Swaps

1
Nature of Swaps
A swap is an agreement to exchange
cash flows at specified future times
according to certain specified rules

2
An Example of a “Plain Vanilla” Interest
Rate Swap

An agreement by Apple to receive 6-month

LIBOR & pay a fixed rate of 3% per annum
every 6 months for 3 years on a notional
principal of $100 million
Next slide illustrates cash flows that could
occur (Day count conventions are not
considered)

3
Cash Flows to Apple
(See Table 7.1, page 157
---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar. 8, 2016 2.2%
Sept. 8, 2016 2.8% +1.10 –1.50 –0.40
Mar. 8, 2017 3.3% +1.40 –1.50 –0.10
Sept. 8, 2017 3.5% +1.65 –1.50 +0.15
Mar. 8, 2018 3.6% +1.75 –1.50 +0.25
Sept. 8, 2018 3.9% +1.80 –1.50 +0.30
Mar. 8, 2019 3.4% +1.95 –1.50 +0.45

4
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
5
Interest Rate Swap Between
Apple and Citigroup (Figure 7.1, page
156)

3.0%
Citi Apple
LIBOR

6
Apple Transforms a Liability
from Floating to Fixed
(Figure 7.2, page 158)

3.0%
LIBOR+0.1%
Citi Apple
LIBOR

7
Interest Rate Swap Between
Citigroup and Intel (Figure 7.3, page 159)

2.97%
Citi Intel
LIBOR

8
Intel Transforms a Liability
from Fixed to Floating (Figure 7.4,
page 159)

2.97%
3.2%
Citi Intel
LIBOR

9
Apple Transforms an Asset from
Fixed to Floating (Figure 7.5, page 159)
3.0%
2.7%
Citi Apple
LIBOR

10
Intel Transforms an Asset from
Floating to Fixed (Figure 7.6, page 160)

2.97%
LIBOR−0.2%
Citi Intel
LIBOR

11
 Quotes By a Swap Market
Maker (Table 7.3, page 161)
Maturity Bid (%) Offer (%) Swap Rate (%)
2 years 2.55 2.58 2.565
3 years 2.97 3.00 2.985
4 years 3.15 3.19 3.170
5 years 3.26 3.30 3.280
7 years 3.40 3.44 3.420
10 years 3.48 3.52 3.500

12
Day Count
A day count convention is specified for fixed
and floating payments
For example, LIBOR is likely to be actual/360
in the U.S. because LIBOR is a money
market rate

13
Confirmations
Confirmations specify the terms of a transaction
The International Swaps and Derivatives has
developed Master Agreements that can be used
to cover all agreements between two
counterparties
CCPs are used for most standard swaps
between two financial institutions

14
The Comparative Advantage Argument
(Table 7.4, page 163)

AAACorp wants to borrow floating

BBBCorp wants to borrow fixed

Fixed Floating

AAACorp 4.00% 6-month LIBOR − 0.1%

BBBCorp 5.20% 6-month LIBOR + 0.6%

15
A Swap where Companies Trade
Directly with Each Other (Figure 7.7,
page 164)

4.35%
4% LIBOR+0.6%
AAACorp BBBCorp
LIBOR

16
The Swap when a Financial
Institution (F.I.) is Involved
(Figure 7.7, page 164)

4.33% 4.37%
4% LIBOR+0.6%
AAACorp F.I. BBBCorp
LIBOR LIBOR

17
Criticism of the Comparative
Advantage Argument
The 4.0% and 5.2% rates available to
AAACorp and BBBCorp in fixed rate markets
are 5-year rates
The LIBOR−0.1% and LIBOR+0.6% rates
available in the floating rate market are six-
month rates
BBBCorp’s fixed rate depends on the spread
above LIBOR it borrows at in the future

18
Valuation of an Interest Rate
Swap
Initially interest rate swaps are worth close to
zero
At later times they can be valued as a portfolio
of forward rate agreements (FRAs)
The procedure is to
Calculate LIBOR forward rates
Calculate the swap cash flows that will occur if
LIBOR forward rates are realized
Discount these swap cash flows at OIS rates

19
Example 7.1 (page 166)
Swap involves paying 3% per annum and receiving LIBOR
every six months on $100 million
Swap has 15 months remaining (exchanges in 3, 9, and 15
months)
LIBOR rate applicable to exchange in 3 months was
determined 3 months ago and is 2.9%
Forward LIBOR rates for 3-9 month period and 9-15 month
periods are 3.429% and 3.734%, respectively
OIS zero rates for maturities of 3, 9, and 15 months are
2.8%, 3.2%, and 3.4%, respectively

20
Calculations ($ million)
Time Fixed Floating Net cash Discount PV of net
(yrs) cash flow cash flow flow factor cash flow
0.25 −1.5000 +1.4500 −0.0500 0.9930 −0.0497
0.75 −1.5000 +1.7145 +0.2145 0.9763 +0.2094
1.25 −1.5000 +1.8672 +0.3672 0.9584 +0.3519
+0.5117

Value of swap is $0.5117 million

21
Bootstrapping LIBOR forward
rates: Example 7.2 (page 167)
6,12,18, and 24 month OIS rates are 3.8%, 4.3%, 4.6%,
and 4.75% respectively with cont. comp.
6-month LIBOR rate is 4% (sa comp.)
Suppose forward LIBOR rates for 6-12 and 12-18 months
have already been calculated as 5% and 5.5%,
respectively (sa comp)
The two year swap rate is 5%
The next step is to calculate the LIBOR forward rate, F, for
the18-24 month period.

