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Lecture 5 Swap

**Overview of this lecture
**

I. II. III. IV. V. Introduction Main uses of Swaps Valuation of Interest Rate Swap Currency Swap Credit Risk

I. Introduction

Swap is an agreement to exchange cash flows at specified future times according to certain specified rules. A swap is equivalent to a coupon-bearing asset plus a coupon-bearing liability. Note that the coupons might be fixed or floating. Swaps can also be thought of as a package of forward contract. Two most common swaps: Plain vanilla interest rate swaps Fixed-for-fixed currency swaps

I. Introduction

Mechanics of Interest Rate Swap (Plain Vanilla)

Party A (buyer who longs the contract) agrees to pay fixed rate and receive floating rate, from counter-party B (seller who short the contract). There is no initial exchange of principal Define

r fix

r

flo a t

as the fixed rate. as the floating rate. Receives variable cash flows

r0 r

fix

r1 flo a t r

fix

r2 flo a t r

fix

r3 flo a t r

fix

r4 flo a t r

fix

Pays fixed cash flows

Introduction Mechanics of Interest Rate Swap (Plain Vanilla) One cash flows based on a fixed interest rate and another referenced to an index that varies over time. The time t variable cash flow is based on the time t-1 floating interest rate. The principal (termed the notional principal) itself is not exchanged. the two rates are compared and the difference (times the notional principal) is paid by one counterparty to the other. At each settlement period. .I. therefore the first cash flow is known all subsequent cash flows are unknown (but always known one period in advance).

5 m -$2.5 m Net CF -$0.053 0.40 m $2.80 m $2.04 05-Mar.15 m $0.5 m -$2.056 0.I.25 m $0.a.95 m Fixed CF -$2.75 m $2.5 m -$2.059 Floating CF $2.05 05-Sep. Intel agrees to pay Microsoft the six-month LIBOR rate.10 m $0.30 m $0. The 5% interest rate is quoted with semi-annual compounding Analysis of cash Flows (CFs ) to Microsoft Date 05-Mar -04 05-Sep.5 m -$2.40 m -$0.10 m $2.45 m .048 0. Introduction Mechanics of Interest Rate Swap (Plain Vanilla) Example: A 3-year swap initiated on 5 March 2004 between Microsoft and Intel.042 0. In return. Payments are to be exchanged every six months.05 05 -Mar-06 05-Sep -06 05-Mar -07 LIBOR 0. A notional principal of $100 million.5 m -$2. Microsoft agrees to pay to Intel an interest rate of 5% p.65 m $2.055 0.

II.0% 1.2% LIBOR +0.7% Both companies want to borrow $10 million for 5 years Company A wants the liability to be in the floating rate Company B wants the liability to be in the fixed rate .5% B 7.2% Diff (B-A) 2.2% LIBOR +1. Main uses of Swaps Converting a Liability Example: Suppose the following: A Fixed Rate Floating Rate 5.

Company A has absolute advantage in both floating rate and fixed rate markets. But in comparative term. Main uses of Swaps Converting a Liability Do nothing: Company A borrows at the floating rate of LIBOR + 0. Company B has a comparative advantage in the floating rate market Company A has a comparative advantage in the fixed rate market Hence.5% Company B borrows at the fixed rate of 7.2% Using swap: In absolute term.II. an interest rate swap for 5 years between A and B but how? .

II. Company A has a comparative advantage in the fixed rate market but wants borrow floating rate. Suppose the term of the swap is that Company A agreed to pay LIBOR + 1. .8% to Company A. Main uses of Swaps Converting a Liability Recall: Company B has a comparative advantage in the floating rate market but wants to borrow fixed rate.7% to Company B and Company B agreed to pay 6.

7% 5. Main uses of Swaps Converting a Liability That is.II.7% .receive 6.8% Effectively.7% .8% A LIBOR +1. Borrow from outside at a fixed rate of 5.pay LIBOR + 1. A borrows a floating rate contract 6.2% B LIBOR + 1.2% At the same time. for A. swap with B .

5%) 0.2%) -(LIBOR + 1.1%) -(LIBOR + 0.8%) -(7.7%) -(6.7% -(LIBOR + 0.4% Gain .8%) 6.8% LIBOR + 1.7%) -(LIBOR + 1.2%) 0.II Main uses of Swaps Converting a Liability A n a ly s is o f c a s h lo s Company B Company A Pays outside lenders Pay under the swap Receives under the Swap Net interest If no swap Net Effect -(5.4% gain -(6.

25% Company A wants the asset to be in the fixed rate Company B wants the asset to be in the floating rate .2% LIBOR -0. Main uses of Swaps Converting an asset Example: Suppose the following A Fixed Rate Floating Rate 5.7% LIBOR -1.5% Diff (A-B) 0.5% 1.II.25% B 4.

