Professional Documents
Culture Documents
1
SWAPS
A SWAP is a contractual
arrangement between two
parties for an
exchange of cash flows.
1. Two parties
2. A notional amount
3. Cash flows
4. A payment schedule
5. An agreement as to
how to resolve
problems
3
1. Two parties:
$100,000,000
£50,000,000
Fixed price
Vs.
Market price
6
3. The cash flows
8
5. How to resolve problems:
1. Cost saving.
10
1. INTEREST RATE
SWAPS
Example: Plain Vanilla
Fixed for Floating rates swap
A swap is to begin in two weeks.
Party A will pay a fixed rate 7.19% per
annum on a semi-annual basis, and will
receive the floating rate: six-month
LIBOR + 30bps from from Party B. The
notional principal is $35million. The
swap is for five years.
Two weeks later, the six-month LIBOR
rate is 6.45% per annum.
11
The fixed rate in a swap is usually quoted
on a
semi-annual bond equivalent yield
basis. Therefore, the amount that is paid
every six months is:
Party A Party B
FLOATING
LIBOR 30 bps
$1,254,802.74 - $1,194,375.00
= $60,427.74.
14
This example illustrates five points:
16
Example: A FIXED FOR FLOATING SWAP
18
The SWAP always begins
with each party borrowing capital in the
market in which it has a
RELATIVE ADVANTAGE.
Thus, F1 borrows S $10,000,000
in the market for floating rates, I.e., for
LIBOR + 2% for 5 years.
F2 borrows $10,000,000
in the market for fixed rates, I.e.,
for 12%.
NOW THE TWO PARTIES
EXCHANGE THE TYPE OF CASH
FLOWS BY ENTERING THE SWAP
FOR FIVE YEARS 19
A fundamental implicit
assumption:
The swap will take place
only if
F1 wishes to borrow capital
for a FIXED RATE, While
F2 wishes to borrow capital
for a FLOATING RATE.
That is, both firms want to change the
nature of their payments.
20
Two ways to negotiate the
contract:
1. Direct negotiations
between the two parties.
2. Indirect negotiations
between the two parties.
In this case each party
separately negotiates with
an intermediary party.
21
Usually,
The intermediary is a
financial institution – a
swap dealer - who
possesses a portfolio of
swaps.
The intermediary charges
both parties commission
for its services and also as
a compensation for the risk
it assumes by entering the
two swaps
22
FIXED FOR FLOATING SWAP
1. A DIRECT SWAP:
FIRM FIXED RATE FLOATING RATE
F1 15% LIBOR + 2%
F2 12% LIBOR + 1%
notional: $10M
LIBOR
12% LIBOR+2%
F2 F1
12%
L+25bps L
L + 2%
12% F2 F1
I
12% 12,25%
12%
L+5bp L L+2%
F2 I F1
12% 12%+5bp
26
EXAMPLE: A RISK MANAGEMENT
SWAP
LOAN FL1
10%
COUNTERPARTY
BANK
A
FL2
LOAN 12%
FIRM A
BORROWS AT
A FIXED RATE
FOR 5 YEARS
27
THE BANK’S CASH FLOW:
FL1
10%
BANK COUNETRPARTY
a
FL2
FL2
FL1
12% COUNTERPARTY
b
FIRM A 29
THE BANK’S CASH FLOW:
RESULTS
THE BANK EXCHANGES THE RISK
ASSOCIATED WITH THE
SPREAD = FL2 - FL1
WITH A FIXED RATE OF 2%.
THIS RATE IS A
RISK-FREE RATE!
30
VALUATION OF SWAPS
The swap coupons (payments) for
short-dated fixed-for-floating
interest rate swaps are routinely
priced off the Eurodollar futures
strip (Euro strip). This pricing
method works provided that:
(1) Eurodollar futures exist.
(2) The futures are liquid.
As of June 1992, three-month
Eurodollar futures are traded in
quarterly cycles - March, June,
September, and December - with
delivery (final settlement) dates
as far forward as five years. Most
times, however, they are only
liquid out to about four years,
thereby somewhat limiting the
use of this method. 31
The Euro strip is a series of
successive three-month Eurodollar
futures contracts.
