SWAPS

VDMV Lakshmi

Forwards and Swaps are over-the counter (OTC) contracts, where as futures and options are
exchange traded. Swap means exchange. Financial swaps involve exchange of cash flows.
There are various types of swaps such as interest rate swaps (IRS), currency swaps etc.

Interest rate swaps: An interest rate swap is a forward contract in which one stream of
future interest payments is exchanged for another based on a specified principal amount.
Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or
vice versa, to reduce or increase exposure to fluctuations in interest rates. There is no
exchange of principal. However, notional amount of principal is fixed to determine the
interest amount to be paid or received.

Fixed to floating swap: It involves receiving cash flows based on fixed rate and paying cash
flows based on floating rate. The party who enters this swap is said to have taken long
position in fixed rate bond and short position in floating rate bond.

Floating to fixed swap: It involves receiving cash flows based on floating rate and paying
cash flows based on fixed rate. The party who enters this swap is said to have taken long
position in floating rate bond and short position in fixed rate bond.

Transformation of nature of liability using swaps:

1. Microsoft borrowed $ 100 million in the market at a floating rate of LIBOR+0.1%

and Intel borrowed at a fixed rate of 5.2%. Microsoft is concerned about rise in
interest rates and Intel opines that there would be a fall in interest rates. Both enter the
swap transaction on March 5, 2022 first payment of which would commence from
September 5, 2022 and payments are to be exchanged every 6 months for three years.
Microsoft agrees to pay Intel an interest rate of 5% per annum on a principal of $ 100
million (notional), and in return Intel agrees to pay Microsoft the 6-month LIBOR rate
on the same principal. If the following LIBOR rates prevail during the tenure of the
swap, show net cash flows to both the parties during the tenure of the swap.

Date Mar 5, Sep 5, Mar 5, Sep 5, Mar 5, Sep 5,

2022 2022 2023 2023 2024 2024
6-month LIBOR
4.20% 4.80% 5.30% 5.50% 5.60% 5.90%
Rate (%)

Sol 1: Trade Date: The day on which swap agreement is entered into. i.e. March 5, 2022
Effective Date: The day on which the exchange of cash flows commences. i.e.
September 5, 2022
Interest Reset Date: Applicable interest to be paid on floating leg is based on
selected benchmark rate on previous date. Ex: Cash flows in floating leg to be
exchanged on September 5, 2022 is based on LIBOR on Mar 5, 2022. Hence, Interest
reset date is March 5, 2022 for September 5, 2022.

1
 Maturity Date: Since swap is for three years, maturity date is last date of exchange
of cash flows i.e. March 5, 2025.
Transformation of nature of liability:

Since Microsoft borrowed at floating rate, its concern is rise in interest rate. To
protect from increase in interest rates, it converts its floating rate loan into fixed rate
loan by entering into swap transaction. Under swap, it pays fixed and received
floating. Hence, it is said to have entered floating to fixed swap.

Since Microsoft borrowed at fixed rate, its concern is fall in interest rate. To protect
from fall in interest rates, it converts its fixed rate loan into floating rate loan by
entering into swap transaction. Under swap, it pays floating and received fixed.
Hence, it is said to have entered fixed to floating swap.

Intel Microsoft
(Concern is fall in interest rates. (Concern is rise in interest rates.
Hence suitable swap is fixed to Hence suitable swap is floating to
floating swap) fixed swap)
Original Pays Fixed 5.2% (-) Pays LIBOR +0.1% (-)
borrowing in Floating
the market at
Under Swap Pays Floating LIBOR (-) Pays Fixed 5% (-)
pays
Receives 5% (+) Receives LIBOR (+)
Fixed Floating
Net Effect Pays Floating LIBOR +0.2% Pays Fixed 5.1% (-)
Thus, nature of liability is Thus, nature of liability is
transformed by converting fixed transformed by converting
rate loan into floating rate loan to floating rate loan into fixed rate
protect from fall in interest rates. loan to protect from rise in
interest rates.

