Swaps

1
Introduction
• Both swaps and interest rate options are relatively
new, but very large
• In mid-2000, there was over $60 trillion outstanding in
interest rate swaps, foreign currency swaps, and other
interest rate options

2
Interest Rate Swaps
• Introduction
• Immunizing with interest rate swaps
• Exploiting comparative advantage in the
credit market

3
Introduction
• Popular with bankers, corporate treasurers,
and portfolio managers who need to manage
interest rate risk

• A swap enables you to alter the level of risk

without disrupting the underlying portfolio

4
Introduction (cont’d)
• The most common type of interest rate swap is the
fixed for floating rate swap
• One party makes a fixed interest rate payment to another
party making a floating interest rate payment
• Only the net payment is made (difference check)
• The firm paying the floating rate is the swap seller
• The firm paying the fixed rate is the swap buyer

5
Introduction (cont’d)
• Typically, the floating interest rate is linked to a
market rate such as LIBOR or T-bill rates

• The swap market is standardized partly by the

International Swaps and Derivatives Association
(ISDA)
• ISDA provisions are master agreements

6
Introduction (cont’d)
• A plain vanilla swap refers to a standard contract
with no unusual features or bells and whistles
• The swap facilitator will find a counterparty to a
desired swap for a fee or take the other side
• A facilitator acting as an agent is a swap broker
• A swap facilitator taking the other side is a swap dealer
(swap bank)

7
Introduction (cont’d)
Plain Vanilla Swap Example

A large firm pays a fixed interest rate to its bondholders, while a smaller
firm pays a floating interest rate to its bondholders.

The two firms could engage in a swap transaction which results in the
larger firm paying floating interest rates to the smaller firm, and the
smaller firm paying fixed interest rates to the larger firm.

8
Introduction (cont’d)
Plain Vanilla Swap Example (cont’d)

LIBOR – 50 bp

Big Firm 8.05%

Smaller
Firm

8.05% LIBOR +100 bp

Bondholder Bondholder
s s

9
Introduction (cont’d)
Plain Vanilla Swap Example (cont’d)

A facilitator might act as an agent in the transaction and charge a 15 bp

fee for the service.

10
Introduction (cont’d)
Plain Vanilla Swap Example (cont’d)

LIBOR -50 bp LIBOR -50 bp

Big Firm Facilitator Smaller

8.05% 8.20%
Firm

8.05% LIBOR +100 bp

Bondholder Bondholder
s s

11
Introduction (cont’d)
• The swap price is the fixed rate that the two parties
agree upon
• The tenor is the term of the swap
• The notional value determines the size of the
interest rate payments
• Counterparty risk refers to the risk that one party to
the swap will not honor its part of the agreement

12
Immunizing With Interest Rate Swaps
• Interest rate swaps can be used by corporate
treasurers to adjust their exposure to interest rate
risk
• The duration gap is:

Total Liabilitie s
D gap  D asset   D liabilities
Total assets

13
Immunizing With Interest Rate Swaps (cont’d)
• A positive duration gap means a bank’s net worth
will suffer if interest rates rise
• The treasurer may choose to move the duration gap to
zero
• This could be accomplished by selling some of the bank’s loans
and holding cash equivalent securities instead

14
Immunizing With Interest Rate Swaps (cont’d)
• Using the bank’s balance sheet, we can algebraically
solve for the proportion of the firm’s assets to be
held in cash so that the duration gap is zero:

D gap  x cash  0.00  1  x cash average loan asset duration  -

 Total Liabilitie s 
  D liabilities   0
 Total assets 
15
Exploiting Comparative Advantage in the Credit Market

• Interest rate swaps can be used to exploit

differentials in the credit market

16
Exploiting Comparative Advantage in the Credit
Market
Credit Market Example
AAA Bank and BBB Bank currently face the following borrowing
possibilities:

Firm Fixed Rate Floating Rate

AAA Current 5-yr LIBOR

T-bond + 25 bp

BBB Current 5-yr LIBOR + 30 bp

T-bond + 85 bp

Quality Spread 60 bp 30 bp
17
Exploiting Comparative Advantage in the Credit
Market
Credit Market Example (cont’d)

AAA Bank has an absolute advantage over BBB in both the fixed and
the floating rate markets. AAA has a comparative advantage in the fixed
rate market.