22
Bootstrapping LIBOR forward
rates: Calculations
A 2-year swap where 5% is paid and LIBOR is received
on $100 is worth zero.
Value of first three exchanges are
0.5×(0.04− 0.05)×100×e−0.038×0.5 = −0.4906
0.5×(0.05 − 0.05)×100×e−0.043×1.0 = 0
0.5×(0.055 − 0.05)×100×e−0.046×1.5 = +0.2333
The value of the fourth payment must be +0.2573 so that
the total value is zero
0.5×(F−0.05)×100×e−0.0475×2.0 = 0.2573
F = 0.05566 or 5.566% per annum

23
An Example of a Fixed-for-
Fixed Currency Swap (Figure 7.10, page
169)

Five year agreement by BP to

Pay 3% on a US dollar principal of
$15,000,000
Receive 4% on a sterling principal of
£10,000,000

24
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

25
The Cash Flows (Table 7.5, page 170)
Date Dollar Cash Flows Sterling cash flow
(millions) (millions)

Feb 1, 2016 +15.00 −10.00

Feb 1, 2017 −0.45 +0.40
Feb 1, 2018 −0.45 +0.40
Feb 1, 2019 −0.45 +0.40
Feb 1, 2020 −0.45 +0.40
Feb 1, 2021 −15.45 +10.40

26
Typical Uses of a
Currency Swap
Conversion from a liability in one currency
to a liability in another currency

Conversion from an investment in one

currency to an investment in another
currency

27
Comparative Advantage May Be
Real Because of Taxes
General Electric wants to borrow AUD
Quantas wants to borrow USD
Borrowing costs after adjusting for the
differential impact of taxes could be:

USD AUD

General Electric 5.0% 7.6%

Quantas 7.0% 8.0%

28
Valuation of Fixed-for-Fixed
Currency Swaps

Fixed for fixed currency swaps can be

valued either using forward rates or as
the difference between 2 bonds

29
Examples 7.3 and 7.4 (pages 172-174)
All Japanese interest rates are 1.5% per annum
(cont. comp.)
All USD interest rates are 2.5% per annum (cont.
comp.)
3% is received in yen; 4% is paid in dollars.
Payments are made annually
Principals are $10 million and 1,200 million yen
Swap will last for 3 more years
Current exchange rate is 110 yen per dollar

30
Valuation in Terms of Forward
Rates (page 173)

Time Dollar Yen Forward Dollar value Net cash Present

Cash cash rate of yen cash flow value
Flow flow flow
1 −0.4 +36 0.009182 0.3306 −0.0694 −0.0677
2 −0.4 +36 0.009275 0.3339 −0.0661 −0.0629
3 −10.4 +1236 0.009368 11.5786 +1.1786 +1.0934
Tota +0.9629
l

31
Valuation in Terms of Bonds
(page 174)

Time Cash Flows ($ PV Cash flows PV ( millions

millions) ($ millions) (millions of yen) of yen)
1 0.4 0.3901 36 35.46
2 0.4 0.3805 36 34.94
3 10.4 9.6485 1,236 1,181.61
Total 10.4191 1,252.01

Value = 1,252.01/110−10.4191 = +0.9629

millions of dollars

32
Other Currency Swaps
Fixed-for-floating: equivalent to a fixed-for-
fixed currency swap plus a fixed for floating
interest rate swap
Floating-for-floating: equivalent to a fixed-for-
fixed currency swap plus two floating interest
rate swaps

33
Swaps & Forwards
A swap can be regarded as a convenient way
of packaging forward contracts
When a swap is initiated the swap has zero
value, but typically some forwards have a
positive value and some have a negative
value

34
Credit Risk
When derivatives transactions with a
counterparty are cleared bilaterally, they are
netted
There is exposure if the net value of
outstanding transactions is greater than the
collateral posted

35
Credit Default Swaps: A Quick
First Look
Notional principal (e.g. $100 million) and maturity
(e.g. 5 yrs) specified
Protection buyer pays a fixed rate (e.g. 150 bp) on
the notional principal (the CDS spread)
If the reference entity (a country or company)
defaults protection seller buys bonds issued by the
reference entity for their face value and the spread
payments stop. Total face value of bonds bought
equals notional principal

36
Other Types of Swaps
Amortizing/ step up
Compounding swap
Constant maturity swap
LIBOR-in-arrears swap
Accrual swap
Equity swap

37
Other Types of Swaps continued
Cross currency interest rate swap
Floating-for-floating currency swap
Diff swap
Commodity swap
Variance swap

38