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.

©David Dubofsky and 11- 1

Thomas W. Miller, Jr.
A “Plain Vanilla” Interest Rate Swap, I.

• Party B agrees to pay a fixed payment and receive a

floating payment, from counter-party A.
• Party B is the fixed rate payer-floating rate receiver
(the “pay-fixed” party).
• Party A is the fixed rate receiver-floating rate payer
(the “receive-fixed” party).
• Typically, there is no initial exchange of principal (i.e.,
no cash flow at the initiation of the swap).

©David Dubofsky and 11- 2

Thomas W. Miller, Jr.
A “Plain Vanilla” Interest Rate Swap, II.
• On 3/1/02, an agreement is struck wherein for the next
3 years, every six months, company B receives from
company A, a payment on a notional principal of $100
million, based on 6-mo LIBOR. Company B makes a
fixed payment on the same notional principal to
company A, based on a rate of 5% per annum.
• Define as the fixed rate.
• Define as the variable (floating) rate.
• Define NP as the notional principal.
• Note that 6-month LIBOR at origination is R0 = 4.20%.
• The next two slides illustrate the cash flows.
©David Dubofsky and 11- 3
Thomas W. Miller, Jr.
 Multiply each “R” by NP
times #days between
payments over 360
0 (or use a 365-day year)

• Each actual payment (“difference check”) equals the difference between the interest
rates times NP times #days between payments over 360, or #days/365.
• The time t variable cash flow is typically based on the time t-1 floating interest rate.
• Thus, the first floating cash flow, based on the rate, R 0, is known: it is 4.20%.
• All subsequent floating cash flows are random variables as of time zero (but always
known one period in advance).
©David Dubofsky and 11- 4
Thomas W. Miller, Jr.
 The Cash Flows to Company B

---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar.1, 2002 4.2%
Sept. 1, 2002 4.6% +2.10 –2.50 –0.40
Mar.1, 2003 5.1% +2.30 –2.50 –0.20
Sept. 1, 2003 5.5% +2.55 –2.50 +0.05
Mar.1, 2004 5.6% +2.75 –2.50 +0.25
Sept. 1, 2004 4.9% +2.80 –2.50 +0.30
Mar.1, 2005 4.4% +2.45 –2.50 - 0.05

©David Dubofsky and 11- 5

Thomas W. Miller, Jr.
 A Closer Look at the Cash Flows on
September 1, 2002

• Floating Payment:
– Based on the 6-month LIBOR rate that existed on March 1, 2002:
4.20%.
– ($100,000,000)(0.042)(1/2) = +$2,100,000.

• Fixed Payment:
– Based on 5% rate.
– ($100,000,000)(0.05)(1/2) = -$2,500,000.

• Net Cash Flow: -$400,000.

©David Dubofsky and 11- 6

Thomas W. Miller, Jr.
 Quoting Plain Vanilla Swaps
• Typically, the floating index, e.g. LIBOR, is bought or sold “flat.”
• If you buy LIBOR (pay-fixed), you pay a spread over the most
recently issued Treasury with the same maturity as the swap (the
asked swap spread).
• If you receive fixed (sell LIBOR) then you receive the Treasury
rate plus the bid swap spread, which is smaller than the asked
swap spread.
• Example:
– For a 5-year swap, a dealer might quote 20 (bid) and 24 (asked).
– Suppose the yield midpoint of the most recently issued 5-year T-note
is 5.40%.
– Then, the pay-fixed party will pay 5.64%, and receive LIBOR.

©David Dubofsky and 11- 7

Thomas W. Miller, Jr.
 Typical Uses of an
Interest Rate Swap

• To convert a liability from:

– a fixed rate to floating rate.
– a floating rate to fixed rate.

• To convert an investment (asset) from:

– a fixed rate to floating rate.
– a floating rate to fixed rate.

©David Dubofsky and 11- 8

Thomas W. Miller, Jr.
 Other Interest Rate Swap Structures

• Off market swaps: The fixed rate may be away from the market;
an initial payment will have to be negotiated.

