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Introduction To Swaps

The document provides an introduction to swaps, detailing their structure and types, including interest rate swaps and currency swaps. It explains the mechanics of cash flow exchanges, settlement calculations, and applications such as arbitrage and financial restructuring. Additionally, it discusses the pricing of swaps, their representation on balance sheets, and their relationship with forward rate agreements (FRAs).

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0% found this document useful (0 votes)
18 views36 pages

Introduction To Swaps

The document provides an introduction to swaps, detailing their structure and types, including interest rate swaps and currency swaps. It explains the mechanics of cash flow exchanges, settlement calculations, and applications such as arbitrage and financial restructuring. Additionally, it discusses the pricing of swaps, their representation on balance sheets, and their relationship with forward rate agreements (FRAs).

Uploaded by

spamme
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Introduction to swaps

Steven C. Mann
M.J. Neeley School of Business
Texas Christian University

incorporating ideas from


“Teaching interest rate and currency swaps"
by Keith C. Brown (Texas-Austin)
and Donald J. Smith (Boston U.)

S.Mann, 1999
Swaps: contracts specifying
exchange of cash flows:
fixed price traded for floating price
fixed rate traded for floating rate

Swap structures include:


interest rate swaps
currency swaps
commodity swaps
vast assortment of variations
quantro, basis, index differential, etc.
S.Mann, 1999
Interest rate swap

exchange of fixed rate for a floating reference rate,


or exchange of one variable rate for another.

periodic net settlements made by comparing rates,


adjusting for day-count conventions, then
multiplying rate difference by notional principal:

Settlement amount = notional principal times:

(Fixed rate x #days ) - (Floating rate x #days )


year year
S.Mann, 1999
where #days and year are determined by day-count convention
Day-count conventions:

The number of days assumed to be in a month


and in a year when calculating the interest
accrued on a debt instrument.

Treasury notes, bonds: actual over actual


Corporate bonds: 30 over 360
money-market
(Libor): actual over 360 (usual)
actual days is actual number of days in period
actual for years is either 365 or 366.
S.Mann, 1999
Interest rate swap "Buyer" and "Seller"

payer of fixed rate is "buyer".


Fixed rate payer "buys" floating rate (LIBOR),
the fixed rate is the "price"

Floating Rate (LIBOR)

Fixed-Rate Fixed-Rate
Payer Receiver
6.75% Fixed Rate

Swap "Buyer" Swap "Seller"


S.Mann, 1999
Currency swaps

exchange fixed (or floating) cash flows


denominated in one currency for fixed (or floating)
cash flows denominated in another currency.
Examples:
fixed $ for fixed DM
fixed $ for floating DM
floating $ for fixed DM
floating $ for floating DM
Usually principal is exchanged at origination
and at maturity.
S.Mann, 1999
Fixed/floating $/DM swap

DM 7.25% Fixed
US $ DM
(times DM 30 million)
payer payer

U.S. $ LIBOR
(times $ 20 million)

settlement dates: April 11, October 11 of each year


rate set 2 days prior. payment: $ is actual/360; DM is 30/360
Oct. 9, 1998, $ LIBOR is 5.5%.
Assume payment is in arrears on April 11, 1999:
US$ payer owes $556,111.11 (= .055 x 182/360x $20 million)
DM payer owes DM 1,087,500 (=.0725 x 180/360 x DM 30 mm)
Settlement on either gross basis
or net based on spot $/DM exchange rate on 4/11/99.
S.Mann, 1999
Swap Applications

New Issue "Arbitrage"


(lower borrowing costs)
Access new markets
lower borrowing costs (borrower)
increase returns (investor)
Financial restructuring (transform risks)
Hedge exposures
create synthetic portfolios

S.Mann, 1999
New issue "arbitrage"

Straight Debt Swap-Driven Debt Structure


LIBOR Swap
Corporation Corporation Counterparty
6.75%

7.00% Fixed-Rate
Note LIBOR Floating-Rate
+ 0.10% Note

Fixed- Income Variable- Income


Investor Investor

Cost of Funds with swap structure: 6.85%


S.Mann, 1999
Comments on "New issue arbitrage"
Is the swap structure comparable to straight debt?
not if straight debt is callable - straight debt
rate is higher as payment for call option.

Swap structures may have embedded options


(credit triggers, e.g. Texaco & Banker's Trust)

Swap structure should provide lower cost of funds,


as swap contains counterparty credit risk:
joint probability of default and replacement
swap with higher fixed rate.
Tax and accounting conventions may matter also.
S.Mann, 1999
Swaps to access new markets
Straight Debt Swap-Driven Debt Structure
DM 30,000,000
7.25%
Swap
Corporation Corporation Counterparty
6.85%
on US$20,000,000
Fixed-rate
7.00% Note in
US $ Fixed-rate
note in DM 7.25%

