FINA2322EFG Tutorial 7

THE UNIVERSITY OF HONG KONG

HKU BUSINESS SCHOOL
FINA2322EFG – DERIVATIVES
SECOND SEMESTER, 2022-2023

Tutorial 7 – Swap

✓ Swap Features
It is a contract calling for an exchange of payments, on one or more dates, determined by
the difference in two prices to hedge a stream of risky payments.

• A single-payment swap is the same thing as a cash-settled forward contract

• Zero market value at initial time (today)

• An offsetting swap can help exit the swap contract

• Market value of swap = difference in the PV of payments between original and new
swap rates

✓ Swap Counterparty
• The dealer can choose to act as the broker between buyer and seller (Back to Back
transaction), or become the counterparty himself.
• Back to back transaction:
- The difference in the payment and receivable of buyer and seller is the bid-ask
spreads
- Dealers are exposed to credit risk, but not price risk in a back to back transaction
• Become the counterparty:
- Dealers can also hedge the risk by entering into forward or futures (if they act as
a counterparty). They will also need interest rates contracts to hedge the interest
rates risk.
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✓ Settlement methods
1. Physical settlement
Pay the cash; receive the commodity (e.g. oil)
2. Financial settlement
Buyer will pay (swap price – spot price). i.e. the payoff is spot price – swap price
i.e. if spot price > swap price, the buyer receive
The buyer in a swap contract will have a long position on the underlying

✓ Commodity Swap
1. Pay everything at initial (Prepaid swap)
To pay PV of all CFs in the future right now (today)

2. Pay same amount of money every year.

Find an annuity with a PV = PV of all CFs in the futures
Determining the swap price (the fixed payment)
∑𝑛𝑖=1 𝑃0,𝑡𝑖 𝐹0,𝑡𝑖
𝐹̅ =
∑𝑛𝑖=1 𝑃0,𝑡𝑖

✓ Interest rate swap

Swap term: life of the swap
Swap rate formula (the PV of all payments = 0, fair price)
𝑛

∑ 𝑃(0, 𝑡𝑖 )[𝑅 − 𝑟0 (𝑡𝑖−1 , 𝑡𝑖 )] = 0

𝑖=1

∑𝑛𝑖=1 𝑃(0, 𝑡𝑖 )𝑟0 (𝑡𝑖−1 , 𝑡𝑖 )

𝑅=
∑𝑛𝑖=1 𝑃(0, 𝑡𝑖 )
𝑛
𝑃(0, 𝑡𝑖 ) 1 − 𝑃(0, 𝑡𝑛 )
𝑅 = ∑ [[ 𝑛 ] 𝑟0 (𝑡𝑖−1 , 𝑡𝑖 )] = 𝑛
∑𝑖=1 𝑃(0, 𝑡𝑖 ) ∑𝑖=1 𝑃(0, 𝑡𝑖 )
𝑖=1

which suggest that the swap rate is a weighted average of the implied forward rates or
alternatively, it is the coupon rate on a par coupon bond.

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 FINA2322EFG Tutorial 7

✓ Deferred Swap
A swap that begins at some day in the future, but the swap rate begins today.

∑𝑛𝑖=𝑘 𝑃(0, 𝑡𝑖 )𝐹(0, 𝑡𝑖 )

𝑅=
∑𝑛𝑖=𝑘 𝑃(0, 𝑡𝑖 )

✓ Currency Swap
∑𝑛𝑖=1 𝑃(0, 𝑡𝑖 ) 𝑅 ∗ 𝐹0,𝑡𝑖
𝑅=
∑𝑛𝑖=1 𝑃(0, 𝑡𝑖 )

• R* is the fixed payment of another currency.

• 𝑃(0, 𝑡𝑖 ) is the dollar ZCB.
• 𝐹0,𝑡𝑖 is the forward exchange rate

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Tutorial Exercise
Question 1
Suppose that oil forward prices for 1 year, 2 years, and 3 years are $20, $21, and $22. The
effective annual interest rate is 6%, 6.5% and 7% for 1 year, 2 years and 3 years
respectively.

(a) What is the 3-year swap price?

(b) What is the price of a 2-year swap beginning in one year?
(c) Suppose you wish to enter into a swap contract, but you predict that you will need 10
barrels of oil in year 1 and year 3. For year 2, you predict that you need 20 barrels of
oil. Calculate the swap price of your contract.

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Question 2

Quarter 1 2 3 4
$ ZCB price 0.9852 0.9701 0.9546 0.9388
Euro ZCB price 0.9913 0.9825 0.9735 0.9643
Euro forward price ($ per euro) 0.9056 0.9115 0.9178 0.9244

What 4-quarter dollar annuity is equivalent to an 4-quarter annuity of 1 euro?

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Question 3 (Value of Swap)

Suppose you have entered into a 4-year swap (long position) with a swap price of 50. 1
year later, after paying the first payment, what would be the value of your swap position
if the new swap price is 52? Suppose the risk-free interest rate remains the same at 5%
p.a. effectively.