Chapter 8: Swaps

What is a swap?

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.
• A forward contract can be viewed as a simple example of a swap. A
forward contract is equivalent to the exchange of cash flows on just
one future date. On the other hand, swaps typically lead to cash flow
exchanges on several future dates.
In an interest rate swap, one company agrees to pay to another
company cash flows equal to interest at a predetermined fixed rate on
a notional principal for a predetermined number of years. In return, it
receives interest at a floating rate on the same notional principal for
the same period of time from the other company.
LIBOR
The floating rate in most interest rate swap agreements is the London
Interbank Offered Rate (LIBOR).
LIBOR is short for London Interbank Offered Rate. It is an unsecured
short-term borrowing rate between banks. In other word, It is the rate
of interest at which a bank with a AA credit rating is able to borrow from
other banks.
LIBOR rates have traditionally been calculated each business day for 10
currencies and 15 borrowing periods. The borrowing periods range from
one day to one year.
 ‘‘LIBOR-for-fixed’’ swap.

Consider a hypothetical 3-year swap initiated on March 5, 2014,

between Microsoft and Intel. Microsoft agrees to pay Intel an interest
rate of 5% per annum on a principal of $100 million, and in return Intel
agrees to pay Microsoft the 6-month LIBOR rate on the same principal.
Microsoft is the fixed-rate payer; Intel is the floating rate payer. The
agreement specifies that payments are to be exchanged every 6
months.
Using the Swap to Transform a Liability

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%.
Using the Swap to Transform an Asset

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:

First, it receives 4.7% on the bonds.

Second, It receives LIBOR under the terms of the swap.

Third, It pays 5% under the terms of the swap.

These three sets of cash flows net out to an interest rate inflow of LIBOR - 0.3%.
Thus, one possible use of the swap for Microsoft is to transform an asset earning 4.7% into an asset earning LIBOR -0.3%
Role of Financial Intermediary
Market Makers
The comparative-advantage Argument
• Some companies 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.
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 above.
AAACorp has a AAA credit rating; BBBCorp has a BBB credit rating.
We assume that BBBCorp wants to borrow at a fixed rate of interest, whereas AAACorp wants to borrow at a
floating rate of interest linked to 6-month LIBOR.
• Assume that AAACorp and BBBCorp get in touch with each other
directly.
• AAACorp agrees to pay BBBCorp interest at 6-month LIBOR on $10
million. In return, BBBCorp agrees to pay AAACorp interest at a fixed
rate of 4.35% per annum on $10 million.
AAACorp has three sets of interest rate cash flows:
1. It pays 4% per annum to outside lenders.
2. It receives 4.35% per annum from BBBCorp.
3. It pays LIBOR to BBBCorp.
The net effect of the three cash flows is that AAACorp pays LIBOR minus 0.35% per annum. This is 0.25% per
annum less than it would pay if it went directly to floating rate markets.
BBBCorp also has three sets of interest rate cash flows:
1. It pays LIBOR + 0.6% per annum to outside lenders.
2. It receives LIBOR from AAACorp.
3. It pays 4.35% per annum to AAACorp.

The net effect of the three cash flows is that BBBCorp pays 4.95% per annum. This
is 0.25% per annum less than it would pay if it went directly to fixed-rate markets.
• In this example, the swap has been structured so that the net gain to
both sides is the same 0.25%.

• The total gain from a 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 a-b= 0.5%
or both sides is the same 0.25%.
If AAACorp and BBBCorp did not deal directly with each other and used a financial institution, an
arrangement such as that shown in figure above might result.

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 0.04% 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 0.5%.
Fixed-for-fixed currency swap
This swap 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.
Illustration

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.
Comparative Advantage

Suppose the 5-year fixed-rate borrowing cost to General Electric and Qantas Airways in US dollars (USD) and
Australian dollars (AUD)
Australian rates are higher than USD interest rates, and also that General Electric is more creditworthy than
Qantas Airways, because it is offered a more favorable rate of interest in both currencies.

Qantas Airways pays 2% more than General Electric in the US dollar market and only 0.4% more than General
Electric in the AUD market.

General Electric has a comparative advantage in the USD market, whereas Qantas Airways has a comparative
advantage in the AUD market.
Comparative Advantage

The difference between the USD interest rates is a= 2%, whereas the difference between the AUD interest
rates is b= 0.4%. The total gain to all parties to be 2% - 0.4% = 1.6% per annum.

Assume that the financial institution makes a net gain of 0.2% per annum.

As a result, General Electric is 0.7% per annum better off than it would be if it went directly to AUD markets.

Similarly, Qantas is 0.7% per annum better off than it would be if it went directly to USD markets.
For General Electric, 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. As a result, General Electric is 0.7% per annum better off than it would be if it went directly
to AUD markets (7.6%).

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 (7%).

The financial institution gains 1.3% per annum on its USD cash flows and loses 1.1% per annum on its AUD flows.