Chapter 7 – Swaps

Introduction
The birth of the over-the-counter swap market can be traced to a currency swap negotiated
between IBM and the World Bank in 1981. The World Bank had borrowings denominated in
US dollars while IBM had borrowings denominated in German deutsche marks and Swiss
francs. The World Bank (which was restricted in the deutsche mark and Swiss franc borrowing
it could do directly) agreed to make interest payments on IBM’s borrowings while IBM in
return agreed to make interest payments on the World Bank’s borrowings.
Since that first transaction in 1981, the swap market has seen phenomenal growth. Swaps
now occupy a position of central importance in over-the-counter derivatives market. The
statistics produced by the Bank for International Settlements show that about 58.5% of all
over-the-counter derivatives are interest rate swaps and a further 4% are currency swaps.
Most of this chapter is devoted to discussing these two types of swap. Other swaps are briefly
reviewed at the end of the chapter and discussed in more detail in later chapters.
A swap is an over-the-counter 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 calculated. Usually, the calculation of the cash flows involves the
future value of an interest rate, an exchange rate, or other market variable.
The most popular (plain vanilla) interest rate swap is one where LIBOR is exchanged for a
fixed rate of interest. When valuing swaps, we require a ‘‘risk-free’’ discount rate for cash
flows. As mentioned in Section 4.1, LIBOR has traditionally been used as a proxy for the ‘‘risk-
free’’ discount rate. As it happens, this greatly simplifies valuation of plain vanilla interest
rate swaps because the discount rate is then the same as the reference interest rate in the
swap. Since the 2008 credit crisis, other risk-free discount rates have been used, particularly
for collateralized transactions. In this chapter, we assume that LIBOR is used as the risk-free
discount rate.

Nature of Swaps
A swap is an agreement to exchange cash flows at specified future times according to certain
specified rules. Plain Vanilla Interest rate swap:
• Receive fix rate on principal
• Pay floating rate (LIBOR) on principal
Basis Swap
Both paying floating rates (but different payment frequencies)

Mechanics of Interest Rate Swaps

Illustration
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.
• The graph below illustrates cash flows that could occur (Day count conventions are not
considered)

One Possible Outcome for Cash Flows to Microsoft:

Table 7.1: Cash flows (millions of dollars) to Microsoft in a $100 million 3-year interest rate
swap when a fixed rate of 5% is paid and LIBOR is received.
Table 7.2: Cash flows (in millions) from Table 7.1 when there is a final exchange of principal.

• MS: Long floating-rate bond and short fix-rate bond

• Intel: Short floating-rate bond and long fix-rate bond

Using the Swap to Transform a Liability

• Converting a liability from
o fixed rate to floating rate
o floating rate to fixed rate

Example: Intel and Microsoft (MS) Transform a Liability

For Microsoft, the swap could be used to transform a floating-rate loan into a fixed-rate loan.
Suppose that Microsoft has arranged to borrow $100 million at LIBOR plus 10 basis points.
(One basis point is one-hundredth of 1%, so the rate is LIBOR plus 0.1%.) After Microsoft has
entered into the swap, it has the following three sets of cash flows:
1. It pays LIBOR plus 0.1% to its outside lenders.
2. It receives LIBOR under the terms of the swap.
3. It pays 5% under the terms of the swap.
These three sets of cash flows net out to an interest rate payment of 5.1%. Thus, for
Microsoft, the swap could have the effect of transforming borrowings at a floating rate of
LIBOR plus 10 basis points into borrowings at a fixed rate of 5.1%.
Figure 7.2: Microsoft & Intel use the swap to transform a liability
For Intel, the swap could have the effect of transforming a fixed-rate loan into a floating-rate
loan. Suppose that Intel has a 3-year $100 million loan outstanding on which it pays 5.2%.
After it has entered into the swap, it has the following three sets of cash flows:
1. It pays 5.2% to its outside lenders.
2. It pays LIBOR under the terms of the swap.
3. It receives 5% under the terms of the swap.
These three sets of cash flows net out to an interest rate payment of LIBOR plus 0.2% (or
LIBOR plus 20 basis points). Thus, for Intel, the swap could have the effect of transforming
borrowings at a fixed rate of 5.2% into borrowings at a floating rate of LIBOR plus 20 basis
points. These potential uses of the swap by Intel and Microsoft are illustrated in Figure 7.2.
Summary Diagram

Using the Swap to Transform an Asset

• Converting an investment from
o fixed rate to floating rate
o floating rate to fixed rate

