The Swaps Market: Introduction

1
The Swaps Market Introduction

• 1. Definitions
• -- A swap involves two parties exchanging a set
  of cash flows in a predetermined manner. The
  exchange of cash flows is based upon a fixed
  notional principal.
• The two parties involved in the swap are called
  counterparties. If the counterparties do not
  arrange the swap themselves, the often seek a
  swap facilitator.

2
Plain vanilla interest rate swap

• The most common type of interest rate swap
  involves two companies exchanging a fixed rate
  contract for a floating rate contract.
• Suppose that two companies (AB) want to borrow
  10 million and A wants to borrow at a floating
  rate and B wants to borrow at a fixed rate. They
  are offered the following rates
• Company A Fixed 10 Floating 6-month LIBOR
  .3
• Company B Fixed 11.2 Floating 6-month
  LIBOR 1.0

3
Plain vanilla interest rate swap

• Clearly, company A must have a higher credit
  rating than company B. Notice, however, that
  company B pays 1.2 more than company A in the
  fixed market, but pays only .7 more in the
  floating market. This means company B has a
  comparative advantage in the floating rate
  market.
• What we will see is that the difference between
  As advantage in the fixed versus floating market
  (1.2 - .7 .5) is what can be saved by both
  firms by engaging in a swap.

4
Plain vanilla interest rate swap

• To execute the swap, A will borrow in the fixed
  market and B will borrow in the floating market.
  Then, B will pay A a fixed rate and A will pay B
  a floating rate, thereby creating the swap.
• The rates paid will be structured so that the
  companies will share equally in the benefits from
  the swap. Hence, each company should save .25.

5
Plain vanilla interest rate swap

• The transactions are as follows
• Company A
• Pays 10 per annum to outside lenders
• Pays Libor to company B
• Receives fixed rate payments of 9.95 from B
• Company B
• Pays LIBOR plus 1 to outside lenders
• Pays 9.95 to company A
• Receives LIBOR from company A.

6
Plain vanilla interest rate swap

• NET EFFECT
• Company A Pays LIBOR .05
• Company B Pays 10.95
• Both companies save .25 by engaging in the swap.
• In reality swap rates are quoted by banks.
  Individual companies examine their current debt
  position and determine if a swap would be
  beneficial.

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• If LIBOR was 8 and the notional principal was
  1,000,000 company B would owe a net payment of
  99,500 - 80,000 15,500 to A. The net
  payment represents the difference between the two
  obligations.

8
Plain vanilla currency swap

• The most common type of currency swap involves
  exchanging fixed-rate loan contracts denominated
  in different currencies. Thus, companies can
  exchange loans denominated in one currency for
  loans denominated in another currency.

9
Reasons for engaging in currency swaps

• 1. Exchange rate risk allocation
• a. In its simplest form, a currency swap allows
  a loan in one currency to be transformed to a
  loan in another currency.
• b. It may very well be that a company will
  desire to issue debt in a foreign currency due to
  its current exchange rate exposure in some other
  area of the company.
• c. A currency swap is a quick, cost effective
  way of transforming the companies obligations.

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Reasons for engaging in currency swaps

• 2. Regulatory barriers to capital flows
• a. Companies may be prevented from issuing debt
  in foreign currencies.
• b. A currency swap allows the company to
  circumvent such regulation.

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Example of a typical currency swap

• The most common type of currency swap involves
  exchanging fixed-rate loan contracts denominated
  in different currencies. Thus, companies can
  exchange loans denominated in one currency for
  loans denominated in another currency.

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Example of a typical currency swap

• 1. The following borrowing rates are available
  to two companies in the dollar market and the
  pound market
• Company A Dollar 8 Pound 11.6
• Company B Dollar 10 Pound 12.0
• 2. Like the plain vanilla interest rate swap,
  the amount that can be saved through a swap is
  2 - .4 1.6.

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Example of a typical currency swap

• 3. The swap should be structured so that both
  firms will share in the profits.
• 4. In this case, company A will borrow dollars
  while company B borrows pounds.
• 5. We assume that the principal, after
  accounting for differences in exchange rates will
  be the same. Also, principal amounts are also
  exchanged at the beginning and the ending of the
  swap.

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Example of a typical currency swap

• 6. The swap occurs when company B pays company
  A, 9.2 per year in dollars and company A pays B
  12 per year in pounds.
• 7. Company A makes 1.2 per year on the dollar
  payments and loses .4 per year on the pound
  payments.
• 8. Company B saves .8 per year on its interest
  payments on the dollar.
• 9. Company A is now paying a fixed rate on a
  pound denominated note and company B is paying a
  fixed rate on a dollar denominated note.

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• Assume that the exchange rate is such that the
  principal amounts are equivalent when 15,000,000
  10,000,000 pounds. The net payment in this case
  would be the difference between the 1.2 million
  pounds and the 1.38 million dollars, after
  accounting for exchange rates.

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Why do people use derivatives

• Speculation
• Hedging Hedging is the more interesting of the
  two reasons for the use of derivative contracts.
  Corporation face risks in the form of changes in
  interest rates, changes in exchange rates, and
  changes in input (commodity ) prices. Thus, it
  is not surprising that most corporation cite
  hedging as the reason that they use derivative
  contracts.

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Why would a company choose to hedge

• Lets first consider what the value of the firm
  is

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Why would a company choose to hedge

• It is easy to see from this equation that
  expected cash flows must be increased or the
  firms discount rate must be decreased in order
  for the value of the firm to rise.
• It is somewhat unclear how hedging can affect a
  firms discount rate (or cost of capital).
• For now, will focus on how hedging can increase
  our expected cash flows.

19
Why would a company choose to hedge

• Hopefully, we remember that Modigliani and Miller
  (MM) showed us, in a perfect world, a firms
  financing choice will not affect the value of the
  firm.
• This also applies with hedging. Under the MM
  assumptions, hedging should have no effect on the
  value of the firm, since financing choice does
  not affect cash flows.
• Also, if we believe in portfolio theory, the
  riskiness of the firm is not important to
  investors since they can diversify on their own.

20
Why would a company choose to hedge

• In the real-world, there are taxes, bankruptcy
  costs, financing costs, and conflicts between
  different types of investors. It is in these
  market imperfections that a firm can increases
  its value by increasing its expected cash flows.

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Why would a company choose to hedge

• 1. Taxes Hedging can reduce a firms tax
  burden if the firm has a convex tax function.
  The best way to see this is through a simple
  example.
• Suppose that we have a firm that has a 50 chance
  of earning 10 million and a 50 chance of
  earning 100 million. Suppose that the firm
  faces a convex tax schedule such that 10million
  is taxed at 20, 55 million is taxed at 25, and
  100 million is taxed at 40.

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Why would a company choose to hedge

• 2. Reducing the probability of bankruptcy If a
  firm hedges its value, there is less of a chance
  that it will earn an income that would be
  insufficient to meet it obligations.
• a. Direct costs
• b. Indirect costs
• c. Reduction of agency costs

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Why would a company choose to hedge

• 3. Reducing the cost of financing If a firm
  can maintain a more constant cash flow stream, it
  is more likely that the firm will have cash on
  hand in order to finance projects.
• Going into the capital markets for financing is
  extremely expensive and not always feasible.
• Thus, by hedging and keeping cash flows constant,
  a firm has a higher probability of having the
  cash available to invest in positive NPV projects.