While identical contracts trade on
different futures exchanges, the
International Monetary Market (IMM)
is the most widely used. It is worth
mentioning that the Eurodollar
futures are the most heavily traded
futures anywhere in the world. This
is partly as a consequence of swap
dealers' transactions in these
markets. Swap dealers synthesize
short-dated swaps to hedge
unmatched swap books and/or to
arbitrage between real and synthetic
swaps.
32
Eurodollar futures provide a way to
do that. The prices of these
futures imply unbiased estimates
of three-month LIBOR expected to
prevail at various points in the
future. Thus, they are conveniently
used as estimated rates for the
floating cash flows of the swap.
The swap fixed coupon that
equates the present value of the
fixed leg with the present value of
the floating leg based on these
unbiased estimates of future
values of LIBOR is then the
dealer’s mid rate.
33
The estimation of a “fair” mid rate is
complicated a bit by the facts
that:
(1) The convention is to quote swap
coupons for generic swaps on a
semiannual bond basis, and
(2) The floating leg, if pegged to
LIBOR, is usually quoted on a
money market basis.
Note that on very short-dated swaps
the swap coupon is often quoted
on a money market basis. For
consistency, however, we
assume throughout that the
swap coupon is quoted on a
bond basis.
34
The procedure by which the dealer
would obtain an unbiased mid rate
for pricing the swap coupon
involves three steps.
The first step: Use the implied
three-month LIBOR rates from the
Euro strip to obtain the implied
annual effective LIBOR for the
full-tenor of the swap.
The second step: Convert this full-
tenor LIBOR to an effective rate
quoted on an annual bond basis.
The third step: Restate this
effective bond basis rate on the
actual payment frequency of the
swap.
35
NOTATIONS: Let the swap have a
tenor of m months (m/12 years). The
swap is to be priced off three-month
Eurodollar futures, thus, pricing requires n
sequential futures series; n = m/3 or,
equivalently, m = 3n.
Step 1: Use the futures Euro strip to
Calculate the implied effective annual
LIBOR for the full tenor of the swap:
k
n
N(t)
r0,3n [1 (r3(t-1),3(t) )] 1,
t 1 360
360
where : k ; N(t) denotes
N(t)
the actual number of days covered
by the t - th Eurodollar futures.
36
N(t) is the total number of days covered
by the swap, which is equal to the sum of
the actual number of days in the
succession of Eurodollar futures.
Step 2: Convert the full-tenor LIBOR,
which is quoted on a money market basis,
to its fixed-rate equivalent FRE(0,3n),
which is stated as an effective annual rate
on an annual bond basis. This simply
reflects the different number of days
underlying bond basis and money market
basis:
365
FRE(0,3n) r0,3n .
360
37
Step 3: Restate the fixed-rate on the
same payment frequency as the floating
leg of the swap. The result is the swap
coupon, SC.
Let f denote the payment frequency, then
the coupon swap is given by:
1
SC {[1 FRE(0,3n)] - 1}(f),
f
38
Example: For illustration purposes let
us observe Eurodollar futures settlement
prices on April 24, 2001.
Eurodollar Futures Settlement Prices
April 24,2001.
CONTRACT PRICE LIBOR FORWARD DAYS
JUN01 95.88 4.12 0,3 92
SEP91 95.94 4.06 3,6 91
DEC9195.69 4.31 6,9 90
MAR92 95.49 4.51 9,12 92
JUN92 95.18 4.82 12,15 92
SEP92 94.92 5.08 15,18 91
DEC9294.64 5.36 18,21 91
MAR93 94.52 5.48 21,24 92
JUN93 94.36 5.64 24,27 92
SEP93 94.26 5.74 27,30 91
DEC9394.11 5.89 30,33 90
MAR94 94.10 5.90 33,36 92
JUN94 94.02 5.98 36,39 92
39
SEP94 93.95 6.05 39,42 91
These contracts imply the three-month
LIBOR (3-M LIBOR) rates expected to
prevail at the time of the Eurodollar
futures contracts’ final settlement, which
is the third Wednesday of the contract
month. By convention, the implied rate
for three-month LIBOR is found by
deducting the price of the contract from
100. Three-month LIBOR for JUN 91 is a
spot rate, but all the others are forward
rates implied by the Eurodollar futures
price. Thus, the contracts imply the 3-M
LIBOR expected to prevail three months
forward, (3,6) the 3-M LIBOR expected to
prevail six months forward, (6,9), and so
on. The first number indicates the month
of commencement (i.e., the month that
the underlying Eurodollar deposit is lent)
and the second number indicates the
month of maturity (i.e., the month that
the underlying Eurodollar deposit is
repaid). Both dates are measured in
months forward. 40
In summary, the spot 3-M LIBOR is
denoted r 0,3 , the corresponding forward
rates are denoted r3,6, r6,9, and so on.
