Swaps
Fixed by floating and foreign
currency swaps.
Nature of Swaps
A swap is an agreement to
exchange cash flows at specified
future times according to certain
specified rules
An 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
Next slide illustrates cash flows
Cash Flows to Microsoft
---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar.5, 2004 4.2%
Sept. 5, 2004 4.8% +2.10 –2.50 –0.40
Mar.5, 2005 5.3% +2.40 –2.50 –0.10
Sept. 5, 2005 5.5% +2.65 –2.50 +0.15
Mar.5, 2006 5.6% +2.75 –2.50 +0.25
Sept. 5, 2006 5.9% +2.80 –2.50 +0.30
Mar.5, 2007 6.4% +2.95 –2.50 +0.45
Swap Bank
A swap bank is a generic term used to describe a
financial institution that facilitates swaps between
counterparties.
The swap bank serves as either a broker or a dealer.
A broker matches counterparties but does not assume any
of the risk of the swap. The swap broker receives a
commission for this service.
Today most swap banks serve as dealers or market
makers. As a market maker, the swap bank stands willing
to accept either side of a currency swap.
5
Example of an Interest Rate Swap
Bank A is a AAA-rated international bank located
in the U.K. that wishes to raise $10,000,000 to
finance floating-rate Eurodollar loans.
Bank A is considering issuing 5-year fixed-rate
Eurodollar bonds at 10 percent.
It would make more sense for the bank to issue
floating-rate notes at LIBOR to finance the floating-
rate Eurodollar loans.
6
Example of an Interest Rate Swap
Company B is a BBB-rated U.S. company. It
needs $10,000,000 to finance an investment
with a five-year economic life, and it would
prefer to borrow at a fixed rate.
Firm B is considering issuing 5-year fixed-rate
Eurodollar bonds at 11.75 percent.
Alternatively, Firm B can raise the money by
issuing 5-year floating rate notes at LIBOR + ½
percent.
Firm B would prefer to borrow at a fixed rate.
7
Example of an Interest Rate Swap
The borrowing opportunities of the two firms are
shown in the following table.
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + 0.50% LIBOR 0.50%
8
Example of an Interest Rate Swap
Bank A has an absolute advantage in borrowing
relative to Company B
Nonetheless, Company B has a comparative
advantage in borrowing floating, while Bank A
has a comparative advantage in borrowing fixed.
That is, the two together can borrow more cheaply
if Bank A borrows fixed, while Company B
borrows floating.
9
Example of an Interest Rate Swap
To see the potential advantages to a swap, imagine
the two entities trying to minimize their combined
borrowing costs:
COMPANY B BANK A TOGETHER
Borrow preferred
11.75% LIBOR LIBOR + 11.75%
method
Borrow opposite
LIBOR + 0.50% 10% LIBOR + 10.50%
and swap
POTENTIAL SAVINGS: 1.25%
10
Example of an Interest Rate Swap
COMPANY B BANK A TOGETHER
Borrow preferred
11.75% LIBOR LIBOR + 11.75%
method
Borrow opposite
LIBOR + 0.50% 10% LIBOR + 10.50%
and swap
POTENTIAL SAVINGS: 1.25%
Now, we must determine how to split the swap savings!
If Swap Bank takes 0.25% that leaves 1% for Bank A &
Company B. If they share this equally then:
- Bank A pays LIBOR - 0.5% = LIBOR – 0.5%
- Company B pays 11.75% - 0.5% = 11.25%
11
Example of an Interest Rate Swap
Swap
Bank
10 3/8%
LIBOR – 1/8%
Bank The swap bank makes
A this offer to Bank A:
You pay LIBOR – 1/8 %
per year on $10 million
for 5 years, and we will
pay you 10 3/8% on
$10 million for 5 years.
12
Example of an Interest Rate Swap
Swap
Bank
10 3/8%
LIBOR – 1/8% Why is this swap desirable to
Bank A?
