Swaps

Swaps
7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 Mechanics of interest rate swaps Day count issues Confirmation The comparative-advantage argument Currency swaps Valuation of currency swaps Credit risk Other types of swaps

Nature of Swaps
A swap is an agreement between two companies to exchange cash flows in the future. The agreement defines the dates when the cash flows are to be paid and the way in which they are to be calculate. Examine:
How swaps are designed. How swaps are used. How swaps are valued.
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7.1 Mechanics of Interest Rate Swaps

plain vanilla interest rate swap.
The most common type of swap. In this swap a company agrees to pay cash flow equal to interest at a predetermined fixed rate on a notional principal for a number of years. In return, it receives interest at a floating rate on the same notional principal for the same period.

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To understand how it is used

illustration
Consider a hypothetical 3-year swap initiated on March 5, 2007, between Microsoft and Intel. We suppose Microsoft agrees to pay Intel an Interest rate of 5% per annum on a principal of $100 millions, and in return Intel agrees to pay Microsoft the 6-month LIBOR rate on the same principal. We assume the agreement specifies that payments are to be exchanged every 6 months and that the 5% interest rate is quote with semiannual compounding.
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Interest rate swap between Microsoft and Intel. (see figure 7.1,p. 148)

floating-rate payer

fixed-rate payer 5.0%

Intel
LIBOR
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Microsoft
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Cash Flows to Microsoft

(See Table 7.1, p. 149)

Date
Mar.5, 2007 Sept.5, 2007 Mar.5, 2008 Sept.5, 2008 Mar.5, 2009 Sept.5, 2009 Mar.5, 2010
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-------------Millions of Dollars-------------------LIBOR floating fixed Net Rate Cash Flow Cash Flow Cash Flow 4.2% 4.8% 5.3% 5.5% 5.6% 5.9%
0.5*0.042*$100=$2.1

+2.10 +2.40 +2.65 +2.75 +2.80 +2.95

2.50 2.50 2.50 2.50 2.50 2.50

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0.40 0.10 +0.15 +0.25 +0.30 +0.45

Cash Flows to Microsoft when there is a final exchange of principal (See Table 7.2, p. 149)
-------------Millions of Dollars-------------------LIBOR floating fixed Net Rate Cash Flow Cash Flow Cash Flow 4.2% 4.8% 5.3% 5.5% 5.6% 5.9% 2.50 2.50 2.50 2.50 2.50 102.50
8

Date
Mar.5, 2007 Sept.5, 2007 Mar.5, 2008 Sept.5, 2008 Mar.5, 2009 Sept.5, 2009 Mar.5, 2010
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+2.10 +2.40 +2.65 +2.75 +2.80 +102.95

0.40 0.10 +0.15 +0.25 +0.30 +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 asset from

fixed rate to floating rate floating rate to fixed rate

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Using the Swap to Transform a Liability

(See Figure 7.2, p. 150)

5.2%

5.0%

Intel
LIBOR

Microsoft

LIBOR+0.1%

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Role of Financial Intermediary

From Figure 7.2 when Financial institution is involved. (See Figure 7.4, p. 151)

5.2%

4.985%

Intel
LIBOR

Financial institution

5.015%

MS
LIBOR LIBOR+0.1%

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Using the Swap to Transform an Asset

(See Figure 7.3, p. 151)
5.0%

LIBOR-0.2%

Intel
LIBOR

Microsoft

4.7%

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Role of Financial Intermediary

From Figure 7.3 when Financial institution is
involved. (See Figure 7.5, p. 152)

4.985% LIOBR-0.2%

Intel
LIBOR

Financial institution

5.015%

4.7%

MS
LIBOR

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Quotes By a Swap Market Maker

(See Table 7.3, p. 155)
Maturity Bid (%) Offer (%) Swap Rate (%)

2 years
3 years

6.03
6.21

6.06
6.24

6.045
6.225

4 years
5 years 7 years 10 years

6.35
6.47 6.65 6.83
fl

6.39
6.51 6.68 6.87
fix

6.370
6.490 6.665 6.850

B B
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7.2 Day Count Issues

LIBOR is a US money market rate6-month LIBOR is quote on an actual/360 basis.
(Table 7.1) 100*0.042*0.5=$2.1 (million)

n L * R * 360

184 100 * 0.042 * $2.146 llion 360

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7.3 Confirmations
the legal agreement underlying a swap.

signed by representatives of the two parties.