Exchange of Cash flows between Microsoft and Intel are as follows:

Microsoft (exposed to rise in interest rate as it originally borrowed in floating, through

swap it converted floating rate loan into fixed rate loan)

Date 6-month Re-set rate Floating cash flow Fixed cash Net cash
LIBOR rate LIBOR received flow paid flow ($
(%) (100mn×LIBOR/2) (100mn×5%/2) mn)
Mar 5, 2022 4.20% - - -
Sep 5, 2022 4.80% 4.20% 2.10 mn -2.50 mn -0.40 mn
Mar 5, 2023 5.30% 4.80% 2.40 mn -2.50 mn -0.10 mn
Sep 5, 2023 5.50% 5.30% 2.65 mn -2.50 mn 0.15 mn
Mar 5, 2024 5.60% 5.50% 2.75 mn -2.50 mn 0.25 mn
Sep 5, 2024 5.90% 5.60% 2.80 mn -2.50 mn 0.30 mn
Mar 5, 2025 5.90% 2.95 mn -2.50 mn 0.45 mn

2
 Net cash flows to Microsoft are positive when interest rates go up and negative when interest
rates come down. Thus, it protects itself from rise in interest rates using swap.

Intel (exposed to fall in interest rate as it orginally borrowed in fixed, through swap it
converted fixed rate loan into floating rate loan)

Date 6-month LIBOR Fixed cash flow Floating cash Net cash flow
rate (%) received flow paid
Mar 5, 2022 4.20%
Sep 5, 2022 4.80% 2.50 mn - 2.10 mn 0.40 mn
Mar 5, 2023 5.30% 2.50 mn - 2.40 mn 0.10 mn
Sep 5, 2023 5.50% 2.50 mn - 2.65 mn -0.15 mn
Mar 5, 2024 5.60% 2.50 mn - 2.75 mn -0.25 mn
Sep 5, 2024 5.90% 2.50 mn - 2.80 mn -0.30 mn
Mar 5, 2025 2.50 mn - 2.95 mn -0.45 mn
Net cash flows to Intel are positive when interest rates go down and negative when interest
rates go up. Thus, it protects itself from fall in interest rates using swap.

LIBOR

Intel Microsoft

Borrows from Borrows from outside

5%
outside market market at LIBOR + 0.1%
at 5.2%

2. How does the above swap transaction change, if financial institution enters into two
offsetting swap transaction with Intel and Microsoft to earn 0.03%, how can the cash
flows be modified?
Sol 2:

LIBOR
LIBOR
Intel FI Microsoft

Borrows from 4.985% Borrows from outside

outside market 5.015%
% market at LIBOR + 0.1%
at 5.2% %%

Comparative Advantage Argument:

Some companies, it is argued, have a comparative advantage when borrowing in fixed-rate

markets, whereas other companies have a comparative advantage when borrowing in
floating-rate markets. To obtain a new loan, it makes sense for a company to go to the market
where it has a comparative advantage. As a result, the company may borrow fixed when it
wants floating, or borrow floating when it wants fixed. The swap is used to transform a fixed-
rate loan into a floating-rate loan, and vice versa.

3
3. The following are borrowing rates of two companies in fixed and floating rate market.
Fixed Floating
AAACorp 4.0% 6 month LIBOR - 0.1%
BBBCorp 5.2% 6 month LIBOR + 0.6%
Observe which company has comparative advantage in which market. If AAA Corp
wants to borrow in floating rate market and BBB Corp in fixed rate market,
a. Design a swap transaction between both the companies in such a way that both
the parties share the benefit equally and financial institution enters the swap
transaction to share 0.04%.
Sol 4: In this case, AAA Corp is able to borrow at lower interests than BBB Corp in both
fixed and floating rate markets due to its better credit rating. It is able to borrow at 1.2%
lesser rate in fixed rate market and 0.7% lesser rate in floating rate market compared to BBB
Corp. Thus, BBB Corp has lesser disadvantage in floating rate market.

Thus, AAA has comparative advantage in fixed rate market and BBB Corp has comparative
advantage in floating rate market.

