CH 07 Hull OFOD8 TH Edition

2/4/2013
Chapter 7
Swaps
Options, Futures, and Other Derivatives, 8th Edition,

Copyright John C. Hull 2012
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 6month 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 that could
occur (Day count conventions are not
considered)
2/4/2013
One Possible Outcome for Cash

Flows to Microsoft (Table 7.1, page 150)
Date
LIBOR
Floating Cash
Flow
Fixed Cash
Flow
Net Cash
Flow
Mar 5, 2012
4.20%
Sep 5, 2012
Mar 5, 2013
4.80%
+2.10
2.50
0.40
5.30%
+2.40
2.50
0.10
Sep 5, 2013
5.50%
+2.65
2.50
+ 0.15
Mar 5, 2014
5.60%
+2.75
2.50
+0.25
Sep 5, 2014
5.90%
+2.80
2.50
+0.30
+2.95
2.50
+0.45
Mar 5, 2015

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 7.2, page 151)
5%
5.2%
Intel
MS
LIBOR+0.1%
LIBOR

2/4/2013
Financial Institution is Involved

(Figure 7.4, page 152)
4.985%
5.015%
5.2%
Intel
F.I.
MS
LIBOR
LIBOR
LIBOR+0.1
%
Financial Institution has two offsetting

swaps

Intel and Microsoft (MS) Transform an

Asset (Figure 7.3, page 152)
5%
4.7%
Intel
MS
LIBOR-0.2%
LIBOR
Financial Institution is Involved

(See Figure 7.5, page 153)
4.985%
5.015%
4.7%
Intel
F.I.
MS
LIBOR-0.2%
LIBOR
LIBOR

2/4/2013
Quotes By a Swap Market Maker

(Table 7.3, page 154)
Maturity
2 years
Bid (%)
6.03
Offer (%)
6.06
Swap Rate (%)

6.045
3 years
6.21
6.24
6.225
4 years
6.35
6.39
6.370
5 years
6.47
6.51
6.490
7 years
6.65
6.68
6.665
10 years
6.83
6.87
6.850

10
Day Count
A day count convention is specified for for
fixed and floating payment
For example, LIBOR is likely to be actual/360
in the US because LIBOR is a money market
rate

11
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
Governments now require central clearing to
be used for most standardized derivatives
12
2/4/2013
The Comparative Advantage Argument

AAACorp wants to borrow floating

BBBCorp wants to borrow fixed
Fixed
Floating
AAACorp
4.0%
6 month LIBOR 0.1%
BBBCorp
5.2%
6 month LIBOR + 0.6%

13
The Swap (Figure 7.6, page 157)

4.35%
4%
AAACorp
BBBCorp
LIBOR+0.6%
LIBOR

14
The Swap when a Financial

Institution is Involved (Figure 7.7, page 157)
4.33%
4.37%
4%
AAACorp
LIBOR
F.I
.
BBBCorp
LIBOR+0.6%
LIBOR

15
2/4/2013
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 LIBOR0.1% and LIBOR+0.6% 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
16
The Nature of Swap Rates

Six-month LIBOR is a short-term AA borrowing
rate
The 5-year swap rate has a risk corresponding to
the situation where 10 six-month loans are made
to AA borrowers at LIBOR
This is because the lender can enter into a swap
where income from the LIBOR loans is
exchanged for the 5-year swap rate

17
Using Swap Rates to Bootstrap the

LIBOR/Swap Zero Curve
Consider a new swap where the fixed rate is the
swap rate
When principals are added to both sides on the final
payment date the swap is the exchange of a fixed
rate bond for a floating rate bond
The floating-rate rate bond is worth par. The swap is
worth zero. The fixed-rate bond must therefore also
be worth par
This shows that swap rates define par yield bonds
that can be used to bootstrap the LIBOR (or
LIBOR/swap) zero curve
18
2/4/2013
Example of Bootstrapping the

LIBOR/Swap Curve (Example 7.1, page 160)
6-month, 12-month, and 18-month
LIBOR/swap rates are 4%, 4.5%, and 4.8%
with continuous compounding.
Two-year swap rate is 5% (semiannual)
2.5e
0.04 0.5
2.5e 0.045 1.0