4% to Company B and Company B agreed to pay 5.II. . Main uses of Swaps Converting an asset Do nothing: Company A receives at the fixed rate of 5.5% Using Swaps: Company B has a comparative advantage in the fixed rate market (but prefer floating rate) Company A has a comparative advantage in the floating rate market (but prefer fixed rate) Enter to an interest rate swap with the following term of the swap: Company A agreed to pay LIBOR-0.2% Company B receives at the floating rate of LIBOR-1.4% to Company A.

II.4 % A LIBOR-0.25% 4. Main uses of Swaps Converting an asset An interest benefit for both companies.7% B .4% LIBOR-0. 5.

Main uses of Swaps Converting an asset Analysis of cash Flows Company A Receives from outside borrowers Pay under the swap Receives under The Swap Net interest If no swap Net Effect 5.1% LIBOR-1.4%) LIBOR ± 0.7% -(LIBOR-0.2% 0.5% 0.4% Gain LIBOR-0.35% gain LIBOR-1.25% Company B 4.55% 5.4%) 5.4% .4% -(5.II.

03%) B LIBOR.385 5.25 % LIBOR .0.4 LIBOR .03% (spread) The spread depends on supply and demand .4 % 4.415 A Intermediary (Gain=0. the gains for the counterparties will be a little bit lower.0.II. 5.7% In our case here.0. Main uses of Swaps Role of financial intermediary If the swap is intermediated by a swap dealer. The intermediary enters into an offsetting contract with A and B and nets 0.

II. This refers to as warehousing interest rate swap. Main uses of Swaps Role of financial intermediary. Intermediary can enter into the swap and hedge its exposure until having an offsetting contract. Both parties to a swap do not contract the intermediary at the same time. .

Valuation of Interest Rate Swap A. the value of swap is Vswap ! B float B fix . The position of a fixed rate payer/floating rate receiver is equivalent to long a swap: Interest rate swap = Long floating rate note + short fixed rate note if you long a swap (fixed rate payer). Valuation in terms of bond prices An interest rate swap can be valued as the difference between value of fixed and floating rate bond.III.

III. Valuation in terms of bond prices Long an interest rate swap: = long floating rate note and short fixed rate note Floating rate note: Principal r0 Fixed rate note: r1 float r2float r3float r4float r fix r fix r fix r fix r fix Principal Combined r0 r fix r1 float r fix r2float r fix r3 float r fix r4 float r fix . Valuation of Interest Rate Swap A.

III. and vice versa for another party. Fixed rate debt is just ordinary coupon bond: n fix Where ! § i !1 k e ri t i L e rn t n t i is the time until ith payments are exchanged. . L is the notional principal in swap agreement. LIBOR) and borrow principal amount at the fixed rate.g. Valuation in terms of bond prices Swaps is then the same as an agreement in which one party lends principal amount at the variable rate (e. ri is the LIBOR zero rate corresponding to maturity ti. k is the fixed payment made on each payment date. Valuation of Interest Rate Swap A.

Valuation of Interest Rate Swap A. value of floating rate debt = PV of next cash flow + PV of notional principal. Valuation in terms of bond prices Floating rate debt reprices to par immediately after each payment Par is the notional principal Next payment is known with certainty Hence.III. B Where flo a t ! ( k *)e r1 t 1 K * is the floating rate payment that will be made on the next the next payment date. . or.

5% for 9 months 11% for 15 months The LIBOR 6-months rate at the last payment date (3 months ago) was 10. Valuation of Interest Rate Swap A.III.2% (semi-annual) Calculate the value of the swap. 10. Remaining life: 1. .25 years LIBOR (continuous compounding) 10% for 3 months. Valuation in terms of bond prices Example: Bank has agreed to pay 6-month LIBOR and Receive 8% (semi-annual) on $100 million.

24m .11x15 /12 B fix ! $98.III. Valuation in terms of bond prices Example Fixed rate bond Semi-annual Coupon payment ! $100m * 8% / 2 ! $4m B fix ! 4mxe 0.1*3/12 4 m xe 0.105 x9 /12 ($100 4) mxe0. Valuation of Interest Rate Swap A.

1% ! $5.1x3/12 ! $102.24 102.51 ! $4.2%/2 = 5.51 float Hence.1% k * ! $100m * 5.III.1 )e 0. Valuation in terms of bond prices Example Floating rate bond The semi-annual LIBOR used = 10.27 m . s ap ! fix float ( as the bank shorts the swap) ! 98. Valuation of Interest Rate Swap A.1m ! ($100 $5.

it does not mean that each forward contract underlying a swap is zero initially .III. Valuation in Terms of Forward Rate Agreements A one-year swap with semi-annual payments is just a package of two forward contracts one with a six-month maturity another with a 12-month maturity An interest rate swap can also be viewed as a convenient package of forward rate agreements (FRA). Valuation of Interest Rate Swap B. each exchange of payments (except the first payment) is an FRA The value of swap is the sum of the values of the forward rate agreements underlying the swap Note that the fixed rate in an interest rate swap is chosen so that the swap is worth zero initially.