US $ Investor DM Investor

Cost of Funds with S.Mann,


swap 1999
structure: 6.85%
Swaps to restructure debt

Straight Debt Swap-Driven Debt Structure


LIBOR
Institutional Institutional Swap
Investor Investor Counterparty
6.85%

Fixed-Rate Fixed-rate
8.00% 8.00%
Note Note

Debt Issuer Debt Issuer

Asset return with swapS.Mann,


structure:
1999 LIBOR + 1.15%
Interpretations of swap contracts

1. Series of Forward Contracts


useful to understand initial pricing
interest rate swap is series of FRAs
currency swap is series of FX forwards
2. Combination of Bonds
useful for mark-to-market
insights from duration and convexity
3. Combination of Options
multiperiod put-call parity
risk management insights
S.Mann, 1999
Forward Rate Agreements (FRAs)

FRA is one-date interest rate swap


usually LIBOR for fixed.
cash-settled, OTC forward contract
(no margin account, mark-to market)

Settlement and maturity dates part of FRA name:

l3x6 FRA is 3-month LIBOR, 3 months forward


l6x9 FRA is 3-month LIBOR, 6 months forward
l6x12 FRA is 6-month LIBOR, 6 months forward

S.Mann, 1999
FRAs
Dates 0 3 6 9 12
3x6
6x9
9 x 12
FRAs at 3x9
Date 0 6 x 12

0x3

0x6
Cash
Market at 0x9
Date 0 0 x 12
S.Mann, 1999
FRA payoffs

Payoff to long FRA holder (pays fixed) is:


(Notional Principal) times:
(LIBOR - FRA rate) x ( days/360)

Example: Notional principal = $10,000,000


3 x 6 FRA : 3 month forward, 90 day FRA
FRA is 7.00 today.
Assume that 3 months later, 3 month LIBOR is 7.10%
Then Payoff to long is:
$10 million x (.0710 -.0700)(90/360) = $2500
Payoff per million on any forward 90 day FRA ( X x 3)
is $25 per basis point change in forward LIBOR
S.Mann, 1999
Pricing FRAs

0 x 3 rate is 5.00 % ; 0 x 6 rate is 5.25 %


What is 3 x 6 FRA rate?
Unless (1+ r(0x6)).5 = (1+ r(0x3)).25(1+ r(3x6)).25
there is arbitrage.
So
.5 4
{
r(3 x 6) =
(1+ r(0x6))
(1+ r(0x3))
}
.25 - 1

Thus r (3x6) = 5.55006 %

$ FRAs usually priced off Eurodollar futures


S.Mann, 1999
Swaps versus series of FRAs

Series of FRAs: each FRA will likely have a


different rate (fixed payer pays different rates)
according to the shape of the spot yield curve.

Swap: usually has the same fixed rate for all


settlement periods.

At Origination:
Each FRA has zero economic value
Swap has zero value, but some settlement dates
have positive value and some negative
S.Mann, 1999
Swap vs. FRA series
Dec.
Sept. LIBOR
June LIBOR
LIBOR
6.00%
Series of
FRAs
(pay-fixed) 6.00% 6.87%
7.32%
7.68%

Pay-Fixed
Interest rate
Swap

6.96% 6.96% 6.96% 6.96%


S.Mann, 1999
Pricing Interest rate swaps

swap fixed rate found by treating the swap as a


series of "off market" FRAs, and setting the swap
price such that the present value of the "off market"
FRAs is equal to zero.

The June (3 x 6) FRA rate is 6.87%.


Let SFR be the Swap Fixed Rate,
Present value of the off market June FRA is:
(.0687 - SFR)
x (Notional principal) x (90/360)
(1+ r (0x3)).25(1+ r(3x6)).25
S.Mann, 1999
"Off market" FRA values

June swap leg value ("off market" FRA value):


(.0687 - SFR)
x (Notional principal) x (90/360)
(1+ r(0x3)).25(1+ r(3x6)).25

or
(.0687 - SFR)
x (Notional principal) x (90/360)
(1.0600).25(1.0687) .25

Note that:
(.0687 - SFR) (.0687 - SFR) (.0687 - SFR)
= .50
=
(1.0600).25(1.0687) .25 (1.064341) (1 + r(0x6)).50
S.Mann, 1999
Set PV of Swap legs equal to zero

(.06 - SFR) (.0687 - SFR)


0= +
(1+r(0x3) ).25 (1+r(0x6)).50

(.0732 - SFR) (.0768 - SFR)


+ + (1+r(0x12))1.00
(1+r(0x9) ).75

solve for SFR to find SFR = 6.96%

Note:
eliminated notional principal term (same multiple for each term)
each term is simply the current value of a forward contract:
value = PV (contract price - current forward price)
S.Mann, 1999
Value of swap legs Dec.
Sept. LIBOR
June LIBOR
FRAs 6.00% LIBOR

Forward rates 6.00% 6.87%


7.32%
7.68%

swap rate swap rate


too high too low

Swap

S.Mann, 1999
Swap Fixed rate 6.96% 6.96% 6.96% 6.96%
Swaps on a balance sheet
If swap pieces were placed on balance sheets:

