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DERIVATIVES: FUTURES, OPTIONS AND SWAPS

A derivative is a financial instrument whose value depends on or is derived from the value of
some other financial instruments, called underlying asset. Some common examples of
underlying assets are stocks, bonds, wheat, snowfall, and stock market indices. A simple
example of derivative is a contractual agreement between two investors that obligates one to
make a payment to the other, depending on the movement in the interest rates over the next year.
This type of derivative is called an interest rate futures contract. This is different from purchasing
a bond because, while a fall in bond price is profitable for a derivative investment, it is not
desirable for a bond investment. Second, in derivative transactions, one partys loss is the other
partys gain. Risk can be bought and sold using derivatives. Thus, the purpose of derivative is to
transfer risk from one person or firm to another.
Derivatives may be divided into three major categories: forwards and futures, options and swaps.
Forwards and Futures they are the simplest derivative instruments. A forward or forward
contract is an agreement between a buyer and a seller to exchange a commodity or financial
instrument for a specified amount of cash on a pre-arranged future date. It is a private agreement
between two parties, usually two financial institutions or between a financial institution and one
of its clients. And since, it is customized, it is very difficult to resell.
Forward contracts on foreign exchanges are very popular. The following table shows quotes on
the exchanges between the British pound (GBP) and US dollar that might be made by a large
bank on July 20, 2007. If the treasurer of a US corporation knows that the corporation will pay
1 million in 6 months and wants to hedge against exchange rate moves, the treasurer can buy 1
million 6-month forward at an exchange rate of 2.0489.
Spot and forward quotes for the USD/GBP exchange rate, July 20, 2007
Bid
Offer
Spot
2.0558
2.0562
1-month forward
2.0547
2.0552
3-month forward
2.0526
2.0531
6-month forward
2.0483
2.0489
Following the contract the corporation is obligated to buy 1 million for US$ 2,048,900. If the
spot exchange rate rose to 2.1 at the end of 6 months, the contract would be worth $51,100 to the
corporation. If the spot exchange rate fell to 1.9 at the end of 6 months, the forward contract
would have a negative value of $ 148900. In general the pay off from a long position in a
forward contract on one unit of an asset is ST K, where ST is the spot price and K is the delivery
price at the maturity of the contract. Similarly the pay off from a short position is K ST. They
are shown in the following figures.

Pay offs from a forward contract: a ) long position, b) short position


Payoff

Payoff

a) Long Position

ST

ST

b) Short Position

A future or futures contract is a forward contract that has been standardized and sold through an
organized exchange. It specifies that the seller who has the short position will deliver some
quantity of a commodity or financial instrument to the buyer who has the long position on a
specific date, called the settlement or delivery date for a predetermined price. In order to ensure
that both the buyer and the seller meet their obligations, each makes an agreement with a
clearing corporation. The clearing corporation operates like a large insurance company
guaranteeing that they will meet their obligations. It is the counterparty to both sides of
transactions. If you hedge billions of dollars worth of bets through derivatives offered by another
firm, and that firm then goes insolvent, you suddenly have a serious exposure problem, which
can ripple through the financial system. A central clearinghouse aims to change the system from
one which is vulnerable to the loss of any big player to one which isn't. The arrangement reduces
the risk the buyers and the sellers face.

The clearing corporation requires both parties to a futures contract to place a deposit with the
corporation. This practice is called posting margin in a margin account. It also posts daily gains
and losses on the contract to the margin accounts of the parties involved. This process is called
marking to market.
The investor is entitled to withdraw any balance in margin account in excess of the initial
margin. To ensure that the initial margin account never becomes negative a maintenance margin,

somewhat lower than the initial margin is set. If the balance in the margin account falls below the
maintenance margin, the investor gets a margin call to top up the margin account to the initial
margin level the next day. The extra funds deposited are known as variation margin. If the
investor does not provide variation margin, the broker closes out the position. The following
table illustrates the operations of a margin account. Assume that on June 5 an investor buys two
December gold futures contracts (each contract is of 100 ounces) at a price of $600 per ounce.
The initial margin is $2000 per contract and the minimum margin is $3000 in total. The margin
accounts transactions on the basis of daily settlement prices are listed below.
Day

