Section 3: Swaps

Overview of Section 3

3.1: Introduction
3.2: Interest Rate Swaps
3.3: Valuation of Interest rate Swaps
3.4: Currency Swaps
3.5: Valuation of Currency Swaps
3.6: Other Types of Swaps
3.7: Credit Derivatives
3.8: Review of Section 3
Section 3.6: Other Types of Swaps

Forward swaps interest payments do not begin to change

hands until a future date.
Extendable swaps one party has the option to extend the
life of the swap.
Puttable swaps floating rate payer has right to end the
swap before it matures.
Swaptions options on swaps the right to enter a swap in
the future.
 Step-up Swaps (Accreting Principal Swap)

The notional principal is an increasing function of time.

Where a borrower expects to draw down funds over a
period of time (in response to a projects funding
requirements) but wants to fix in advance the cost of
funds.
 Amortizing Swaps the notional principal is a decreasing
function of time.

Principal different on two sides.

Payment frequency different on two sides.

Can be floating for floating instead of floating for fixed.

Basis Swap exchanging cash flows using one floating rate

for those calculated using another floating rate.

LIBOR and T-bills
 Compounding Swaps interest is compounded instead of
being paid. There is only one payment date at the end of the
life of the swap.

Currency Swaps several variations exist such as fixed for

fixed, fixed for floating and floating for floating.

LIBOR-in-arrears swaps the floating rate paid on a payment

date equals the rate observed on that date.

Fixed side payment the same but the payment on the
floating side is paid at the end of the period.

Investor believes that LIBOR will fall over the period and
therefore is lower at the end of the period.
 Differential swaps a floating interest rate is observed in one
currency and applied to a principal in another currency.

e.g. LIBOR for $ LIBOR payments are in one currency.

Also called diff swaps and quantos.
Equity Swaps one party agrees to pay the return on an equity
index applied to a notional principal and the other agrees to pay
a fixed or floating return on the notional principal.

e.g. bond portfolio manager swaps fixed income for returns
on equity index.
Accrual Swaps the interest on one side accrues only when
the floating reference rate is within a certain range.

Sometimes, the range remains fixed during the life of the
swap, sometimes it is reset periodically.
 Cancelable Swaps a plain vanilla interest rate swap where
one party has the option to terminate on one or more
payment dates.
Index Amortizing Swaps (Indexed Principal Swap) the
principal reduces in a way dependent on the level of interest
rates.

The lower the interest rate, the greater the reduction in the
principal.

Notional amount used ($100million).
Commodity Swaps
Volatility swap payments depend on the volatility of a stock
or other asset.
Swaps can be engineered in many other ways.
Section 3.7: Credit Derivatives

Derivatives where the payoff depends on the credit quality of

a company or sovereign entity.
Credit derivatives allow firms to trade credit risks in much the
same way that they trade market risks.
Since the late 1990s banks have been the biggest buyers of
credit protection and insurance firms have been the biggest
sellers.
During the 1990s banks created ABS (and MBS) to pass
loans (and their credit risk) on to investors.
Therefore, the financial institution bearing the credit risk of a
loan is often different from the financial institution that did the
original credit checks.
Asset Backed Securities (ABS)

An asset backed security (ABS) is financial security backed

by a loan, lease or receivables against assets other than real
estate and mortgage-backed securities. For investors, asset-
backed securities are an alternative to investing in corporate
debt.
A mortgage-backed security (MBS) is an asset-backed
security or debt obligation that represents a claim on the cash
flows from mortgage loans, most commonly on residential
property.
An ABS is essentially the same thing as a mortgage-backed
security, except that the securities backing it are assets such
as loans, leases, credit card debt, a company's receivables,
royalties and so on, and not mortgage-based securities.
Collateralized Debt Obligations
One of the key instruments in the growing market of
securitized products in the run up to the 2008 financial crisis
was the collateralized debt obligation or CDO.
Banks originating mortgage loans, and corporate loans and
bonds, could now create a portfolio of these debt instruments
and package them as an asset-backed security.
Once packaged, the bank passed the security to a special
purpose vehicle (SPV).
From there, the CDO was sold into a growing market through
underwriters freeing up the banks financial resources to
originate more and more loans, earning a variety of fees.

