MEB

Financial Strategy

Session 4 – swaps
 Nature of Swaps

A swap is an agreement to exchange

cash flows at specified future times
according to certain specified rules

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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)
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 One Possible Outcome for Cash Flows to
Microsoft

Date LIBOR Floating Cash Flow Fixed Cash Net Cash Flow
Flow
Mar 5, 2014 4.20%
Sep 5, 2014 4.80% +2.10 −2.50 −0.40
Mar 5, 2015 5.30% +2.40 −2.50 −0.10
Sep 5, 2015 5.50% +2.65 −2.50 + 0.15
Mar 5, 2016 5.60% +2.75 −2.50 +0.25
Sep 5, 2016 5.90% +2.80 −2.50 +0.30
Mar 5, 2017 +2.95 −2.50 +0.45

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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

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Interest Rate Swaps: curve

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Spread of Corporate bond yields AAA on swaps and governments
Spread of Corporate bond yields BBB on swaps and e governments
INTEREST RATE RISK MANAGEMENT TOOLS
CHOOSE THE RIGHT INSTRUMENTS

UP DOWN
expectations

Derivative

(FRA) BUY SELL

FUTURE SELL BUY
SWAP PAY FIXED SELL FIXED

CAP BUY SELL

FLOOR SELL BUY
COLLAR BUY SELL

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 HOW TO EVALUATE
COUNTERPARTY RISK

• RATING

• ASSET SWAP SPREAD

• CREDIT DEFAULT SWAP

 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
• Many interest rate swaps are now cleared
through a CCP such as LCH Clearnet or the
CME Group
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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)

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 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

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 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

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 Credit Default Swaps
• Buyer of the instrument acquires protection from the seller
against a default by a particular company or country (the
reference entity)
• Example: Buyer pays a premium of 90 bps per year for $100
million of 5-year protection against company X
• Premium is known as the credit default spread. It is paid for
life of contract or until default
• If there is a default, the buyer has the right to sell bonds with
a face value of $100 million issued by company X for $100
million (Several bonds are typically deliverable)

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 CDS Structure (Figure 25.1, page 573)

90 bps per year

Default Default
Protection Protection
Buyer, A Seller, B
Payoff if there is a default by reference
entity=100(1-R)

Recovery rate, R, is the ratio of the value of the bond issued by

reference entity immediately after default to the face value of the
bond

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CREDIT DEFAULT SWAPS
Attractions of the CDS Market
• Allows credit risks to be traded in the
same way as market risks
• Can be used to transfer credit risks
to a third party
• Can be used to diversify credit risks

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 Credit Indices
• CDX NA IG is a portfolio of 125 investment grade
companies in North America
• iTraxx Europe is a portfolio of 125 European
investment grade names
• The portfolios are updated on March 20 and Sept 20
each year
• The index can be thought of as the cost per name of
buying protection against all 125 names

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CREDIT DEFAULT SWAPS
 Asset Backed Securities
• Securities created from a portfolio of loans, bonds, credit
card receivables, mortgages, auto loans, aircraft leases,
music royalties, etc
• Usually the income from the assets is tranched
• A “waterfall” defines how income is first used to pay the
promised return to the senior tranche, then to the next
most senior tranche, and so on.

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 Collateralized Debt Obligations
• A cash CDO is an ABS where the underlying assets are
debt obligations
• A synthetic CDO involves forming a similar structure with
short CDS contracts
• In a synthetic CDO most junior tranche bears losses first.
After it has been wiped out, the second most junior
tranche bears losses, and so on

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