Futures price

June 5
June 6
June 9
June 10
June 11
June 12
June 13
June 16
June 17
June 18
June 19
June 20
June 23
June 24
June 25
June 26

600
597
596.1
598.2
597.1
596.7
595.4
593.3
593.6
591.8
592.7
587
587
588.1
588.7
591.0
592.3

Daily
(loss)

(600)
(180)
420
(220)
(80)
(260)
(420)
60
(360)
180
(1140)
0
220
120
460
260

gain Cumulative
gain (loss)

(600)
(780)
(360)
(580)
(660)
(920)
(1340)
(1280)
(1640)
(1460)
(2600)
(2600)
(2380)
(2260)
(1800)
(1540)

Margin
account
balance
4000
3400
3220
3640
3420
3340
3080
2660
4060
3700
3880
2740
4000
4220
4340
4780
4060

Margin call

1340

1260

Transfer of risk using forwards and futures contract is accomplished through hedging and
speculation. The above example of an importing firm receiving 1 million in 6-months and
buying a futures contract was of hedging. Similarly, if an exporting firm knows that it is going to
receive 30 million after 3 months then it can hedge its foreign exchange risk by getting into a
forward contract to lock in the US dollars to be realized for the sterling. Note that a company
might do better or worse if it chooses to hedge than if it chooses not to hedge.
In futures contract a seller or short position benefits from a price fall while the buyer at the long
position benefits from a rise in price. Suppose a govt. security dealer wants to insure against
decline in the value of an inventory of bonds. Now, he would hedge against this by investing in
another financial instrument that delivers a high pay-off when bond prices fall. A futures contract
can guarantee the price at which the bonds would be sold. The buyer might be a pension fund
manager who plans to purchase bonds in the future but want to insure against possible price

increases. Again buying a futures contract fixes the price that the fund will need to pay. Thus,
both sides use futures contract as a hedge. Similarly, farmers, mining companies, oil drillers, all
these sellers use futures contract to stabilize the revenue they receive when they sell. In contrast,
millers, jewellers, and oil distributors want to buy futures to take long position to reduce risk
arising from fluctuations in the cost of essential inputs.
Speculators try to make profit by betting on price movements. Sellers of futures bet that prices
will fall while buyers bet that prices will rise. Futures contract are popular tools for speculation
because they are cheap. An investor needs only a relatively small amount of investment the
margin to purchase a futures contract that is worth a great deal. Margin requirements of 10
percent or less are common. For example consider a speculator who thinks that GBP will
strengthen in the next 2 months against USD. He has two options: either to buy 250000 in the
spot market and sell later at a higher price or take a long position in futures contract on sterling.
If the current exchange rate 2.0470 dollars per sterling and the futures price is 2.0410
dollar/pound and it increases to 2.1000 after 2 months then the speculator makes a profit of
$14750. The spot market alternative leads to a profit of $13250. On the other hand, if the
exchange rate falls to 2.0000 dollars/pound the loss from a futures contract would be $10250
while the loss from the spot market alternative would be $11750. The futures market is highly
leveraged. Therefore, the interest earned or paid actually makes the losses or profits from both
alternatives same. But the first alternative requires an upfront investment of $511750 while the
second alternative requires a small amount that needs to be posted in the margin account. Thus,
with a relatively small initial outlay, the investor is able to take a large speculative position.
The practice of buying and selling financial instruments in order to benefit from temporary price
differences is called arbitrage and the people who are engaged in it are called arbitrageurs. If for
example, the price of a bond is higher in one market than in another, an arbitrageur can buy at
the low price and sell in the market with high price. The increase in the demand in the low-price
market will drive the price up there while an increase in the supply in the high-price market will
lower the price. This process will continue until prices are equal in both the markets. As long as
there are arbitrageurs, the price of a bond futures contract on the day it is settled will be same as
the market price of the bond, called the spot price. Therefore, on the settlement date the price of
a futures contract must equal the spot price of the underlying asset. But arbitrage takes place
because the prices were not same before the settlement date. Here is how it is done.
First, the arbitrageur borrows at the current market interest rate. Then with the funds, the
arbitrageur buys a bond and sells a bond futures contract. The arbitrageur has to pay interest on
the loan and at the same time bond would yield interest income. They generally cancel out and
this position costs nothing to initiate. If the market price is below the futures contract price, the
bond will yield a risk-free profit. So the investor will continue to engage in the transactions
needed to generate it. This implies, continue to buy bonds, driving the price up and sell futures,
forcing the price down, until the prices converge and no further profit is available.