The total gain available to be shared among the swap participants is the
differential in the fixed rate market minus the differential in the
variable rate market, or 30 bps.

18
Exploiting Comparative Advantage in the Credit Market

Credit Market Example (cont’d)

AAA Bank wants to issue a floating rate bond, while BBB wants to
borrow at a fixed rate. Both banks will borrow at a lower cost if they
agree to an interest rate swap.

AAA Bank should issue a fixed rate bond because it has a comparative
advantage in this market. BBB should borrow at a floating rate. The
swap terms split the rate savings 50-50. The current 5-yr T-bond rate is
4.50%.

19
Exploiting Comparative Advantage in the Credit
Market
Credit Market Example (cont’d)

LIBOR

AAA Treasury + 40 bp
BBB

Treasury + 25 bp LIBOR +30 bp

Bondholder Bondholder
s s

20
Exploiting Comparative Advantage in the Credit
Market

Credit Market Example (cont’d)

 The net borrowing rate for AAA is LIBOR – 15 bps

 The net borrowing rate for BBB is Treasury + 70 bps

 The net rate for both parties is 15 bps less than without the
swap.

21
Foreign Currency Swaps
• In a currency swap, two parties
• Exchange currencies at the prevailing exchange rate
• Then make periodic interest payments to each other
based on a predetermined pair of interest rates, and
• Re-exchange the original currencies at the conclusion of
the swap

22
Foreign Currency Swaps (cont’d)
• Cash flows at origination:

FX Principal

US $ Principal

Party 1 Party 2

23
Foreign Currency Swaps (cont’d)
• Cash flows at each settlement:

$ LIBOR

FX Fixed Rate

Party 1 Party 2

24
Foreign Currency Swaps (cont’d)
• Cash flows at maturity:

US $ Principal

FX Principal

Party 1 Party 2

25
Foreign Currency Swaps (cont’d)
Foreign Currency Swap Example

A multinational US corporation has a subsidiary in Germany. It just

signed a 3-year contract with a German firm. The German firm will
provide raw materials, with the US firm paying 1 million Euros every 6
months for the 3-year period. The current exchange rate is $0.90/Euro.

The contract is fixed in Euro terms, but if the dollar depreciates against
the Euro, dollar accounts payable would increase.

26
Foreign Currency Swaps (cont’d)
Foreign Currency Swap Example (cont’d)

A currency swap is possible with the following terms:

 Tenor = 3 years
 Notional value = 25 million Euros ($22.5 million)
 Floating rate = $ LIBOR
 Fixed rate = 8.00% on Euros

27
Foreign Currency Swaps (cont’d)
Foreign Currency Swap Example (cont’d)

The swap will result in the following payments every six months:

 Fixed rate payment = 25,000,000 Euros x 8.00% x 0.5 =

1,000,000 Euros
 Floating rate payment = $22.5 million x 0.5 x LIBOR

28
Foreign Currency Swaps (cont’d)
Foreign Currency Swap Example (cont’d)
Cash Flows at Origination

25 million euros

Party 1 Party 2
$22.5 million

29
Foreign Currency Swaps (cont’d)
Foreign Currency Swap Example (cont’d)
Cash Flows at Each Settlement

$ LIBOR

Party 1 Party 2
1 million euros

30
Foreign Currency Swaps (cont’d)

Foreign Currency Swap Example (cont’d)

Cash Flows at Maturity

$22.5 million

Party 1 Party 2
25 million euros

31
Introduction
• A circus swap combines an interest rate and a
currency swap
• Involves a plain vanilla interest rate swap and an ordinary
currency swap
• Both swaps might be with the same counterparty or with
different counterparties

32
Introduction (cont’d)
• Circus swap with two counterparties:
8% on Euros

$ LIBOR

Party 1 Party 2

33
Introduction (cont’d)
• Circus swap with two counterparties (cont’d):
$ LIBOR

6.50% US

Party 1 Party 3

34
Introduction (cont’d)
• Circus swap with two counterparties (cont’d):
8% on Euros

6.50% US

Party 1 Net

35
Introduction (cont’d)
• Circus swap with two counterparties (cont’d):
• Party 1 is effectively paying 8% on Euros and receiving
6.5% in U.S. dollars

