Swaps
Chapter 5
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 “Company B” to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million
Next slide illustrates cash flows
Cash Flows to Company B
(See Table , page 123)
Typical Uses of an
Interest Rate Swap
Converting a liability from
fixed rate to floating rate
floating rate to fixed rate
Converting an investment from
fixed rate to floating rate
floating rate to fixed rate
A and B Transform a Liability
(Figure , page 125)
A
B
LIBOR
5%
LIBOR+%
%
Financial Institution is Involved
(Figure , page 126)
A
.
B
LIBOR
LIBOR
LIBOR+%
%
%
%
A and B Transform an Asset
(Figure , page 125)
A
B
LIBOR
5%
%
%
Financial Institution is Involved
(See Figure , page 126)
A
.
B
LIBOR
LIBOR
%
%
%
%
The Comparative Advantage Argument (Table , page 129)
Company A wants to borrow floating
Company B wants to borrow fixed
The Swap (Figure , page 130)
A
B
LIBOR
LIBOR+1%
%
10%
The Swap when a Financial Institution is Involved
(Figure , page 130)
A
.
B
10%
LIBOR
LIBOR
LIBOR+1%
%
%
Criticism of the Comparative Advantage Argument
The % and % rates available to A and B in fixed rate markets are 5-year rates
The LIBOR+% and LIBOR+1% rates available in the floating rate market are six-month rates
B’s fixed rate depends on the spread above LIBOR it borrows at in the future
Valuation of an Interest Rate Swap
Interest rate swaps can be valued as the difference between the value of a fixed-rate bond & the value of a floating-rate bond
Alternatively, they can be valued as a portfolio of forward rate agreements (FRAs)
Valuation in Terms of Bonds
The fixed rate bond is valued in the usual way
The floating rate bond is valued by noting that it is worth par immediately after the next payment date
Valuation in Terms of FRAs
Each exchange of payments in an interest rate swap is an FRA
The FRAs can be valued on the assumption that today’s forward rates are realized
An Example of a Currency Swap
An agreement to pay 11% on a sterling principal of £10,000,000 & receive 8% on a US$ 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 exchanged at the beginning & the end of the swap
The Cash Flows (Table , page 137)
Years
Dollars
Pounds
$
------millions------
0
–
+
1
+
–
2
+
–
3
+
–
4
+
–
5
+
£
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
Comparative Advantage Arguments for Currency Swaps (Table , page 137)
Company A wants to borrow AUD
Company B wants to borrow USD
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
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
Examples of Other Types of Swaps
Amortizing & step-up swaps
Extendible & puttable swaps
Index amortizing swaps
Equity swaps
Commodity swaps
Differential swaps