Bank
A With the swap, Bank A pays
LIBOR-1/2%
10%
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + 0.50% LIBOR 0.50%
13
Example of an Interest Rate Swap
Swap
Bank
10 ½%
The swap bank makes LIBOR – ¼%
this offer to Company
B: You pay us 10 ½ % Compan
y
per year on $10 million
for 5 years, and we will B
pay you LIBOR – ¼ %
per year on $10 million
for 5 years.
14
Example of an Interest Rate Swap
Swap
Bank
10 ½%
Why is this swap
LIBOR – ¼%
desirable to Company B?
Compan
With the swap, Company B y
pays 11¼%
BLIBOR + ½%
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + 0.50% LIBOR 0.50%
15
Example of an Interest Rate Swap
Will the swap
bank make Swap
money?
10 3/8 % Bank 10 ½%
LIBOR – 1/8% LIBOR – ¼%
Bank Compan
y
A
B
16
Example of an Interest Rate Swap
The swap bank Swap
makes ¼ %
Bank
10 3/8 % 10 ½%
LIBOR – ¼%
LIBOR – 1/8%
Bank Compan LIBOR
10%
Note that the total y + ½%
A savings ½ + ½ + ¼ =
A saves ½ 1.25 % = QSD BB
saves ½ %
% COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + 0.50% LIBOR 0.50%
QSD = 1.25%
17
Typical Uses of an
Interest Rate Swap
Converting a liability from
fixed rate to floating rate
floating rate to fixed rate
Converting an investment from
fixed rate to floating rate
floating rate to fixed rate
Intel and Microsoft (MS)
Transform a Liability
(Figure 7.2, page 152, Hull)
5%
5.2%
Intel MS
LIBOR+0.1%
LIBOR
Intel and Microsoft (MS)
Transform an Asset
(Figure 7.3, page 153, Hull)
5%
4.7%
Intel MS
LIBOR-0.2%
LIBOR
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
Valuation of an Interest Rate
Swap that is not New
Interest rate swaps can be valued as
the difference between the value of a
fixed-rate bond and the value of a
floating-rate bond
Alternatively, they can be valued as a
portfolio of forward rate agreements
(FRAs)
Valuation in Terms of Bonds
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
Swap rate: par rate on the the fixed
coupon bond .
See attached note with details on
valuation.
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
An Example of a Currency Swap
An agreement to pay 11% on a sterling
principal of £10,000,000 & receive 8% on
a US$ principal of $15,000,000 every
year for 5 years
Exchange of Principal
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
The Cash Flows (Table 7.7, page 166,Hull)
Dollars Pounds
$ £
Year ------millions------
2004 –15.00 +10.00
2005 +0.60 –0.70
2006 +0.60 –0.70
2007 +0.60 –0.70
2008 +0.60 –0.70
2009 +15.60 −10.70
Typical Uses of a
Currency Swap
Conversion from a liability in one currency to
a liability in another currency
Conversion from an investment in one
currency to an investment in another currency
Valuation of 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
Fixed by fixed currency swap is valued as
the difference between the two fixed rate
bonds, valued in a common currency.
The Principal of bonds such that they have
the same value at time zero.
Valuation of 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
Fixed by floating currency swap is valued as
the difference between a fixed and floating
bond, valued in a common currency.
The Principal of bonds such that they have
the same value at time zero.
Swaps & Forwards
A swap can be regarded as a
convenient way of packaging forward
contracts
The “plain vanilla” interest rate swap in
our example consisted of 6 FRAs
The “fixed for fixed” currency swap in
our example consisted of a cash
transaction & 5 forward contracts
Swaps & Forwards
(continued)
The value of the swap is the sum of the
values of the forward contracts underlying
the swap
Swaps are normally “at the money” initially
This means that it costs nothing to enter
into a swap
It does not mean that each forward
contract underlying a swap is “at the
money” initially
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
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……..