Example: Intel and Microsoft (MS) Transform an Asset (Figure 7.3, page 178)
The swap could have the effect of transforming an asset earning a fixed rate of interest into
an asset earning a floating rate of interest. Suppose that Microsoft owns $100 million in
bonds that will provide interest at 4.7% per annum over the next 3 years.
After Microsoft has entered into the swap, it has the following three sets of cash flows:
1. It receives 4.7% on the bonds.
2. It receives LIBOR under the terms of the swap.
3. It pays 5% under the terms of the swap.
These three sets of cash flows net out to an interest rate inflow of LIBOR minus 30 basis
points. Thus, one possible use of the swap for Microsoft is to transform an asset earning 4.7%
into an asset earning LIBOR minus 30 basis points.
Next, consider Intel. The swap could have the effect of transforming an asset earning a
floating rate of interest into an asset earning a fixed rate of interest. Suppose that Intel has
an investment of $100 million that yields LIBOR minus 20 basis points. After it has entered
into the swap, it has the following three sets of cash flows:
1. It receives LIBOR minus 20 basis points on its investment.
2. It pays LIBOR under the terms of the swap.
3. It receives 5% under the terms of the swap.
These three sets of cash flows net out to an interest rate inflow of 4.8%. Thus, one possible
use of the swap for Intel is to transform an asset earning LIBOR minus 20 basis points into an
asset earning 4.8%.
Figure 7.3: Microsoft & Intel use the swap to transform an asset
Role of Financial Intermediary
Usually two nonfinancial companies such as Intel and Microsoft do not get in touch directly
to arrange a swap in the way indicated in Figures 7.2 and 7.3. They each deal with a bank or
other financial institution. ‘‘Plain vanilla’’ LIBOR-for-fixed swaps on US interest rates are
usually structured so that the financial institution earns about 3 or 4 basis points (0.03% or
0.04%) on a pair of offsetting transactions.
Figure 7.4: Interest rate swap from Figure 7.2 when financial institution is involved
Financial institution is responsible for paying out losses

Figure 7.4 shows what the role of the financial institution might be in the situation in Figure
7.2. The financial institution enters into two offsetting swap transactions with Intel and
Microsoft. Assuming that both companies honour their obligations, the financial institution
is certain to make a profit of 0.03% (3 basis points) per year multiplied by the notional
principal of $100 million. This amounts to $30 000 per year for the 3-year period. Microsoft
ends up borrowing at 5.115% (instead of 5.1%, as in Figure 7.2), and Intel ends up borrowing
at LIBOR plus 21.5 basis points (instead of at LIBOR plus 20 basis points, as in Figure 7.2).
Figure 7.5: Interest rate swap from Figure 7.3 when financial institution is involved
Figure 7.5 illustrates the role of the financial institution in the situation in Figure 7.3. The
swap is the same as before and the financial institution is certain to make a profit of 3 basis
points if neither company defaults. Microsoft ends up earning LIBOR minus 31.5 basis points
(instead of LIBOR minus 30 basis points, as in Figure 7.3), and Intel ends up earning 4.785%
(instead of 4.8%, as in Figure 7.3).
Note:
In each case the financial institution has entered into two separate transactions: one with
Intel and the other with Microsoft. In most instances, Intel will not even know that the
financial institution has entered into an offsetting swap with Microsoft, and vice versa. If one
of the companies defaults, the financial institution still has to honour its agreement with the
other company. The 3-basis-point spread earned by the financial institution is partly to
compensate it for the risk that one of the two companies will default on the swap payments.

Market Makers
In practice, it is unlikely that two companies will contact a financial institution at the same
time and want to take opposite positions in exactly the same swap. For this reason, many
large financial institutions act as market makers for swaps. This means that they are
prepared to enter into a swap without having an offsetting swap with another counterparty.
Market makers must carefully quantify and hedge the risks they are taking. Bonds, forward
rate agreements, and interest rate futures are examples of the instruments that can be used
for hedging by swap market makers. Table 7.3 shows quotes for plain vanilla US dollar swaps
that might be posted by a market maker. As mentioned earlier, the bid–offer spread is 3 to 4
basis points. The average of the bid and offer fixed rates is known as the swap rate. This is
shown in the final column of Table 7.3.
Table 7.3: Bid & offer fixed rates in the swap market & swap rates (percent per annum)
Quotes By a Swap Market Maker
• Consider Table 7.3
o “Bid rate”: Market maker pays fix rate & receives floating rate.
o “Offer rate”: Market maker pays floating rate & receives fix rate.
o “Swap rate”: average of bid and offer rate.
• It can be assumed that the swap rate is the fix rate that makes the value of the swap equal
to 0, i.e. the fix rate is such that:

𝐵𝑓𝑖𝑥 = 𝐵𝑓𝑙

• Consider Table 7.2 where the swap rate of 5% should have been determined such that the
values of the two bonds were equal on 5 March 2014.
• Usually the LIBOR zero rates are used to discount back the cash flows while the
corresponding LIBOR forward rates for every 6-month period, determined from the LIBOR
zero rates, are used to calculate the LIBOR interest (floating) amounts & hence 𝑩𝒇𝒍 .
• Remember on 5 March 2014 the future LIBOR rates for each 6-months period were not
known.

