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……..