36
Swap Variations
• Deferred swap
• Floating for floating swap
• Amortizing swap
• Accreting swap

37
Deferred Swap
• In a deferred swap (forward start swap), the cash
flows do not begin until sometime after the
initiation of the swap agreement
• If the swap begins now, the deferred swap is called a spot
start swap

38
Floating for Floating Swap

• In a floating for floating swap, both parties pay a

floating rate, but with different benchmark indices

39
Amortizing Swap
• In an amortizing swap, the notional value declines
over time according to some schedule

40
Accreting Swap
• In an accreting swap, the notional value increases
through time according to some schedule

41
Intuition Into Swap Pricing
• Swaps as a pair of bonds
• Swaps as a series of forward contracts
• Swaps as a pair of option contracts

42
Swaps as A Pair of Bonds
• If you buy a bond, you receive interest
• If you issue a bond you pay interest

• In a plain vanilla swap, you do both

• You pay a fixed rate
• You receive a floating rate
• Or vice versa

43
Swaps as A Pair of Bonds (cont’d)
• A bond with a fixed rate of 7% will sell at a premium
if this is above the current market rate

• A bond with a fixed rate of 7% will sell at a discount

if this is below the current market rate

44
Swaps as A Pair of Bonds (cont’d)
• If a firm is involved in a swap and pays a fixed rate of
7% at a time when it would otherwise have to pay a
higher rate, the swap is saving the firm money

• If because of the swap you are obliged to pay more

than the current rate, the swap is beneficial to the
other party

45
Swaps as A Series of Forward Contracts
• A forward contract is an agreement to
exchange assets at a particular date in the
future, without marking-to-market

• An interest rate swap has known payment

dates evenly spaced throughout the tenor of
the swap

46
Swaps as A Series of Forward Contracts (cont’d)
• A swap with a single payment date six months
hence is no different than an ordinary six-
month forward contract
• At that date, the party owing the greater amount
remits a difference check

47
Swaps as A Pair of Option Contracts
• Assume a firm buys a cap and writes a floor, both
with a 5% striking price

• At the next payment date, the firm will

• Receive a check if the benchmark rate is above 5%
• Remit a check if the benchmark rate is below 5%

48
Swaps as A Pair of Option Contracts (cont’d)
• The cash flows of the two options are identical to
the cash flows associated with a 5% fixed rate swap
• If the floating rate is above the fixed rate, the party
paying the fixed rate receives a check
• If the floating rate is below the fixed rate, the party
paying the floating rate receives a check

49
Swaps as A Pair of Option Contracts (cont’d)
• Cap-floor-swap parity

Write floor Buy cap Long swap

+ =
5% 5% 5%

50
Solving for the Swap Price
• Introduction
• The role of the forward curve for LIBOR
• Implied forward rates
• Initial condition pricing
• Quoting the swap price
• Counterparty risk implications

51
Introduction
• The swap price is determined by fundamental
arbitrage arguments
• All swap dealers are in close agreement on what this rate
should be

52
The Role of the Forward Curve for LIBOR
• LIBOR depends on when you want to begin a loan
and how long it will last

• Similar to forward rates:

• A 3 x 6 Forward Rate Agreement (FRA) begins in three
months and lasts three months (denoted by )
• A 6 x 12 FRA begins in six months and lasts six months
(denoted by )

3 f6

f
6 12

53
The Role of the Forward Curve for LIBOR (cont’d)
• Assume the following LIBOR interest rates:

Spot (0f3) 5.42%

Six Month (0f6) 5.50%

Nine Month (0f9) 5.57%

Twelve Month (0f12) 5.62%

54
The Role of the Forward Curve for LIBOR (cont’d)
LIBOR yield curve

5.62
5.57 0 x 12
0x9
5.50
0x6
5.42
spot

0 6 9 12 Months

55
Implied Forward Rates
• We can use these LIBOR rates to solve for the
implied forward rates
• The rate expected to prevail in three months, 3f6
• The rate expected to prevail in six months, 6f9
• The rate expected to prevail in nine months, 9f12