For example, consider a stock which is traded in both NY stock exchange as well as London
stock exchange. Suppose, that the stock price is $200 in NY while 100 in London while the
exchange rate is 2.0300 dollars/pound. An arbitrageur can simultaneously buy 100 shares of the
stock in NY and sell them in London and make a risk-free profit of 100 [($2.03100) - $200] =
$300; we assume away any transaction costs. However, for large investment banks transaction
costs are very low and thus, they find arbitrage opportunity very attractive. But as explained
above arbitrage opportunities do not last long.
Options like futures, options are also agreement between two parties, an option writer, and an
option holder. Option writers incur obligations while option holders obtain rights. There are two
basic options: puts and calls.
A call option is the right to buy or call away a given quantity of underlying asset at a
predetermined price, called the strike price or exercise price, on or before a specific date. The
writer of the call option must sell the shares if and when the holder chooses to use the call option.
The holders of the call are not obligated to buy the shares; rather they have the option to buy and
will do so if it is beneficial. For example, a January 2008 call option on 100 shares of IBM stock
at a strike price of 90 gives the option holder to buy 100 shares of IBM for Rs 90 a piece prior to
the third Friday of January 2008. When the IBM stock exceeds the option strike price of 90, say
Rs 95, the option holder can call away the 100 shares from the option writer for Rs 90 per share
and reap Rs 5 per share profit. Whenever the price of the stock is above the strike price of the
call option, exercising the call option is profitable for the holder and the option is said to be in
the money. If price of stock equal the strike price, the option is said to be at the money and when
the strike price exceeds the market price of the underlying asset, the option is termed out of
money.
A put option gives the holder the right but not the obligation to sell the underlying asset at a
predetermined price on or before a fixed date. The holder can put the asset in the hands of the
option writer. Again the writer is obliged to buy the shares should the holder choose to sell them.
Continuing with the previous example, the right to sell 100 IBM stocks with strike price of Rs 90
per share becomes profitable when the market price of IBM stocks fall below Rs 90. For
instance, a stock price of Rs 80 would give a profit of Rs 10 per share. The put option is in the
money when the options strike price above the market price. And it is out of money when strike
price is below the market price. Just like futures contracts, a clearing corporation guarantees the
obligations embodied in the option those of the option writer. And the option writer is required
to post margin. Since option holders incur no obligation, they are not required to post margin.
There are four types of participants in options markets:
1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts

There are two types of calls and puts: American and European. American options can be
exercised on any date from the time they are written till they expire. Therefore, during the
holding period an American option holder can i) continue to hold the option, ii) sell the option to
someone else or iii) exercise the option. But European options can be exercised only on the day
of expiration. Therefore, during the holding period, the option holders can either hold them or
sell them. Most of the options that are traded in the markets are American.
Consider an example. Suppose an investor instructs a broker to buy one April call option contract
on Intel with a strike price of $20. The broker will relay these instructions to a trader who will
then find another trader who wants to sell one April call contract on Intel with a strike price of
$20. Suppose the call price is $1.65. This is the price for an option to buy one share. In the US an
option contract is a contract to buy or sell 100 shares. Therefore, the investor must arrange for
$165 to be remitted to the exchange through the broker and the exchange will arrange for this
amount to be passed on to the party on the other side of the transaction. If the price of Intel
shares does not rise above $20 per share before the expiration date the option is not exercised
and the investor looses $165. But if the share price rises to say $30, then the investor makes a
gain of $1000 - $165 = $835.
An alternative trade for the investor would be to purchase one April put option contract with a
strike price of $17.5. If the put price is $0.725 then it costs $72.5 to the investor. If Intel share
price stays above $17.5 then the option is not exercised and the investor looses $72.5. If the stock
price falls to $15 net profit to the investor is $250 - $72.5 = $177.5.
Functions: options transfer risk from the buyer to the seller. So, they can be used for both
hedging and speculation. Lets take hedging first. A hedger buys insurance. For someone who
wants to purchase an asset such as a bond or a stock in future, a call option ensures that the cost
of buying the asset wont rise. For someone who plans to sell the asset in the future, a put option
ensures that the price at which the asset can be sold will not go down. To understand the
correspondence between insurance and options, consider the example of auto insurance. An
automobile owner pays insurance premium and obtains the right to file a claim in the event of an
accident. If the terms of the policy are met the insurance company is obligated to pay the claim.
If there is no accident, then no claim and no payment, the premium paid is lost. Here, the
insurance company has sold an American call option to a car owner where the underlying asset is
the car and the strike price is zero.
Options can be used for speculation as well. If you believe that interest rates are going to fall
over the next few months, then there are three ways to bet on this possibility. First, purchase
bonds and wait for a price rise and second, buy a futures contract. However, if interest rates rise
then the losses from both the strategies will be very high. The third option is to buy a call option.
If you are right and interest rate falls then the value of the call option will rise. But if you are
wrong and interest rates rise then call will expire and your loss will be limited to the price you
paid for it. This bet is highly leveraged and limited in its potential loss. In a similar fashion

