Swaps

Presentation on

Swaps

By

Dr B Brahmaiah

SwapsA contract between two parties to exchange two streams of payments for an agreed period of time.

The interest payments are calculated based on the underlying notionals using applicable rates.

Swaps are arranged in many different currencies and different periods of time.

US$ swaps are most common followed by Japanese yen, sterling and

SwapsThe swaps market has had an exceptional growth since its inception in 1979.

The swaps volume exceeds $10 trillion today.

Swaps not only often replace other derivative instruments such as futures and forwards, but also complement those products.

Why did swaps emerge?In the late 1970’s, the first currency swap was engineered to circumvent the currency control imposed in the UK.

back-to-back loans were used to exchange debts in different currencies.

A British company wanting to raise capital in France with a French company which was in a reciprocal position.

Back-to-back loans required drafting multiple loan agreements to state respective loan obligations with clarity.

FacilitatorsThe swaps dealer earns the difference between the amount received from a party and the amount paid to the other party.

The dealer would offset his risks by matching one swap with another to streamline his payments.

Swaps Market Participants

1. Banks

2. Multinational Companies

3. Sovereign and public sector institutions

4. Money Managers

Interest Rate Swaps

With its absolute advantage in the capital markets, Deutsche mark was able to receive floating rate below the London Interbank Offer Rate, (LIBOR.)

Coupon swaps are basically swaps contracts dealing with an exchange o a fixed rate payment stream for a floating rate one.

The counterparty who pays the fixed rate is referred to as the payer or buyer and the counterparty who pays the floating rate is called the receiver or the seller.

Since the notional principal is an identical amount in the same currency, the actual principal is not exchanged. If the payment schedules are identical, only the difference between the two payments is delivered.

Currency SwapsCurrency swaps are also used to lower the risk of currency exposure or to change returns on investment into another, more favourable currency.

Currency swaps are used to exchange assets or capital in one currency for another for the purpose of financial management.

A currency swap transaction involves an exchange of a major currency against the U.S. dollar.

In order to swap two other non-U.S currencies, a dealer may need to arrange two separate swaps.

currency swaps involve the exchange of two or more types of currencies.

The actual excahange of principals takes place at the commencement and the termination of the swaps.

Principals and interest payments are exchanged based on the spot rate agreed at the inception of the swaps.

The uses of currency swaps are:

1. Lowering funding cost

2. Entering restricted capital markets

3. Reducing currency risk

4. Supply-demand imbalances in the markets

Many variants of the plain vanilla currency swaps were created to meet some of the common financial management needs.

Different kinds of Swaps

1. Amortizing and Accreting SwapsThe notional principals of an amortizing swap decrease one or more times during the tenor of the swap.

Accreting swaps are swaps with increasing notional principals.

2. Forward SwapsCoupons are set on the transaction date.

However the swap does not start until the given date.

The interest accrual commences on the given date based on interest rates set on the transaction date.

3. Reversible Swaps Counterparties of reversible swaps change their roles one or more times during the duration of the swap.

The payer becomes the receiver and the receiver becomes the payer

4. Basis Swaps

Basis swaps are swaps on which both counterparties pay floating rate.

Each counterparty’s interest payments are tied to different floating rate indices.

Some of the indices are 3 months, 6 months LIBOR, T-bill rate, and the US commercial paper rate.

Non-par swaps : The market value of the swap at initiation is not zero, and therefore one party pays the other at the beginning of the contract.

Forward or deferred swaps : The exchange of net interest payments does not begin until some point in the future.

Arrears-reset swaps : The floating rate is set and paid at the end of the period.

5. Amortizing currency swaps

The notional principals of these swaps are scheduled to decrease over the life of the swaps.

6. Accreting currency swaps

The notional principals of these swaps increase periodically. Principals are exchanged as scheduled.

7. Floating-for-floating rate currency swaps

This swap involves the exchange of a a floating interest rate payment schedule in one currency against another floating interest rate payment schedule in another currency.

ExampleConsider Company A and Company B who have entered into a $100-million interest rate swap in which A commits to pay a fixed rate and B commits to pay a floating rate for the next three years (called the “maturity” or “tenor” of the swap.

Assume that A’s fixed rate is 5% and B’s floating rate (called the “reference rate”) is the 6-month London Interbank Offered Rate (6-month LIBOR).

