6.

Swaps

6.2

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 6-month 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

6.3

Cash Flows to Microsoft

(See Table 6.1, page 127)
---------Millions of Dollars--------LIBOR FLOATING Date Rate FIXED Net Cash Flow Cash Flow Cash Flow +2.10 2.50 0.40

6.4

Mar.1, 1998
Sept. 1, 1998

4.2%
4.8%

Mar.1, 1999
Sept. 1, 1999 Mar.1, 2000

5.3%
5.5% 5.6%

+2.40
+2.65 +2.75

2.50
2.50 2.50

0.10
+0.15 +0.25

Sept. 1, 2000
Mar.1, 2001

5.9%
6.4%

+2.80
+2.95

2.50
2.50

+0.30
+0.45

6.5

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 6.2, page 128)
5% 5.2%

6.6

Intel
LIBOR

MS
LIBOR+0.1%

6.7

Financial Institution is Involved

(Figure 6.4, page 129)
4.985% 5.2% 5.015%

Intel
LIBOR

F.I.
LIBOR

MS
LIBOR+0.1%

Dealer spread = .03% evenly split

Intel and Microsoft (MS) Transform an Asset

(Figure 6.3, page 128)
5% 4.7%

6.8

Intel
LIBOR-0.25% LIBOR

MS

6.9

Financial Institution is Involved

(See Figure 6.5, page 129)
4.985% 5.015% 4.7%

Intel
LIBOR-0.25%

F.I.
LIBOR
LIBOR

MS

Dealer spread = .03 %

6.10

The Comparative Advantage Argument (Table 6.4, page 132)

AAACorp wants to borrow floating BBBCorp wants to borrow fixed
Fixed AAACorp BBBCorp 10.00% 11.20% Floating 6-month LIBOR + 0.30% 6-month LIBOR + 1.00%

6.11

The Comparative Advantage Argument

AAACorp has absolute advantage in both markets But a comparative advantage in fixed BBBCorp has comparative advantage in floating If AAA borrows fixed, the gain is 1.2% If BBB borrows floating, the gain is reduced by .7% Therefore, we have a net gain of 1.2 - .7 = .5% If the gain is split evenly, we have a gain per party of: G = (1.2 - .7)/2 = .25%

6.12

Swap Design
Design the swap so AAAs borrowing rate equals the comparative disadvantage (CD) rate minus the gain: LIBOR + .3 - .25 Do the same thing for BBB BBBs rate with swap: 11.2 - .25 Now, draw the diagram

6.13

The Swap (Figure 6.6, page 132)

9.95% 10%

AAA
LIBOR

BBB
LIBOR+1%

The floating rate leg should be LIBOR

6.14

Swap Design with FI

Adjust swap gain for dealer spread Suppose dealer spread = .04% Then gain: G = (1.2 - .7 - .04)/2 = .23% AAAs rate with swap: LIBOR + .3 - .23 = LIBOR + .07 BBBs rate with swap: 11.2 - .23 = 10.97% Draw swap diagram

The Swap when a Financial Institution is Involved

(Figure 6.7, page 133)
9.93% 10%
9.97%

6.15

AAA
LIBOR

F.I.
LIBOR

BBB
LIBOR+1%

Check that dealer spread = .04%

6.16

Criticism of the Comparative Advantage Argument

The 10.0% and 11.2% rates available to AAACorp and BBBCorp in fixed rate markets are 5-year rates The LIBOR+0.3% and LIBOR+1% 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

6.17

Valuation of an Interest Rate Swap

Interest rate swaps can be valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bond

6.18

Swap Valuation
Fixed Receive: Vswap = Vfixed Vfloating Fixed Pay: Vswap = Vfloating - Vfixed The fixed rate stream is valued as an annuity The floating rate stream is valued by noting that it is worth par immediately after the next payment date

6.19

Floating Rate Perpetuity

To create a floating rate perpetuity, invest principal value in 6-month LIBOR At the end of 6-months, remove the interest and reinvest the principal value at the new 6month LIBOR Therefore, the cost of a floating rate perpetuity is principal value It always sells for its par value immediately after interest payment

6.20

Floating Rate Instrument with Maturity T

At the end of T years, floating rate perpetuity is worth the principal value M Therefore, the floating rate instrument is worth: M MdT Or M - M/(1+y/2)2T, where is the rate on a zero-coupon bond maturing in T years

