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Swap Derivatives
Today, there are a number of nonstandard or non-generic
swaps used by financial and non-financial corporations to
manage their varied cash flow and asset and liability
positions.
Two of the most widely used non-generic swaps are the
forward swap and options on swaps or swaptions.
A forward swap is an agreement to enter into a swap that
starts at a future date at an interest rate agreed upon today.
A swaption, in turn, is a right, but not an obligation, to take
a position on a swap at a specific swap rate.
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Forward Swaps
Like futures and farward contracts on debt
securities, forward swaps provide borrowers and
investors with a tool for locking in a future
interest rate.
As such, they can be used to manage interest rate
risk for fixed-income positions.
Example:
A company wishing to lock in a rate on a 5-year, fixedrate $100,000,000 loan to start two years from today,
could enter a 2-year forward swap agreement to pay
the fixed rate on a five-year 9%/LIBOR swap.
At the expiration date on the forward swap, the
company could issue $100,000,000 floating-rate debt
at LIBOR that, when combined with the fixed position
on the swap, would provide the company with a
synthetic fixed rate loan paying 9% on the floating
debt.
Action
Pay LIBOR
Pay Fixed Rate
LIBOR
Receive LIBOR
+LIBOR
Net Payment
9%
9%
fix
(.10 / 2) (.09 / 2)
t
t 1 (1 (.10 / 2))
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If the rate on 5-year fixed rate loans were lower than 9%, say 8%,
then the company would benefit from the lower fixed rate loan, but
would lose an amount equal to the present value of a 5-year
annuity equal to 1% (difference in rates: 8% 9%) times the NP
when it closed the fixed position.
(.08 / 2) (.09 / 2)
SV
$100 million
t
t 1 (1 (.08 / 2))
SV fix $4.055 million
fix
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The company would therefore have to pay the swap bank $4.055
million for assuming its fixed-payers position.
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Forward swaps can also be used on the asset side to fix the
rate on a future investment.
The investor could lock in the future rate by entering a 1year forward swap agreement to receive the fixed rate and
pay the floating rate on a 3-year, 9%/LIBOR swap with a
NP of $10 million.
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Action
Receive LIBOR
Pay LIBOR
LIBOR
LIBOR
+9%
Net Receipt
9%
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Example:
If at the forward swaps expiration date, the rate on 3-year,
fixed rate bonds were at 8%, and the fixed rate on a 3-year
par value swap were at 8%, then the investment firm
would be able to sell its floating-payers position on the 3year 9%/LIBOR swap underlying the forward swap
contract to a swap bank for $262,107 (using the YTM
approach with a discount rate of 8%):
(.09 / 2) (.08 / 2)
SV
$10,000,000 $262,107
t
t 1 (1 (.08 / 2))
fl
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Swaptions
If the holder exercises, she takes the swap position, with the
swap seller obligated to take the opposite counterparty
position.
Swaptions
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Swaptions
Swaptions can be either European or
American:
A European swaption can be exercised only at a
specific point in time, usually just before the
starting date on the swap.
An American swaption is exercisable at any point
in time during a specified period of time.
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Swaptions
Swaptions
Like interest rate and debt options, swaptions
can be used for:
1. Speculating on interest rates
2. Hedging debt and asset positions against market
risk
3. Combined with other securities to create
synthetic positions
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Swaptions: Speculation
Suppose a speculator expects the rate on high
quality, 5-year fixed rate bonds to increase from
their current 8% level.
As an alternative to a short T-note futures
position or an interest rate call, the speculator
could buy a payer swaption.
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Swaptions: Speculation
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Swaptions: Speculation
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Swaptions: Speculation
(.09 / 2) (.08 / 2)
($10,000,000)
t
t 1 (1 (.09 / 2))
Value of Swap $395,636
Value of Swap
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If the swap rate at the expiration date were less than 8%,
then the payer swaption would have no value and the
speculator would simple let it expire, losing the premium
she paid.
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Swaptions: Speculation
t
(1 (R / 2))
t 1
10
For rates, R, on par value 5-year swaps exceeding the exercise rate of
8%, the value of the payer swaption will be equal to the present value of
the interest differential times the notional principal on the swap.
The next slide shows graphically and in a table the values and
profits at expiration obtained from closing the payer swaption on
the 5-year 8%/LIBOR swap given different rates at expiration.
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Swaptions: Speculation
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Swaptions: Speculation
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Swaptions: Speculation
(.08 / 2) (.07 / 2)
Value of Swap
($10,000,000) $415,830
t
t 1 (1 (.07 / 2))
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Swaptions: Speculation
Max[(.08 / 2) ( R / 2), 0]
($10,000,000)
t
(1 (R / 2))
t 1
For rates, R, on par value 5-year swaps less than the exercise rate of 8%,
the value of the receiver swaption will be equal to the present value of the
interest differential times the notional principal on the swap.
