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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