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Swaps

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6.* Swaps 6.* 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 ... – PowerPoint PPT presentation

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Title: Swaps


1
Swaps
2
Nature of Swaps
  • A swap is an agreement to exchange cash flows at
    specified future times according to certain
    specified rules

3
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
  • Next slide illustrates cash flows

4
Cash Flows to Microsoft(See Table 6.1, page 127)
5
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

6
Intel and Microsoft (MS) Transform a
Liability(Figure 6.2, page 128)
5
5.2
Intel
MS
LIBOR0.1
LIBOR
7
Financial Institution is Involved(Figure 6.4,
page 129)

4.985
5.015
5.2
F.I.
MS
Intel
LIBOR0.1
LIBOR
LIBOR
Dealer spread .03 evenly split
8
Intel and Microsoft (MS) Transform an
Asset(Figure 6.3, page 128)

5
4.7
Intel
MS
LIBOR-0.25
LIBOR
9
Financial Institution is Involved(See Figure
6.5, page 129)

5.015
4.985
4.7
F.I.
MS
Intel
LIBOR-0.25
LIBOR
LIBOR
Dealer spread .03
10
The Comparative Advantage Argument (Table 6.4,
page 132)
  • AAACorp wants to borrow floating
  • BBBCorp wants to borrow fixed

11
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

12
Swap Design
  • Design the swap so AAAs borrowing rate equals
    the comparative disadvantage (CD) rate minus the
    gain
  • LIBOR .3 - .25
  • Do the same thing for BBB
  • BBBs rate with swap
  • 11.2 - .25
  • Now, draw the diagram

13
The Swap (Figure 6.6, page 132)

9.95
10
AAA
BBB
LIBOR1
LIBOR
The floating rate leg should be LIBOR

14
Swap Design with FI
  • Adjust swap gain for dealer spread
  • Suppose dealer spread .04
  • Then gain
  • G (1.2 - .7 - .04)/2 .23
  • AAAs rate with swap
  • LIBOR .3 - .23 LIBOR .07
  • BBBs rate with swap
  • 11.2 - .23 10.97
  • Draw swap diagram

15
The Swap when a Financial Institution is Involved
(Figure 6.7, page 133)

9.93
9.97
10
AAA
F.I.
BBB
LIBOR1
LIBOR
LIBOR
Check that dealer spread .04
16
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 LIBOR0.3 and LIBOR1 rates available in
    the floating rate market are six-month rates
  • BBBCorps fixed rate depends on the spread above
    LIBOR it borrows at in the future

17
Valuation of an Interest Rate Swap
  • 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 with the
    same par value
  • Par values will cancel at maturity

18
Swap Valuation
  • Fixed Receive Vswap Vfixed Vfloating
  • Fixed Pay Vswap Vfloating - Vfixed
  • The fixed rate bond is valued using the term
    structure of interest rates
  • The floating rate stream is valued by noting that
    it is worth par immediately after the next
    payment date

19
Floating Rate Bond
  • To create a floating rate bond, invest principal
    value in 6-month LIBOR
  • At the end of 6-months, pay the interest and
    reinvest the principal value at the new 6-month
    LIBOR
  • At maturity pay last interest payment and
    principal value
  • Therefore, the cost of a floating rate bond is
    the principal value
  • It always sells for its par value immediately
    after interest payment

20
Swap Valuation
  • The swap is structured such that initial value is
    zero to either party
  • Set Vswap 0
  • Vfixed Vfloating M
  • Since the bond is selling at par, CR C/M y
  • For the swap to have zero value the fixed rate
    must equal the yield to maturity on a par bond
  • The swap rate is the coupon rate on a fixed rate
    bond that causes it to be worth par

21
Example
  • Zero coupon LIBOR curve is 5, 6, and 7 for
    one, two, and three years
  • What is the swap rate on a three year interest
    rate swap?
  • Assume payments are annual and yields are
    compounded annually
  • Solve for LIBOR par yield
  • M CRxM(d1 d2 d3) Md3

22
Example Continued
  • Solution

23
Interest Rate Risk
  • Receive Fixed Vswap Vfixed Vfloating
  • Pay Fixed Vswap Vfloating Vfixed

24
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

25
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

26
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

27
The Cash Flows (Table 6.6, page 140)
Dollars
Pounds


Years
------millions------
0
15.00
10.00
1.20
1
1.10
2
1.20
1.10
3
1.20
1.10
4
1.20
1.10
5
16.20
-11.10
28
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

29
Comparative Advantage Arguments for Currency
Swaps (Table 6.7, page 141)
  • General Motors wants to borrow AUD
  • Qantas wants to borrow USD

30
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

31
Comparative Advantage
  • Gain per party G (2 - .4)/2 .8
  • GMs rate with swap 12. 6 - .8 AUD 11.8
  • Qantas rate with swap 7 - .8 USD 6.2

32
Qantas Assumes Exchange Rate Risk
USD 5
USD 5
AUD 13
GM
Qantas
AUD 11.8
33
GM Assumes Exchange Rate Risk
USD 6.2
USD 5
AUD 13
GM
Qantas
AUD 13.0
34
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
  • GMs rate with swap 12. 6 - .7 AUD 11.9
  • Qantas rate with swap 7 - .7 USD 6.3

35
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
36
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

37
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

38
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

39
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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