Derivatives (BU7508)

Class 2 & 3
SECTION 3 Mr Periklis Boumparis
SWAP S Trinity College
Dublin
Swaps

Overview

• Interest Rate Swaps

• Currency Swaps
• Other Types of Swaps
• Credit Derivatives
• Securitization and the credit crisis
Swaps

Introduction
• A swap is an over the counter agreement between 2 firms to exchange cash flows
in the future according to a pre-arranged formula.
• The agreement defines when and how cash flows are to be paid. Usually the
calculation involves the future value of an interest rate, an exchange rate or other
market variables.
• A forward contract can be viewed as a simple example of a swap.
• The 2 most common types of swaps are plain vanilla interest rate swaps and
fixed-for-fixed currency swaps.
Swaps
Interest Rate Swaps

Interest rate swaps

• Plain vanilla interest rate swap: A firm agrees to pay cash flows equal to fixed interest
rate payments on a notional principal for a number of years. In return, it receives
floating interest rate payments on the same notional principal for the same period of
time. The floating rate in most interest rate swaps is the London Interbank Offered
Rate (LIBOR)*.

*Interest rate at which a bank is prepared to deposit money with other banks that have an AA credit
rating
Swaps
Interest Rate Swaps

Interest rate swaps

Example
Consider a hypothetical 3 year swap initiated on 5 March, 2009 between Microsoft
and Intel.
• Microsoft agrees to pay Intel 5% per annum (semi-annually compounded) every 6
months on a notional principal of $100 million.
• Intel agrees to pay Microsoft the 6 month LIBOR on the same principal. Note that
the $100 million never changes hands – it is used only for the calculation of
interest payments
5.0%
Microsoft Intel
Libor
Swaps
Interest Rate Swaps

Cash Flows to Microsoft

Only net cash flows
will change hands ---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar.5, 2009 4.2%
The principal never
changes hands – it is Sept. 5, 2009 4.8% +2.10 –2.50 –0.40
the same for both Mar.5, 2010 5.3% +2.40 –2.50 –0.10
sides so exchanging
principals will not Sept. 5, 2010 5.5% +2.65 –2.50 +0.15
affect cash flows
Mar.5, 2011 5.6% +2.75 –2.50 +0.25
Sept. 5, 2011 5.9% +2.80 –2.50 +0.30
Mar.5, 2012 6.4% +2.95 –2.50 +0.45
Swaps
Interest Rate Swaps
Using the swap to transform a
liability
A swap can be regarded as changing a fixed for a floating rate loan.
 Microsoft has arranged to borrow $100m at LIBOR plus 0.1%. After entering the
swap, it has the following 3 cash flows.
1. It pays LIBOR plus 0.1% to its outside lenders.
2. It receives LIBOR under the terms of the swap
3. It pays 5% under the term of the swap

Result: Microsoft transformed borrowing at a floating rate of LIBOR plus 0.1% into
borrowing at a fixed rate of 5.1%
Swaps
Interest Rate Swaps
Using the swap to transform an
asset
The swap could have the effect of transforming an asset earning a fixed rate of
interest into an asset earning a floating rate of interest.
 Suppose Microsoft owns $100m bond that provide 4.7% over the next 3 years.
After entering the swap, it has the following 3 cash flows.
1. It receives 4.7% on the bonds .
2. It receives LIBOR under the terms of the swap
3. It pays 5% under the term of the swap

Result: Microsoft transformed an asset earning 4.7% into an asset earning LIBOR-
0.3%
Swaps
Interest Rate Swaps

Financial Intermediary
• A financial intermediary is typically involved in the swap, earning about 3 or 4
basis points (0.03% or 0.04%).
• The financial intermediary enters into 2 offsetting swap transactions with Intel
and Microsoft in the example.
• If the financial institution charges 3 basis points, it makes a profit of $30,000 per
year for the 3 year swap.
• If one firm defaults, the financial institution still has to honour its agreement with
the other firm.

5.015% 4.985%
Microsoft F.I Intel
Libor Libor
Swaps
Interest Rate Swaps

Market makers

• Many large financial institutions act as market makers for swaps.

