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6.

Swaps

6.2

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

6.3

Cash Flows to Microsoft

6.4

(See Table 6.1, page 127)


---------Millions of Dollars--------LIBOR FLOATING

FIXED

Net

Date

Rate

Cash Flow Cash Flow Cash Flow

Mar.1, 1998

4.2%

Sept. 1, 1998

4.8%

+2.10

2.50

0.40

Mar.1, 1999

5.3%

+2.40

2.50

0.10

Sept. 1, 1999

5.5%

+2.65

2.50

+0.15

Mar.1, 2000

5.6%

+2.75

2.50

+0.25

Sept. 1, 2000

5.9%

+2.80

2.50

+0.30

Mar.1, 2001

6.4%

+2.95

2.50

+0.45

6.5

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 6.2, page 128)
5%
5.2%

Intel

MS
LIBOR+0.1%
LIBOR

6.6

6.7

Financial Institution is Involved


(Figure 6.4, page 129)
4.985%
5.2%

5.015%

F.I.

Intel
LIBOR

MS
LIBOR

Dealer spread = .03% evenly split

LIBOR+0.1%

Intel and Microsoft (MS)


Transform an Asset
(Figure 6.3, page 128)
5%
4.7%

Intel

MS

LIBOR-0.25%
LIBOR

6.8

6.9

Financial Institution is Involved


(See Figure 6.5, page 129)
4.985%

5.015%

F.I.

Intel

MS

LIBOR-0.25%
LIBOR

Dealer spread = .03 %

LIBOR

4.7
%

6.10

The Comparative Advantage


Argument (Table 6.4, page 132)
AAACorp wants to borrow floating
BBBCorp wants to borrow fixed

Fixed

Floating

AAACorp

10.00%

6-month LIBOR + 0.30%

BBBCorp

11.20%

6-month LIBOR + 1.00%

6.11

The Comparative Advantage


Argument
AAACorp has absolute advantage in both
markets
But a comparative advantage in fixed
BBBCorp has comparative advantage in
floating
If AAA borrows fixed, the gain is 1.2%
If BBB borrows floating, the gain is
reduced by .7%
Therefore, we have a net gain of
1.2 - .7 = .5%
If the gain is split evenly, we have a gain
per party of:
G = (1.2 - .7)/2 = .25%

6.12

Swap Design
Design the swap so AAAs
borrowing rate equals the
comparative disadvantage (CD)
rate minus the gain:

LIBOR + .3 - .25
Do the same thing for BBB
BBBs rate with swap:

11.2 - .25
Now, draw the diagram

6.13

The Swap (Figure 6.6, page 132)


9.95%
10%

AAA

BBB
LIBOR+1%
LIBOR

The floating rate leg should be LIBOR

6.14

Swap Design with FI


Adjust swap gain for dealer spread
Suppose dealer spread = .04%

Then gain:
G = (1.2 - .7 - .04)/2 = .23%
AAAs rate with swap:
LIBOR + .3 - .23 = LIBOR + .07
BBBs rate with swap:
11.2 - .23 = 10.97%
Draw swap diagram

The Swap when a Financial


Institution is Involved

6.15

(Figure 6.7, page 133)


9.93%
10%

AAA

9.97%

F.I.

BBB
LIBOR+1%

LIBOR

LIBOR

Check that dealer spread = .04%

6.16

Criticism of the Comparative


Advantage Argument
The 10.0% and 11.2% rates available to
AAACorp and BBBCorp in fixed rate markets
are 5-year rates
The LIBOR+0.3% and LIBOR+1% rates
available in the floating rate market are sixmonth rates
BBBCorps fixed rate depends on the spread
above LIBOR it borrows at in the future

6.17

Valuation of an Interest Rate


Swap
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

6.18

Swap Valuation
Fixed Receive: Vswap = Vfixed Vfloating
Fixed Pay: Vswap = Vfloating - Vfixed
The fixed rate stream is valued as an
annuity
The floating rate stream is valued by
noting that it is worth par immediately
after the next payment date

6.19

Floating Rate Perpetuity


To create a floating rate perpetuity, invest
principal value in 6-month LIBOR
At the end of 6-months, remove the interest
and reinvest the principal value at the new 6month LIBOR
Therefore, the cost of a floating rate
perpetuity is principal value
It always sells for its par value immediately
after interest payment

