Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 12: 1

Chapter 12: Swaps

Markets are an evolving ecology. New Markets are an evolving ecology. New risks arise all the time.risks arise all the time.

Andrew LoAndrew Lo

CFA MagazineCFA Magazine, March-April, 2004, p. , March-April, 2004, p. 3131

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Important Concepts in Chapter 12

The concept of a swapThe concept of a swap Different types of swaps, based on Different types of swaps, based on

underlying currency, interest rate, underlying currency, interest rate, or equityor equity

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Definition of a swapDefinition of a swap Four types of swapsFour types of swaps

CurrencyCurrency Interest rateInterest rate EquityEquity CommodityCommodity

Characteristics of swapsCharacteristics of swaps No cash up frontNo cash up front Notional principal (a measure of the size of a Notional principal (a measure of the size of a

swap or derivative stated in units of currency swap or derivative stated in units of currency on which the payments are calculated)on which the payments are calculated)

Settlement date, settlement periodSettlement date, settlement period Credit riskCredit risk Dealer marketDealer market

See See Figure 12.1, p. 409 for growth in world-wide 409 for growth in world-wide notional principalnotional principal

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Definition of a swapDefinition of a swap Swaps is a financial derivative in which 2 Swaps is a financial derivative in which 2

parties make series of payments to each other parties make series of payments to each other at specific dates.at specific dates.

While a forward contract is a single payment, While a forward contract is a single payment, a swap is a series of payments.a swap is a series of payments. E.g. In some cases, a party would like to E.g. In some cases, a party would like to

make a series of purchase, instead of a make a series of purchase, instead of a single purchase, from the other at fixed single purchase, from the other at fixed price at various date (different dates).price at various date (different dates).

Exclusively customized, over-the-counter Exclusively customized, over-the-counter instruments.instruments.

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Swaps & Forward contracts(Similarities)

Swaps are similar to forward contracts -fixed Swaps are similar to forward contracts -fixed payment or receive a floating payment at a payment or receive a floating payment at a future date. future date.

Both swaps and forward contracts require no Both swaps and forward contracts require no up front payments, and both are subject to up front payments, and both are subject to default risk. Thus, swaps have zero value at default risk. Thus, swaps have zero value at the start the start

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Swaps Vs. Forward contracts

SwapsSwaps Both sides of the first payment are Both sides of the first payment are

known. Also, for a swap, all of the fixed known. Also, for a swap, all of the fixed payments are the same. payments are the same.

Forward contracts Forward contracts each contract would be priced each contract would be priced

separately and would have different separately and would have different fixed ratesfixed rates

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Types of Swaps

Interest rate SwapsInterest rate Swaps Series of interest payments between two Series of interest payments between two

parties.parties. The two parties agree to exchange a The two parties agree to exchange a

series of interest payments in the same series of interest payments in the same currency at the various settlement dates.currency at the various settlement dates.

more widely used than currency and more widely used than currency and equity swaps, because nearly all equity swaps, because nearly all businesses face some form of interest businesses face some form of interest rate risk. rate risk.

A plain vanilla swap (a.k.a. vanilla swap) A plain vanilla swap (a.k.a. vanilla swap) is a swap in which on party pays a fixed is a swap in which on party pays a fixed rate & the other pays a floating raterate & the other pays a floating rate

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Interest rate Swaps

Interest rate swaps are the primary Interest rate swaps are the primary means of managing that risk means of managing that risk (interest rates risk). (interest rates risk).

A company will typically use interest A company will typically use interest rate swaps to limit, or manage, its rate swaps to limit, or manage, its exposure to fluctuations in interest exposure to fluctuations in interest rates, or to obtain a marginally lower rates, or to obtain a marginally lower interest rate.interest rate.

Widely used by corporations to Widely used by corporations to manage interest rate risk.manage interest rate risk.

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Interest Rate Swaps (continued)

Interest Rate Swap StrategiesInterest Rate Swap Strategies See Figure 12.5, p. 421 for example See Figure 12.5, p. 421 for example

of converting floating-rate loan into of converting floating-rate loan into fixed-rate loanfixed-rate loan

Other types of swapsOther types of swaps• Index amortizing swapsIndex amortizing swaps• Diff swapsDiff swaps• Constant maturity swapsConstant maturity swaps

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Types of swaps

Currency SwapsCurrency Swaps Involves the exchange of principal and Involves the exchange of principal and

interest in one currency for the same in interest in one currency for the same in another currency.another currency.

E.g. Supposed Malaysian based company E.g. Supposed Malaysian based company needs to acquired Japanese Yen and a needs to acquired Japanese Yen and a Japanese based company needs to acquire Japanese based company needs to acquire Malaysian Ringgit. These 2 companies could Malaysian Ringgit. These 2 companies could arrange to swap currencies by establishing arrange to swap currencies by establishing an interest rate, an agreed upon amount and an interest rate, an agreed upon amount and maturity date of exchange.maturity date of exchange.

Often combined with interest rate swaps.Often combined with interest rate swaps.

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Currency Swaps (continued)

Currency Swap StrategiesCurrency Swap Strategies A typical case is a firm borrowing in one A typical case is a firm borrowing in one

currency and wanting to borrow in currency and wanting to borrow in another. See Figure 12.8, p. 432 for another. See Figure 12.8, p. 432 for Reston-GSI example. Reston could get a Reston-GSI example. Reston could get a better rate due to its familiarity to GSI better rate due to its familiarity to GSI and also due to credit risk.and also due to credit risk.

Also a currency swap be used to convert Also a currency swap be used to convert a stream of foreign cash flows. This type a stream of foreign cash flows. This type of swap would probably have no of swap would probably have no exchange of notional principals.exchange of notional principals.

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Types of Swaps

EquityEquity Equity swaps are exchanges of cash Equity swaps are exchanges of cash

flows in which at least one of the flows in which at least one of the indices is an equity index.indices is an equity index.

An index equity is a measure of the An index equity is a measure of the performance of an individual stock performance of an individual stock or a basket of stocks.or a basket of stocks.

Common equity indices with which Common equity indices with which the general investor is probably the general investor is probably familiar include the S&P’s 500 Index, familiar include the S&P’s 500 Index, and Dow Jones Industrial Average.and Dow Jones Industrial Average.

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Equity Swaps

CharacteristicsCharacteristics One party pays the return on an One party pays the return on an

equity, the other pays fixed, floating, equity, the other pays fixed, floating, or the return on another equityor the return on another equity

Rate of return is paid, so payment Rate of return is paid, so payment can be negativecan be negative

Payment is not determined until end Payment is not determined until end of periodof period

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Equity Swaps (continued) Equity Swap StrategiesEquity Swap Strategies

Used to synthetically buy or sell Used to synthetically buy or sell stockstock

See Figure 12.9, p. 440 for example.See Figure 12.9, p. 440 for example. Some risksSome risks

• defaultdefault• tracking errortracking error• cash flow shortagescash flow shortages

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Types of Swaps

Commodity SwapsCommodity Swaps A swaps where exchanged cash A swaps where exchanged cash

flows are dependent on the price flows are dependent on the price of an underlying commodity.of an underlying commodity.

Usually use to hedge against the Usually use to hedge against the price of commodity.price of commodity.

The vast majority of commodity The vast majority of commodity swaps involve oil.swaps involve oil.

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Some Final Words About Swaps Similarities to forwards and futuresSimilarities to forwards and futures Offsetting swapsOffsetting swaps

Go back to dealerGo back to dealer Offset with another counterpartyOffset with another counterparty Forward contract or option on the Forward contract or option on the

swapswap

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