Swap fixed payer Swap fixed receiver

Assets Liabilities Assets Liabilities

6x9 6x9
0x3 0x3

9 x 12 9 x 12
3x6 3x6

credit risk is front-loaded for fixed-receiver,


back-loaded for fixed-payer
(if forward curve is upwardS.Mann,
sloping)
1999
Swaps after first settlement

Swap fixed payer Swap fixed receiver

Assets Liabilities Assets Liabilities


3x6 3x6
6x9 6x9

9 x 12 9 x 12

swap becomes an asset swap becomes a liability


(unless rates (unless rates
drop substantially) drop substantially)
S.Mann, 1999
Swaps as Combination of Bonds
value swaps after origination (marking to market)
calculate swap duration and convexity
Example:
5-year swap: receive fixed 10%, pay LIBOR.
$10 million Notional Principal with Semi-annual settlement

Net cash flows will be same as if corp had


l Buys 5-year, $10 million, 10% coupon bond
l Issues $10 million floating rate note (FRN)
at LIBOR flat

If bonds have same value, then swap is "at market"


otherwise swap is "off market"
S.Mann, 1999
with initial payment
$10,500,000
Swap as bond combination
Buy $10 million, 10% fixed coupon, 5-year bond
$500,000 coupons

0 1 2 3 4 5 Years

market value

Issue $10 million, 5-year floating note at LIBOR flat

0 1 2 3 4 5 Years

LIBOR x (# of days/360) x $10,000,000


S.Mann, 1999
Swap as bond combination

Gross Settlement Flows on 10% versus LIBOR receive-fixed swap

0 1 2 3 4 5 Years

Net Settlement Cash Flows

0 1 2 3 4 5 Years
S.Mann, 1999
Swaps as bonds: Mark to market
At origination:
Swap fixed payer Swap fixed receiver
Assets Liabilities Assets Liabilities
Floater Fixed Fixed Floater
Note Note

mark to market is zero (if "on market")

If swap fixed rate rises:


Swap fixed payer Swap fixed receiver
Assets Liabilities Assets Liabilities
Fixed Fixed
Floater Floater
Note Note

S.Mann, 1999

swap value positive for fixed-payer, negative for fixed-receiver


Swaps as Option Combinations
Cap (interest rate cap agreement)
l series of European, cash settled put options
l underlying asset is hypothetical debt security
l Eurodollar time deposit for caps on LIBOR
l gains value as rates rise
l (underlying asset price drops with rate increase)
Floor (interest rate floor agreement)
l series of European, cash settled call options
l underlying asset is hypothetical debt security
l Eurodollar time deposit for LIBOR floors
l gains value as rates drop
l (underlying asset S.Mann,
price1999rises as rates fall)
Cap example
firm pays 250 basis points times Notional Principal
for a 5-year, 8% cap on six-month LIBOR
Cap buyer receives settlement payments
whenever LIBOR exceeds cap strike rate

The settlement payment:


if LIBOR <= 8.00% if LIBOR > 8.00%
0 (LIBOR - .08) x (180/360)x
Notional Principal
example :
LIBOR is 8.50% at settlement, payment received
is (.005)(1/2)(NP) = $2500 per $1 million
cap owner receives $50 per million
for each basis point above the strike
S.Mann, 1999
Floor example
firm pays 150 basis points times Notional Principal
for a 5-year, 4.50% floor on six-month LIBOR
Floor buyer receives settlement payments
whenever LIBOR is less than floor strike rate

The settlement payment:


if LIBOR < 4.50% if LIBOR > = 4.50%
(.045-LIIBOR) x (180/360) 0
x ( Notional Principal)
example :
LIBOR is 4.25% at settlement, payment received
is (.0025)(1/2)(NP) = $1250 per $1 million
floor owner receives $50 per million
for each basis point below the strike
S.Mann, 1999
Caplet and Floorlet payoffs
For any particular settlement period, the payoff
for individual caplets or floorlets:

0 0
8% LIBOR 4.5% LIBOR

Buy 4.5% floor


Buy 8% cap

Write 8% cap Write 4.5% cap

0 0
8% LIBOR 4.5% LIBOR

S.Mann, 1999
Interest rate collar
gains Buy a cap

floor premium {
cap premium { LIBOR

cap strike

write a floor
losses
floor strike

S.Mann, 1999
If cap premium = floor premium, it is zero-cost collar
Swap is Zero cost collar with same strike
gains
pay-fixed swap

floor premium {
=
cap premium { LIBOR

cap strike
=
floor strike

losses

Pay fixed swap is buying cap, writing floor


to create zero-cost collar with same strikes
S.Mann, 1999
Swaps as options on the balance sheet
assume swap fixed rate (SFR) is 7.00 %

Swap fixed payer Swap fixed receiver


Assets Liabilities Assets Liabilities

cap floor floor cap


with with with with
7% 7% 7% 7%
strike strike strike strike

swap fixed payer swap fixed receiver


buys cap and writes floor writes cap and buys floor
S.Mann, 1999

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