Net Present

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

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