T Note that all the rates are measured with a compounding frequency reflecting their maturity .III. RK is the FRA rate. Valuation of Interest Rate Swap B. 1 R 2 is the (continuously compounded) zero rate for a maturity T 2 . Valuation in Terms of Forward Rate Agreement Recall: FRA RK 0 R2 T1 RF T2 The value of FRA V ! L *( RK RF )* (T2 T1 ) e R2T2 where L is the principal value. RF is the forward LIBOR rate for the period between and T 2 .

. we follow the following steps: 1.III. calculate swap cash flows on the assumption that the LIBOR rates will equal to the forward rate (i. Valuation in Terms of Forward Rate Agreements To value IRS in terms of FRA. calculate each of the forward rates for each of the LIBOR rates that will determine swap cash flows. expectations theory holds) set swap rates equal to the PV of these cash flows 3.e. Valuation of Interest Rate Swap B. 2.

The LIBOR 6-month rate at the last payment date (3 months ago) was 10.III.25 years LIBOR (continuous compounding) 10% for 3 months.2% (semi-annual) Calculate the value of the swap. Remaining life: 1. 10.5% for 9 months. . 11% for 15 months. Valuation of Interest Rate Swap B. Valuation in Terms of Forward Rate Agreements Example: Bank has agreed to pay 6-month LIBOR and Receive 8% (semi-annual) on $100 million.

080.5 x $100m x (0.07 .2%. The first cash flow (in 3 months): The cash flows for the payments 3 months have already been set.102)e 0.III. The value of the exchange is NPV !0.1x3/12 !$1. A rate of 8% will be the exchanged for a rate of 10. Valuation of Interest Rate Swap B. Valuation in Terms of Forward Rate Agreements 1.

Valuation of Interest Rate Swap B.1 0 5 x (9 / 1 2 ) 0 .1 0 x . The second cash flow (in 9 months): Forward rate corresponding to 3 and 9 months is : R 2 T 2 R 1T1 0 . Valuation in Terms of Forward Rate Agreements 2.III.

1 0 7 5 9 /12 3 /12 T 2 T1 The rate of 10.75% obtained is a rate with continuous compounding Need to convert it to a rate with semi-annual compounding. R m! m e .3 / 1 2 RF ! ! ! 0 .

Rc / m 1 ! 2 x .

41m The value of the exchange is : 0.08 0.1075/2 1 ! 11.044% ! $1.11044)e 0.5 x 100 x (0.105 x (9/12) .e 0.

III.07m) ($1.41m) ($1.79m 4.2 7 m .08 0.11x15/12 !$1.79m) ! $ 4 .5x100 x (0. Valuation of Interest Rate Swap B. Total value of the swap !($1. Valuation in Terms of Forward Rate Agreements 3. The third cash flows The value of the exchange is !0.12102)e0.

the principal is exchanged at the beginning and the end of the swap There are four types of basic currency swaps: fixed for fixed fixed for floating floating for fixed floating for floating . Introduction Currency Swap (CCS) Exchanging principal and interest payments in one currency for principal and interest payments in another currency. Currency Swap A.IV. In a currency swap. two different currencies are periodically exchanged.

A At origination: £10 m B $15m At each annual settlement date: $15m *0. Currency Swap A.2m A B £10m *11% ! £1. A pays a fixed rate of 11% in sterling and receives a fixed rate of 8% in dollar from B (a fixed for fixed currency swap). Interest payments once a year.IV. Introduction Example of Currency Swap A five-year currency swap agreement between A and B.08 ! $1. The principal amounts are $15m and £10m.1m At Maturity: $15m A B £10m .

4% GM has a comparative advantage in the USD market but want to borrow in AUS. .IV.0% 7.0% 0. Currency Swap A. Instruction Example: Suppose the following: US GM Qantas Diff 5. Qantas has a comparative advantage in the AUD market but want to borrow in USD.0% 2.6% 13.0% AUD 12.

Currency Swap A. Introduction S5 GM S5 A .IV. S . Bank A QF A .

IV. Valuation CCS in terms of Bond Prices Long a currency swap: the domestic currency is received and a foreign currency is paid The value (in domestic currency) of a long position in swap is: Vs ap ! BD S0BF where B F is the value of the foreign-denominated bond underlying the swap (in the foreign currency). . B D is the value of home-denominated bond (in the home currency). S 0 is the spot exchange rate (number of units of domestic currency per units of foreign currency). Currency Swap B.