Every six months, A pays B the fixed 5% rate (adjusted for semiannual payments) on $100 million (the notional amount), or $2.5 million.

At the same time, B pays to A the then-prevailing 6-month LIBOR rate on $100 million. The two opposing payments under the swap are netted so that only the difference between them is paid semiannually.

In a standard “par swap”, the market value of the swap at the time of inception is zero, so no cash is exchanged when the swap is first arranged.

No principal would be exchanged between the counterparties either at the initiation or at the maturity of the swap.

The semiannual cash flows of the above swap can be represented.

Company BCompany A

1/2 x 5% x $100 mm = $2.5 million

1/2 x 6 month LIBOR x $100 mm

Swap Cash Flow

Asset SwapsAssets swaps are used to change the characteristics of an asset.

Asset swaps are not only used by investors to change the characteristics of their investments, but also by banks to create synthetic investment packages for their clients.

A bank purchases a bond which can be converted into a more desirable asset. Then the bank arranges a currency swap with the purchased bond and puts together an investment package.

Investor

Potential Counterparty

Dealer

Bond

6M US$ LIBOR

FF 6.50%

FF 7.00%

FF 6.45%

6M US$ LIBOR

Commodity Swaps

A corn producer wanting to receive fixed unit price payments for a given amount of corn produced may enter into a swap to receive payments from a counterparty who wants to pay a fixed unit price for a given amount of corn bought.

Dealers involve multiple counterparties to complete their books as well as use futures to hedge their open position.

Swaps are arranged with swaps dealers to arrive at a desired outcome, but the transactions of the actual goods are performed in the cash markets.

Equity SwapsEquity swaps are used to hedge the downside risk of the market.

Equity swaps involve a counterparty exchanging scheduled payments based on the total return, including the capital appreciation and dividend, of a market index for fixed rate payments.

The notional principal, tenor and payment schedule are specified.

For instance a NIFTY Index correlated portfolio holder can make periodical payments based on the NIFTY Index return to receive fixed rate payments.

Swap DocumentationSwaps agreements are usually initiated over the phone.

The phone agreement is confirmed, usually within 24 hrs., by a telex, fax or letter.

The agreement is not final until proper documentation covering all the relative issues are exchanged and signed by counterparties.

The documentation of swaps was standardized by new York based International Swap and Derivatives Association (ISDA), British Bankers’ Association (BBA) and Australian Bankers’ Association (ABA) code 1987, standard forms of agreements.

The documentation covers the following issues.

1. Payments : Payment terms specifies payment dates, currency, interest rates, and the amount of notional principals.

2. Representations: Each party provides representations to each other by validating that they have the authority to enter into the swap agreement and that they are free of certain events such as being in default or in a litigation suit.

3. Agreements : This section is supplemental to the master agreement and provides for the furnishing of financial statements.

Risks Associated With Swaps

1. Interest rate risk

2. Exchange rate risk

3. Default risk

4. Sovereign risk

5. Mismatch risk

6. Basis risk

7. Capital requirement

Under the Basle Accord, dealers of swaps and other off-balance sheet instruments are imposed risk-adjusted capital requirements.

Capital requirements for swaps are ascertained according to the following steps.

The add-on-amount is calculated by multiplying the notional amount by the add-on-factor.

Sassy Threads

Dealer6M US$ LIBOR

Fixed Rate 7.0%

Sassy Threads

Dealer Counterparty1Y US$LIBOR

Fixed Rate 7.0%

6M US$LIBOR

Fixed Rate 7.3%

1Y US$LIBOR 6M US$

LIBOR

Treasury

Japanese Co.

Counterparty ADealer

Counterparty B

Fixed DM

6M US$LIBOR

Fixed DM

FixedYen

FixedYen

6M US$LIBOR

1. Interest Payment Flow

Kithirst

Fesserus Bank

Fesserus Bank

Kithirst

Fixed EUP 6.35%

6M US$ LIBOR

EUP 12,000,000

US$ 18,000,000

2. Principal exchange at the maturity date

Investor Eurobond

Potential Counterparty

LIBOR6.50% s.a.

LIBOR+20% 7.07% s.a.

