Outline

Introduction to swaps using an example of a

commodity swap.
MFIN6003 Derivative Securities
• Swap settlement; swap counterparty; market
Lecture Note Five value of a swap; computing swap price (rate).
Interest Rate Swaps
HKU Business School Currency Swaps

University of Hong Kong Appendix:

• (1) Swaptions (2) Total Return Swaps
Dr. Huiyan Qiu
5-1
Reading: Chapter 8 5-2

Introduction to Swaps An Example of a Commodity Swap

A swap is a contract calling for an exchange of
payments over time
• The swap payments are determined by the
difference in swap price and market price over
time
• A swap provides a means to hedge a stream of
risky payments (lower transaction cost)
• A single-payment swap is the same thing as a
cash-settled forward contract
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An industrial producer, IP Inc., needs to buy
100,000 barrels of oil 1 year from today and 2
years from today (concern? P↑)
How to hedge against the risk in oil cost?
Relevant information:
• The forward prices for deliver in 1 year and 2
years are $20 and $21/barrel.
• The risk-free 1- and 2-year zero-coupon bond
yields are 6% and 6.5%
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 A Commodity Swap (cont’d) A Commodity Swap (cont’d)
Strategy 1: Long forward contracts for 100,000 Strategy 3: Swap
barrels in each of the next 2 years
• Defer payments until the oil is delivered, while still
• IP pays $20 in year one and $21 in year two for oil fixing the total price
Strategy 2: Prepaid swap • A swap usually calls for equal payment in each year
• A single payment today for multiple deliveries of x x
oil in the future. + = $37.383 Þ x = $20.483
$ 20 $ 21 1.06 1.0652
PV = + = $37.383
1.06 1.0652
• The 2-year swap price is $20.483
• IP pays an oil supplier $37.383 per barrel in
exchange for a commitment to delivering one Any series of payments that have a PV of $37.383
barrel in each of the next two years. Credit risk? is acceptable (ignoring the credit risk)
5-5 5-6

Time Line – Payments Swaps, Forwards, and Financing

Swaps are nothing more than forward contracts
0 1 2 coupled with borrowing and lending money
• Compare the swap price and the forward prices, we
Unhedged S1 S2 are overpaying by $0.483 in the first year, and we
Strategy 1 20 21 are underpaying by $0.517 in the second year

Strategy 2 37.873
• We are lending the counterparty money for 1 year.
The interest rate on this loan is
Strategy 3 20.483 20.483
0.517/0.483 – 1 = 7%.
• Given 1- and 2-year zero-coupon bond yields of 6%
and 6.5%, 7% is the 1-year implied forward yield
All series of payments have a PV of $37.383.
from year 1 to year 2. (Fair pricing!)
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 No-Arbitrage Principle Computing the Swap Price
The present value of future payments for the Suppose there are n swap settlements, occurring
same series of future commodity delivery should on dates ti, i = 1,… , n. What is the swap price R?
be the same. Otherwise, arbitrage! PV (swap price) = PV (forward price)

If the present value of payment using two R F0 ,t

åi =1 = åin=1
n i

forward contracts for the oil delivery in year 1 [1 + r ( 0, ti )]

it
[1 + r ( 0, ti )]t i

and in year 2 is lower than that of payment

åi =1 RP (0, ti ) = åi =1 F0,t P (0, ti )
n n
using two-year swap, one can long the two i

forward contracts and short the swap to gain the

å F P (0, ti )
n
arbitrage profit. i =1 0 ,ti P ( 0, ti )
R= = åin=1 n F0 ,t
å P (0, ti ) å j =1 P (0, t j )
n i

5-9
i =1 5-10

Physical vs. Financial Settlement Financial Settlement

The results for the buyer are the same whether the The oil buyer, IP, pays the swap counterparty the
difference between $20.483 and the spot price, and the oil
swap is settled physically or financially. In both
buyer then buys oil at the spot price
cases, the net cost of the buyer is fixed at the swap
price of $20.483, whatever the market price of oil.
Physical settlement

100,000 barrels are the notional amount of the swap,

used to determine the magnitude of the payments when
5-11 the swap is settled financially 5-12
 The Swap Counterparty Matched Book Transaction
The swap counterparty is a dealer, who is, in The dealer bears the credit risk of both parties,
effect, a broker between buyer and seller but is not exposed to price risk

The fixed price paid by the buyer, usually,

exceeds the fixed price received by the seller.
This price difference is a bid-ask spread, and is
the dealer’s fee

Back-to-back transaction or “matched book”

transaction: the situation where the dealer
matches the buyer and seller.
5-13 5-14

Unmatched Book Transaction Unmatched Book Transaction

To hedge the swap transaction with the buyer,
In the case that the swap transaction is not
the dealer can enter into long forward or futures
matched, the dealer serves as counterparty to contracts.
the oil buyer and is facing future oil price risk:
Cash flows:
obligation to receive fixed price and pay
floating price.