Fixed Floating Advantage Objective Cost as Cost after

per swap
objective
1 2 3 4 5 6 = 5-
(0.25%)
AAACorp 4.0% L - 0.1% Fixed Floating L - 0.1% L-0.35%
BBBCorp 5.2% L + 0.6% Floating Fixed 5.2% 4.95%
Credit quality 1.2% 0.7%
spread

Difference in quality spread = 1.2%-0.7% = 0.5%. If it is shared equally by both

parties, their borrowing cost comes down by 0.25% each.
As the markets in which the companies have comparative advantage are different
from the markets in which they have objective of borrowing, they do the following:

1. They borrow in the markets where they have comparative advantage

2. They enter swap to fulfil their objectives and share benefit (to reduce
borrowing cost)

If FI enters, it requires 0.04%, benefit that goes to both parties is 0.5%-0.04% = 0.46%. When
it is shared equally between both, each will be able to reduce borrowing cost by 0.23% as
follows.

L% L% L+0.6
4%
%
AAA FI BBB

4.33% 4.37%
% %
4
 Fixed Floating Advantage Objective Cost as Cost after
per swap
objective
AAACorp 4.0% L - 0.1% Fixed Floating L - 0.1% L-0.33%
BBBCorp 5.2% L + 0.6% Floating Fixed 5.2% 4.97%
Credit quality 1.2% 0.7%
spread

Financial Institution
Receives floating L% (+)
from AAA
Pays fixed to AAA 4.33% (-)
Receives fixed from 4.37% (+)
BBB
Pays floating to BBB L (-)
Net benefit 0.04%

Currency Swaps:

4. Consider the following information:

US$ AUD
General Electric 5% 7.6%
Qantas Airways 7% 8.0%
If General Electrics wants to borrow 20 million AUD and Qantas Airways wants to
borrow 15 million US$ and current exchange rate is 0.80 USD per AUD. Design a
swap transaction in such a way that swap is equally attractive to both the companies
and financial intermediary gains 0.2%. Ensure that all foreign exchange risk is
assumed by the bank.

US$ AUD Advantage Objective Cost as per Cost

objective after
swap
General Electric 5% 7.6% US$ AUD 7.6% 6.9%
Qantas Airways 7% 8.0% AUD US$ 7.0% 6.3%
Quality spread 2% 0.4%
GE has advantage in both
QA has disadvantage in both
GE’s advantage is more in US$: GE has comparative advantage in US$
QA’s disadvantage is less in AUD: QA has comparative advantage in AUD
As their objectives are different from their advantages, they
1. Borrow in the currency as per comparative advantage
2. Enter swap to fulfil object and to benefit (to reduce borrowing cost)
Difference in Quality Spread = 2% - 0.4% = 1.6% -0.2% (to FI) = 1.4%

5
If it is shared equally by both parties, their borrowing cost comes down by 0.70% each.

GE QA
Borrows as Pays in US$ 5% (-) Pays in AUD 8% (-)
per to market to market
advantage
Under swap Pays in AUD 6.9% (-) Pays in US$ 6.3% (-)
to FI to FI
Receives in 5% (+) Receives in 8% (+)
US$ from FI AUD from FI
Net effect Pays in AUD 6.9% (-) Pays in US$ 6.3% (-)
(as per (as per
objective) objective)

Financial Institution
Receives from 6.9% (+)
GE in AUD
Pays to GE in 5% (-)
US$
Receives in US$ 6.3% (+)
from QA
Pays to in AUD 8% (-)
QA
Net Benefit 0.2%

Valuation of Swaps in terms of bond prices:

Points to remember:

Valuation of Interest Rate Swap (IRS):

Principal payments are not exchanged in an interest rate swap.
Value of the swap for floating rate payer (Long position in a fixed rate bond and short
position in a floating rate bond) = Vswap =Bfix-Bfl
Value of the swap for fixed rate payer (Long position in a floating rate bond and short
position in a fixed rate bond) = Vswap = Bfl - Bfix
Valuation of Currency Swap:
When domestic currency is received and foreign currency is paid
Vswap = BD – S0BF
When foreign currency is received and domestic currency is paid
Vswap = S0BF – BD