102 .5e 2 R 100
2.5e
0.048 1.5
The 2-year LIBOR/swap rate, R, is 4.953%

19
Valuation of an Interest Rate Swap

Initially interest rate swaps are worth close
to zero
At later times they can be valued as the
difference between the value of a fixed-rate
bond and the value of a floating-rate bond
Alternatively, they can be valued as a
portfolio of forward rate agreements (FRAs)

20
Valuation in Terms of Bonds

The fixed rate bond is valued in the usual way
The floating rate bond is valued by noting that
it is worth par immediately after the next
payment date

21
2/4/2013
Valution of Floating-Rate Bond

Value = PV
of L+k* at t*
Value =
L+k*
Value = L
t*
0
Valuation
Date
First Pmt
Date
Floating
Pmt =k*
Second
Pmt Date
Maturity
Date

22
Example
Pay six-month LIBOR, receive 8% (s.a.
compounding) on a principal of $100 million
Remaining life 1.25 years
LIBOR rates for 3-months, 9-months and 15months are 10%, 10.5%, and 11% (cont
comp)
6-month LIBOR on last payment date was
10.2% (s.a. compounding)
23
Valuation Using Bonds (page 161)

Time
Bfix cash
flow
Bfl cash
flow
Disc
factor
PV
Bfix
PV
Bfl
0.25
4.0
105.100
0.9753
3.901
102.505
0.75
4.0
0.9243
3.697
1.25
104.0
0.8715
90.640
Total
98.238
102.505
Swap value = 98.238 102.505 = 4.267

24
2/4/2013
Valuation in Terms of FRAs

Each exchange of payments in an interest
rate swap is an FRA
The FRAs can be valued on the
assumption that todays forward rates are
realized

25
Valuation of Example Using FRAs

(page 163)
Time
Fixed cash
flow
Floating
cash flow
Net Cash
Flow
Disc factor
PV
Bfl
0.25
4.0
-5.100
-1.100
0.9753
-1.073
0.75
4.0
-5.522
-1.522
0.9243
-1.407
1.25
4.0
-6.051
-2.051
0.8715
-1.787
Total
-4.267

26
Overnight Indexed Swaps

Fixed rate for a period is exchanged for the
geometric average of the overnight rates
Should OIS rate equal the LIBOR rate? A
bank can
Borrow $100 million in the overnight market,
rolling forward for 3 months
Enter into an OIS swap to convert this to the 3month OIS rate
Lend the funds to another bank at LIBOR for 3
months
27
2/4/2013
Overnight Indexed Swaps continued

...but it bears the credit risk of another bank in
this arrangement
The OIS rate is now regarded as a better proxy
for the short-term risk-free rate than LIBOR
The excess of LIBOR over the OIS rate is the
LIBOR-OIS spread. It is usually about 10 basis
points but spiked at an all time high of 364 basis
points in October 2008
28
An Example of a Currency Swap

An agreement to pay 5% on a sterling
principal of 10,000,000 & receive 6% on
a US$ principal of $18,000,000 every year
for 5 years

29
Exchange of Principal
In an interest rate swap the principal is not
exchanged
In a currency swap the principal is usually
exchanged at the beginning and the end of
the swaps life

30
10
2/4/2013
The Cash Flows (Table 7.7, page 166)

Date
Dollar Cash Flows

(millions)
Sterling cash flow

(millions)
Feb 1, 2011
-18.0
+10.0
Feb 1, 2012
+1.08
0.50
Feb 1, 2012
+1.08
0.50
Feb 1, 2014
+1.08
0.50
Feb 1, 2015
+1.08
0.50
Feb 1, 2016
+19.08
10.50

31
Typical Uses of a
Currency Swap
Convert a liability in one currency to a
liability in another currency
Convert an investment in one currency to
an investment in another currency

32
Comparative Advantage May Be

Real Because of Taxes
General Electric wants to borrow AUD
Quantas wants to borrow USD
Cost after adjusting for the differential impact
of taxes
USD
AUD
General Electric
5.0%
7.6%
Quantas
7.0%
8.0%