Consider for example the 2-year swap in Table 7.3:

• 𝐵𝑓𝑖𝑥=6.045 = 𝐵𝑓𝑙 ⇒ Value of swap = 𝐵𝑓𝑖𝑥=6.045 − 𝐵𝑓𝑙 = 0
• If the market maker quotes a swap rate of 6.045% he will make no profit.
• Therefore he quotes a bid rate of 6.03% and an offer rate of 6.06% - this implies a spread
of 3 basis points.
• For the bid rate of 6.03% follows that 𝑩𝒇𝒊𝒙=𝟔.𝟎𝟑 < 𝑩𝒇𝒍 so that the value for the market
maker is 𝐵𝑓𝑙 − 𝐵𝑓𝑖𝑥=6.03 > 0.
• For the offer rate of 6.06% follows that 𝑩𝒇𝒊𝒙=𝟔.𝟎𝟔 > 𝑩𝒇𝒍 so that the value for the market
maker is 𝐵𝑓𝑖𝑥=6.06 − 𝐵𝑓𝑙 > 0.

Day Count Issues

• A day count convention is specified for fixed and floating payment
• E.g., LIBOR is likely to be actual/360 in the US because LIBOR is a money market rate

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
• Governments now require central clearing to be used for most standardized derivatives
The Comparative-Advantage Argument
An explanation commonly put forward to explain the popularity of swaps concerns
comparative advantage. Consider the use of an interest rate swap to transform a liability.
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.
Example
Suppose that two companies, AAACorp and BBBCorp, both wish to borrow $10 million for 5
years and have been offered the rates shown in Table 7.4. AAACorp has a AAA credit rating;
BBBCorp has a BBB credit rating. Because it has a worse credit rating than AAACorp, BBBCorp
pays a higher rate of interest than AAACorp in both fixed and floating markets.
Table 7.4: Borrowing rates that provide a basis for the comparative-advantage argument
• AAACorp wants to borrow floating
• BBBCorp wants to borrow fixed

Difference in fixed = 1.2% (AAA comparative advantage)

Difference in floating = 0.7% (BBB comparative advantage)
1.2% − 0.7%
= 0.25%
2
𝐴𝐴𝐴: −4 − 𝐿𝐼𝐵𝑂𝑅 + 𝑥 = −(𝐿𝐼𝐵𝑂𝑅 − 0.1 − 0.25) = −𝐿𝐼𝐵𝑂𝑅 + 0.35 ⇒ 𝑥 = 4.35%
𝐵𝐵𝐵: −𝐿𝐼𝐵𝑂𝑅 − 0.6 + 𝐿𝐼𝐵𝑂𝑅 − 4.35 = −4.95%
Now:
• BBB is borrowing at 4.95% fixed instead of 5.2%.
• AAA now receives 4.35% from BBB for this lower borrowing rate.
Figure 7.6: Swap agreement between AAACorp and BBBCorp when rates in Table 7.4 apply

The Swap when a Financial Institution is Involved

In this example, the swap has been structured so that the net gain to both sides is the same,
0.25%. This need not be the case. However, the total apparent gain from this type of interest
rate swap arrangement is always 𝑎 − 𝑏, where 𝑎 is the difference between the interest rates
facing the two companies in fixed-rate markets, and 𝑏 is the difference between the interest
rates facing the two companies in floating-rate markets. In this case, 𝑎 = 1.2% and 𝑏 =
0.7%, so that the total gain is 0.5%.
If AAACorp and BBBCorp did not deal directly with each other and used a financial institution,
an arrangement such as that shown in Figure 7.7 might result. (This is similar to the example
in Figure 7.4.) In this case, AAACorp ends up borrowing at LIBOR minus 0.33%, BBBCorp ends
up borrowing at 4.97%, and the financial institution earns a spread of 4 basis points per year.
The gain to AAACorp is 0.23%; the gain to BBBCorp is 0.23%; and the gain to the financial
institution is 0.04%. The total gain to all three parties is 0.50% as before.
Figure 7.7: Swap agreement between AAACorp & BBBCorp when rates 7.4 apply and a
financial intermediary is involved.
Criticism of the Argument
Markets
• The 4.0% and 5.2% rates available to AAACorp and BBBCorpin fixed rate markets are 5-
year rates.
• The LIBOR−0.1% and LIBOR+0.6% rates available in the floating rate market are 6-month
rates.

Credit Rating
The spreads between the rates offered to AAACorp and BBBCorp are a reflection of the
extent to which BBBCorp is more likely than AAACorp to default. During the next 6 months,
there is very little chance that either AAACorp or BBBCorp will default. As we look further
ahead, the probability of a default by a company with a relatively low credit rating (such as
BBBCorp) is liable to increase faster than the probability of a default by a company with a
relatively high credit rating (such as AAACorp). This is why the spread between the 5-year
rates is greater than the spread between the 6-month rates.