$20.483
Swap
Oil Buyer Counterparty The net cash flow for the hedged dealer is a loan
Oil spot price
Thus, the dealer also has interest rate exposure (which
can be hedged by using Eurodollar futures or FRAs)
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 The Market Value of a Swap
The market value of a swap is zero at interception
• Once the swap is struck, its market value will
generally no longer be zero (change in forward price,
in interest rate…)
• Even if there is no change in interest rates or the
forward prices, the swap changes value after
payment.
The market value of the swap is the difference in
the PV of payments between the original and new
swap prices
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The Market Value of a Swap
Example: change in forward price
• Assume immediately after the initiation of the swap,
the forward curve for oil rises by $2 in both years
• Assume interest rates are unchanged
• The new swap price will be $22.483, $2 higher than
the old one (check and understand why exactly $2)
• PV of the differences = 2/1.06 + 2/(1.0652) = $3.65
• $3.65 is the market value of the old swap
5-18

Misuse of Swap: Enron’s Case Enron’s Hidden Debt

Energy giant Enron collapsed in 2001.
Figure
As charged by SEC, other companies helped
Enron’s swaps
Enron mislead investors. with Mahonia
One case: J.P Morgan Chase had helped Enron and Chase.
Source:
characterize loan proceeds as operating income
Securities and
by using swaps. Exchange
Commission.

5-19 5-20
 Kinds of Swaps
Interest Rate Swaps: payments are the difference
of interest payments based on floating rate and
fixed rate (swap rate)
• The notional principle of the swap is the amount on
which the interest payments are based
• The life of the swap is the swap term or swap
tenor
Currency Swaps: entail an exchange of payments
in different currencies
• A currency swap is equivalent to borrowing in one
currency and lending in another
5-21
An Example of an Interest Rate Swap
XYZ Corp. has $200M of floating-rate debt at
LIBOR, i.e., every year it pays that year’s LIBOR.
XYZ would prefer to have fixed-rate debt with 3
years to maturity
• Retire the floating-rate and issue fixed rate debt
(Transaction cost? Feasible? )
• Enter a strip of FRAs (FRA rates for each year
varies)
• Enter a swap, in which they receive a floating rate
and pay the fixed rate
5-22

An Example (cont’d) Computing the Swap Rate

How to determine this swap rate of 6.9548%?
Suppose the notional principle is 𝑄 and there are
n floating interest payments, occurring on dates
ti, i = 1,… , n.
• The implied forward interest rate from date ti-1 to
date ti, known at date 0, is r0(ti-1, ti). By using
forward rate agreement, interest payment at ti can
On net, XYZ pays 6.9548% be fixed at 𝑄×𝑟$ 𝑡&'( , 𝑡& .

XYZ net payment = – LIBOR + LIBOR – 6.9548% = –6.9548%

Now consider the swap with n swap settlements.
Swap rate is R.
Floating Payment Swap Payment
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Computing the Swap Rate (cont’d) Computing the Swap Rate (cont’d)
By using swap, the interest payment at all dates Rewrite
åi =1 P ( 0, ti ) r0 ( ti -1 , ti )
n
will be fixed at 𝑄×𝑅. R=
å i =1 P ( 0, ti )
n

Suppose the price of a zero-coupon bond maturing

on date ti is P(0, ti).
n P ( 0, t i )
=å r0 ( ti -1 , ti )
i =1 å
n
Using FRAs to hedge or using swap to hedge à P ( 0, t j )
j =1

same present value:

Thus, the fixed swap rate is as a weighted
average of the implied forward rates, where
å i = 1 P ( 0 , t i ) r0 ( t i - 1 , t i ) = å i = 1 P ( 0 , t i ) R
n n
zero-coupon bond prices are used to determine
the weights
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Computing the Swap Rate (cont’d) Computing the Swap Rate (cont’d)
Note P(0, ti -1 ) Use the same interest rate information as before:
1 + r0 (ti -1 , ti ) =
P(0, ti )
An alternative way to express the swap rate is