• This means that they enter into swaps without having offsetting swaps with other
parties.
• Market makers must carefully quantify and hedge the risks they are taking.
• Bonds, forward rate agreements and interest rate futures are examples of
instruments that can be used for hedging by swap market makers.
Swaps
Interest Rate Swaps
The comparative advantage
argument

The popularity of swaps is commonly explained using comparative advantages

arguments.
• Some companies have a comparative advantage when borrowing in the fixed
rate markets whereas other companies have a comparative advantage when
borrowing in floating rate markets.
Swaps
Interest Rate Swaps

Example
Example: Two firms AAACorp and BBBCorp, both want to borrow $10 million for
5 years and have been offered the rates shown below.
• AAACorp has a AAA credit rating and BBBCorp has a BBB credit rating.

Fixed Floating
AAACorp 4.0% 6-month LIBOR − 0.1%
BBBCorp 5.2% 6-month LIBOR + 0.6%
Swaps
Interest Rate Swaps

Example
• Note that the difference between the 2 fixed rates is greater than the difference
between the 2 floating rates.
• BBBCorp has a comparative advantage in floating rate markets while AAACorp
has a comparative advantage in fixed rate markets.
AAACorp borrows fixed at 4%.
BBBCorp borrows floating at LIBOR plus 0.6%.
They then enter a swap agreement where AAACorp agrees to pay BBBCorp
interest at 6 month LIBOR on $10 million and BBBCorp agrees to pay
AAACorp interest at a fixed rate of 4.35% per annum on $10 million.
Swaps
Interest Rate Swaps
4.35%
4%
AAACorp
Libor
AAACorp has 3 sets of interest rate cash
flows:
i. It pays 4% per annum to outside
lenders
ii.It receives 4.35% from BBBCorp
iii.It pays LIBOR to BBBCorp
The net effect is that AAACorp pays
LIBOR minus 0.35% per annum – 0.25%
per annum less than it would have paid if
it went directly to floating rate markets.
Libor+0.6%
BBBCorp
BBBCorp has 3 sets of interest rate
cash flows
i. It pays LIBOR + 0.6% per annum to
outside lenders
ii. It receives LIBOR from AAACorp
iii.It pays 4.35% per annum to AAACorp
The net effect is that BBBCorp pays
4.95% per annum – 0.25% per annum
less than if it went directly to fixed rate
markets
Swaps
Interest Rate Swaps

In this example, the net gain to both parties is the same – this may not always be
the case. When a financial institution is involved, the structure of the swap may be
as follows:
4.33% 4.37%
4% AAACorp BBBCorp LIBOR+0.6%
F.I.
LIBOR LIBOR
In this case, AAACorp ends up borrowing at LIBOR minus 0.33%, BBBCorp ends up
borrowing at 4.97% and the financial institution earns a spread of 4 basis points
per year.
The gain to AAACorp is 0.23%, the gain to BBBCorp is 0.23% and the gain to the
financial institution is 0.04%.
Swaps
Interest Rate Swaps

Criticism of the argument

• The spread between fixed and floating rates may not differ between firms.
• 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.
• The spread between the rates offered to AAACorp and BBBCorp are a reflection of
the extent to which BBBCorp is more likely to default.
• The likelihood of default is lower over the next 6 months than over the next 5
years.
Swaps
Interest Rate Swaps

Criticism of the argument

• BBBCorp obtains a fixed rate loan of 4.97%, but in reality, the rate paid is 4.97%
only if BBBCorp can continue to borrow floating rate funds at a spread of 0.6%
over LIBOR.
• If the credit rating of BBBCorp declines, the rate it pays increases.
• It appears that AAACorp locks in a rate of LIBOR minus 0.33% for 5 years (not just
6 months). This appears to be a good deal.
• The downside is that AAACorp is bearing the risk of a default by the financial
institution. If it borrowed floating rate funds in the usual way, it would not be
bearing this risk.
Swaps
Interest Rate Swaps

Valuation of Interest Rate Swaps

 An interest rate swap is worth zero, or close to zero, when it is first initiated.

 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.
Swaps
Interest Rate Swaps

Valuation in terms of bond prices

Principal payments are not exchanged in an interest rate swap. However, we can
assume that principal payments are both received and paid at the end of the swap
without changing its value.
Floating rate payer: a swap can be regarded as a long position in a fixed rate bond
and a short position in a floating rate bond.
 Vswap=Bfix-Bfl
Fixed rate payer: a swap can be regarded as a long position in a floating rate bond
and a short position in a fixed rate bond.
 Vswap=Bfix-Bfl
The fixed rate bond is valued in the usual way. The floating rate bond is valued by
noting that it is worth par (the notional principal) immediately after an interest
payment.
Swaps
Interest Rate Swaps