Sustainability
After negotiating a floating-rate loan at LIBOR + 0.6% and entering into the swap shown in
Figure 7.7, BBBCorp appears to obtain a fixed-rate loan at 4.97%. The arguments just
presented show that this is not really the case. In practice, the rate paid is 4.97% only if
BBBCorp can continue to borrow floating-rate funds at a spread of 0.6% over LIBOR. If, for
example, the creditworthiness of BBBCorp declines so that the floating-rate loan is rolled
over at LIBOR + 1.6%, the rate paid by BBBCorp increases to 5.97%. The market expects that
BBBCorp’s spread over 6-month LIBOR will on average rise during the swap’s life. BBBCorp’s
expected average borrowing rate when it enters into the swap is therefore greater than
4.97%.

Risk of a default by Financial Institution

The swap in Figure 7.7 locks in LIBOR – 0.33% for AAACorp for the next 5 years, not just for
the next 6 months. This appears to be a good deal for AAACorp. The downside is that it is
bearing the risk of a default on the swap by the financial institution. If it borrowed floating-
rate funds in the usual way, it would not be bearing this risk.
The Nature of Swap Rates
• Six-month LIBOR is a short-term AA borrowing rate
• The 5-year swap rate has a risk corresponding to the situation where 10 six-month loans
are made to AA borrowers at LIBOR
• This is because the lender can enter into a swap where income from the LIBOR loans is
exchanged for the 5-year swap rate.

At this stage it is appropriate to examine the nature of swap rates and the relationship
between swap and LIBOR markets. We explained in Section 4.1 that LIBOR is the rate of
interest at which AA-rated banks borrow for periods up to 12 months from other banks. Also,
as indicated in Table 7.3, a swap rate is the average of (a) the fixed rate that a swap market
maker is prepared to pay in exchange for receiving LIBOR (its bid rate) and (b) the fixed rate
that it is prepared to receive in return for paying LIBOR (its offer rate). Like LIBOR rates, swap
rates are not risk-free lending rates. However, they are reasonably close to risk-free in normal
market conditions. A financial institution can earn the 5-year swap rate on a certain principal
by doing the following:
1. Lend the principal for the first 6 months to a AA borrower and then relend it for successive
6-month periods to other AA borrowers; and
2. Enter into a swap to exchange the LIBOR income for the 5-year swap rate.

This shows that the 5-year swap rate is an interest rate with a credit risk corresponding to
the situation where 10 consecutive 6-month LIBOR loans to AA companies are made.
Similarly the 7-year swap rate is an interest rate with a credit risk corresponding to the
situation where 14 consecutive 6-month LIBOR loans to AA companies are made. Swap rates
of other maturities can be interpreted analogously. Note that 5-year swap rates are less than
5-year AA borrowing rates. It is much more attractive to lend money for successive 6-month
periods to borrowers who are always AA at the beginning of the periods than to lend it to
one borrower for the whole 5 years when all we can be sure of is that the borrower is AA at
the beginning of the 5 years. In discussing the above points, Collin-Dufesne and Solnik refer
to swap rates as ‘‘continually refreshed’’ LIBOR rates.
Determining LIBOR/Swap Zero Rates
Using Swap Rates to Bootstrap the LIBOR/Swap Zero Curve
• Consider a new swap where the fixed rate is the swap rate.
• When principals are added to both sides on the final payment date the swap is the
exchange of a fixed rate bond for a floating rate bond.
• The floating-rate rate bond is worth par. The swap is worth zero. The fixed-rate bond
must therefore also be worth par.
• This shows that swap rates define par yield bonds that can be used to bootstrap the LIBOR
(or LIBOR/swap) zero curve.

Consider the following notation:

• 𝑅𝑇 p.u.p.a. ≡ T-year LIBOR zero rate – compounded semi-annually.
• 𝑅𝐹𝑇 p.u.p.a. ≡ Forward LIBOR for period 𝑇 − 1 to 𝑇, compounded semi-annually (follows
from 𝑅𝑇 with maturity 𝑇 and 𝑅𝑇−1 with maturity 𝑇 − 1).
• 𝑅𝑇∗ p.u.p.a. ≡ T-year LIBOR zero rate – continuously compounded.
• 𝑅𝑆𝑇 p.u.p.a. ≡ T-year swap rate – payments semi-annually.

• Let 𝑃 be the principal of a swap and consider a two-year swap, then:

𝑅0.5 −𝑅∗ (0.5) 𝑅𝐹1 −𝑅∗ (1) 𝑅𝐹1.5 −𝑅∗ (1.5) 𝑅𝐹2 −𝑅∗ (2)
𝐵𝑓𝑙 = (𝑃 ∙ ) 𝑒 0.5 + (𝑃 ∙ ) 𝑒 1 + (𝑃 ∙ ) 𝑒 1.5 + (𝑃 ∙ )𝑒 2
2 2 2 2
=𝑃
• Coupon rate as well as discount rate is LIBOR rate, therefore the value of the bond is equal
to 𝑃.
• Because the value of the swap is zero when it is initiated it follows that:

𝐵𝑓𝑖𝑥=𝑠𝑤𝑎𝑝 𝑟𝑎𝑡𝑒 = 𝐵𝑓𝑙 = 𝑃

But
𝑅𝑆2 −𝑅∗ (0.5) 𝑅𝑆2 −𝑅∗ (1) 𝑅𝑆2 −𝑅∗ (1.5) 𝑅𝑆2 −𝑅∗ (2)
𝐵𝑓𝑖𝑥 = (𝑃 ∙ ) 𝑒 0.5 + (𝑃 ∙ ) 𝑒 1 + (𝑃 ∙ ) 𝑒 1.5 + (𝑃 ∙ )𝑒 2
2 2 2 2
=𝑃
Therefore
𝑆𝑤𝑎𝑝 𝑟𝑎𝑡𝑒 ≡ 𝐿𝐼𝐵𝑂𝑅 𝑝𝑎𝑟 𝑦𝑖𝑒𝑙𝑑 ≡ 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 𝑐𝑎𝑢𝑠𝑒𝑠 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 𝑒𝑞𝑢𝑎𝑙𝑠 𝑃
• The swap rate cannot be determined from the 𝐵𝑓𝑖𝑥 equation (2) – LIBOR rate is only
quoted for maturities out to 1 year.
• What happens in practice?
• For maturities out to 5 years Eurodollar futures used to determine the LIBOR zero rates.
• For maturities beyond 5 years the following approach is used.
o The swap rate is determined for longer periods by the market from supply and
demand, the market perception of future interest rates and economical factors i.e.
𝑅𝑆𝑇 in (2) is assumed to be known.
o Hence, equation (2) is used to determine the LIBOR zero rate for maturities beyond
5 years (looking at example 7.1 below).

Example 7.1: Bootstrapping the LIBOR/Swap Curve (pg 186)

• 6-month, 12-month, and 18-month LIBOR/swap rates (zero rates) are 4%, 4.5%, and 4.8%
with continuous compounding.

• Two-year swap rate is 5% (semiannual)

2.5𝑒 −0.04(0.5) + 2.5𝑒 −0.045(1.0) + 2.5𝑒 −0.048(1.5) + 102.5𝑒 −2𝑅 = 100

102.5𝑒 −2𝑅 = 100 − 2.5𝑒 −0.04(0.5) − 2.5𝑒 −0.045(1.0) − 2.5𝑒 −0.048(1.5)
• The 2-year LIBOR/swap rate, 𝑅 = 0.049529327 = 4.953%.
Valuation of Interest Rate Swaps
• 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.
o Floating rate Payer: 𝑉𝑠𝑤𝑎𝑝 = 𝐵𝑓𝑖𝑥 − 𝐵𝑓𝑙
o Fix rate Payer: 𝑉𝑠𝑤𝑎𝑝 = 𝐵𝑓𝑙 − 𝐵𝑓𝑖𝑥
• Alternatively, they can be valued as a portfolio of forward rate agreements (FRAs)

Valuation in Terms of Bond Prices

• The fixed rate bond is valued in the usual way.
• The floating rate bond is valued by noting that it is worth par immediately after the next
payment date.

Valuation of Floating-Rate Bond

Example 7.2 (pg 181)

• Receive six-month LIBOR, pay 3% (s.a. compounding) on a principal of $100 million
• Remaining life 1.25 years
• LIBOR rates for 3-months, 9-months and 15-months are 2.8%, 3.2%, and 3.4% (continuous
compounding)
• 6-month LIBOR on last payment date was 2.9% (s.a. compounding)
 2.9%(0.5) × 100
= 1.45
𝐵𝑓𝑙 = 100 + 1.45

Swap value (Fix-rate payer) = 𝐵𝑓𝑙 − 𝐵𝑓𝑖𝑥 = 100.7423 − 100.2306 = 0.5117

Valuation in Terms of FRAs

• Each exchange of payments in an interest rate swap is an FRA.
• The FRAs can be valued on the assumption that today’s forward rates are realized.