purchasing a put option allows the investor to bet that the price will fall. Again, if the investor is
wrong, all that is lost is the price paid for the option. However, there are situations where a profit
from a call option is much higher than trading in the spot market and alternatively the losses are
also much higher if the spot price becomes unfavourable.
Suppose the current stock price is $20 and a 2-month call option is selling for $1 at a strike price
of $22.5. Assume that the speculator is willing to invest $2000. He can either purchase 100
shares or 2000 call options. Now if the stock price goes up to $27 then from the first option the
speculator makes a profit of $700 while from the second option the profit becomes $9000 $2000 = $7000. Similarly, if the price falls to $15 then the loss from the first option is $500
while from the second option is $2000 because the speculator wont exercise the option.
Now the question is who writes options? An option writer can take a large loss. Nevertheless,
there are people who are willing to take the risk for a fee. They are simply speculators. A second
group of people who are willing to write options are insured against any losses that may arise.
They are primarily dealers who engage in the regular purchase and sale of underlying assets.
These people or institutions are called the market makers. Market makers both own the
underlying asset so that they can deliver it and are willing to buy the underlying asset so that they
have it ready to sell to someone else. Since they own the underlying asset, writing a call option
that obligates them to sell it at a fixed price is not that risky, rather it fetch them a fee.
Options are very versatile and can be bought and sold in many combinations. For example the
purchase of an at the money call and simultaneous sale of an at the money put gives the exact
same payoff pattern as the purchase of a futures contract. If the price of the underlying asset rises
the calls value increases while the put remains worthless. If the price falls the put holder gains
while the call is out of the money. Finally, options allow investors to bet that prices will be
volatile. Buy a put and the call at the same strike price, and you have a bet that pays off only if
the underlying asset price moves up or down significantly.
Pricing options: intrinsic value and the time value
An option price has two parts. The first is the value of option if it is exercised immediately,
referred to as the intrinsic value and the second is the fee paid for the options potential benefits
called the time value of the option to emphasize its relationship to the time of the options
expiration. Therefore, option price = intrinsic value + time value of the option.
Consider the example of an at-the-money European call option on the stock of a corporation that
expires in one month. Since the call option is at-the-money, the strike and the current price are
the same, say $100. Since it is an European call, it cannot be exercised now and hence, the
intrinsic value is zero. Therefore, the call option has only time value. Assume that over the next
month, the price of the stock will either rise or fall by $10 with equal probability. The option is
worth something only if the price goes up otherwise it will not be exercised. Thus, for a call
option we need to concern with the upside when the price of the stock increases. The expected

pay off is the probability times the pay off which is 100.5 = 5. This is the time value of the
option. If the price is expected to fall or rise by $20, then the expected pay off become $10.
Therefore, with the increase in the stock price volatility, the time value of option increases.
Since the option can be either exercised or expire worthless, the intrinsic value depends on what
the holder receives if the option is exercised. The intrinsic value is the difference between the
price of the underlying asset and the strike price. If the option is at-the-money or out-of-money
then it does not have any intrinsic value or intrinsic value is equal to zero. Analogously, the
intrinsic value of a put option equals the strike price minus the market price of the underlying
asset or zero whichever is greater.
At expiration the value of an option equals its intrinsic value. Prior to expiration the potential
benefit is represented by the options time value. The longer the time to expiration, the bigger the
likely pay off. In the last example, consider what happens if the option expires in three months
and the stock price has an equal probability of rising or falling $10 each month. The following
table shows the eight possible payoff at the end of three months. And the expected payoff is
1