• The technique to obtain the implied forward rates is

called bootstrapping

56
Implied Forward Rates (cont’d)
• An investor can
• Invest in six-month LIBOR and earn 5.50%
• Invest in spot, three-month LIBOR at 5.42% and re-invest
for another three months at maturity

• If the market expects both choices to provide the

same return, then we can solve for the implied
forward rate on the 3 x 6 FRA

57
Implied Forward Rates (cont’d)
• The following relationship is true if both alternatives
are expected to provide the same return:

2
 0 f 3  3 f6   0 f6 
1  1    1  
 4  4   4 

58
Implied Forward Rates (cont’d)
• Using the available data:

2
 .0542  3 f 6   .0550 
1  1    1  
 4  4   4 
3 f 6  5.58%

59
Implied Forward Rates (cont’d)
• Applying bootstrapping to obtain the other implied
forward rates:
• 6f9 = 5.71%
• 9f12 = 5.77%

60
Implied Forward Rates (cont’d)
LIBOR forward rate curve

5.77
5.71 9 x 12
6x9
5.58
3x6
5.42
spot

0 3 6 9 12 Months

61
Initial Condition Pricing
• An at-the-market swap is one in which the
swap price is set such that the present value
of the floating rate side of the swap equals
the present value of the fixed rate side
• The floating rate payments are uncertain
• Use the spot rate yield curve and the implied forward
rate curve

62
Initial Condition Pricing (cont’d)
At-the-Market Swap Example

A one-year, quarterly payment swap exists based on actual days in the

quarter and a 360-day year on both the fixed and floating sides. Days in
the next 4 quarters are 91, 90, 92, and 92, respectively. The notional
principal of the swap is $1.

Convert the future values of the swap into present values by

discounting at the appropriate zero coupon rate contained in the
forward rate curve.

63
Initial Condition Pricing (cont’d)
At-the-Market Swap Example (cont’d)
First obtain the discount factors:

 91 
1  R3  1    .0542   1.013701
 360 

 91  90 
1  R6  1    .0550   1.027653
 360 

64
Initial Condition Pricing (cont’d)
At-the-Market Swap Example (cont’d)
First obtain the discount factors:

 91  90  92 
1  R9  1    .0557   1.042239
 360 

 91  90  92  92 
1  R12  1    .0562   1.056981
 360 

65
Initial Condition Pricing (cont’d)
At-the-Market Swap Example (cont’d)
Next, apply the discount factors to both the fixed and floating rate sides
of the swap to solve for the swap fixed rate that will equate the two
sides:
91 90 92 92
5.42% 5.58% 5.71% 5.77%
PVfloating  360  360  360  360
1.013701 1.027653 1.042239 1.056981
 .013515  .013575  .014001  .013951
 0.055042

66
Initial Condition Pricing (cont’d)
At-the-Market Swap Example (cont’d)
Apply the discount factors to both the fixed and floating rate sides of
the swap to solve for the swap fixed rate that will equate the two sides:

91 90 92 92
X% X% X% X%
PVfixed  360  360  360  360
1.013701 1.027653 1.042239 1.056981
 .249361X  .243273 X  .245199 X  .241779 X
 0.979612 X

67
Initial Condition Pricing (cont’d)
At-the-Market Swap Example (cont’d)
Solving the two equations simultaneously for X gives X = 5.62%. This is
the equilibrium swap fixed rate, or swap price.