Example 7.3
Under the terms of the swap, a financial institution has agreed to receive 6-month LIBOR and
pay 3% per annum (with semiannual compounding) on a notional principal of $100 million.
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 2.8%, 3.2%, and 3.4%, respectively. The
6-month LIBOR rate at the last payment date was 2.9% (with semiannual compounding).
The calculations are summarized in Table 7.6. The first row of the table shows the cash flows
that will be exchanged in 3 months. These have already been determined. The fixed rate of
1.5% will lead to a cash outflow of 100 0:030 0:5 = $1:5 million. The floating rate of 2.9%
(which was set 3 months ago) will lead to a cash inflow of 100 0:029 0:5 = $1:45 million. The
second row of the table shows the cash flows that will be exchanged in 9 months assuming
that forward rates are realized. The cash outflow is $1.5 million as before. To calculate the
cash inflow, we must first calculate the forward rate corresponding to the period between 3
and 9 months. From equation (4.5), this is
0.032 × 0.75 − 0.028 × 0.25
= 0.034
0.5
or 3.4% with continuous compounding. From equation (4.4), the forward rate becomes
3.429% with semiannual compounding. The cash inflow is therefore 100 × 0.03429 × 0.5 =
$1.7145 𝑚𝑖𝑙𝑙𝑖𝑜𝑛. The third row similarly shows the cash flows that will be exchanged in 15
months assuming that forward rates are realized. The discount factors for the three payment
dates are, respectively,
𝑒 −0.028(0.25) , 𝑒 −0.032(0.75) , 𝑒 −0.034(1.25)
The present value of the exchange in three months is – $0.0497 million. The values of the
FRAs corresponding to the exchanges in 9 months and 15 months are +$0.2094 and +$0.3519
million, respectively. The total value of the swap is +$0.5117 million. This is in agreement
with the value we calculated in Example 7.2 by decomposing the swap into bonds.
Table 7.6: Valuing swap in terms of FRAs. Floating cashflows are calculated by assuming
that forward rates will be realised.
Term Structure Effects
A swap is worth close to zero initially. This means that at the outset of a swap the sum of the
values of the FRAs underlying the swap is close to zero. It does not mean that the value of
each individual FRA is close to zero. In general, some FRAs will have positive values whereas
others have negative values.
Consider the FRAs underlying the swap between Microsoft and Intel in Figure 7.1:
• Value of FRA to Microsoft > 0 when forward interest rate > 5.0%
• Value of FRA to Microsoft = 0 when forward interest rate = 5.0%
• Value of FRA to Microsoft < 0 when forward interest rate < 5.0%.

Suppose that the term structure of interest rates is upward-sloping at the time the swap is
negotiated. This means that the forward interest rates increase as the maturity of the FRA
increases. Since the sum of the values of the FRAs is close to zero, the forward interest rate
must be less than 5.0% for the early payment dates and greater than 5.0% for the later
payment dates. The value to Microsoft of the FRAs corresponding to early payment dates is
therefore negative, whereas the value of the FRAs corresponding to later payment dates is
positive. If the term structure of interest rates is downward-sloping at the time the swap is
negotiated, the reverse is true. The impact of the shape of the term structure of interest rates
on the values of the forward contracts underlying a swap is illustrated in Figure 7.9.
Figure 7.9
Valuing of forward rate agreements underlying a swap as a function of maturity. In (a) the
term structure of interest rates is upward-sloping and we receive fixed, or it is downward-
sloping and we receive floating; in (b) the term structure of interest rates is upward-sloping
and we receive floating, or it is downward-sloping and we receive fixed.
Fixed-for-fixed Currency Swaps
Another popular type of swap is known as a fixed-for-fixed currency swap. This involves
exchanging principal and interest payments at a fixed rate in one currency for principal and
interest payments at a fixed rate in another currency.
A currency swap agreement requires the principal to be specified in each of the two
currencies. The principal amounts are usually exchanged at the beginning and at the end of
the life of the swap. Usually the principal amounts are chosen to be approximately
equivalent using the exchange rate at the swap’s initiation. When they are exchanged at the
end of the life of the swap, their values may be quite different.
• 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.

Illustration
Example
Consider a hypothetical 5-year currency swap agreement between IBM and British Petroleum
entered into on February 1, 2014. We suppose that IBM pays a fixed rate of interest of 5% in
sterling and receives a fixed rate of interest of 6% in dollars from British Petroleum. Interest
rate payments are made once a year and the principal amounts are $15 million and £10
million. This is termed a fixed-for-fixed currency swap because the interest rate in each
currency is at a fixed rate.
An agreement to pay 5% on a sterling principal of £10 000 000 & receive 6% on a US$ principal
of $15 000 000 every year for 5 years.
Figure 7.10: A currency swap

The swap is shown in Figure 7.10. Initially, the principal amounts flow in the opposite
direction to the arrows in Figure 7.10. The interest payments during the life of the swap and
the final principal payment flow in the same direction as the arrows. Thus, at the outset of
the swap, IBM pays $15 million and receives £10 million. Each year during the life of the swap
contract, IBM receives $0.90 million (= 6% of $15 million) and pays £0.50 million (= 5% of £10
million). At the end of the life of the swap, it pays a principal of £10 million and receives a
principal of $15 million. These cash flows are shown in Table 7.7.
Table 7.7 (pg 192): The Cashflows

Use of a Currency Swap to Transform Liabilities & Assets

• Convert a liability in one currency to a liability in another currency
• Convert an investment in one currency to an investment in another currency