5-11
Global CDO Issuance, 20042008
(billions of U.S. dollars)

[Insert Exhibit 5.6]

5-12
Collateralized Debt Obligations
CDOs were sold to the market in categories representing the
credit quality of the borrowers in the mortgages senior
tranches (rated AAA), mezzanine or middle tranches (AA
down to BB), and equity tranches (below BB or junk status).
The actual marketing and sales of the CDOs was done by the
major investment banking houses.
CDOs would be rated by rating agencies, often without
undertaking the typical ground-up credit analysis themselves.
Further, combinations of bonds were able to achieve higher
ratings than any of the individual bonds a confounding
issue.

5-13
The Collateralized Debt Obligation

5-14
Credit Default Swaps

The most popular credit derivative is CDS a contract

that provides insurance against the risk of default by a
particular company or country (the reference entity).
A buyer of a credit default swap makes regular nominal
premium payments to the seller for the length of the
contract.
If there is no significant negative credit event during the
term of the contract, the protection seller earns its
premiums over time, never having to payoff a significant
claim.
If a credit event occurs however, the protection seller
must fulfill its obligation to make a settlement payment to
the protection buyer.
Exhibit 5.7 Cash Flows under a Credit
Default Swap

5-16
Credit Default Swaps (CDS)
Example: Suppose 2 parties enter into a 5 year CDS on 1
March, 2007. The notional principal is $100 million and the
buyer agrees to pay 90 bps annually for protection against
default by Company X.
Premium is known as the credit default spread. It is paid for
life of contract or until default.
If there is a default, the buyer has the right to sell bonds with
a face value of $100 million issued by company X for $100
million (Several bonds may be deliverable).
CDS Structure

90 bps per year

Default Default
Protection Protection
Buyer, A Seller, B
Payoff if there is a default by
reference entity=100(1-R)

Recovery rate, R, is the ratio of the value of the bond

issued by reference entity immediately after default to the
face value of the bond.
Other Details

Payments are usually made quarterly or semiannually in

arrears.
In the event of default there is a final accrual payment by the
buyer.
Settlement can be specified as delivery of the bonds or a
cash equivalent amount.
Credit Default Swap Market Growth

5-20
 CDS Spreads and Bond Yields

A CDS can be used to hedge a position in a corporate bond.

Suppose an investor buys a 5-year corporate bond yielding 7% per year
and at the same time enters a 5-year CDS to buy protection against the
issuer of the bond defaulting. Suppose that the CDS spread is 200 bps
(2%).
The effect of the CDS is to convert the corporate bond to a risk free bond
(at least approximately).
If the bond issuer defaults, the investor earns 5% up to the time of the
default. She is then able to exchange the bond for its face value, which
can then be invested at the risk free rate for the remainder of the 5 years.
This shows that CDS spreads should be approximately the same as bond
yield spreads.
 A credit default swap is like insurance on bonds, but different from
insurance in important ways:
Insurance companies make sure you own the asset you are insuring, but
you can buy credit default swaps for bonds you do not own. One estimate
claims that up to 80% of CDSs are thought to be naked (The Economist)
The insurance market is highly regulated
Insurance companies must have enough money in case lots of people
need to collect insurance at the same time. CDS sellers do not have to
be as careful.
American International Group (AIG)

http://www.reuters.com/article/2008/09/18/us-how-aig-fell-apart-
idUSMAR85972720080918
AIG sold CDS. They never bought.
Once bonds started defaulting, they had to pay out and nobody was
paying them.
AIG seems to have thought CDS were just an extension of the insurance
business. But they're not.
When you insure homes or cars or lives, you can expect steady,
actuarially predictable trends. If you sell enough and price things right,
you know that you'll always have more premiums coming in than
payments going out. That's because there is low correlation between
insurance triggering events. My death doesn't, generally, hasten your
death. My house burning down doesn't increase the likelihood of your
house burning down.
 Not so with bonds. Once some bonds start defaulting, other
bonds are more likely to default. The risk increases
exponentially.
Credit default swaps written by AIG covered more than $440
billion in bonds and exceeded its ability to pay.
Once the credit-rating agencies lowered AIGs credit rating AIG
had to put up more collateral to guarantee its ability to pay.
AIG didn't have more money.
The company started selling assets it owned-like its aircraft-
leasing division.
All of this pushed AIG's stock price down dramatically.
That made it even harder for AIG to convince companies to give
it money to pitch in.
This led to the government bailout.
Credit Default Swaps