30 8 + 10 8 = 7.5.
Months
1st
2nd
3rd
Payoffs

1
+10
+10
+10
30

2
+10
-10
+10
10

3
+10
-10
-10
-10

Possible outcomes
4
5
+10
-10
+10
+10
-10
+10
10
10

6
-10
-10
+10
-10

7
-10
-10
-10
-30

8
-10
+10
-10
-10

The likelihood that an option will pay off depends on the volatility or standard deviation of the
price of the underlying asset. If there is no volatility of a stock price, i.e. the price is fixed, then
no one is going to pay for the option since it will never pay off. If some variability is added to the
price, then there is some chance that the price will rise and the option will be in the money.
Moreover, regardless of how far the price of an option fall, the holder of a call option cannot lose
more than the price paid for the option. Alternatively, whenever the price rises higher, the call
options value increases. Therefore, increased volatility has no cost to the option holder, only
benefits. As mentioned earlier options provide insurance. The bigger the risk being insured, the
more valuable is the insurance and the higher the price investors will pay.
Consider examples of two sets of calls and puts of IBM stocks at a given price. The first set of
options in Panel A of the following table will have same expiration date but different strike
prices while the second set in Panel B will have same strike price but different expiration dates.
The following are observed by studying the tables:

At a given price of the underlying asset and time to expiration, the higher the strike price
of a call option, the lower its intrinsic value and the less expensive the option.

At a given price of the underlying asset and time to expiration, the higher the strike price
of a put option the higher the intrinsic value and the more expensive is the option.
The closer the strike price to the current price, the larger the options time value.
Deep in-the-money options have lower time value, because such an option is very likely
to expire in-the-money. Therefore, buying such an option is much like buying the stock
itself.
The longer the time to expiration at a given strike price the higher the option price.

Prices of IBM Puts and Calls, Feb 20, 2007, IBM Stock Price at close = 99.35
A. April Expiration
Strike Price
Call Price
80
20.20
90
10.40
95
5.80
100
2.55
105
0.75
110
0.15
B. Strike Price of 95
Expiration month
April
5.80
July
7.70
October
9.4

Calls
Intrinsic
Value
19.35
9.35
4.35
0
0
0
Calls
4.35
4.35
4.35

Time
Value
0.85
1.05
1.45
2.55
0.75
0.15

1.45
3.35
5.05

0.20
0.75
2.35
5.80
-

Puts
Intrinsic
Value
0
0
0
0.65
5.65
10.65

Time
Value
0.20
0.75
1.70
0.15
-

0.75
1.75
2.6

Puts
0
0
0

0.75
1.75
2.60

Put Price

Swaps a swap is an agreement between two companies to exchange cash flows in future. The
agreement defines the dates of cash flows and the way in which they are to be calculated.
Usually, the calculation of cash flows involves the future value of an interest rate, an exchange
rate or other market variable. The most common type of swap is a plain vanilla interest rate
swap. In this a company agrees to pay cash flows at a predetermined fixed interest rate on a
notional principal for a number of years. In return, it receives interest at a floating rate on the
same notional principal for the same period of time.
The principal involved is called notional principal or notional because this principal is used to
only calculate interest payment that needs to be exchanged. It is actually never paid or received
by any of the parties involved in a swap. Now consider an example. Consider a 3-year swap that
has been initiated between Microsoft and Intel on March 5, 2010. Suppose, Microsoft agrees to
pay Intel an interest rate of 5 percent per annum on a notional principal of $100 million and in
return Intel agrees to pay Microsoft the 6-month LIBOR (London Interbank Offered Rate) on the
same principal.