Example
Suppose that IBM can issue $15 million of US dollar-denominated bonds at 6% interest. The
swap has the effect of transforming this transaction into one where IBM has borrowed £10
million at 5% interest. The initial exchange of principal converts the proceeds of the bond
issue from US dollars to sterling. The subsequent exchanges in the swap have the effect of
swapping the interest and principal payments from dollars to sterling.
Suppose that IBM can invest £10 million in the UK to yield 5% per annum for the next 5 years,
but feels that the US dollar will strengthen against sterling and prefers a US-dollar-
denominated investment. The swap has the effect of transforming the UK investment into a
$15 million investment in the US yielding 6%.
Comparative Advantage
Comparative Advantage May Be Real Because of Taxes
Suppose the 5-year fixed-rate borrowing costs to General Electric and Qantas Airways in US
dollars (USD) and Australian dollars (AUD) are as shown in Table 7.8.
• General Electric (GE) wants to borrow AUD (20 Million)
• Quantas wants to borrow USD (18 Million)
• Current exchange rate (USD per AUD) is 0.9000.
• Cost after adjusting for the differential impact of taxes

Table 7.8: Borrowing rates providing basis for currency swap

The data in the table suggest that Australian rates are higher than USD interest rates, and
also that GE is more creditworthy than Qantas, because it is offered a more favourable rate
of interest in both currencies. From the viewpoint of a swap trader, the interesting aspect of
Table 7.8 is that the spreads between the rates paid by GE and Qantas in the two markets
are not the same. Qantas pays 2% more than GE in the US dollar market and only 0.4% more
than GE in the AUD market. GE has a comparative advantage in the USD market, whereas
Qantas Airways has a comparative advantage in the AUD market. One possible source of
comparative advantage is tax. GE’s position might be such that USD borrowings lead to lower
taxes on its worldwide income than AUD borrowings. Qantas’ position might be the reverse.
GE and Qantas Airways each borrow in the market where they have a comparative
advantage; that is, GE borrows USD whereas Qantas borrows AUD. They then use a currency
swap to transform GE’s loan into an AUD loan and Qantas’ loan into a USD loan.
Figure 7.11 shows one way swaps might be entered into with a financial institution (FI). GE
borrows USD and Qantas borrows AUD. The effect of the swap is to transform the USD
interest rate of 5% per annum to an AUD interest rate of 6.9% per annum for GE. As a result,
GE is 0.7% per annum better off than it would be if it went directly to AUD markets. Similarly,
Qantas exchanges an AUD loan at 8% per annum for a USD loan at 6.3% per annum and ends
up 0.7% per annum better off than it would be if it went directly to USD markets. The FI gains
1.3% per annum on its USD cash flows and loses 1.1% per annum on its AUD flows. If we
ignore the difference between the two currencies, the financial institution makes a net gain
of 0.2% per annum. As predicted, the total gain to all parties is 1.6% per annum.
Figure 7.11: A currency swap motivated by comparative advantage

Each year the financial institution makes a gain of USD 234 000 (= 1.3% of 18 million) and
incurs a loss of AUD 220 000 (= 1.1% of 20 million). The financial institution can avoid any
foreign exchange risk by buying AUD 220 000 per annum in the forward market for each
year of the life of the swap, thus locking in a net gain in USD.
It is possible to redesign the swap so that the financial institution makes a 0.2% spread in
USD. Figures 7.12 and 7.13 present two alternatives. These alternatives are unlikely to be
used in practice because they do not lead to GE and Qantas being free of foreign exchange
risk.
In Figure 7.12, Qantas bears some foreign exchange risk because it pays 1.1% per annum in
AUD and pays 5.2% per annum in USD.
Figure 7.12: Alternative arrangement for currency swap: Qantas Airways bears some
foreign exchange risk

In Figure 7.13, General Electric bears some foreign exchange risk because it receives 1.1%
per annum in USD and pays 8% per annum in AUD.
Figure 7.13: Alternative arrangement for currency swap: General Electric bears some
foreign exchange risk.
Valuation of Fixed-for-fixed 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.

Valuation in Terms of Bond Prices

If we define 𝑉𝑠𝑤𝑎𝑝 as the value in US dollars of an outstanding swap where dollars are
received and a foreign currency is paid, then
𝑉𝑠𝑤𝑎𝑝 = 𝐵𝐷 − 𝑆0 𝐵𝐹
Where 𝐵𝐹 is the value, measured in the foreign currency, of the bond defined by the foreign
cash flows on the swap and 𝐵𝐷 is the value of the bond defined by the domestic cash flows
on the swap, and 𝑆0 is the spot exchange rate (expressed as number of dollars per unit of
foreign currency). The value of a swap can therefore be determined from interest rates in the
two currencies and the spot exchange rate. Similarly, the value of a swap where the foreign
currency is received and dollars are paid is
𝑉𝑠𝑤𝑎𝑝 = 𝑆0 𝐵𝐹 − 𝐵𝐷
Example 7.4
• 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 ($1 = 110 yen)

Solution:
The calculations are summarized in Table 7.9. In this case, the cash flows from the dollar bond
underlying the swap are as shown in the second column. The present value of the cash flows
using the dollar discount rate of 9% are shown in the third column. The cash flows from the
yen bond underlying the swap are shown in the fourth column of the table. The present value
of the cash flows using the yen discount rate of 4% are shown in the final column of the table.