68
Quoting the Swap Price
• Common practice to quote the swap price relative to
the U.S. Treasury yield curve
• Maturity should match the tenor of the swap

• There is both a bid and an ask associated with the

swap price
• The dealer adds a swap spread to the appropriate
Treasury yield

69
Counterparty Risk Implications
• From the perspective of the party paying the fixed
rate
• Higher when the floating rate is above the fixed rate

• From the perspective of the party paying the floating

rate
• Higher when the fixed rate is above the floating rate

70
Valuing an Off-Market Swap
• The swap value reflects the difference between the
swap price and the interest rate that would make
the swap have zero value
• As soon as market interest rates change after a swap is
entered, the swap has value

71
Valuing an Off-Market Swap (cont’d)
• An off-market swap is one in which the fixed rate is
such that the fixed rate and floating rate sides of the
swap do not have equal value
• Thus, the swap has value to one of the counterparties

72
Valuing an Off-Market Swap (cont’d)
• If the fixed rate in our at-the-market swap example
was 5.75% instead of 5.62%
• The value of the floating rate side would not change
• The value of the fixed rate side would be lower than the
floating rate side
• The swap has value to the floating rate payer

73
Hedging the Swap
• Introduction
• Hedging against a parallel shift in the yield curve
• Hedging against any shift in the yield curve
• Tailing the hedge

74
Introduction
• If interest is predominantly in one direction (e.g.,
everyone wants to pay a fixed rate), then the dealer
stands to suffer a considerable loss
• E.g., the dealer is a counterparty to a one-year, $10
million swap with quarterly payments and pays floating
• The dealer is hurt by rising interest rates

75
Introduction (cont’d)
• The dealer can hedge this risk in the eurodollar
futures market
• Based on LIBOR
• If the dealer faces the risk of rising rates, he could sell
eurodollar futures and benefit from the decline in value
associated with rising interest rates

76
Hedging Against A Parallel Shift in the Yield Curve
• Assume the yield curve shifts upward by one basis
point
• The present value of the fixed payments decreases
• The present value of the floating payments also
decreases, but by a smaller amount
• The net effect hurts the floating rate payer

77
Hedging Against A Parallel Shift in the Yield Curve
(cont’d)
• The dealer could sell eurodollar (ED) futures to
hedge
• Need one ED futures contract for every $25 change in
value of the swap
• Need to choose between the various ED futures contracts
available

78
Hedging Against A Parallel Shift in the Yield Curve
(cont’d)
• How to choose between the ED futures contracts
available?
• With a stack hedge, the hedger places all the futures
contracts at a single point on the yield curve, usually using
a nearby delivery date
• With a strip hedge, the hedger distributes the futures
contracts along the relevant portion of the yield curve
depending on the tenor of the swap

79
Hedging Against Any Shift in the Yield Curve
• The yield curve seldom undergoes a parallel shift

• To hedge against any change, determine how the

swap value changes with changes at each point
along the yield curve

80
Hedging Against Any Shift in the Yield Curve (cont’d)
• Steps involved in hedging:
• Convert the annual LIBOR rate into effective rates :

 R
T
 N
Z T  1    1 
 N   T
where
Z T  effective interest rate for payment T
R  LIBOR over the tenor of the swap
N  number of swap payments per year
T  payment number

81
Hedging Against Any Shift in the Yield Curve (cont’d)
• Steps involved in hedging (cont’d):
• Next, determine the number of futures needed at each
payment date:

Swap notional principal

$1,000,000
FT 
 T
1   ZT  
 N

82
Tailing the Hedge
• Futures contracts are marked to market daily
• Forward contracts are not marked to market

• This introduces a time value of money differential

for long-tenor swaps
• Hedging equations would overhedge

83
Tailing the Hedge (cont’d)
• To remedy the situation, simply reduce the size of
the hedge by the appropriate time value of money
adjustment (tail the hedge):

Hedge untailed
Hedge tailed 
(1  R)T

84
Tailing the Hedge (cont’d)
Tailing the Hedge Example
Assume we have determined that we need 100 ED futures contracts for
delivery two years from now. The two-year interest rate is 6.00%. How
many ED futures do you need if you tail the hedge?

85
Tailing the Hedge (cont’d)
Tailing the Hedge Example (cont’d)
You need 89 ED futures contracts:

100
Hedge tailed  2
 89
(1.06)

86
Pricing A Currency Swap
• To value a currency swap:
• Solve for the equilibrium fixed rate on a plain vanilla
interest rate swap for each of the two countries
• Determine the relevant spot rates over the tenor of the swap
• Determine the relevant implied forward rates

• Find the equilibrium swap price for an interest rate swap

in both countries

87