Under the FORWARD column, the first
month represents the starting month and
the second month represents the ending
month, both referenced from the current
month, JUNE, which is treated as month
zero.
Eurodollar futures contracts assume a
deposit of 91 days even though any actual
three-month period may have as few as
90 days and as many as 92 days. For
purposes of pricing swaps, the actual
number of days in a three-month period
is used in lieu of the 91 days assumed by
the futures. This may introduce a very
small discrepancy between the
performance of a real swap and the
performance of a synthetic swap created
from a Euro strip.
41
Suppose that we want to price a one-
year fixed-for-floating interest rate
swap against 3-M LIBOR. The fixed rate
will be paid quarterly and, therefore, is
quoted quarterly on bond basis. We need
to find the fixed rate that has the same
present value (in an expected value sense)
as four successive 3-M LIBOR payments.
Step 1: The one-year implied LIBOR rate,
based on k =360/365, m = 12, n = 4
and f=4 is:
k
n
N(t)
r0,3n [1 (r3(t -1),3(t) )] 1
t 1 360
360
92 91 365
(1 .0412 )(1 .0406 )
360 360
1
90 92
(1 .0431 )(1 .0451 )
360 360
4.34%, on money market basis. 42
Step 2 and 3:
1
SC {[1 FRE(0,3n)] - 1}(f),
f
43
4.33%+s
FIXED
Client Swap
7.19
dealer
3-M %
LIBOR
FLOATING
LIBOR
+ 30
4.35%+s
FIXED
Client Swap
dealer
6-M LIBOR
FLOATING
45
The procedure above allows a dealer to
quote swaps having tenors out to the
limit of the liquidity of Eurodollar futures
on any payment frequency desired and to
fully hedge those swaps in the Euro Strip.
The latter is accomplished by purchasing
the components of the Euro Strip to
hedge a dealer-pays-fixed-rate swap or,
selling the components of the Euro Strip
to hedge a dealer-pays-floating-rate
swap.
Example: Suppose that a dealer wants
to price a three-year swap with a
semiannual coupon when the floating leg
is six-month LIBOR. Three years: m=36
months requiring 12 separate Eurodollar
futures; n = 12. Further, f = 2 and the
actual number of days covered by the
swap is N(t) = 1096.
Step 1: The implied LIBOR rate for the
entire period of the swap:
46
360
12 N(t) 1096
r0,36 [1 (r3(t-1),3(t) )] 1
t 1 360
360
92 91 90 1096
(1 .0412 )(1 .0406 )(1 .0431 )
360 360 360
92 92 91
(1 .0451 360 )(1 .0482 360 )(1 .0508 360 )
1
(1 .0536 91 )(1 .0548 92 )(1 .0564 92 )
360 360 360
91 90 92
(1 .0574 )(1 .0589 )(1 .0590 )
360 360 360
5.17%, on money market basis.
47
Finally,
Step 3: The equivalent semiannual
Swap Coupon is calculated:
6
12 4.35%
18
24
30
36 5.17%
42
* All swaps above are priced against 6-month
LIBOR flat and assume that the notional principal
is non amortizing.
49
Swap Valuation
The example below illustrates the valuation
of an interest rate swap, given the coupon
payments are known. Consider a financial
institution that receives fixed payments at
the annual rate 7.15% and pays floating
payments in a two-year swap. Payments are
made every six months. The data are:
Payments Days Treasury Euro
dates between Bills Dollar
payment Prices Deposit
Dates B(0,T) L(0,T)
t1 = 182 182 .9679 .9669
t2 = 365 183 .9362 .9338
t3 = 548 183 .9052 .9010
t4 = 730 182 .8749 .8684
B(0,T)=PV of $1.00 paid at T.L(0,T)=PV of 1Euro$
paid at T. These prices are respectively, derived
from the Treasury and Eurodollar term structures.50
The fixed side of the swap.
