Swaps Chapter 7

1
SwapsChapter 7
2
Nature of Swaps

• A swap is an agreement to exchange cash flows at
  specified future times according to certain
  specified rules

3
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

4
Cash Flows to Microsoft(See Table 7.1)
5
Typical Uses of anInterest 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

6
Intel and Microsoft (MS) Transform a
Liability(Figure 7.2)
5
5.2
Intel
MS
LIBOR0.1
LIBOR
7
Financial Institution is Involved(Figure 7.4)

4.985
5.015
5.2
F.I.
MS
Intel
LIBOR0.1
LIBOR
LIBOR
Dealer spread .03 evenly split
8
Intel and Microsoft (MS) Transform an
Asset(Figure 7.3)

5
4.7
Intel
MS
LIBOR-0.20
LIBOR
9
Financial Institution is Involved(See Figure 7.5)

5.015
4.985
4.7
F.I.
MS
Intel
LIBOR-0.20
LIBOR
LIBOR
Dealer spread .03
10
The Comparative Advantage Argument (Table 7.4)

• AAACorp wants to borrow floating
• BBBCorp wants to borrow fixed

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The Comparative Advantage Argument

• AAACorp has absolute advantage in both markets
• But a comparative advantage in fixed
• BBBCorp has comparative advantage in floating
• If AAA borrows fixed, the gain is 1.2
• If BBB borrows floating, the gain is reduced by
  .7
• Therefore, we have a net gain of 1.2 - .7
  .5
• If the gain is split evenly, we have a gain per
  party of G (1.2 - .7)/2 .25

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Swap Design

• Design the swap so AAAs borrowing rate equals
  the comparative disadvantage (CD) rate minus the
  gain
• LIBOR .3 - .25
• Do the same thing for BBB
• BBBs rate with swap
• 5.2 - .25 4.95
• Now, draw the diagram

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The Swap (Figure 7.6)

3.95
4
AAA
BBB
LIBOR1
LIBOR
The floating rate leg should be LIBOR

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Swap Design with FI

• Adjust swap gain for dealer spread
• Suppose dealer spread .04
• Then gain
• G (1.2 - .7 - .04)/2 .23
• AAAs rate with swap
• LIBOR .3 - .23 LIBOR .07
• BBBs rate with swap
• 5.2 - .23 4.97
• Draw swap diagram

15
The Swap when a Financial Institution is Involved
(Figure 7.7)

3.93
3.97
4
AAA
F.I.
BBB
LIBOR1
LIBOR
LIBOR
Check that dealer spread .04
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Criticism of the Comparative Advantage Argument

• The 4.0 and 5.2 rates available to AAACorp and
  BBBCorp in fixed rate markets are 5-year rates
• The LIBOR0.3 and LIBOR1 rates available in
  the floating rate market are six-month rates
• BBBCorps fixed rate depends on the spread above
  LIBOR it borrows at in the future

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Valuation of an Interest Rate Swap

• 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

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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

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An Example of a Currency Swap

• An agreement to pay 5 on a sterling principal
  of 10,000,000 receive 6 on a US principal of
  18,000,000 every year for 5 years

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Exchange of Principal

• In an interest rate swap the principal is not
  exchanged
• In a currency swap the principal is exchanged at
  the beginning and the end of the swap

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Three Cash Flow Components

• t 0 exchange principal based upon
  current exchange rates Pay
  18 M
  Rcv 10 M
• t 1, 2, 3, 4, 5
  Pay .05x10 .5 M
  Rcv
  .06x18 1.08 M
• t 5 Pay 10 M Rcv 18 M

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The Cash Flows (Table 7.5)
Dollars
Pounds


Years
------millions------
0
18.00
10.00
1.08
1
.50
2
1.08
.50
3
1.08
.50
4
1.08
.50
5
19.08
-10.50
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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

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Comparative Advantage Arguments for Currency
Swaps (Table 7.6)

• General Electric wants to borrow AUD
• Qantas wants to borrow USD

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Comparative Advantage

• GE has absolute advantage in both markets
• But GE has comparative advantage in dollars
• Qantas has comparative advantage in Australian
  dollars
• So GE should borrow dollars and Qantas Australian
  dollars
• Then swap cash flows to earn gain from
  comparative advantage

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Comparative Advantage

• Gain per party G (2 - .4)/2 .8
• GEs rate with swap 7.6 - .8 AUD 6.8
• Qantas rate with swap 7 - .8 USD 6.2

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Qantas Assumes Exchange Rate Risk
USD 5
USD 5
AUD 8.0
GE
Qantas
AUD 6.8
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GE Assumes Exchange Rate Risk
USD 6.2
USD 5
AUD 8
GM
Qantas
AUD 8.0
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FI Assumes Exchange Rate Risk

• Adjust swap gain for dealer spread
• Suppose dealer spread .2
• Then gain
• Gain per party G (2 - .4 - .2)/2 .7
• GEs rate with swap 7. 6 - .7 AUD 6.9
• Qantas rate with swap 7 - .7 USD 6.3

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FI Assumes Exchange Rate Risk

USD 5
USD 6.3
USD 5
GE
F.I.
Q
AUD 8
AUD 6.9
AUD 8
Check that dealer spread .2 Pay 13.0 11.9
AUD 1.1 Rcv 6.3 5.0 USD 1.3
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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

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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 Fraps
• The fixed for fixed currency swap in our
  example consisted of a cash transaction 5
  forward contracts

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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

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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