The next slide shows graphically and in a table the values and profits at
expiration obtained from closing the receiver swaption on the 5-year
8%/LIBOR swap given different rates at expiration.
Value of Swap
10
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Swaptions: Hedging
Like other option hedging tools, swaptions
give investors or borrowers protection
against adverse interest rate movements, but
still allow them to benefit if rates move in
their favor.
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Swaptions: Hedging
As a hedging tool, swaptions serve as a rateprotection tool:
As rates increase, the value of the payer swaptions
increases in value, making the payer swaption act as
a cap on the rates paid on debt positions.
As rates decrease, receiver swaptions increase in
value, making them act as a floor on the rates earned
from asset positions.
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Swaptions: Floor
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Swaptions: Floor
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Swaptions: Floor
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Swaptions: Floor
$30,000,000
1/ 6
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Swaptions: Floor
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Swaptions: Cap
Swaptions: Cap
To cap the rate, suppose the company purchases a 3year payer swaption on a 5-year, 9%/LIBOR generic
swap with notional principal of $60,000,000 from First
Bank for $200,000.
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Swaptions: Cap
$60,000,000
1/ 10
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Swaptions: Cap
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If the current swap rate exceeded the strike rate and the
bonds were put back to the issuer, the manager could
exercise his payer swaption to take the fixed payer
position at the strike rate and then sell the swap and use
the proceeds to defray part of higher financing cost of
buying the bonds on the put.
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Synthetic Positions
Synthetic Positions
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Cancelable Swap
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Cancelable Swap
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Cancelable Swap
Note:
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Cancelable Swap
A 5-year putable swap to receive 6% and pay LIBOR that is cancelable after
two years is equivalent to a floating position in a 5-year 6%/LIBOR generic
swap and a long position in a 2-year payer swaption on a 3-year 6%/LIBOR
swap.
5-year Putable Swap
Pay LIBOR and receive 6%
fixed rate
Cancelable after 2 years
After two years, the payer swaption gives the holder the right to take a fixedpayers position on a 3-year swap at 6% that offsets the floating position on
the 6% generic swap.
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Cancelable Swap
A 5-year callable swap to pay 6% and receive LIBOR that is cancelable after
two years would be equivalent to a fixed position in a 5-year 6%/LIBOR
generic swap and a long position in a 2-year receiver swaption on a 3-year
6%/LIBOR swap.
5-year Callable Swap
Pay 6% fixed Rate and
receive LIBOR
Cancelable after 2 years
After two years, the receiver swaption gives the holder the right to take a
floating-payers position on a 3-year swap at 6% that offsets the fixed-payers
position on the 6% generic swap.
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Extendable Swap
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Extendable Swap
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Extendable Swap
At the end of 3 years, the receiver swaption gives the holder the right to take
a floating-payers position on a 2-year swap at 6% which in effect extends
the maturity of the expiring floating position on the 6% generic swap.
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Extendable Swap
At the end of 3 years, the payer swaption gives the holder the right to take a
fixed-rate payers position on a 2-year swap at 6% which in effect extends
the maturity of the expiring fixed-payers position on the 6% generic swap.
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Non-Generic Swaps
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Non-Generic Swap
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Non-Generic Swap
For example, on an S&P 500/LIBOR swap, the equitypayer would agree to pay the 6-month rate of change
on the S&P 500 (e.g., proportional change in the index
between effective dates) times a NP in return for
LIBOR times NP, and the debt payer would agree to
pay the LIBOR in return for the S&P 500 return.
Non-Generic Swap
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Non-Generic Swap
Non-LIBOR Swap: Swaps with floating rates different than LIBOR. Example: Tbill rate, CP rate, or Prime Lending Rate.
2.
Delayed-Rate Set Swap allows the fixed payer to wait before locking in a fixed
swap rate the opposite of a forward swap.
3.
4.
Prepaid Swap: Swap in which the future payments due are discounted to the
present and paid at the start.
5.
Delayed-Reset Swap: The effective date and payment date are the same. The
cash flows at time t are determined by the floating rate at time t rather than the
rate at time t 1.
6.
Amortizing Swaps: Swaps in which the NP decreases over time based on a set
schedule.
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Set-Up Swap or Accreting Swap: Swaps in which the NP increases over time
based on a set schedule
8.
9.
Equity Swap: Swap in which one party pays the return on a stock index and the
other pays a fixed or floating rate.
10. Basis Swap: Swaps in which both rates are floating; each party exchanges
different floating payments: One party might exchange payments based on
LIBOR and the other based on the T-bill yield.
11. Total Return Swap: Returns from one asset are swapped for the returns on
another asset.
12. Non-U.S. Dollar Interest Rate Swap: interest-rate swap in a currency different
than U.S. dollar with a floating rate often different than the LIBOR: Frankfort
rate (FIBOR), Vienna (VIBOR), and the like.
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