As a result of the CDS market growth in a completely

deregulated segment, there was no real record or registry of
issuances, no requirement on writers and sellers that they
had adequate capital to assure contractual fulfillment, and no
real market for assuring liquidity depending on one-to-one
counterparty settlement.
New proposals for regulation have centered first on requiring
participants to have an actual exposure to a credit instrument
or obligation, eliminating outside speculators, and the
formation of some type of clearinghouse to provide
systematic trading and valuation of all CDS positions at all
times.
5-25
Other Credit Derivatives

1. Binary Credit Default Swaps the payoff in the event of

default is a fixed cash amount.

2. Basket Credit Default Swaps similar to a regular CDS

except that several reference entities are specified. A first-
to-default CDS provides a payoff when the first default
occurs. Second, third, and nth to default deals are defined
similarly. After the relevant default occurs there is a
settlement. The swap then terminates and there are no
further payments by either party.
3. Total Return Swap
An agreement to exchange total return on a bond (or any
portfolio of assets) for LIBOR plus a spread.
At the end there is a payment reflecting the change in
value of the bond.
Usually used as financing tools by companies that want
an investment in the corporate bond.

Total Return on Bond

Total Return Total Return
Payer Receiver
LIBOR plus 25bps
Case Study: Long-Term Capital Management (LTCM)

Long-Term Capital Management (LTCM) was a US hedge fund that failed

spectacularly in the late 1990s, leading to a massive bailout by other
major banks and investment houses, which was supervised by the
Federal Reserve.
LTCM always collateralized its transactions. The hedge funds investment
strategy was known as convergence arbitrage.
Example of convergence arbitrage: LTCM would find 2 bonds X and Y,
issued by the same company that promised the same payoffs, with X
being less liquid (i.e. less actively traded) than Y. The market always
places a value on liquidity, As a result, the price of X would be less than
the price of Y.
LTCM would buy X, short Y, and wait, expecting the prices of the 2 bonds
to converge at some future time.
It also hedged any residual risks.
 When interest rates increased, LTCM expected both bonds to
move down in price by about the same amount so that the
collateral it paid on bond X would be about the same as the
collateral it received on bond Y.
Similarly, when interest rates decreased, LTCM expected
both bonds to move up in price by about the same amount
so that the collateral it received on bond X would be about
the same as the collateral it paid on bond Y.
It, therefore, expected that there would be no significant
outflow of funds as a result of its collateralization
agreements.
 In August 1998, Russia defaulted on its debt and this led to a
flight to quality in capital markets.
One result was that investors valued liquid instruments more
highly than usual and the spreads between the prices of the
liquid and illiquid instruments in LTCMs portfolio increased
dramatically.
The prices of the bonds LTCM had bought went down and
the prices of those it has shorted increased. It was required
to post collateral on both.
The company was highly levered and unable to make the
payments required under the collateralization agreements.
 The result was that positions had to be closed out and LTCM
lost about $4 billion.
If the firm had been less highly levered, it would probably
have been able to survive the flight to quality and could have
waited for the prices of the liquid and illiquid bonds to move
back closer to each other.
The hedge fund was considered too large to fail. The New
York Federal Reserve organised a $3.5 billion bailout by
encouraging 14 banks to invest in the fund.
Section 3.8:Review of Section 3

3.1: Introduction
3.2: Interest Rate Swaps
3.3: Valuation of Interest rate Swaps
3.4: Currency Swaps
3.5: Valuation of Currency Swaps
3.6: Other Types of Swaps
3.7: Credit Derivatives
3.8: Review of Section 3