B is the value of home-denominated bond (in the home currency).IV. is the spot exchange rate (number of units of domestic 0 currency per units of foreign currency). . Valuation CCS in terms of Bond Prices The value of a swap where the foreign currency is received and a domestic currency is paid is: Vs ap ! S 0 BF BD where B F is the value of the foreign-denominated bond underlying the swap (in the foreign currency). Currency Swap B.

in Yen with a principal of Yen 1200 million. Currency Swap B.IV. with a principal of $10 million. and pays 8% p. The swap lasts for three years and the exchange rate is $0.00909/yen (or 110 yen=$1).a.a. What is the value of this swap? . Assume annual interest payments.a. A US company enters a swap where it receives 5% p.a. and the US interest rate is 9% p. Valuation CCS in terms of Bond Prices Example: The Japanese interest rate is 4% p.

Currency Swap B.55m The value of domestic bond is: BD ! 0.04x1 60e0.8e0.09x1 0. Valuation CCS in terms of Bond Prices Example: The value of foreign bond is: BF !60e0.IV.8e0.09x2 .04*3 !Yen 1230.04x2 (120060)e0.

09*3 ! $9.10 0.00909 9.644 m In our case. foreign currency is received and domestic currency is paid short Hence.54m .8 e0. Vswap ! S0 BF BD ! 1230.644! $1.55*0.

a.a. Example: The Japanese interest rate is 4% p. The swap lasts for three year and the exchange rate is $0. Valuation in terms of forward contracts The currency swap can also be viewed a series of forward contracts.IV. Currency Swap C. Hence. and pays 8% p.00909/yen. What is the value of this swap? . With a principal of $10 million. A US company enters a swap where it receives 5% p. Assume annual interest payments. and the US interest rate is 9% p. the value of the swap is the sum of the values of the values of the forward contracts underlying the swap. in Yen with a principal of yen 1200 million.a.a.

IV. K is delivery price in the contract. f ! ( F0 K )e rT . Currency Swap C. Valuation in terms of forward contracts 1 2 3 1 2 3 4 Recall : where f is the value of the contract today. F 0 is the forward price today.

Ft . r is the domestic risk-free interest rate. Currency Swap Valuation in terms of forward contracts To determine the Recall: we need forward exchange rate. The relationship between forward and spot exchange rate is: where F 0F X ! S F X 0 e (r r f ) T F0FX is the forward exchange rate. .IV. rf is the foreign risk-free interest rate. 1 S 0 is the spot exchange rate.

09 0.00909 x e (0. Currency Swap c. Valuation in terms of forward contracts One-year forward exchange rate: 0.090.04) x 2 ! 0.00909 x e(0.05 = 60 million Yen Pay: USD 10 million * 0.IV.04) x1 ! 0.00909 x e (0.8 million USD .08 = 0.090.010047 three-year forward exchange rate: 0.010562 The exchange of interests involves: Receive: Yen 1200 m * 0.04) x 3 ! 0.009557 two-year forward exchange rate: 0.

1 6 4 7 m U S D 0 .0 0 9 5 5 7 0 .1269 + 2.0 9 x 2 (6 0 m Y e n x 0 .0.2071 ± 0.8 m U S D ) e 0 .543 million USD .1 2 6 9 m U S D The value of forward contract corresponding to the exchange of principal at maturity is (1200 m Yen x 0.8 m U S D ) e 0 .0 9 x 1 ! 0 .09x 3 ! 2. Currency Swap C.8 m U S D ) e 0 .0 9 x 3 ! 0 .0416 m USD Total = .0 1 0 0 4 7 ! 0 .2 0 7 1 m U S D ( 6 0 m Y e n x 0 .010562 10 m USD)e0.0416 = 1.0 1 0 5 6 2 0 .1647 ± 0.IV. Valuation in terms of forward contracts The values of forward contracts corresponding to three exchanges of interests are: ( 6 0 m Y e n x 0 .

because there is a higher probability of a large buildup in value. its value is liable to be either positive or negative. At a future time. Credit risk is risk resulting from uncertainty in a counterparty¶s ability or willingness to meet its contractual obligation. Credit Risk C. A financial intermediary has credit risk exposure from a swap only when the value of the swap to the financial intermediary is positive. this means that it costs nothing to enter into a swap it does not mean that the each forward contract underlying a swap is worth zero initially. The value of swap is normally zero when it is first negotiated.V. . Note that there is greater credit risk with a currency swap when there will be a final exchange of principal. given one of the counterparties the incentive to default.

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