At the first payment date, t1, the
dollar value of the payment is:
182
VFIXED (t1 , t1 ) N P (.0715) ,
365
where NP denotes the notional
principal.
The present value of receiving one
dollar for sure at date t1, is
0.9679. Therefore, the present
value of the first fixed swap
payment is:
VFIXED (0, t1 ) [.9679]VR (t1 , t1 ).
51
By repeating, this analysis, the
present value of all fixed
payments is:
VFIXED(0)
= NP[(.9679)(.0715)(182/365)
+ (.9362)(.0715)(183/365)
+ (.9052)(.0715)(183/365)
+ (.8749)(.0715)(182/365)]
= NP[.1317].
52
On the floating side of the swap, the
pattern of payments is similar to that of a
floating rate bond, with the important
proviso that there is no principal
payment in a swap. Thus, when the
interest rate is set, the bond sells at par
value. Given that there is no principal
payment, we must subtract the present
value of principal from the principal itself.
The present value of the floating rate
payments depends on L(0, t4) - the
present value of receiving one Eurodollar
at date t4:
Value of Swap
= VFIXED(0) - VFLOATING(0)
= NP[.1317 - .1316]
= (.0001)NP.
NP – NP{L(T1, TN)}.
k1
VFLOATING (T1 ) N P λ
360
N P N P L(T1 , Tn ).
The value of the floating rate payments
at date 0 is the PV of:
VFLOATING (T1 ) :
k1
VFLOATING (0) N P λ 1 L(0, T1 )
360
- N P L(0, Tn ).
This holds true because
L(T1 , Tn )L(0, T1 ) L(0, Tn ).
57
2. If the swap is initiated at date 0,
then the above equation simplifies as
follows:
Let λ(0) denote the current LIBOR rate.
By definition:
1
L(0, T1 ) and because
T1
1 λ(0)
360
k1 T1 , the value of the floating
rate payments is :
T1
VFLOATING (0) N P λ(0) 1 L(0, T1 )
360
- N P L(0, Tn ).
60
PAR SWAP Valuation
The example below illustrates the valuation
of an interest rate par swap.
Consider a financial institution that receives
fixed payments at the rate 7.15% per annum
and pays floating payments in a two-year
swap. Payments are made every six months.
The data are:
Payments Days Treasury Euro
dates between Bills Dollar
payment Prices Deposit
Dates B(0,T) L(0,T)
t1 = 182 182 .9679 .9669
t2 = 365 183 .9362 .9338
t3 = 548 183 .9052 .9010
t = 730 182 .8749 .8684
4
B(0,T)=PV of $1.00 paid at T.L(0,T)=PV of 1Euro$
paid at T. These prices are respectively, derived
from the Treasury and Eurodollar term structures.61
PAR SWAP VALUATION:
Solve for R, the equation:
[
NP (R/100)(.9679)(182/365)
+ (R/100)(.9362)(183/365)
+ (R/100)(.9052)(183/365)
+ (R/100)(.8749)(182/365) ]
= NP[1 - .8684]
R/100 = .1316/1.8421
64
In the mid 1970s, IBM had issued bonds in
German marks, DEM, and Swiss francs,
CHF. The bonds maturity date was March
30, 1986. The issued amount of the CHF
bond was CHF200 million, with a coupon
rate of 6 3/16% per annum. The issued
amount of the DEM bond was DEM300
million with a coupon rate of 10% per
annum.
During 1981 the USD appreciated sharply
against both currencies. The DEM, for
example, fell in value from $.5181/DEM in
March 1980 to $.3968/DEM in August 1981.
Thus, coupon payments of DEM100 had
fallen in USD cost from $51.81 to $39.68.
The situation with the Swiss francs was the
Same. Thus, IBM enjoyed a sudden,
unexpected capital gain from the reduced
USD value of its foreign debt liabilities.