Aside: LIBOR (or ICE LIBOR) is the worlds most widely-used benchmark for short-term
interest rates. It serves as the primary indicator for the average rate at which banks that
contribute to the determination of LIBOR may obtain short-term loans in the London interbank
market. Currently there are 11 to 18 contributor banks for five major currencies (US$,
EUR, GBP, JPY, CHF), giving rates for seven different maturities. A total of 35 rates are posted
every business day (number of currencies x number of different maturities) with the 3-month
U.S. dollar rate being the most common one (usually referred to as the current LIBOR rate).
(From investopedia.com)
The first exchange would take place after 6-months on September 5, 2010 where Microsoft
would pay Intel $ 2.5 million. If the 6-month LIBOR rate prevailing 6-month prior to September
5, 2010 was 4.2% then Intel would pay Microsoft 0.5 0.042 1000000 = $2.1 million. The
second exchange would take place again after 6 months on March 5, 2011, where Microsoft
would again pay $2.5 million to Intel. If the LIBOR rate on September 5, 2010 was 4.8% then
Intel would pay Microsoft $2.4 million. An interest rate is swap is generally structured so that
one side remits the difference between the two payments to the other side. For instance, in this
example Microsoft would pay Intel $0.4 million on September 5, 2010 and again $0.1 million on
March 05, 2011. In total there will be six exchanges on the swap with a fixed payment of $ 2.5
million from Microsoft. The floating rate payments on a payment date are calculated using the 6month LIBOR rate prevailing 6-months before the payment date.
If the notional principal is actually transacted between the two companies then it is not going to
make any difference in the cash flows calculated. Therefore, this transaction can also be seen as
exchange of bonds between the two companies. Here Microsoft buys floating rate bonds from
Intel while Intel buys fixed rate bonds from Microsoft. So, Microsoft takes a long position in
floating rate bonds and takes a short position in fixed rate bonds while the reverse is true for
Intel.
Swap could be used to transform liability. For instance, Microsoft could use the swap to
transform a floating-rate loan into a fixed-rate loan. Suppose, Microsoft has borrowed $100
million dollars at LIBOR plus 10 basis point or LIBOR plus 0.1 percent. After Microsoft has
entered the swap, it has the following three sets of cash flows:
1. It pays LIBOR plus 0.1 to its outside lenders
2. It receives LIBOR under the terms of the swap
3. It pays 5 percent under the swap
These three sets of cash flows net out to an interest payment of 5.1 percent. Thus, the swap has
the effect of transferring borrowings at a floating rate to borrowing at a fixed rate. Alternatively
for Intel the swap can transform a fixed rate loan into a floating rate loan. Suppose, Intel has a 3year $100 million loan outstanding on which it pays 5.2%. Because of the swap it also has three
sets of cash flows:
1. It pays 5.2% to its outside lenders
2. It pays LIBOR under the terms of the swap

3. It receives 5% under the terms of swap.


These three sets of cash flows net out to an interest rate payment of LIBOR plus 0.2 percent.
Thus, Intel transforms borrowing at a fixed rate into borrowing at a floating rate.
Swap could also be used to transform the nature of an asset. For instance, if Microsoft owns
bonds worth $100 million which will provide interest at 4.7% per annum over the next three
years then getting into the swap would render the asset to be floating rate asset with interest
received LIBOR minus 0.3 percent following the same arguments as presented above, i.e.
1. It receives 4.7% on the bonds
2. It receives LIBOR under the terms of the swap
3. It pays 5% under the terms of swap.
Similarly for Intel the swap could have the effect of transforming an asset earning a floating rate
of interest into an asset earning a fixed rate of interest. Suppose, Intel has an investment of $100
million that yields LIBOR minus 20 basis points. After the swap, the sets of cash flows are,
1. It receives LIBOR minus 20 basis points
2. 2. It pays LIBOR under the terms of the swap
3. It receives 5% under the terms of the swap
Therefore, it receives a net interest inflow of 4.8%.
Usually two non-financial companies do not get into contract directly, rather they each deal with
a financial intermediary and most of they do not know that the financial intermediary is into an
offsetting deal with another company. The financial intermediary acts as counterparty and earns
a fee for this which is generally 0.03 to 0.04 percent on a pair of offsetting transactions. If it is
0.03% then Microsoft will be paying 5.015% interest and Intel will receive 4.985% from
Microsoft under the swap. The financial intermediary makes a profit of $30,000 each year. If one
company defaults, the financial institution still has to honour its agreement with the other
company.
It is unlikely that two companies will contact a financial institution at the same time and would
take opposite position in exactly the same swap. Here large financial institutions acting as a
market maker agree to enter into a swap without having an offsetting swap with another
company. This is often referred to as warehousing swaps. The following table shows the quotes
for plain vanilla US dollar swaps posted by a market maker. The bid-offer spread is 3 to 4 basis
points while the average of the bid and offer fixed rates is known as the swap rate.
Maturity (years)
2
3
4
5
7
10

