8/27/2018

SWAPS
MARK HUMPHERY-JENNER

AN INTRODUCTION TO SWAPS

 A swap is an agreement between counter-parties to exchange cash

flows at specified future times according to pre-specified
conditions.

 A swap is equivalent to a coupon-bearing asset plus a coupon-

bearing liability. The coupons might be fixed or floating.

 A swap is equivalent to a portfolio, or strip, of forward contracts--

each with a different maturity date, and each with the same forward
price.

 An agreement between two (or

more) parties and often a bank
INTEREST RATE  Involves one party swapping
fixed payments for floating

SWAPS: payments and vice-versa

 Carries some default risk; extent
of default risk can depend on
FIXED TO FLOATING whether there is an intermediary
that manages the exchange of
payments

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INTEREST RATE SWAP EXAMPLE

Borrower Fixed Rate Floating Rate

 There are two parties A and B

A (BBB Rated) 8.5% LIBOR + 0.5%
B (AAA Rated) 7.0% LIBOR
 A and B have differential access to floating and fixed
interest rates (i.e., due to differences in banking Difference 1.5% 0.5%
relationships etc)
 B has comparatively better access to fixed rates than
A
 Suppose that A wants to pay a fixed rate and B is OK
with paying a floating rate

INTEREST RATE SWAP EXAMPLE

Steps
1. A borrows 100m in the floating rate market (at LIBOR +
0.5%)
2. B borrows 100m in the fixed rate market (at 7%)
3. A and B reach the following agreement with the bank
1. For A:
1. A agrees to pay the bank at (say) 7.35%
2. A will receive LIBOR from the bank
3. A’s effective borrowing rate is 7.35% + 0.5% = 7.85%
2. For B:
1. B agrees to pay LIBOR to the bank
2. B will receive (say) 7.25% from the bank
3. B’s effective borrowing cost is LIBOR – 0.25%

INTEREST RATE SWAP

EXAMPLE

 The bank benefits by charging a spread Item Flow

 The other parties also benefit Receive (from A) 7.35%
Pay (to B) -7.25%
Receive (from B) LIBOR
Pay (to B) -LIBOR
Total 10 bps

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 An agreement between two (or

potentially more) parties to
exchange payments in different
currencies

CURRENCY SWAPS:  Often done in the context of

borrowing arrangements

FIXED-FOR-FIXED
 Often, parties borrow in their
home currency and swap
repayment schedules with the
counter-party
 Carries potentially significant
default risk

CURRENCY SWAPS

 Suppose party A is based in the US and party B is located in Europe

 But, the parties want liabilities denominated in each-other’s
currencies (i.e., to match expenses with revenues)
 For example:
 Dow
 Can borrow in USD at 7.5% and in EUR at 8.25%
 Wants to borrow in EUR
 Michelin
 Can borrow in USD at 7.7% and in EUR at 8.1%
 Wants to borrow in USD
 Assume
 Both parties want to borrow the equivalent of USD 200m
 Prevailing exchange rate is EUR 1.1/USD (i.e., 1 USD buys 1.1 EUR, so USD
200m = EUR 220m)
 Similar credit ratings

CURRENCY SWAPS: CASH FLOWS

What does Dow Do? What does Michelin Do?

1. Borrows $200m in the US market at the US interest 1. Borrows EUR 220m in the European market at the
rate of 7.5% interest rate of 8.1%
2. Dow is now liable to its bank to repay the debt 2. Cash flows for Michelin are now
1. Repays to BANK 1. Pays to its bank
1. USD 15m per year from years 1-10 (i.e., 7.5% x 200m) 1. EUR 17.82m from years 1-10 (i.e., 8.1% x 220m)
2. USD 200m in year 10 2. EUR 220m principal in year 10
2. Receives from MICHELIN USD 15m per year from years 2. Pays to DOW USD 15m from years 1-10 and USD 200m
1-10 and USD 200m in year 10 in year 10
3. Pays to MICHELIN EUR 17.82 each year and EUR 220m 3. Receives from Dow EUR 17.82 each year and EUR 220m
in year 10 in year 10