65
In the beginning of 1981, The World
Bank wanted to borrow capital in
German marks and Swiss francs against
USD. Around that time, the World Bank
had issued comparatively little USD
paper and could raise funds at an
attractive rate in the U.S. market.
Both parties could benefit from USD for
DEM and CHF swap. The World Bank
would issue a USD bond and swap the $
proceeds with IBM for cash flows in CHF
and DEM.
The bond was issued by the World Bank
on August 11, 1981, settling on August
25, 1981. August 25, 1981 became the
settlement date for the swap. The first
annual payment under the swap was
determined to be on March 30, 1982 – the
next coupon date on IBM's bonds. I.e.,
215 days (rather than 360) from the swap
starting date. 66
The swap was intermediated by Solomon
Brothers.
The first step was to calculate the value of
the CHF and DEM cash flows. At that
time, the annual yields on similar bonds
were at 8% and 11%, respectively.The
initial period of 215-day meant that the
discount factors were calculated as
follows:
1
Discount Factor n
,
(1 y) 360
67
The discount factors were calculated:
Date Days CHF DEM
3.30.82 215 .9550775 .9395764
3.30.83 575 .8843310 .8464652
3.30.84 935 .8188250 .7625813
3.30.85 1295 .7581813 .6870102
3.30.86 1655 .7020104 .6189281.
Next, the bond values were calculated:
NPV(CHF) =
12,375,000[.9550775 + .8843310
+ .8188250 + .7581813]
+ 212,375,000[.7020104]
= CHF191,367,478.
NPV(DEM)=
30,000,000[.9395764 + .8464652
+.7625813+.6870102]
+330,000,000[.61892811]
= DEM301,315,273.
68
The terms of the swap were agreed upon
on August 11, 1981. Thus, The World Bank
would have been left exposed to currency
risk for two weeks until August 25. The
World Bank decided to hedge the above
derived NPV amounts with 14-days
currency forwards.
Assuming that these forwards were at
$.45872/CHF and $.390625/DEM, The World
Bank needed a total amount of
$205,485,000;
$87,783,247 to buy the CHF and
$117,701,753 to buy the DEM.
$205,485,000.
This amount needed to be divided up to the
various payments. The only problem was
that the first coupon payment was for 215
days, while the other payments were based
on a period of 360 days. 69
Assuming that the bond carried a coupon
rate of 16% per annum with intermediary
commissions and fees totaling 2.15%, the
net proceeds of .9785 per dollar meant
that the USD amount of the bond issue
had to be:
$205,485,000/0.9785 = $210,000,000.
$210,000,000(.16)[215/360]
= $20,066,667.
70
The cash flows are summarized in the
following table:
Date USD CHF DEM
3.30.82 20,066,667 12,375,000 30,000,000
3.30.83 33,600,000 12,375,000 30,000,000
3.30.84 33,600,000 12,375,000 30,000,000
3.30.85 33,600,000 12,375,000 30,000,000
3.30.86 243,600,000 212,375,000 330,000,000
YTM 8% 11% 16.8%
NPV 205,485,000 191,367,478
301,315,273
73
DIRECT SWAP FIXED FOR FIXED
$9.35%
F1 F2
£11.5%
£11.5%
75
DIRECT SWAP FIXED FOR FIXED
$9.55%
F1 F2
£11.25%
£11.5%
COUNTRY A COUNTRY B
F1 F2
PROJECT OF PROJECT OF
F2 F1
77
CURRENCY SWAP
78
CURRENCY SWAP FIXED FOR FIXED
CP = Chilean Peso
R = Brazilian Real
Firm CH1, is a Chilean firm who
needs capital for a project in Brazil,
while,
A Brazilian firm, BR2, needs capital
for a project in Chile.
The market for fixed interest rates in
these countries makes a swap
beneficial for both firms as follows:
79
FIRM CHILE BRAZIL
CH1 $12% R16%
BR2 $15% R17%
With these rates, CH1 has absolute
advantage in both markets but,
comparative advantage in Chile only.
CH1 borrows in Chile in Chilean Pesos and
BR2 borrows in Brazil in Reals. The swap
begins with the interchange of the
principal amounts borrowed at the current
exchange rate.