𝑉𝑠𝑤𝑎𝑝 = 𝑆0 𝐵𝐹 − 𝐵𝐷
The value of the dollar bond, 𝐵𝐷 , is $9.6439 million.
The value of the yen bond, 𝐵𝐹 , is ¥1 230.55 million.
The value of the swap in dollars is therefore:
1 230.55
𝑉𝑠𝑤𝑎𝑝 = − 9.6439 = $1.5430 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
110
Valuation as Portfolio of Forward Contracts
Each exchange of payments in a fixed-for-fixed currency swap is a forward foreign exchange
contract. Forward foreign exchange contracts were valued by assuming that forward
exchange rates are realized.
• The one-year, two-year and three-year forward exchange rates can be obtained using

𝑭𝟎 = 𝑆0 𝑒 (𝑟−𝑟𝑓)𝑇
• Where 𝑆0 = 0.009091, 𝑟 = 0.09, 𝑟𝑓 = 0.04 and 𝑇 = 1,2 and 3 i.e.

𝐹0 = 0.009091𝑒 (0.09−0.4)1 = 0.009557 for 𝑇 = 1

𝐹0 = 0.009091𝑒 (0.09−0.4)2 = 0.010047 for 𝑇 = 2
𝐹0 = 0.009091𝑒 (0.09−0.4)3 = 0.010562 for 𝑇 = 3
• The value of the forward contracts corresponding to the exchange of interest (in millions
of dollars) can be obtained, using

𝑓 = (𝐹0 − 𝐾)𝑒 −𝑟𝑇

• Where 𝐹0 is calculated above for 𝑇 = 1,2 and 3, 𝐾 = 0.8 and 𝑟 = 0.09 i.e.

𝑓 = (60 × 0.009557 − 0.8)𝑒 −0.09(1) = −0.2071 for 𝑇 = 1

𝑓 = (60 × 0.010047 − 0.8)𝑒 −0.09(2) = −0.1647 for 𝑇 = 2
𝑓 = (60 × 0.010562 − 0.8)𝑒 −0.09(3) = −0.1269 for 𝑇 = 3
• The final exchange of principal involves receiving 1 200 million yen and paying $10 million.
The value of the forward contract corresponding to the exchange is (in millions of $) is:

𝑓 = (1 200 × 0.010562 − 10)𝑒 −0.09(3) = 2.0416

• Hence the total value of the swap is:

2.0416 − 0.2071 − 0.1647 − 0.1269 = $1.543

Other Currency Swaps
1. Fixed-for-floating where a floating interest rate in one currency is exchanged for a fixed
interest rate in another currency.
2. Floating-for-floating where a floating interest rate in one currency is exchanged for a
floating interest rate in another currency.

Credit Risk
• A swap is worth zero to a company initially
• At a future time its value is liable to be either positive or negative
• The company has credit risk exposure only when its value is positive

Some swaps are more likely to lead to credit risk exposure than others
Suppose that, sometime after the initiation of the transactions in Figure 7.4, the transaction
with Microsoft has a positive value to the financial institution, whereas the transaction with
Intel has a negative value. Suppose further that the financial institution has no other
derivatives transactions with these companies and that no collateral is posted. If Microsoft
defaults, the financial institution is liable to lose the whole of the positive value it has in this
transaction. To maintain a hedged position, it would have to find a third party willing to take
Microsoft’s position. To induce the third party to take the position, the financial institution
would have to pay the third party an amount roughly equal to the value of its contract with
Microsoft prior to the default.
Market Risk vs Credit Risk
A financial institution clearly has credit-risk exposure from a swap when the value of the swap
to the financial institution is positive. What happens when this value is negative and the
counterparty gets into financial difficulties? In theory, the financial institution could realize a
windfall gain, because a default would lead to it getting rid of a liability. In practice, it is likely
that the counterparty would choose to sell the transaction to a third party or rearrange its
affairs in some way so that its positive value in the transaction is not lost. The most realistic
assumption for the financial institution is therefore as follows. If the counterparty goes
bankrupt, there will be a loss if the value of the swap to the financial institution is positive,
and there will be no effect on the financial institution’s position if the value of the swap to
the financial institution is negative. This situation is summarized in Figure 7.14.

Central Clearing
Credit Default Swaps
Swaps & Forwards
• A swap can be regarded as a convenient way of packaging forward contracts.
• Although the swap contract is usually worth close to zero at the outset, each of the
underlying forward contracts are not worth zero.

Other Types of Swaps

Floating-for-floating interest rate swaps, amortizing swaps, step up swaps, forward swaps,
constant maturity swaps, compounding swaps, LIBOR-in-arrears swaps, accrual swaps, diff
swaps, cross currency interest rate swaps, equity swaps, extendable swaps, puttable swaps,
swaptions, commodity swaps, volatility swaps.