Example
• Swap involves paying 3% per annum (semi annually compounding) 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
• Interest rates for maturities of 3, 9, and 15 months are 2.8%, 3.2%, and 3.4%,
respectively
Swaps
Interest Rate Swaps

Example

  ¿   ¿   −0.028 ∗ 0.25
𝑒 −0.05
  ∗ 0.993

Value of swap is $0.5117 million

Swaps
Currency Swaps

Currency Swaps
• In its simplest form, a currency swap involves exchanging principal and fixed
interest payments on a loan in one currency for principal and fixed interest
payments on a loan in another currency.
• In a currency swap the principal is usually exchanged at the beginning and the
end of the swap’s life (in an interest rate swap the principal is not exchanged).
• Usually the principal amounts are chosen to be approximately equivalent using
the exchange rate at the swaps initiation.
• When they are exchanged at the end of the life of the swap, their values may be
quite different.
Swaps
Currency Swaps

Example

• Consider a hypothetical 5 year currency swap agreement between IBM and BP

entered into on 1 February 2007.
• Suppose IBM pays a fixed rate of interest of 5% in pounds and receives a fixed
rate of interest of 6% in dollars from BP.
• Interest rate payments are made once per year and the principal amounts are
$18 million and £10 million.
Swaps
Currency Swaps

The cash flows for IBM

At the outset, IBM Dollars Pounds
pays $18 million $ £
and receives £10 Yea ------millions------
million. r
2007 –18.00 +10.00 Each year, IBM
2008 +1.08 –0.50 receives $1.08 million
(6% of $18m) and
2009 +1.08 –0.50 pays £0.5 million (5%
2010 +1.08 –0.50 of £10m).
At the end of the 2011 +1.08 –0.50
swap, it pays £10 2012 +19.08 −10.50
million and receives
$18 million.
Swaps
Currency Swaps

Why would IBM do that?

1. Transform borrowing from one currency to another
• IBM can issue $18m dollar denominated bond at 6%.
• The swap transforms this transaction into a £10m pound denominated at 5%

2. Transform the nature of assets

• IBM can invest £10m in the UK to yield 5% per year, but feels that US dollar
will be strengthen against sterling and prefers a dollar denominated
investment.
• The swap transforms the UK investment into a $18 million investment in the
US yielding 6%
Swaps
Currency Swaps

Comparative Advantage

• Currency swaps can be motivated by comparative advantage.

• In the case of a currency swap, we are comparing the rates offered in 2 different
currencies, and it is more likely that the comparative advantages are genuine
(compared to an interest rate swap).
• One possible source of comparative advantage is tax.
Swaps
Currency Swaps

Example

Suppose General Electric wants to borrow 20m AUD and Quantas Airways wants to
borrow 15m USD in 0.75 exchange rate.

USD5.0% USD6.3%
USD5.0% General AUD8.0%
F.I. Quantas
Electric
AUD6.9% AUD8.0%
Swaps

Other types of swaps

The principal in a swap agreement can be varied throughout the term of the swap.

 Forward swaps – interest payments do not begin to change hands until a future
date.
 Step-up Swaps – the notional principal is an increasing function of time.
 Amortizing Swaps – the notional principal is a decreasing function of time.
Swaps

Other types of swaps

• Constant Maturity Swap (CMS) – agreement to exchange LIBOR rate for a swap
rate.
• Compounding Swaps – interest is compounded instead of being paid. There is
only one payment date at the end of the life of the swap.
• LIBOR-in-arrears swaps – the floating rate paid on a payment date equals the
rate observed on that date.
• Accrual swap – interest on one side of the swap accrues only when the floating
reference rate is in a certain range
• Equity Swaps – one party agrees to pay the return on an equity index applied to
a notional principal and the other agrees to pay a fixed or floating return on the
notional principal.
Swaps

Other types of swaps

Options
• Extendable swaps – one party has the option to extend the life of the swap.
• Puttable swaps – one party has the option to terminate the swap early.
• Swaptions – options on swaps – the right to enter a swap in the future.
Swaps

Other types of swaps

• Cancellable Swaps – a plain vanilla interest rate swap where one party has the
option to terminate on one or more payment dates.
• Index Amortizing Swaps (Indexed Principal Swap) – the principal reduces in a
way dependent on the level of interest rates. The lower the interest rate, the
greater the reduction in the principal.
• Commodity Swaps – series of a forward contracts on a commodity with different
maturity dates and same delivery prices
• Volatility swap – payments depend on the volatility of a stock or other asset.
CDS

