Chapter 6

Swaps
Quynh Trang Phan
outline
• Interest rate swap
• Cross-currency swap
• Other swaps
Concepts

• A swap is an OTC agreement between two companies

to exchange cash flows in the future
• Currency swap between IBM and the World Bank in
1981
• The most popular (plain vanilla) interest rate swap is
one where LIBOR is exchanged for a fixed rate of
interest
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.
Reference rate
• LIBOR (London Interbank Offered Rate)
• SOFR (Secured Overnight Financing Rate)
• Repo
 Reference rate

https://www.global-rates.com/en/interest-rates/sofr/sofr.aspx
Example
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
Example
• Notional principal: $100 million
• Fixed-rate payer: Microsoft
• Floating-rate payer: Intel
• Frequency of payment: semiannually
• Fixed rate: 5% per annum (semiannual compounding)
• Reference rate: 6-month LIBOR (assumed as in Table)
• Maturity: 3 years
Example
• Calculate cash flows to Microsoft?
Date 6-moth Floating cash Fixed cash Net cash flow
LIBOR rate flow received flow paid
(%)
Mar. 5, 2014 4.2
Sep. 5, 2014 4.8
Mar. 5, 2015 5.3
Sep. 5, 2015 5.5
Mar. 5, 2016 5.6
Sep. 5, 2016 5.9
Mar. 5, 2017
Example
• Calculate cash flows to Intel?
Date 6-moth Floating cash Fixed cash Net cash flow
LIBOR rate flow paid flow received
(%)
Mar. 5, 2014 4.2
Sep. 5, 2014 4.8
Mar. 5, 2015 5.3
Sep. 5, 2015 5.5
Mar. 5, 2016 5.6
Sep. 5, 2016 5.9
Mar. 5, 2017
Usage of swap
• Transform a Liability (Loan, Bond)
• Transform a Asset (Investment, Bond)
Financial Intermediary
Day count issue
• Day count convention issue
• Calculation
Confirmation
• A confirmation is the legal agreement underlying a swap
and is signed by representatives of the two parties
• The drafting of confirmations has been facilitated by the
work of the International Swaps and Derivatives
Association (ISDA)
• Master Agreements: consists of clauses
Valuation
• In terms of bond prices
• In term of FRAs
Bond pricing approach
• Floating-rate payer: long(fixed-rate bond) + short(floating-
rate bond)
= −
• Fixed-rate payer: long(floating-rate bond) + short(fixed-
rate bond)
= −
Example
• FI agreed to receive 6-month LIBOR and pay 3% per
annum (with semiannual compounding) on a notional
principal of $100 million
• The swap has a remaining life of 1.25 years.
• The LIBOR rates with continuous compounding for 3-
month, 9-month, and 15- month maturities are 2.8%,
3.2%, and 3.4%, respectively.
• The 6-month LIBOR rate at the last payment date was
2.9% (with semiannual compounding).
Example

Date (T) B(fix) CF B(floating) CF PV(B(fix)) PV(B(floating)

0.25 1.5 101.45
0.75 1.5
1.25 101.5
FRAs
• FW rate (3-9 months): 3.4% (continuous compounding)
(3.429%)
• FW rate(9-15 months): 3.7% (3.7344%)
Conversion formula
 Compounding to continuous compounding

R
R = mln(1 + )
m
 Continuous compounding to compounding
R = m(e( )
− 1)
 Forward rate
FRAs
• FW rate: 3.4%
Date (T) Fixed CF Floating CF Net CF PV(Net CF)
0.25 -1.5 +1.45
0.75 -1.5 +1.7145
1.25 -1.5 +1.8672
Currency swap
Fixed-for-fixed currency 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
Example
• 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.
Example
• Maturity: 5 year
• Frequency of payment: annually
• Notional amount: $15 million and £10 million
• Fixed rate: 6% per annum in dollars 5% per annum in
sterling
Example
• Calculate cash flows to IBM?
Date Dollar cash flow Sterling cash flow

Feb. 1, 2014
Feb. 1, 2015
Feb. 1, 2016
Feb. 1, 2017
Feb. 1, 2018
Feb. 1, 2019
Example
• Calculate cash flows to Intel?
Date 6-moth Floating cash Fixed cash Net cash flow
LIBOR rate flow paid flow received
(%)
Mar. 5, 2014
Sep. 5, 2014
Mar. 5, 2015
Sep. 5, 2015
Mar. 5, 2016
Sep. 5, 2016
Mar. 5, 2017
Usage of swap
• Transform a Liability (Loan, Bond)
• Transform a Asset (Investment, Bond)
Valuation
• In terms of bond prices
• In term of FRAs
Bond pricing approach
• Dollar receiver
= −
• Foreign currency receiver
= −
Example
• FI agreed to receive JPY with 5% per annum and pay USD
with 8% per annum
• At the beginning: 10 m USD=1,200m JPY
• Current rate: 1 USD = 110 JPY
• The swap has a remaining life of 3 years.
• Discount rate: 9% for USD and 4% for JPY
Example

Date (T) USD CF JPY CF PV(USD CF) PV(JPY CF)

1 0.8 60
2 0.8 60
3 0.8 60
3 10.0 1,200

V=+$1.5430 m
FW and futures price on FX

F = S × e( )×

Notes: r and r are risk-free rate of interest for

foreign and local currency, respectively
FW price
• 1-year FW price
• 2-year FW price
• 3-year FW price
Example

Date (T) USD CF JPY CF Exchange Net CF(USD- PV(Net CF)

rate JPY)
1 0.8 60
2 0.8 60
3 0.8 60
3 10.0 1,200
V=+$1.5430 m
Credit risk
• Central clearing
• Credit default swap
Other types of swap
• Commodity swap
• Diff swap
• Equity swap
• Options swap
• Basis swap
• ….