• Amortizing swap: varying NP according to a predetermined

schedule.

• Index amortizing swap: The NP, or term of the swap, varies

according to some randomly changing interest rate index.

• Basis swap: The two interest rates both float (e.g., LIBOR and
the prime rate; or 2-year Treasury rate and 10-year Treasury
rate).

• Forward swap: The first cash flow takes place in the “far” future,
“long” after the terms of the swap have been negotiated.
©David Dubofsky and 11- 9
Thomas W. Miller, Jr.
 Currency Swaps
• There are four types of basic currency swaps:
– fixed for fixed.
– fixed for floating.
– floating for fixed.
– floating for floating.

• N.B.: It is the interest rates that are fixed or floating.

• Typically, the NP( notional principal ) is

exchanged at the swap’s initiation and termination
dates.
©David Dubofsky and 11- 10
Thomas W. Miller, Jr.
 Typical Uses of a
Currency Swap

• To convert a liability in one currency into a liability in

another currency.

• To convert an investment (asset) in one currency to an

investment in another currency.

©David Dubofsky and 11- 11

Thomas W. Miller, Jr.
 An Example of a Fixed for
Fixed Currency Swap
• An agreement to pay 1% on a Japanese Yen principal
of ¥1,040,000,000 and receive 5% on a US dollar
principal of $10,000,000 every year for 3 years.
• In a currency swap, unlike in an interest rate swap,
the principal is exchanged at the beginning and at
the end of the swap.
• Note that in currency swaps, the direction of the cash
flows at time zero is the opposite of the direction of the
subsequent cash flows in the swap (see the next slide).

©David Dubofsky and 11- 12

Thomas W. Miller, Jr.
Cash Flows in a Fixed-for-Fixed Currency Swap
At origination:
$10,000,00
Party A 0 Party B
¥1,040,000,000

At each annual settlement date:

$500,000
Party A Party B
¥10,400,000

At maturity:
$10,000,000
Party A Party B
¥1,040,000,000
©David Dubofsky and 11- 13
Thomas W. Miller, Jr.
 Cash Flows in a Fixed-for-Floating
Currency Swap

• On the origination date:

– The fixed rate payer pays $10,000,000 to the fixed rate receiver.
– The fixed rate receiver pays ¥1,040,000,000 to the fixed rate payer.

$10,000,00
Fixed rate payer
0 Fixed rate Receiver
(Floating rate
(Floating Rate
Receiver)
Payer)
¥1,040,000,000

©David Dubofsky and 11- 14

Thomas W. Miller, Jr.
Calculating Subsequent Cash Flows for
this Fixed-for-Floating Currency Swap
• Tenor is three years. NP1 = ¥1,040,000,000 yen, and r1 = 1%
fixed in yen. NP2 = $10,000,000, and r2 = 6 month $-LIBOR
(floating). Settlement dates are every 6 months, beginning 6
months hence.
• On the origination date, 6 month LIBOR is 5.5%.
• Assume that subsequently, 6 mo. LIBOR is:
Time 6 mo. LIBOR
0.5 5.25%
1.0 5.50%
1.5 6.00%
2.0 6.20%
2.5 6.44%
©David Dubofsky and 11- 15
Thomas W. Miller, Jr.
 All Cash Flows for this Fixed-for-
Floating Currency Swap
6-mo. Fixed rate Floating rate
time LIBOR Payment Payment
0.0 5.50% $10MM ¥1,040MM
0.5 5.25% ¥5.2MM $275,000
1.0 5.50% ¥5.2MM $262,5001
1.5 6.00% ¥5.2MM $275,000
2.0 6.20% ¥5.2MM $300,000
2.5 6.44% ¥5.2MM $310,000
3.0 ---- ¥5.2MM $322,000
¥1,040MM $10MM

N.B. The time t floating cash flow is determined using the time t-1 floating rate.
1
Time 1.0 floating rate payment is (0.0525/2)($10,000,000) = $262,500.