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CURRENCY SWAP

CURRENCY SWAPS:
 Corporations can also swap
fixed and floating exchange rates
in addition to swapping fixed rate

FIXED-FOR-
debt
 Process is similar to doing a
fixed-for-fixed currency swap

FLOATING with a fixed-for-floating exchange

swap

EXAMPLE

 Suppose Dow wants to borrow in Euros and wants a floating rate

 Suppose Michelin wants to borrow in USD and wants a fixed rate
 Dow’s borrowing rates
 Floating EUR: LIBOR +0.35%
 Fixed USD: 7.5%
 Fixed EUR: 8.25%
 Michelin’s borrowing rates
 Floating EUR: LIBOR +0.125%
 Fixed USD: 7.7%
 Fixed EUR: 8.1%

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SOLUTION

 Dow:
 Borrows from a bank in Fixed USD (at 7.5%). Dow will need to pay this 7.5% to the bank
 Receives from Michelin the Fixed USD payments (netting out the payments to the bank)
 Pays to Michelin floating EUR rate of LIBOR + 0.125%
 Saves 0.225 (i.e., it would have to borrow at LIBOR +0.35 if it borrowed itself, but because it can use Michelin’s borrowing stream, it
can save 0.35 – 0.125)
 Michelin:
 Borrows from a bank in floating EUR (at LIBOR + 0.125%)
 Receives from Dow the floating EUR amount (LIBOR +0.125%)
 Pays to Dow fixed USD amount (7.5%)
 Saves 20 basis points (i.e., 7.7% - 7.5%)

EXAMPLE

INTEREST RATE
FORWARDS  Forward-Forward

AND FUTURES 

Contract fixes today some future borrowing
Example: fixes an interest rate for a 6 month borrowing that
(FORWARD- will be undertaken in three months

FORWARD)

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INTEREST RATE FORWARDS AND FUTURES (FORWARD-FORWARD

 First, borrow an amount for 3 months such that you get USD 1m in
3 months
1000000
𝑥 983,526
0.067
1
 How do we look at the transactions to this 4
 Say  Second, lend that same amount for 9 months. With this in mind, you
receive:
 The firm wants to borrow USD 1m in 3 months time
9
 The 3 month interest rate is 6.7% 𝑦 𝑥∗ 1 0.0695 1,034,972
12
 The 9 month interest rate is 6.95%
 Third, we can work out the interest rate for 6 months borrowing in
 We want to know the rate to borrow for 6 months in 3 months 3 months time
time
 Note that borrowing for 3 months and lending for 9 months, is the same
as investing for 6 months in 3 months time
, ,
 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 3.4792% (for 6 moths)
 OR 6.958% pa

 An agreement to pay a certain rate of interest on

FORWARD RATE borrowings to be undertaken in the future
 This is an over-the-counter agreement between (generally) a
AGREEMENT party and a bank
(FRA)  Usually, the agreement is settled in cash through a cash
payment at the beginning of the forward period

FORWARD RATE AGREEMENTS

 We want to calculate the forward rate agreement (FRA) payment

Interest Differential
FRA Payment Principal
Discount Rate
 How do we find this?
Days
𝑅 𝐹𝑅𝐴
360
FRA Payment Principal
Days
1 𝑅
360

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FORWARD RATE AGREEMENTS

 Example
 You want to borrow $5m
 Calculation
 You lock in a FRA of 3.5% for 6 months (180 days)
borrowing (say to occur in 3 months time) 180
4% 3.5%
360
 The rate at the beginning of the FRA period is 4% 𝐹𝑅𝐴 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 $5𝑚
180
1 4%
 Assume a 360 day convention here [this would be 360
specified in an exam though]
 Payment is 12,254.9
 What is the FRA payment?

CONCLUSIONS

Things to know from this week

 Knowing fixed-floating swaps (i.e., the payments that would be made; interest rates etc)
 Knowing currency swaps
 Calculating forward rates
 Calculating FRA payments