Explanation: Value of Swap = PV of what you receive – PV of what you pay

5. A financial institution has agreed to pay 6-month LIBOR and receive 8% per annum
(with semi-annual compounding) on a notional principal of $100 mn. The swap has a
remaining life of 1.25 years. The LIBOR rates with continuous compounding for 3-
month, 9-month and 15-month maturities are 10%, 10.5% and 11% respectively. The
6-month LIBOR rate at the last payment date was 10.2% (with semiannual

6
 compounding).Compute the value of the swap. What would be your answer, if FI
receives floating and pays fixed

Since FI entered fixed to floating swap:

PV of Bfix cash flow = 4e-0.1×0.25 + 4e-0.105×0.75 + 104e-0.11×1.25 = $ 98.28 mn

PV of Bfl cash flow = 105.1 e-0.10×0.25 = 102.5051
Value of swap: = PV of Bfix – PV of Bfl = 98.28 – 102.5051 = $-4.22507 mn

If FI enters floating to fixed swap, value of swap is $ 4.22507 mn

Explanation for this is as follows: (you don’t have to show in examination)

3 months 0.25 years ( 3 months) 0.5 years (6 0.5 years (6 Total 1.25
before months) months) years of
remaining
maturity
June 2024 Sep 2024 Dec 2024 Jun 2024 Dec 2024
Valuation
date
Fixed $ 4 mn $ 4 mn $ 4 mn + $
100 mn
Time line 0.25 years (3 0.75 years (9 1.25 years
within months) months) (15 months)
10% 10.5% 11%
4 e-0.1×3/12 4 e-0.105×9/12 104 e-
0.11×15/12

In floating rate bond, on coupon reset date, company is changing next coupon in line with
expectations of investor. Hence, floating rate bond value is equal to face value immediately
after coupon payment. If valuation date is in between two coupon payment dates, present
value of immediate next coupon and face value (as it is the value of bond by next coupon date
immediately after coupon payment) is the value of floating bond.

6. A financial institution enters a swap transaction for three years in which it receives
5% per annum in yen and pays 8% per annum in dollars. Swap payments are semi-
annual. The principals in the two currencies are $ 10 million and 1,200 million yen.
Current exchange rate is 110 yen = 1$. Term structure of interest rates is flat in both
Japan and the United States at 4% and 9% (both with continuous compounding)
respectively. Compute the value of currency swap for financial institution. What
would be the value of swap, if financial institution receives in dollar and pays in yen?

Sol. Value of currency swap in terms of bond prices:

Time Cash Discount PV of Cash Discount PV of

-
(Semi flows on Factor cash flows flows on Factor (e cash flows
annual dollar (e-0.045)^t ($) yen bond 0.02) (yen)

7
 period) bond(
8%/2 × $
10 mn)
1 0.4 0.9560 0.3824 30 0.9802 29.4060
2 0.4 0.9139 0.3656 30 0.9608 28.8237
3 0.4 0.8737 0.3495 30 0.9418 28.2529
4 0.4 0.8353 0.3341 30 0.9231 27.6935
5 0.4 0.7985 0.3194 30 0.9048 27.1451
6 0.4+10 0.7634 0.3054 30+1200 0.8869 26.6076
0.7634 7.6338 1200 0.8869 1064.3045
Total Total Yen
$9.6901 1232.2333
Value of Yen flows in dollars = 1232.2333/110 =$ 11.2 mn
Value of swap =11.2 -9.6901 = 1.5120 million
If you receive $ and pay Yen, value of swap = -1.5120 mn
Note: while computing present value you may adopt any of the following ways (just for
your understanding)
Ex: 9% p.a. on semi annual compounding basis for three years:
Discount factor for semi-annual periods can be
Semi-annual period
1 (e-0.045)^1 (e-0.09)^0.5
2 (e-0.045)^2 (e-0.09)^1
3 (e-0.045)^3 (e-0.09)^1.5
-0.045 4
4 (e )^ (e-0.09)^2
5 (e-0.045)^5 (e-0.09)^2.5
-0.045 6
6 (e )^ (e-0.09)^3

Note:
Term structure of interest rates: It is also called yield curve. It explains the relationship
between time to maturity and yield. If yield curve is flat, it indicates that interest rates
applicable to all maturities are same.

US 9%
Interest rate
Japan 4%

Time to maturity