Investor Bank

Potential CounterpartyEurobond

LIBOR

Fixed 6.5% s.a

7.07% s.a.6.45% s.a

LIBOR

Typical Uses of anInterest 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

The Comparative Advantage Argument (Table 7.4, page 157)

AAACorp wants to borrow floating BBBCorp wants to borrow fixed

Fixed Floating

AAACorp 4.0% 6-month LIBOR + 0.30%

BBBCorp 5.20% 6-month LIBOR + 1.00%

The Nature of Swap Rates

Six-month LIBOR is a short-term AA borrowing rate

The 5-year swap rate has a risk corresponding to the situation where 10 six-month loans are made to AA borrowers at LIBOR

This is because the lender can enter into a swap where income from the LIBOR loans is exchanged for the 5-year swap rate

Using Swap Rates to Bootstrap the LIBOR/Swap Zero Curve Consider a new swap where the fixed rate is

the swap rate When principals are added to both sides on the

final payment date the swap is the exchange of a fixed rate bond for a floating rate bond

The floating-rate rate bond is worth par. The swap is worth zero. The fixed-rate bond must therefore also be worth par

This shows that swap rates define par yield bonds that can be used to bootstrap the LIBOR (or LIBOR/swap) zero curve

Valuation of an Interest Rate Swap that is not New

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

Alternatively, they can be valued as a portfolio of forward rate agreements (FRAs)

Valuation in Terms of Bonds

The fixed rate bond is valued in the usual way

The floating rate bond is valued by noting that it is worth par immediately after the next payment date

Valuation in Terms of FRAs

Each exchange of payments in an interest rate swap is an FRA

The FRAs can be valued on the assumption that today’s forward rates are realized

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

Exchange of Principal

In an interest rate swap the principal is not exchanged

In a currency swap the principal is usually exchanged at the beginning and the end of the swap’s life

The Cash Flows (Table 7.7, page 166)

Year

Dollars Pounds$

------millions------

2004 –15.00 +10.002005 +0.60 –0.70

2006 +0.60 –0.70 2007 +0.60 –0.70

2008 +0.60 –0.70 2009 +15.60 −10.70

£

Typical Uses of a Currency Swap

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

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

Comparative Advantage Arguments for Currency Swaps (Table 7.8, page 167)

General Motors wants to borrow AUD

Qantas wants to borrow USD

USD AUD

General Motors 5.0% 12.6%

Qantas 7.0% 13.0%

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

Swaps & Forwards

A swap can be regarded as a convenient way of packaging forward contracts

The “plain vanilla” interest rate swap in our example (slide 7.4) consisted of 6 FRAs

The “fixed for fixed” currency swap in our example (slide 7.22) consisted of a cash transaction & 5 forward contracts

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

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

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……..

Valuation of Swaps

The standard approach is to assume that forward rates will be realized

This works for plain vanilla interest rate and plain vanilla currency swaps, but does not necessarily work for non-standard swaps

Variations on Vanilla Interest Rate Swaps Principal different on two sides Payment frequency different on two sides Can be floating-for-floating instead of floating-

for-fixed It is still correct to assume that forward rates

are realized How should a swap exchanging the 3-month

LIBOR for 3-month CP rate be valued?

Compounding Swaps (Business Snapshot 30.2, page 699)

Interest is compounded instead of being paid Example: the fixed side is 6% compounded

forward at 6.3% while the floating side is LIBOR plus 20 bps compounded forward at LIBOR plus 10 bps.

This type of compounding swap can be valued using the “assume forward rates are realized” rule. This is because we can enter into a series of forward contracts that have the effect of exchanging cash flows for their values when forward rates are realized.

Currency Swaps

Standard currency swaps can be valued using the “assume forward LIBOR rate are realized” rule.

Sometimes banks make a small adjustment because LIBOR in currency A is exchanged for LIBOR plus a spread in currency B

More Complex Swaps

– LIBOR-in-arrears swaps– CMS and CMT swaps– Differential swaps

These cannot be accurately valued by assuming that forward rates will be realized

LIBOR-in Arrears Swap (Equation 30.1, page 701)

Rate is observed at time ti and paid at time ti rather than time ti+1

It is necessary to make a convexity adjustment to each forward rate underlying the swap

Suppose that Fi is the forward rate between time ti and ti+1 and i is its volatility

We should increase Fi by

when valuing a LIBOR-in-arrears swap

ii

iiiii

F

tttF

1

)( 122

CMS swaps

Swap rate observed at time ti is paid at time ti+1

We must – make a convexity adjustment because

payments are swap rates (= yield on a par yield bond)

– Make a timing adjustment because payments are made at time ti+1 not ti

See equation 30.2 on page 702