MBF1243 Derivatives

L6: Swaps

Nature of Swaps
A swap is an agreement to exchange of payments at
specified future times according to certain specified
rules

A swap provides a means to hedge a stream of risky

payments

An Example of a Plain Vanilla Interest Rate Swap

3-year swap agreement between Microsoft and Intel on 5 March 2014

Microsoft to pay Intel a fixed interest rate of 5% per annum every 6 months
for 3 years on a notional principal of $100 million

In return Intel agrees to pay Microsoft 6-month LIBOR on the same of

principal of $100 million

Microsoft is the fixed-rate payer, and Intel is the floating-rate payer.

Next slide illustrates cash flows that could occur (Day count conventions are
not considered)

>>>The floating rate in most interest swap agreements is the LIBOR. It is the
rate at which a bank is prepared to deposit money with other banks in the
Eurocurrency market.
3

One Possible Outcome for Cash Flows to Microsoft

Date

LIBOR

Floating Cash Flow

Fixed Cash
Flow

Net Cash Flow

Mar 5, 2014

4.20%

Sep 5, 2014

4.80%

+2.10

2.50

0.40

Mar 5, 2015

5.30%

+2.40

2.50

0.10

Sep 5, 2015

5.50%

+2.65

2.50

+ 0.15

Mar 5, 2016

5.60%

+2.75

2.50

+0.25

Sep 5, 2016

5.90%

+2.80

2.50

+0.30

+2.95

2.50

+0.45

Mar 5, 2017

The first exchange of payments would take place on 5 Sept 2014, 6 months after the initiation of
the agreement.
Microsoft would pay Intel $2.5 million. This is the interest on the $100 million principal for 6
months at 5%.
Intel would pay Microsoft interest on the $100 million principal at the 6-month LlBOR rate
prevailing 6 months prior to 5 Sept 2014-that is, on 5 March 2014. Suppose that the 6-month
LlBOR rate on 5 March 2014, is 4.2%. >>>Intel pays Microsoft 0.5 x 0.042 x $100 = $2.1
million.
4

One Possible Outcome for Cash Flows to Microsoft

The second exchange of payments would take place on March 5, 2015, a year
after the initiation of the agreement.

Microsoft would pay $2.5 million to Intel. Intel would pay interest on the $100
million principal to Microsoft at the 6-month LlBOR rate prevailing 6 months prior
to March 5, 2015-that is, on September 5, 2014. Suppose that the 6-month LlBOR
rate on September 5, 2014, is 4.8%. Intel pays 0.5 x 0.048 x $100 = $2.4 million
to Microsoft.

In total, there are six exchanges of payment on the swap.

The fixed payments are always $2.5 million. The floating-rate payments on a
payment date are calculated using the 6-month LlBOR rate prevailing 6 months
before the payment date.

An interest rate swap is generally structured so that one side remits the difference
between the two payments to the other side. In our example, Microsoft would pay
Intel $0.4 million (= $2.5 million - $2.1 million) on September 5, 2007, and $0.1
million (= $2.5 million - $2.4 million) on March 5, 2008

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

>>>Refer to handouts

Typical Uses of an Interest Rate Swap

Converting a liability from

fixed rate to floating rate

floating rate to fixed rate

For Microsoft, the swap could be used to transform a floating-rate loan into a fixed-rate
loan.
Suppose that Microsoft has arranged to borrow $100 million at LlBOR plus
10 basis points. (One basis point is one-hundredth of I %, so the rate is LlBOR
plus 0.1 %.)

After Microsoft has entered into the swap, it has the following three sets
of cash flows:
1. It pays LlBOR plus 0.1 % to its outside lenders.
2. It receives LIBOR under the terms of the swap.
3. It pays 5% under the terms of the swap.
These three sets of cash flows net out to an interest rate payment of 5.1 %. Thus, for
Microsoft, the swap could have the effect of transforming borrowings at a floating rate
of LlBOR plus 10 basis points into borrowings at a fixed rate of 5.1 %.
7

Intel and Microsoft (MS) Transform a Liability

(Figure 7.2, page 155)

5.2%

5%

Intel

MS
LIBOR

LIBOR+0.1%

Typical Uses of an Interest Rate Swap

Converting an investment from

fixed rate to floating rate
floating rate to fixed rate

Swaps can also be used to transform the nature of an asset.

Consider Microsoft in our example. The swap could have the effect of transforming an
asset earning a fixed rate of interest into an asset earning a floating rate of interest.
Suppose that Microsoft owns $100 million in bonds that will provide interest at 4.7% per
annum over the next 3 years.
After Microsoft has entered into the swap, it has the following three sets of cash flows:
l. It receives 4.7% on the bonds.
2. It receives LlBOR under the terms of the swap.
3. It pays 5% under the terms of the swap.
These three sets of cash flows net out to an interest rate inflow of LIBOR minus 30 basis
points. Thus, one possible use of the swap for Microsoft is to transform an asset earning
4.7% into an asset earning LIBOR minus 30 basis points.