33
11
2/4/2013
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

34
Example
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
35
Valuation in Terms of Bonds (Table 7.9,

page 169)
Time
Cash Flows ($)
PV ($)
Cash flows (yen)
PV (yen)
0.8
0.7311
60
57.65
0.8
0.6682
60
55.39
0.8
0.6107
60
53.22
10.0
7.6338
1,200
1,064.30
Total
9.6439
1,230.55
Value of Swap = 1230.55/110 9.6439 = 1.5430

36
12
2/4/2013
Valuation in Terms of Forwards

Time
$ cash
flow
Yen cash
flow
Forward
Exch rate
Yen cash
flow in $
Net
Cash
Flow
Present
value
-0.8
60
0.009557
0.5734
-0.2266
-0.2071
-0.8
60
0.010047
0.6028
-0.1972
-0.1647
-0.8
60
0.010562
0.6337
-0.1663
-0.1269
-10.0
1200
0.010562
12.6746
+2.674
6
2.0417
Total
1.5430

37
Swaps & Forwards

A swap can be regarded as a convenient
way of packaging forward contracts
Although the swap contract is usually
worth close to zero at the outset, each of
the underlying forward contracts are not
worth zero

38
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
Some swaps are more likely to lead to credit risk
exposure than others
What is the situation if early forward rates have a
positive value?
What is the situation when the early forward rates have
a negative value?
39
13
2/4/2013
Other Types of Swaps

Floating-for-floating interest rate swaps,
amortizing swaps, step up swaps, forward
swaps, constant maturity swaps,
compounding swaps, LIBOR-in-arrears
swaps, accrual swaps, diff swaps, cross
currency interest rate swaps, equity swaps,
extendable swaps, puttable swaps,
swaptions, commodity swaps, volatility
swaps..
40
14

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2/4/2013

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

An Example of a Plain Vanilla Interest

One Possible Outcome for Cash

Options, Futures, and Other Derivatives, 8th Edition,

Typical Uses of an Interest Rate

Converting an investment from

Options, Futures, and Other Derivatives, 8th Edition,

Intel and Microsoft (MS)

Options, Futures, and Other Derivatives, 8th Edition,

Financial Institution is Involved

Financial Institution has two offsetting

Options, Futures, and Other Derivatives, 8th Edition,

Intel and Microsoft (MS) Transform an

Financial Institution is Involved

Options, Futures, and Other Derivatives, 8th Edition,

Quotes By a Swap Market Maker

Swap Rate (%)

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

The Comparative Advantage Argument

AAACorp wants to borrow floating

6 month LIBOR 0.1%

6 month LIBOR + 0.6%

Options, Futures, and Other Derivatives, 8th Edition,

The Swap (Figure 7.6, page 157)

Options, Futures, and Other Derivatives, 8th Edition,

The Swap when a Financial

Options, Futures, and Other Derivatives, 8th Edition,

Criticism of the Comparative

The Nature of Swap Rates

Options, Futures, and Other Derivatives, 8th Edition,

Using Swap Rates to Bootstrap the

Example of Bootstrapping the

2.5e 0.045 1.0

The 2-year LIBOR/swap rate, R, is 4.953%

Valuation of an Interest Rate Swap

Options, Futures, and Other Derivatives, 8th Edition,

Valuation in Terms of Bonds

Options, Futures, and Other Derivatives, 8th Edition,

Valution of Floating-Rate Bond

Options, Futures, and Other Derivatives, 8th Edition,

Valuation Using Bonds (page 161)

Swap value = 98.238 102.505 = 4.267

Options, Futures, and Other Derivatives, 8th Edition,

Valuation in Terms of FRAs

Options, Futures, and Other Derivatives, 8th Edition,

Valuation of Example Using FRAs

Options, Futures, and Other Derivatives, 8th Edition,

Overnight Indexed Swaps

Overnight Indexed Swaps continued

An Example of a Currency Swap

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

The Cash Flows (Table 7.7, page 166)

Dollar Cash Flows

Sterling cash flow

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Comparative Advantage May Be

Options, Futures, and Other Derivatives, 8th Edition,

Valuation of Currency Swaps