Credit Derivatives
• Derivatives where the payoff depends on the credit quality of a company or sovereign
entity.
• Credit derivatives allow firms to trade credit risks in much the same way that they trade
market risks.
• Credit derivatives allow a lender or borrower to transfer the default risk of a loan to a
third party.
• Since the late 1990’s banks have been the biggest buyers of credit protection and
insurance firms have been the biggest sellers.
• During the 1990’s banks created products to pass loans (and their credit risk) on to
investors.
• Therefore, the financial institution bearing the credit risk of a loan is often different
from the financial institution that did the original credit checks.
CDS

Credit Default Swaps

The most popular credit derivative is CDS – a contract that provides insurance
against the risk of default by a particular company or country (the reference entity).
Example
• Suppose 2 parties enter into a 5 year CDS on 1 March, 2007. The notional
principal is $100 million and the buyer agrees to pay 90 bps annually for
protection against default by Company X.
• Premium is known as the credit default spread. It is paid for life of contract or
until default.
• If there is a default, the buyer has the right to sell bonds with a face value of
$100 million issued by company X for $100 million (Several bonds may be
deliverable).
CDS

CDS Structure

90 bps per year

Default Default
Protection Protection
Buyer, A Seller, B
Payoff if there is a default by
reference entity

LECTURE 2 & 3: SWAPS (DR. SHAEN CORBET,

TCD)
CDS

CDS spreads and bond yields

A CDS can be used to hedge a position in a corporate bond.
• Suppose an investor buys a 5-year corporate bond yielding 7% per year and at the
same time enters a 5-year CDS to buy protection against the issuer of the bond
defaulting.
• Suppose that the CDS spread is 200 bps (2%).
• The effect of the CDS is to convert the corporate bond to a risk free bond (at least
approximately).
• If the bond issuer defaults, the investor earns 5% up to the time of the default. She is
then able to exchange the bond for its face value, which can then be invested at the
risk free rate for the remainder of the 5 years.
• This shows that CDS spreads should be approximately the same as bond yield
spreads.
CDS

CDS spreads and bond yields

A CDS is like insurance on bonds, but different from insurance in important ways:
Insurance companies make sure you own the asset you are insuring, but you
can buy credit default swaps for bonds you do not own. One estimate claims
that up to 80% of CDSs are thought to be naked (The Economist)
The insurance market is highly regulated
Insurance companies must have enough money in case lots of people need to
collect insurance at the same time. CDS sellers do not have to be as careful.
Securitization

Securitization and the credit crisis of

2007
• Derivatives such as forwards, futures, swaps, and options are concerned with
transferring risk from one entity in the economy to another.
• Securitization is of particular interest because of its role in the credit crisis that
started in 2007.
• The crisis had its origins in financial products created from mortgages in the
United States, but rapidly spread from the United States to other countries and
from financial markets to the real economy.
• Some financial institutions failed. Many more had to be rescued by national
governments.
• There can be no question that the first decade of the twenty-first century was
disastrous for the financial sector.
Securitization

Securitization and the credit crisis of

2007
• Traditionally, banks have funded their loans primarily from deposits.
• In the 1960s, US banks found that they could not keep pace with the demand for
residential mortgages with this type of funding.
• This led to the development of the mortgage-backed security (MBS) market. A
mortgage-backed security (MBS) is an asset-backed security or debt obligation
that represents a claim on the cash flows from mortgage loans, most commonly
on residential property.
• An asset backed security (ABS) is financial security backed by a loan, lease or
receivables against assets other than real estate and mortgage-backed securities.
For investors, asset-backed securities are an alternative to investing in corporate
debt.
Securitization

Securitization and the credit crisis of

2007
• An ABS is essentially the same thing as an MBS, except that the securities backing
it are assets such as loans, leases, credit card debt, a company's receivables,
royalties and so on, and not mortgage-based securities.
• Portfolios of mortgages were created and the cash flows (interest and principal
payments) generated by the portfolios were packaged as securities and sold to
investors.
• The US government created the Government National Mortgage Association
(GNMA, also known as Ginnie Mae) in 1968. This organization guaranteed (for a
fee) interest and principal payments on qualifying mortgages and created the
securities that were sold to investors.
Securitization