The figures below show a direct swap
between CH1 and BR2 as well as an
indirect swap.
The swap terminates at the end of the
swap period when the original principal
amounts exchange hands once more.
80
ASSUME THAT THE CURRENT
EXCHANGE RATE IS:
R1 = CP250
ASSUME THAT CH1 NEEDS
R10.000.000 FOR ITS PROJECT IN
BRAZIL AND THAT BR2 NEEDS
EXACTLY CP2,5B FOR ITS
PROJECT IN CHILE.
AGAIN:
FIRM CHILE BRAZIL
CH1 $12% R16%
BR2 $15% R17%
81
DIRECT SWAP FIXED FOR FIXED
R15%
CH1 BR2
$12%
$12% R17%
CHILE BRAZIL
CH1 BORROWS BR2 BORROWS
CP2.5B AND R10M AND
DEPOSITS IT IN DEPOSITS IT IN
BR2’S CH1’S ACCOUNT
ACCOUNT IN IN SAO PAULO
SANTIAGO
CH1 BR2
$12% R17%
CHILE BRAZIL
CH1 BORROWS BR2 BORROWS
CP2.5B AND R10M AND
DEPOSITS IT IN DEPOSITS IT IN
BR2’S CH1’S ACCOUNT
ACCOUNT IN IN SAO PAULO
SANTIAGO
83
THE CASH FLOWS:
CH1: PAYS R15.50%
BR2: PAYS CP14.50%
THE INTERMEDIARY REVENUE:
CP2.50 – R1.50%
CP2,5B(0.025) – R10M(0.015)(250)
= CP62,500,000 - CP37,500,000 =
CP25,000,000
Notice: In this case, CH1 saves 0.25% and
BR2 saves 0.25%, while the intermediary
bears the exchange rate risk. If the Chilean
Peso depreciates against the Real the
intermediary’s revenue declines. When the
exchange rate reaches CP466,67/R the
intermediary gain is zero. If the Chilean Peso
continues to depreciate the intermediary
loses money on the deal. 84
FIXED FOR FLOATING
CURRENCY SWAP
A Mexican firm needs capital for a project in
Great Britain and a British firm needs capital
for a project in Mexico. They enter a swap
because they can exchange fixed interest
rates into floating and borrow at rates that
are below the rates they could obtain had
they borrowed directly in the same markets.
In this case, the swap is
Fixed-for-Floating rates,
i.e.,
One firm borrows fixed, the other borrows
floating and they swap the cash flows
therby, changing the nature of the payments
from fixed to floating and vice – versa.
85
DIRECT SWAP FIXED FOR FLOATING
INTEREST RATES
MEXICO GREAT BRITAIN
MX1 MP15% £LIBOR + 3%
GB2 MP18% £LIBOR + 1%
ASSUME: The current exchange rate is:
£1 = MP15.
MX1 needs £5.000.000 in England and
GB2 needs MP75.000.000 in Mexico.
THUS:
MX1 borrows MP75m in Mexico and deposits
it in GB2’s account in Mexico D.F., Mexico,
While GB2 borrows £5,000,000 in Great
Britain and deposits it in MX1’s account in
London, Great Britain.
86
DIRECT SWAP FIXED FOR
FLOATING
£L + 1%
MX1 GB2
MP15%
MP15% £L + 1%
MEXICO ENGLAND
MX1 BORROWS GB2 BORROWS
MP75M AND £5,000,000 AND
DEPOSITS IT IN DEPOSITS IT IN
GB2’S MX1’S ACCOUNT
ACCOUNT IN IN LONDON,
MEXICO D.F., GREAT BRITAIN
MEXICO.
88
A plain vanilla CURRENCY
SWAPS VALUATION
Under the terms of a swap, party A
receives French francs (FF) interest rate
payments and making dollar ($) interest
payments. Let us measure the amount
in . Also, use the following notation:
BFF = PV of the payments in FF from party
B, including the principal payment at
maturity. V
3.75 1
[$10M] ( ) $ 187,500.
100 2
92
Therefore, the present value of the
interest rate payments in U.S Dollars plus
principal is:
$187,500[.9840 .9667
B$ .9467 .8249]
$10,000,00 0(.9249)
$9,965,681.