6.20

Floating Rate Instrument with


Maturity T
At the end of T years, floating rate
perpetuity is worth the principal value M
Therefore, the floating rate instrument is
worth: M MdT
Or M - M/(1+y/2)2T, where is the rate on
a zero-coupon bond maturing in T years

6.21

Swap Valuation
The floating rate instrument is worth:
Vfloating = M M/(1+y/2)2T
The fixed rate stream is worth:
Vfixed
= (C/2)(Annuity Factor)
So for Fixed Receive Swap:
Vswap = (C/2)
(Annuity Factor) - M
+M/(1+y/2)2T

6.22

Swap Valuation
The swap is structured such that initial value is zero to
either party
Set Vswap = 0
Rearrange terms:
M=(C/2)(Annuity Factor) + M/
(1+y/2)2T
The left-hand side is the present value of a bond at y
Since the bond is selling at par, CR = C/M = y
For the swap to have zero value the fixed rate must
equal the yield to maturity on a par bond
The swap rate is the coupon rate on a LIBOR bond
that causes it to be worth par

6.23

Example
Zero coupon LIBOR curve is 5%, 6%,
and 7% for one, two, and three years
What is the swap rate on a three year
interest rate swap?
Assume payments are annual and
yields are compounded annually
Solve for LIBOR par yield
M = CRxM(d1 + d2 + d3) + Md3

6.24

Example Continued
Solution:
1
1
3
1
.
07
CR
6.91%
1
1
1

2
1.05 1.06 1.073

6.25

Interest Rate Risk


Receive Fixed: Vswap = Vfixed Vfloating
Pay Fixed: Vswap = Vfloating Vfixed

6.26

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

6.27

Exchange of Principal
In an interest rate swap the
principal is not exchanged
In a currency swap the
principal is exchanged at the
beginning and the end of the
swap

6.28

Three Cash Flow Components


t = 0: exchange principal based
upon
current exchange rates
Pay:
$15 M
Rcv: 10 M
t = 1, 2, 3, 4, 5:
Pay: .11x10 = 1.1 M
Rcv: .08x15 = $1.2 M
t = 5:
Pay: 10 M
Rcv: $ 15 M

6.29

The Cash Flows (Table 6.6, page 140)


Dollars Pounds
$

Years ------millions-----0
15.00 +10.00
+1.20 1.10
1
2
+1.20 1.10
3
+1.20 1.10
4
+1.20 1.10
5
+16.20 -11.10

6.30

Typical Uses of a
Currency Swap
Conversion from Conversion from
a liability in one
an investment in
currency to a
one currency to
liability in
an investment in
another currency
another currency

6.31

Comparative Advantage Arguments


for Currency Swaps (Table 6.7, page 141)
General Motors wants to borrow AUD
Qantas wants to borrow USD
USD

AUD

General Motors 5.0%

12.6%

Qantas

13.0%

7.0%

6.32

Comparative Advantage
GM has absolute advantage in both markets
But GM has comparative advantage in dollars
Qantas has comparative advantage in
Australian dollars
So GM should borrow dollars and Qantas
Australian dollars
Then swap cash flows to earn gain from
comparative advantage

6.33

Comparative Advantage
Gain per party:
G = (2 - .4)/2 = .8%
GMs rate with swap:
12. 6 - .8 = AUD 11.8%
Qantas rate with swap:
7 - .8 = USD 6.2%

6.34

Qantas Assumes Exchange Rate Risk

USD 5%
USD 5%

GM

Qantas
AUD 11.8%

AUD 13%

6.35

GM Assumes Exchange Rate Risk

USD 6.2%
USD 5%

GM

Qantas
AUD 13.0%

AUD 13%

6.36

FI Assumes Exchange Rate Risk


Adjust swap gain for dealer spread
Suppose dealer spread = .2%
Then gain:

Gain per party:


G = (2 - .4 - .2)/2 = .7%
GMs rate with swap:
12. 6 - .7 = AUD 11.9%
Qantas rate with swap:
7 - .7 = USD 6.3%

6.37

FI Assumes Exchange Rate Risk


USD 5%
USD 5%

GM

USD 6.3%

F.I.

Q
AUD 13%

AUD11.9%

AUD 13%

Check that dealer spread = .2%


Pay: 13.0 11.9 = AUD 1.1%
Rcv: 6.3 5.0 = USD 1.3%

6.38

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

6.39

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 Fraps
The fixed for fixed currency swap in
our example consisted of a cash
transaction & 5 forward contracts

6.40

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

6.41

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