International Swaps and Derivatives Association (ISDA) Business day convention
Following business day US calendar
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Extract from Hypothetical Swap Confirmation (p. 154 Business Snapshot 7.1)

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7.4 The Comparative Advantage Argument

AAACorp wants to borrow floating. BBBCorp wants to borrow fixed.
(Table 7.4, page 155) Fixed AAA Corp BBB Corp 4.0%
1.2%

Floating 6-month LIBOR-0.1%

0.7%

5.2%

6-month LIOBR+0.6%

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Swap agreement between AAACorp and BBBCorp when rates in Table 7.4 apply.

(See Figure 7.6, page 156) 4.35% 4%

AAA Corp
LIBOR

BBB Corp

LIBOR+0.6%

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For AAACorp:
1.pay 4% 2.receive 4.35% 3.pay LIBOR pay (LIBOR-0.35%)

For BBBCorp:
1.pay (LIBOR+0.6%) 2.receive LIOBR 3.pay 4.35% pay 4.95%

Total apparent gain=a-b (In this case:1.2%-0.7%=0.5%) *a is the different between the interest rates facing
the two companies in fixed-rate markets. *b is the different between the interest rates facing the two companies in floating-rate markets.
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Swap agreement between AAACorp and BBBCorp when rates in Table 7.4 apply and a financial intermediary is involved.
(See Figure 7.7, page 156)

4%

4.33% AAA

LIBOR

Financial institution

4.37%
BBB

LIBOR

LIBOR+0.6%

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7.5 Currency Swap

Exchanging principal and interest payments in one currency for principal and interest payments in another. 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 swaps life

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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.
Dollars 6%

IBM
Sterling 5%
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British Petroleum
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Cash flow to IBM in currency swap

Date Dollar cash flow Sterling cash flow (millions) (millions)

February 1, 2007 February 1, 2008

February 1, 2009 February 1, 2010 February 1, 2011 February 1, 2012
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-18.00 +1.08
+1.08 +1.08 +1.08 +19.08

+10.00 -0.50
-0.50 -0.50 -0.50 -10.50
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Typical Uses of a Currency Swap

Conversion from a liability in one currency to a liability in another currency.
Conversion from an investment in one currency to an investment in another currency.

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Comparative Advantage
General Electric wants to borrow AUD. Qantas wants to borrow USD.
USD* 5.0%
2.0%

General Electric Qantas Airways

AUD* 7.6% 8.0%

0.4%

7.0%

The total gain for all parties=2.0%-0.4%=1.6%

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7.6 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.

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V swap B D -S 0 B F V swap S 0 B F -B D
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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.
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Valuation in Terms of Bonds

*All amounts in millions
Time 1 2 3 3 Total Cash Flows ($) 0.8 0.8 0.8 10.0 PV ($) 0.7311 0.6682 0.6107 7.6338 9.6439
(Table 7.9, page 167)

Cash flows (yen) 60 60 60 1,200

PV (yen) 57.65 55.39 53.22 1,064.30 1,230.55

The value of the swap in dollars:

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1230.5 =1.543 million V swap S 0 B F B D 9.643 110

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Valuation in Terms of Forwards

*All amounts in millions
Time Dollar Cash flow Yen cash flow Forward exchange rate

(Table 7.10, page 168)

Yen cash flow in Dollar Net Present Cash Flow value ($)

1
2 3 3

-0.8
-0.8 -0.8 -10.0

60
60 60 1200

0.009557
0.010047 0.010562 0.010562

0.5734
0.6028 0.6337 12.6746

-0.2266
-0.1972 -0.1663 +2.6746

-0.2071
-0.1647 -0.1269 2.0417

Total

1.5430

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7.7 Credit Risk

A swap is worth zero to a company initially. The company has credit risk exposure only when its value is positive.

What happens when the value is negative and the counterparty gets into financial difficulties?

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7.8 Other Types of Swaps

amortizing swaps step up swaps constant maturity swaps (CMS swap) constant maturity treasury swaps (CMT swap) compounding swaps accrual swaps LIBOR-in-arrears swaps cross-currency interest rate swaps equity swaps commodity swaps 32 volatility swaps

Thanks for your attention

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