Introduction To Swaps
Introduction To Swaps
Steven C. Mann
M.J. Neeley School of Business
Texas Christian University
S.Mann, 1999
Swaps: contracts specifying
exchange of cash flows:
fixed price traded for floating price
fixed rate traded for floating rate
Fixed-Rate Fixed-Rate
Payer Receiver
6.75% Fixed Rate
DM 7.25% Fixed
US $ DM
(times DM 30 million)
payer payer
U.S. $ LIBOR
(times $ 20 million)
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New issue "arbitrage"
7.00% Fixed-Rate
Note LIBOR Floating-Rate
+ 0.10% Note
US $ Investor DM Investor
Fixed-Rate Fixed-rate
8.00% 8.00%
Note Note
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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
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FRA payoffs
At Origination:
Each FRA has zero economic value
Swap has zero value, but some settlement dates
have positive value and some negative
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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
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
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Set PV of Swap legs equal to zero
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)
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Value of swap legs Dec.
Sept. LIBOR
June LIBOR
FRAs 6.00% LIBOR
Swap
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Swap Fixed rate 6.96% 6.96% 6.96% 6.96%
Swaps on a balance sheet
If swap pieces were placed on balance sheets:
6x9 6x9
0x3 0x3
9 x 12 9 x 12
3x6 3x6
9 x 12 9 x 12
0 1 2 3 4 5 Years
market value
0 1 2 3 4 5 Years
0 1 2 3 4 5 Years
0 1 2 3 4 5 Years
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Swaps as bonds: Mark to market
At origination:
Swap fixed payer Swap fixed receiver
Assets Liabilities Assets Liabilities
Floater Fixed Fixed Floater
Note Note
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0 0
8% LIBOR 4.5% LIBOR
0 0
8% LIBOR 4.5% LIBOR
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Interest rate collar
gains Buy a cap
floor premium {
cap premium { LIBOR
cap strike
write a floor
losses
floor strike
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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