Therefore, the
value of the foreign currency swap
is:
PV(Cash Flow)$ - B$
$10,014,364 - 9,965,681
$48,683. 93
3.COMMODITY SWAPS
95
Example: A Commodity Swap
96
Spot oil
market
Oil Spot
Price
$24.20/bbl
Refinery Swap
Average Spot Price Dealer
97
Note that in the swap no exchange of the
notional commodity takes place between
the counterparties. The refinery has
reduced its exposure to the volatile oil
prices in the markets. It still, however,
bear some risk. This is because there
may be a difference between the spot
price and the average spot price. The
refinery is still buying oil and paying the
spot price, and from the swap dealer it
receives the last month's average spot
price. It also pays to the swap dealer
$24.20 per barrel over the life of the
contract. Therefore, the spread between
the spot and last month average prices
presents some risk to the refinery.
98
A NATURAL(NG) SWAP:
FIXED FOR FLOATING.
MC – a marketing firm buys NG from a
producer for the fixed price of $9.50/UNIT
(1,000 cubic feet). At the same time MC
finds an end user and sells the NG. The end
user insists on paying a floating market price
index. The index is published daily according
NG prices in different locations.
MC’s risk is that the index falls below $9.50.
MC enters a FIXED FOR FLOATING swap in
which it pays the swap dealer the index and
recieves $9.55/tcf
The notional amount of NG is equal to the
amount purchased and sold by MC.
99
A FISED-FOR-FLOATING
NATURAL GAS SWAP
$9.50 INDEX
Gas Gas
$9.55 INDEX
SWAP
DEALER
101
FLOATING-FOR-FLOATING
NATURAL GAS SWAP
INDEX1 INDEX2
producer MC USER
Gas Gas
Swap Dealer
105
Like any forward, the forward price is
set such that no cash is exchanged when
the contract is written. This implies that
the value of the forward contract, when
initiated, is zero. That is:
106
Repeating this argument for the remaining
payments, it can be shown that the
value of the commodity swap
at date 0 is:
n
V0 [F(0, t j ) P(Fixed)]B(0, t j )N p .
j1
107
FINAL EXAMPLE:
From the derivatives trading room of BP:
Hedging the sale and purchase of Natural
Gas, using NYMEX Natural Gas futures and
Creating a sure profit margin swapping the
remaining spread. First, let us define:
August 12
(i) Buy NG from BM Short August NYMEX
S1 = IF . Futures.
(ii) Sell NG to SST for Faug; aug = L3D
S2 = F4, 12; aug – $X
111
A FLOATING FOR FLOATING
SWAP
L3D - $.09
BP SWAP DEALER
IF
112
SUMMARY OF CASH FLOWS
MARKET CASH FLOW
Spot: F4, 12; AUG - $X - IF
F4,12;AUG - $.06
IF
SPOT: BM BP SST
NG NG
LONG SHORT
F4,12;AUG L3D
FUTURES
NYMEX
114
4. BASIS SWAPS
A basis swap is a risk management tool
that allows a hedger to eliminate the
BASIS RISK associated with the hedge.
Recall that a firm faces the CASH PRICE
RISK, opens a hedge, using futures, in
order to eliminate this risk. In most cases,
however, the hedger firm will face the
BASIS RISK when it operates in the cash
markets and closes out its futures hedging
position. We now show that if the firm
wishes to eliminate the basis risk, it may
be able to do so by entering a:
BASIS SWAP.
In a BASIS SWAP, The long hedger
pays the initial basis, I.e., a fixed payment
and pays the terminal basis, I.e., a floating
payment. The short hedger, pays the
terminal basis and receives the initial basis.
1. THE FUTURES SHORT HEDGE:
k Sk Fk, Bk,t =
Sk - Fk,t
F0,t + Bk,t .
B0
2. THE SWAP OF THE SHORT HEDGE:
SHORT SWAP
Bk,t
HEDGER DEALER
k Sk Fk, Bk,t =
Sk - Fk,t
F0,t + Bk,t .
FUTURES HEDGING
2. BASIS RISK
BASIS SWAP
3. NO RISK AT ALL
$3.50
GAS POWER
PRODUCER PLANT
GAS