Bid p.a.
6.03
6.21
6.35
6.47
6.65
6.83

Offer p.a.
6.06
6.24
6.39
6.51
6.68
6.87

Swap rate p.a.


6.045
6.225
6.370
6.490
6.665
6.850

The comparative advantage argument an explanation commonly put forward to explain the
popularity of swaps concerns comparative advantage. Some companies might have a
comparative advantage when borrowing from floating rate markets while some others may have
an advantage in borrowing from fixed-rate market. To obtain a new loan, it makes sense for a
company to go to the market where it has a comparative advantage. As a result the company may
borrow fixed when it wants floating or vice versa. Then swap is used to transform a fixed-rate
loan into a floating rate loan and vice versa. For example, consider 2 companies AAA and BBB
having credit rating AAA and BBB, respectively. They face the following borrowing rates in the
fixed and floating markets:
AAA
BBB

Fixed rate
4.0%
5.2%

Floating rate
6-month LIBOR 0.1%
6-month LIBOR + 0.6%

So, the company with BBB rating faces a 1.2% higher interest rate in the fixed market while in
the floating market it pays only 0.7% higher than company AAA. Therefore, AAA has a
comparative advantage in fixed rate market while BBB has a comparative advantage in the
floating rate market. BBB will choose to borrow from the floating rate market though it wanted
to borrow from the fixed rate market. So, it has an incentive to get into a swap. Similarly, AAA
may also get into swap where it would pay floating rate (say LIBOR) and receive fixed rate (say
4.35%). Then the cash flows AAA would have are,
1. It pays 4% p.a. to outside lenders
2. It receives 4.35% p.a. from BBB
3. It pays LIBOR to BBC
Therefore, the net effect is AAA pays LIBOR minus 0.35 percent p.a. to BBB which is 0.25%
less than what it would pay by directly borrowing from the floating rate market. Similarly for
BBB the cash flows are,
1. It pays LIBOR plus 0.6 percent to outside lenders
2. It receives LIBOR from AAA corporation
3. It pays 4.35% per annum to AAA corporation.
The net effect is it pays 4.95% p.a. This is 0.25% p.a. less than what it would pay in the fixed
rate market. In the presence of a financial intermediary making a profit of 0.04% p.a. the
borrowing rates from AAA and BBB would be LIBOR minus 0.33% and 4.97%, respectively.
Currency swap currency swap in its simplest form involves exchanging principal and interest
payments in one currency for interest and principal payments in another currency. Consider a 5year currency swap agreement between an US company (USC) and a British company (BC) on
Feb 1, 2012. Suppose, that USC pays a fixed interest rate of 5% in sterling and receives a fixed
interest rate of 6% in dollars once in a year and the principal amounts are $18 million and 10
million. This implies that at the outset USC pays $18 million and receives 10 million and at the
end of the life of the swap, USC pays 10 million to BC and BC pays $18 million to USC. Each

year during the life of the swap contract, USC receives $1.08 million and pays 0.5 million. This
is termed as a fixed-for-fixed currency swap because the interest rates on both currencies are
fixed.
There are other types of swaps as well like fixed-for-floating currency swaps and floating-forfloating currency swaps. Additionally, there is equity swap where the total returns (dividends
plus capital gains) realized on an equity index is exchanged for either a fixed or floating rate of
interest. Equity swaps can be used by portfolio managers to convert return from a fixed or
floating investments to the returns from investing in an equity index and vice versa.