SWAPS
Prof. (Dr.) Ajay Kumar Yadav
6.2
Nature of Swaps
A swap is an agreement to exchange cash flows at
specified future times as per the terms of
agreement between the contracting parties.
TYPES OF SWAPS
• Interest Rate Swap
• Equity Swap
• Currency Swap
• Commodity Swap
6.4
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
6.5
Cash Flows to Microsoft
---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar.1, 1998 4.2%
Sept. 1, 1998 4.8% +2.10 –2.50 –0.40
Mar.1, 1999 5.3% +2.40 –2.50 –0.10
Sept. 1, 1999 5.5% +2.65 –2.50 +0.15
Mar.1, 2000 5.6% +2.75 –2.50 +0.25
Sept. 1, 2000 5.9% +2.80 –2.50 +0.30
Mar.1, 2001 6.4% +2.95 –2.50 +0.45
Typical Uses of an Interest Rate Swap
• Converting a liability • Converting an
from investment from
• fixed rate to • fixed rate to floating
floating rate rate
• floating rate to • floating rate to fixed
fixed rate rate
6.6
6.7
Intel and Microsoft (MS) Transform a Liability
5%
5.2%
Intel MS
LIBOR+0.1%
LIBOR
6.8
Financial Institution is Involved
4.985% 5.015%
5.2%
F.I. MS
Intel
LIBOR+0.1%
LIBOR LIBOR
Dealer spread = .03% evenly split
6.9
Intel and Microsoft (MS) Transform an Asset
5%
4.7%
Intel MS
LIBOR-0.25%
LIBOR
6.10
Financial Institution is Involved
4.985% 5.015%
4.7%
Intel F.I. MS
LIBOR-0.25%
LIBOR LIBOR
Dealer spread = .03 %
6.11
The Comparative Advantage Argument
• AAACorp wants to borrow floating
• BBBCorp wants to borrow fixed
Fixed Floating
AAACorp 10.00% 6-month LIBOR + 0.30%
BBBCorp 11.20% 6-month LIBOR + 1.00%
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 AAA’s borrowing rate equals the
comparative disadvantage (CD) rate minus the gain:
• LIBOR + .3 - .25
• Do the same thing for BBB
• BBB’s rate with swap: 11.2 - .25
• Now, draw the diagram
6.13
6.14
The Swap
9.95%
10%
AAA BBB
LIBOR+1%
LIBOR
The floating rate leg should be LIBOR
Question
• Bank A is a AAA-rated international bank located in the UK and wishes to
raise $10M to finance floating-rate Eurodollar loans.
• It would make more sense for the bank to issue floating-rate notes at LIBOR to
finance floating-rate Eurodollar loans.
• Bank A can issue 5-year fixed-rate Eurodollar bonds at 10 %
• Firm B is a BBB-rated U.S. company. It needs $10 M to finance an
investment with a five-year economic life.
• Firm B can issue 5-year fixed-rate Eurodollar bonds at 11.75 %
• Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at
LIBOR + 0.50 percent.
• Firm B would prefer to borrow at a fixed rate because it locks in a financing
cost.
The borrowing opportunities of the two firms are:
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
Question 2
• Company A has requirement for $ 12 million loan for which it is
evaluating its options. Since the companies credit rating is BB+
so the options available to it are as follows:
• Fixed interest loan @ 11%.
• Floating Interest loan @ LIBOR + 1.25%
• At the same time Company B enjoying credit rating of AA
requires a loan of $ 15 million and the terms applicable to him
are as follows:
• Fixed interest loan @ 10%
• Floating Interest Loan @ LIBOR + .25%
• Both the parties have approached the same Bank C
• Is there a Swap agreement possible between the two parties?
If yes calculate the benefits available to both the parties in %
terms and also $ terms.
Swap Design with FI
• Adjust swap gain for dealer spread
• Suppose dealer spread = .04%
• Then gain: G = (1.2 - .7 - .04)/2 = .23%
• AAA’s rate with swap: LIBOR + .3 - .23 = LIBOR + .07
• BBB’s rate with swap: 11.2 - .23 = 10.97%
6.17
6.18
The Swap when a Financial
Institution is Involved
9.93% 9.97%
10%
AAA F.I. BBB
LIBOR+1%
LIBOR LIBOR
Check that dealer spread = .04%
6.19
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 six-month rates
• BBBCorp’s fixed rate depends on the spread above LIBOR it
borrows at in the future
Currency Swap
6.22
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
6.23
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
6.24
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
6.25
The Cash Flows
Dollars Pounds
$ £
Years ------millions------
0 –15.00 +10.00
1 +1.20 –1.10
2 +1.20 –1.10
3 +1.20 –1.10
4 +1.20 –1.10
5 +16.20 -11.10
Typical Uses of a
Currency Swap
• Conversion from a • Conversion from an
liability in one investment in one
currency to a currency to an
liability in another investment in
currency another currency
6.26
6.27
Comparative Advantage Arguments for Currency
Swaps
General Motors wants to borrow AUD
Qantas wants to borrow USD
USD AUD
General Motors 5.0% 12.6%
Qantas 7.0% 13.0%
6.28
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
6.29
Comparative Advantage
• Gain per party: G = (2 - .4)/2
= .8%
• GM’s rate with swap: 12. 6 - .8 =
AUD 11.8%
• Qantas’ rate with swap: 7 - .8 = USD
6.2%
Qantas Assumes Exchange Rate Risk
USD 5%
USD 5%
AUD 13%
GM Qantas
AUD 11.8%
GM Assumes Exchange Rate Risk
USD 6.2%
USD 5%
AUD 13%
GM Qantas
AUD 13.0%
6.31
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%
• GM’s rate with swap:
12. 6 - .7 = AUD 11.9%
• Qantas’ rate with swap:
7 - .7 = USD 6.3% 6.32
FI Assumes Exchange Rate Risk
USD 5% USD 6.3%
USD 5%
GM F.I. Q
AUD 13%
AUD11.9% AUD 13%
Check that dealer spread = .2%
Pay: 13.0 – 11.9 = AUD 1.1%
Rcv: 6.3 – 5.0 = USD 1.3%
6.33
6.34
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
6.35
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
6.36
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
6.37
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