Intel and Microsoft (MS) Transform a Asset

5.2%

5%

Intel

MS
LIBOR

LIBOR + 0.1%

10

Day Count
A day count convention is specified for for fixed and
floating payment
For example, LIBOR is likely to be actual/360 in the US
because LIBOR is a money market rate
In the Microsoft and Intel example, the floating payment is
based on LIBOR rate of 4.2% is shown as $2.10 million.
Because there are 184 days between 5 March 2014 and
5 September 2007, it should be computed as
100 x 0.042 x 184 = $2.147 m
365

11

Confirmations
A confirmations is the legal agreement underlying a
swap and is signed by representatives of the 2
parties
The International Swaps and Derivatives Association
has developed Master Agreements that can be used
to cover all agreements between two counterparties

12

The Comparative Advantage Argument

An explanation commonly put forward to explain the popularity of swaps concerns

comparative advantages.
Some companies, it is argued, have a comparative advantage when borrowing in fixedrate markets, whereas other companies have a comparative advantage in floating-rate
markets.

Example- 2 companies, AAACorp and BBBCorp, both wish to borrow $10 million for 5
years and have been offered the rates shown in the table.

AAACorp wants to borrow floating company is rated AAA

BBBCorp wants to borrow fixed - company is rated BBB

Because it has a worse credit rating than AAACorp, BBBCorp pays a higher rate of interest
than AAACorp in both fixed and floating market.
Fixed

Floating

AAACorp

4.0%

6 month LIBOR 0.1%

BBBCorp

5.2%

6 month LIBOR + 0.6%

13

The Comparative Advantage Argument

(Table 7.4, page 160)

The difference between the two fixed rates is greater than the difference
between the two floating rates.

BBBCorp pays 1.2% more than AAACorp in fixed-rate markets and only
0.7% more an AAACorp in floating-rate markets.

BBBCorp appears to have a comparative vantage in floating-rate

markets, whereas AAACorp appears to have a comparative advantage in
fixed-rate markets.

It is this apparent anomaly that can lead to a swap being negotiated.

AAACorp borrows fixed-rate funds at 4% per annum.
BBBCorp borrows floating-rate funds at LIBOR plus 0.6% per
annum.
They then enter into a swap agreement to ensure that AAACorp
ends up with floating-rate funds and BBBCorp ends up with fixedrate funds.
14

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 LIBOR0.1% and LIBOR+0.6% 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

15

The Nature of Swap Rates

Six-month LIBOR is a short-term AA borrowing rate for
period between 1 and 12 months from other banks
The 5-year swap rate has a risk corresponding to the
situation where 10 six-month loans are made to AA
borrowers at LIBOR
This is because the lender can enter into a swap where
income from the LIBOR loans is exchanged for the 5year swap rate

16

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 $15,000,000 every year for 5
years
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 swaps life

17

Typical Uses of a Currency Swap

Convert a liability in one currency to a liability in
another currency
Convert an investment in one currency to an
investment in another currency

18

Comparative Advantage May Be Real Because of Taxes

General Electric wants to borrow AUD
Qantas wants to borrow USD
The spread between the rates paid by GE and Qantas in the 2
markets are not the same
Qantas pays 2% more than GE in the USD market and only
0.4% more than GE in the AUD market
Hence, GE has comparative advantage in the USD market while
Qantas has comparative advantage in the AUD market
Borrowing rates providing basis for currency swap
USD

AUD

General Electric

5.0%

7.6%

Quantas

7.0%

8.0%

19

Credit Risk: Single Uncollateralized

Transaction with Counterparty
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 ithe value is
positive
Some swaps are more likely to lead to credit risk exposure than
others
What is the situation if early forward rates have a positive value?
What is the situation when the early forward rates have a negative
value?

20

Swaptions
A swaption is an option to enter into a swap with
specified terms. This contract will have a premium
A swaption is analogous to an ordinary option, with
the PV of the swap obligations (the price of the
prepaid swap) as the underlying asset
Swaptions can be American or European

8-21

Swaptions (contd)
A payer swaption gives its holder the right, but not
the obligation, to pay the fixed price and receive the
floating price
The holder of a receiver swaption would exercise
when the fixed swap price is above the strike
A receiver swaption gives its holder the right to pay
the floating price and receive the fixed strike price.
The holder of a receiver swaption would exercise
when the fixed swap price is below the strike

8-22

Total Return Swaps

A total return swap is a swap, in which one party
pays the realized total return (dividends plus capital
gains) on a reference asset, and the other party pays
a floating return such as LIBOR
The two parties exchange only the difference
between these rates
The party paying the return on the reference asset is
the total return payer

8-23

Total Return Swaps (contd)

Some uses of total return swaps are

avoiding withholding taxes on foreign stocks

management of credit risk

A default swap is a swap, in which the seller makes

a payment to the buyer if the reference asset
experiences a credit event (e.g., a failure to make a
scheduled payment on a bond)

A default swap allows the buyer to eliminate bankruptcy risk,

while retaining interest rate risk
The buyer pays a premium, usually amortized over a series
of payments

8-24