åi =1 P(0, ti )r0 (ti -1 , ti )

n
R=
åi =1 P(0, ti )
n

é P(0, ti -1 ) ù 1 − 𝑃(0,3)
åi =1 P(0, ti ) ê - 1ú
n
𝑅=
= ë P(0, ti ) û = 1 - P(0,tn ) 𝑃 0,1 + 𝑃 0,2 + 𝑃(0,3)
1 − 0.816298
åi =1 P(0, ti ) åi =1 P(0,ti )
n n
= = 𝟔. 𝟗𝟓𝟒𝟖𝟓%
0.943396 + 0.881659 + 0.816298
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 Hedging Swap Position
As a counterparty to the swap, the market-
maker receives fixed and pays floating. Thus, the
market-maker is facing the risk of high floating
rate. (The XYZ uses interest rate swap to
transfer the risk to the swap counterparty.)
Hedging Swap Position (cont’d)
The interest rate for year 0 to year 1 is 6%. Forward
rate for year 1 to year 2 is 7.0024% and for year 2 to
year 3 is 8.0071%.
Cash Flow Table

The market-maker will hedge the floating rate

payments by using, for example, forward rate
agreements

5-29 5-30

The Swap Curve The Swap Curve (cont’d)

A set of swap rates at different maturities Table Three-month LIBOR forward rates and swap rates
• The swap curve should be consistent with the implied by Eurodollar futures prices with maturity dates given
in the first column. Prices are from November 8, 2007. Source:
interest rate curve implied by the Eurodollar futures
Wall Street Journal online.
contract, which is used to hedge swaps
Maturity 3-Month Implied Dec Swap Rate (%) for
Computing swap rates Date of Forward Rate 2007 Price of $1 Loan Made Dec
Eurodollar Price of Implied by Paid 3-Months 2007, Ending 3
• The Eurodollar futures contract provides a set of 3- Futures Eurodollar Eurodollar after Futures Months after
month forward LIBOR rates Contract Futures Futures Price Mat. Date Futures Mat. Date
Dec-07 95.250 0.01201 0.98814 4.8028
• In turn, zero-coupon bond prices can be constructed Mar-08 95.720 0.01082 0.97756 4.5664
from implied forward rates Jun-08 95.965 0.01020 0.96769 4.4059
Sep-08 96.075 0.00992 0.95818 4.2982
• We can then use formula to compute swap rates Dec-08 96.080 0.00991 0.94878 4.2326

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Variation of Interest Rate Swaps Currency Swaps
A deferred swap is a swap that begins at some date A currency swap entails an exchange of
in the future, but its swap rate is agreed upon today
payments in different currencies
An amortizing swap is a swap where the notional
value is declining over time (e.g., floating rate
mortgage) A currency swap is equivalent to
An accreting swap is a swap where the notional borrowing in one currency and lending in
value is growing over time
another
General formula for the swap rate:

åi =k Qt P(0, ti )r0 (ti -1 , ti )

n
R=
åi =k Qt P(0, ti )
n

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Currency Swap: An Example Currency Swap Example (cont’d)

A dollar-based firm has a 3-year 3.5% euro- Alternatively, the firm can enter into a currency
dominated bond with a €100 par. Current swap with the market-maker –– making
exchange rate is $0.90/€. payments on a dollar-based bond and receiving
• Use currency forward contracts to hedge payments for its euro-based bond

$, $, $ (how much?)
Unhedged Forward Hedged
Year Euro cash flow Exchange rate Dollar Cash Flow Firm Market-maker
1 -€3.5 0.9217 -$3.226 €3.5, €3.5, €103.5
2 -€3.5 0.9440 -$3.304
3 -€103.5 0.9668 -$100.064 Rule: the present value of the payments (from
and to the market-maker) should be the same!
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Currency Swap Example (cont’d) Hedged or Unhedged Cash Flows
The euro-based par bond has value €100, which is Unhedged cash flows and hedged cash flows
equivalent to $90, given the current exchange rate using either swap or forward contracts.
of $0.90/€.
Therefore, the dollar-based par bond should have
Unhedged €3.5 €3.5 €103.5
value $90.
Swap-hedged $5.4 $5.4 $95.4
Suppose the effective annual dollar-denominated
interest rate is 6% Forward- $3.226 $3.304 $100.064
hedged
The payments on dollar-based bond are:
$5.40, $5.40, and $95.40.
All have PV = €100 = $90
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Currency Swap Currency Swap: Market-Maker