©David Dubofsky and 11- 16

Thomas W. Miller, Jr.
 Credit Risk: Currency Swaps

• Note that there is greater credit risk with a currency

swap when there will be a final exchange of principal.

• This means that there is a higher probability of a large

buildup in value, giving one of the counter-parties (the
one who is losing) the incentive to default.

©David Dubofsky and 11- 17

Thomas W. Miller, Jr.
 Credit Risk

• No credit risk exists when a swap is first created.

• The credit risk in a swap is greater when there is an
exchange of principal amounts at termination.
• Only the winning party (for whom the swap is an
asset) faces credit risk. This risk is the risk that the
counter-party will default.
• Many vehicles exist to manage credit risk:
– Collateral (or collateral triggers)
– Netting agreements
– Credit derivatives
– Marking to market

©David Dubofsky and 11- 18

Thomas W. Miller, Jr.
 Other Currency Swap Structures

• See the different interest rate swap structures

presented earlier. They all apply to currency swaps,
too.

• Index differential swaps, or “diff” swaps:

– The cash flows are based on two floating rates in different
countries, but they are applied to the NP of one of the
currencies.
– For example, pay €-based LIBOR, and receive $-based
LIBOR, on a NP of $20MM. All payments are in $.

©David Dubofsky and 11- 19

Thomas W. Miller, Jr.
 Commodity Swaps

• Equivalent to a strip of forward contracts on a commodity.

• Define NP in terms of the commodity; e.g., 10,000 oz. of gold.
• The NP is not exchanged.
• Define Pfixed as the fixed price.
• Payments are made by comparing the actual price of the
commodity on the settlement date (or an average price over the
period, or the actual price one period earlier) to the fixed price.

©David Dubofsky and 11- 20

Thomas W. Miller, Jr.
 Commodity Swaps: an Example, I.

• A gold mining firm wants to fix the price it will receive for the
gold it will mine over the next 3 years.
• A gold user wants to fix the price it will have to pay for the
gold it needs for the next 3 years.
• NP = 10,000 oz.
• Pfixed = $320/oz.
• Settlement is semi-annual, based on average price of gold
during the past six months.

©David Dubofsky and 11- 21

Thomas W. Miller, Jr.
 Commodity Swaps: an Example, II.
Subsequently:

Avg. gold price Producer pays (-)

Time during past pd. or receives (+)
0.5 $305 +$150,000
1.0 $330 -$100,000
1.5 $368 -$480,000
2.0 $402 -$820,000
2.5 $348 -$280,000
3.0 $300 +$200,000

©David Dubofsky and 11- 22

Thomas W. Miller, Jr.
 Examples

• All Japanese LIBOR/swap rates are 4%

• All USD LIBOR/swap rates are 9%
• 5% is received in yen; 8% 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
©David Dubofsky and 11- 23
Thomas W. Miller, Jr.
• Assume that subsequently, 6 mo. LIBOR and exchange rate are described as follows:

Time 6-month LIBOR Exchange Rate ¥/$

0.5 6.25% 105

IBM and NIPPON decide to sign a currency
1.0 6.5% 108 swap contract with tenor is three years. IBM
will receive a notional principle of ¥1,070,000
1.5 7.00% 109
yen and pay r1 = 2% fixed in yen. Nippon will
2.0 7.20% 102 receive a notional principle of NP 2 = $10,000
2.5 7.50% 108 and pay r2 = 6 month $-LIBOR (floating).
Settlement dates are every 6 months,
3.0 7.00% 104
beginning 6 months hence.
•On the origination date, 6-month LIBOR is
6.5%, and exchange rate ¥/$ is ¥107/1$.
a) Given the information that IBM are financed by 40% of debt and
60% of its own equity. Cost of debt is 7%, corporate tax applied
to IBM is 28%. Cost of equity is 6.20%. Calculate the NPV of
cash flow that IBM can receive from this contract. Should IBM
participate in this swap contract? (15 points)

©David Dubofsky and 11- 24

Thomas W. Miller, Jr.