6.21

Swap Valuation
The floating rate instrument is worth: Vfloating = M M/(1+y/2)2T The fixed rate stream is worth: Vfixed = (C/2)(Annuity Factor) So for Fixed Receive Swap: Vswap = (C/2)(Annuity Factor) - M +M/(1+y/2)2T

6.22

Swap Valuation
The swap is structured such that initial value is zero to either party Set Vswap = 0 Rearrange terms: M=(C/2)(Annuity Factor) + M/(1+y/2)2T The left-hand side is the present value of a bond at y Since the bond is selling at par, CR = C/M = y For the swap to have zero value the fixed rate must equal the yield to maturity on a par bond The swap rate is the coupon rate on a LIBOR bond that causes it to be worth par

6.23

Example
Zero coupon LIBOR curve is 5%, 6%, and 7% for one, two, and three years What is the swap rate on a three year interest rate swap? Assume payments are annual and yields are compounded annually Solve for LIBOR par yield M = CRxM(d1 + d2 + d3) + Md3

6.24

Example Continued
Solution:
1 1 3 1 . 07 CR 6.91% 1 1 1 2 1.05 1.06 1.073

6.25

Interest Rate Risk

Receive Fixed: Vswap = Vfixed Vfloating Pay Fixed: Vswap = Vfloating Vfixed

6.26

An Example of a Currency Swap

An agreement to pay 11% on a sterling principal of 10,000,000 & receive 8% on a US$ principal of $15,000,000 every year for 5 years

6.27

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

6.28

Three Cash Flow Components

t = 0: exchange principal based upon current exchange rates Pay: $15 M Rcv: 10 M t = 1, 2, 3, 4, 5: Pay: .11x10 = 1.1 M Rcv: .08x15 = $1.2 M t = 5: Pay: 10 M Rcv: $ 15 M

6.29

The Cash Flows (Table 6.6, page 140)

Dollars Pounds $ Years ------millions-----0 15.00 +10.00 +1.20 1.10 1 2 +1.20 1.10 3 +1.20 1.10 4 +1.20 1.10 5 +16.20 -11.10

6.30

Typical Uses of a Currency Swap

Conversion from Conversion from a liability in one an investment in currency to a one currency to liability in an investment in another currency another currency

6.31

Comparative Advantage Arguments for Currency Swaps (Table 6.7, page 141)
General Motors wants to borrow AUD Qantas wants to borrow USD
USD
General Motors 5.0% Qantas 7.0%

AUD
12.6% 13.0%

6.32

Comparative Advantage
GM has absolute advantage in both markets But GM has comparative advantage in dollars Qantas has comparative advantage in Australian dollars So GM should borrow dollars and Qantas Australian dollars Then swap cash flows to earn gain from comparative advantage

6.33

Comparative Advantage
Gain per party: G = (2 - .4)/2 = .8% GMs rate with swap: 12. 6 - .8 = AUD 11.8% Qantas rate with swap: 7 - .8 = USD 6.2%

6.34

Qantas Assumes Exchange Rate Risk

USD 5%

USD 5%

GM
AUD 11.8%

AUD 13%

Qantas

6.35

GM Assumes Exchange Rate Risk

USD 6.2% USD 5%

GM
AUD 13.0%

AUD 13%

Qantas

6.36

FI Assumes Exchange Rate Risk

Adjust swap gain for dealer spread Suppose dealer spread = .2% Then gain:

Gain per party: G = (2 - .4 - .2)/2 = .7% GMs rate with swap: 12. 6 - .7 = AUD 11.9% Qantas rate with swap: 7 - .7 = USD 6.3%

6.37

FI Assumes Exchange Rate Risk

USD 5%
USD 5% USD 6.3%

GM
AUD11.9%

F.I.
AUD 13%

Q
AUD 13%

Check that dealer spread = .2% Pay: 13.0 11.9 = AUD 1.1% Rcv: 6.3 5.0 = USD 1.3%

6.38

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

6.39

Swaps & Forwards

A swap can be regarded as a convenient way of packaging forward contracts The plain vanilla interest rate swap in our example consisted of 6 Fraps The fixed for fixed currency swap in our example consisted of a cash transaction & 5 forward contracts

6.40

Swaps & Forwards

(continued)
The value of the swap is the sum of the values of the forward contracts underlying the swap Swaps are normally at the money initially This means that it costs nothing to enter into a swap It does not mean that each forward contract underlying a swap is at the money initially

6.41

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