A currency swap is equivalent to borrowing in one Market-maker use currency forward contracts to hedge
currency and lending in another the Euro interest. The position of the market-maker is
summarized below
$90 now

$5.4, $5.4, $95.4

Firm Market-maker
€3.5, €3.5, €103.5

The PV of the market-maker’s net cash flows is

€100 now ($2.174 / 1.06) + ($2.096 / 1.062) – ($4.664 / 1.063) = 0
5-39 5-40
 Swap Bank
Swap bank is a financial institution that acts as
an intermediary for interest and currency swaps.
• Function: to find counterparties for those who
want to participate in swap agreements.
• The swap bank typically earns a slight premium
for facilitating the swap.
In general, companies do not directly approach
other companies in an attempt to create swap
agreements. In most cases, companies don't even
know the identities of their swap counterparties.
5-41
Swap Bank: Example
Both company A and company B need to take
$5m loan. Company A prefers to pay variable
rate of interest while company B prefers to pay
fixed rate of interest.
Company A is big, well-known, and well-
established. It is offered with 5% fixed rate or
LIBOR by bank X.
Company B is less well-known and smaller. It is
offered with 8% fixed rate or LIBOR+1% by bank
Y.
How can a swap bank help here?
5-42

Swap Bank: Example (cont’d) Swap Bank: Example (cont’d)

The swap bank offers a swap to company A as The swap bank offers a swap to company B as
follows: follows:
LIBOR 6%
Co. A Swap Bank Co. B Swap Bank
5.5% LIBOR

By taking the loan from bank X at 5% and
signing the swap above with the swap bank,
effectively, company A is paying at a variable
rate of LIBOR-0.5%. Great!
5-43
By taking the loan from bank Y at LIBOR+1%
and signing the swap above with the swap bank,
efectively, company B is paying at a fixed rate of
7%. Great!
5-44
Swap Bank: Example (cont’d)
Both company A and company B are better off.
The swap bank earns 0.5%

LIBOR LIBOR End of the Notes!

Co. A Swap Bank Co. B
5.5% 6%

Concerns: default risk (credit risk) …

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Swaptions
A swaption is an option to enter in the future
into a swap with pre-specified terms
Appendix: • Swaption can be used to speculate on the swap
price/rate in the future

More on Swaps A swaption is analogous to an ordinary option.

• Swaption has a premium.
• Swaptions can be American or European.

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 Payer / Receiver Swaption
A payer swaption gives its holder the right, but
not the obligation, to pay the pre-specified price
(strike price) and receive the market swap price
• The holder of a payer swaption would exercise
when the market swap price is above the strike
A receiver swaption gives its holder the right,
but not the obligation to pay the market swap
price and receive the pre-specified strike price
• The holder of a receiver swaption would exercise
when the market swap price is below the strike
5-49
Total Return Swaps
A total return swap is a swap, in which one
party pays the realized total return (dividends
plus capital gains) on a reference asset, and the
other party pays a floating return such as LIBOR
The two parties exchange only the difference
between these rates
The party paying the return on the reference
asset is the total return payer
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Example: Payer Swaption
Suppose we enter into a 3-month European payer
oil swaption: the strike price = $21 and the
underlying swap commences in 1 year and has 2
settlements
After 3 months, the fixed price on the underlying
swap is $21.50: Exercise the option, obligating us
to pay $21/barrel for 2 years and allowing us to
receive $21.5/barrel for 2 years.
• In year 1 and year 2, we will receive $21.50 and pay
$21, for a certain net cash flow each year of $0.50
5-50
Example: Total Return Swap
ABC Asset Management want to sell $1 billion of
investment in S&P index
An alternative is to swap the total stock return
into a floating short-term rate
Table Illustration of cash flows on a total return swap
with annual settlement for 3 years.
5-52
 Total Return Swaps (cont’d)
Why to use a total return swap?
• The total return payer gives up the possible risk
premium on the stock index
• The payoff for the swap is equivalent to direct
selling of the stock and buying a floating-rate
note
• However, the total return swap can allow foreign
investors to own stocks without physically holding
them, so as to avoid withholding foreign taxes
• Flexible management of credit risk
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