Securitization and the credit crisis of

2007
• Thus, although banks originated the mortgages, they did not keep them on their
balance sheets. Securitization allowed them to increase their lending faster than
their deposits were growing. GNMA’s guarantee protected MBS investors against
defaults by borrowers.
• In the 1980s, the securitization techniques developed for the mortgage market
were applied to asset classes such as automobile loans and credit card
receivables in the United States.
• Securitization also become popular in other parts of the world.
• As the securitization market developed, investors became comfortable with
situations where they did not have a guarantee against defaults by borrowers.
Securitization

ABS
A portfolio of income- Senior Tranche
producing assets such Principal: $80 million
as loans is sold by the Asset 1 Return = LIBOR + 60bp
originating banks to a Asset 2
special purpose vehicle Asset 3
(SPV) and the cash
Mezzanine Tranche
flows from the assets  SPV Principal:$15 million
are then allocated to Return = LIBOR+ 250bp
tranches.
Asset n

Principal:
$100 million More likely to lose Equity Tranche
part of its principle
Principal: $5 million
and less likely to
receive the Return =LIBOR+2,000bp
promised interest
payment
Securitization

Waterfall in an ABS
Asset
Cash
Flows

Senior Tranche

Mezzanine Tranche
Securitization

Waterfall in an ABS
• A separate waterfall is applied to interest payments and the repayments of principal on
the assets.
• Principal repayments are allocated to the senior tranche until its principal has been fully
repaid.
• They are then allocated to the mezzanine tranche until its principal has been fully repaid.
• Only after this has happened do principal repayments go to the equity tranche.
• Interest payments are allocated to the senior tranche until the senior tranche has received
its promised return on its outstanding principal.
• Assuming that this promised return can be made, interest payments are then allocated to
the mezzanine tranche.
• If the promised return to the mezzanine tranche can be made and cash flows are left over,
they are allocated to the equity tranche.
Securitization

ABS of ABS
The mezzanine tranche is
repackaged with other mezzanine
tranches

Assets Senior Tranche (80%)

AAA

Senior Tranche (65%)

AAA
Mezzanine Tranche (15%)
BBB

Mezzanine Tranche (25%)

BBB

Equity Tranche (5%)

Not Rated

Equity Tranche (10%)

Securitization

Securitization and the credit crisis of

2007
• It sounds as though the equity tranche has the best deal, but this is not necessarily the
case.
• The payments of interest and principal are not guaranteed.
• The equity tranche is more likely to lose part of its principal, and less likely to receive
the promised interest payments on its outstanding principal, than the other tranches.
• Cash flows are allocated to tranches by specifying what is known as a waterfall.
• The extent to which the tranches get their principal back depends on losses on the
underlying assets. The effect of the waterfall is roughly as follows. The first 5% of losses
are borne by the equity tranche. If losses exceed 5%, the equity tranche loses all its
principal and some losses are borne by the principal of the mezzanine tranche. If losses
exceed 20%, the mezzanine tranche loses all its principal and some losses are borne by
the principal of the senior tranche.
Securitization

Securitization and the credit crisis of

2007
• Cash flows go first to the senior tranche, then to the mezzanine tranche, and
then to the equity tranche. The other is in terms of losses.
• Losses of principal are first borne by the equity tranche, then by the mezzanine
tranche, and then by the senior tranche.
• Rating agencies such as Moody’s, S&P, and Fitch played a key role in
securitization. The ABS in the previous Figure is designed so that the senior
tranche is rated AAA. The mezzanine tranche is typically rated BBB. The equity
tranche is typically unrated.
Securitization

What went wrong?

250.00

200.00

150.00

100.00

U.S. Real Estate Prices, 1987 to 2016: S&P/Case-

50.00 Shiller Composite-10 Index

0.00
8 7 9 0 9 3 9 6 9 9 0 2 0 5 0 8 1 1 1 4
Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan
Securitization

What went wrong?

•It shows that, in about the year 2000, house prices started to rise much faster than
they had in the previous decade.
•The very low level of interest rates between 2002 and 2005 was an important
contributory factor, but the bubble in house prices was largely fuelled by
mortgage-lending practices.
•Starting in 2000, mortgage originators in the US relaxed their lending standards
and created large numbers of subprime first mortgages.
•Subprime mortgages are mortgages that are considered to be significantly more
risky than average.
•Before 2000, most mortgages classified as subprime were second mortgages.
•After 2000, this changed as financial institutions became more comfortable with
the notion of a subprime first mortgage.
Swaps

Learning Outcomes

• How and why interest rate and currency swaps used

• What is the meaning of the comparative advantage
• What is a credit derivative
• What is securitization and how it contributed to financial crisis