Swaps
Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008
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
5%
INTEL LIBOR MICROSOFT
Cash Flows to Microsoft
---------Millions of Dollars--------LIBOR FLOATING FIXED Net
Date
Mar.5, 2004 Sept. 5, 2004 Mar.5, 2005 Sept. 5, 2005 Mar.5, 2006 Sept. 5, 2006 Mar.5, 2007
Rate
4.2% 4.8% 5.3% 5.5% 5.6% 5.9%
Cash Flow Cash Flow Cash Flow
+2.10 +2.40 +2.65 +2.75 +2.80 +102.95 2.50 2.50 2.50 2.50 2.50 102.50 0.40 0.10 +0.15 +0.25 +0.30 +0.45
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
Microsoft has arranged $100m borrowing at LIBOR+0.1% INTEL has $100m loan outstanding and pays fixed rate of 5.2 5% 5.2%
Intel
LIBOR
MS
LIBOR+0.1%
Financial Institution is Involved
4.985% 5.2%
5.015%
Intel
LIBOR
F.I.
LIBOR
MS
LIBOR+0.1 %
Financial Institution has two offsetting swaps
Intel and Microsoft (MS) Transform an Asset
Microsoft has $100m worth of bonds that provides interest at 4.7% per annum INTEL has an investment of $100m that yields LIBOR minus 20 basis points.
5%
4.7%
Intel
LIBOR-0.2% LIBOR
MS
Financial Institution is Involved
4.985%
5.015% 4.7%
Intel
LIBOR-0.2% LIBOR
F.I.
LIBOR
MS
The Comparative Advantage Argument
Liability Transformation:
Comparative advantage when borrowing in fixed markets Comparative advantage when borrowing in floating-rate markets
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Comparative Advantage
A corporation have access to Fixed or floating rate markets. Following table gives Fixed and Floating market rates if the corporation borrows Corporation Fixed Floating 6-month LIBOR + 0.3% 6-month LIBOR + 1.0%
AAA-Corporation 4.0% BBB-Corporation 5.2%
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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
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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..
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