Swaps 10-1. Definitions In a swap, two counterparties agree to a contractual arrangement where in...

Swaps

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Definitions

• In a swap, two counterparties agree to a contractual arrangement where in they agree to exchange cash flows at periodic intervals.

Financial Swaps

• A financial swap is an agreement between two parties to exchange cash flows according to a formula

• Financial swaps are derivative securities• Currency swaps and interest rate swaps are

two types

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• Currency swaps are mainly used for debt financing in the required currency at a reduced cost due to comparative advantage

• Interest rate swaps have become important instruments to match maturities of assets and liabilities and also to obtain cost savings

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Types of Swaps

• Interest rate swaps• Currency swaps• Foreign exchange swaps• Non-deliverable currency swaps

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• There are two types of interest rate swaps:– Single currency interest rate swap• “Plain vanilla” fixed-for-floating swaps are often just

called interest rate swaps.

– Cross-Currency interest rate swap• This is often called a currency swap; fixed for fixed rate

debt service in two (or more) currencies.

Interest rate swaps

• It is an agreement between two parties to exchange interest payments on a specific notional principal amount for a specific maturity

• Notional =theoretical, there is no exchange of principal amount between parties

• Principal amount is simply taken as reference amount for computing the interest amount

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• Users-commercial banks, investment banks , insurance companies, government agencies and trusts

• Interest rate swap helps in hedging interest rate risk

• Also referred as term structure risk or basis risk

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• Term structure risk arises on changes in the fixed interest rate term structure

• E.g. Fixed or floating rate assets are financed –floating or fixed rate liability

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Two types-

• Coupon swaps • Basis swaps• Coupon Swaps: is an agreement between two

parties in which one party agrees to pay other party-

• Cash flow equal to the interest • At a predetermined fixed rate• On a notional principal amount for a certain

no.of years 10-10

• Other party pays the counter party cash flows equal to the interest amount

• At a floating rate • On the same notional principal amount for the

same period of time

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Size of the Swap Market

• In 2005 the notational principal of:interest rate swaps was $12,810,736,000,000(12lakh

crore.Currency swaps $1,197,395,000,000(1 lakh crore)

• The most popular currencies are:– U.S.$ (34%)– ¥ (23%)– DM (11%)– FF (10%)– £ (6%)

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The Swap Bank

• A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.

• The swap bank can serve as either a broker or a dealer.– As a broker, the swap bank matches counterparties

but does not assume any of the risks of the swap.– As a dealer, the swap bank stands ready to accept

either side of a currency swap, and then later lay off their risk, or match it with a counterparty.

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An Example of an Interest Rate Swap

• Consider this example of a “plain vanilla” interest rate swap.

• Bank A is a AAA-rated international bank located in the U.K. who wishes to raise $10,000,000 to finance floating-rate Eurodollar loans.– Bank A is considering issuing 5-year fixed-rate

Eurodollar bonds at 10 percent.– It would make more sense for the bank to issue

floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.

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• Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life.– Firm B is considering issuing 5-year fixed-rate

Eurodollar bonds at 11.75 percent.– Alternatively, firm B can raise the money by

issuing 5-year FRNs at LIBOR + ½ percent.– Firm B would prefer to borrow at a fixed rate.

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The borrowing opportunities of the two firms are shown in the following table:

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%

Floating rate LIBOR + .5% LIBOR .5%

QSD = 1.25%

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The QSD

• The Quality Spread Differential represents ---the potential gains from the swap that can be shared between the counterparties and the swap bank.

• There is no reason to presume that the gains will be shared equally.

• In the above example, company B is less credit-worthy than bank A,

• So they probably would have gotten less of the QSD, ---in order to compensate the swap bank for the default risk.

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An Example of a Currency Swap

• Suppose a U.S. MNC wants to finance a £10,000,000 expansion of a British plant.

• They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds.

– This will give them exchange rate risk: financing a sterling project with dollars.

• They could borrow pounds in the international bond market, but

• Pay a lot since they are not as well known abroad.

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• If they can find a British MNC with a mirror-image financing need they may both benefit from a swap.

• If the exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.

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Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based multinational.

Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below. $ £

Company A 8.0% 11.6%

Company B 10.0% 12.0%

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Company A

Swap

Bank

$8% £12%

$8%

£11% £12%

$9.4%

$ £


Company B 10.0% 12.0%

Company

B

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Company A

Swap

Bank

$8% £12%

$8%

£11% £12%

$9.4%

$ £


Company B 10.0% 12.0%

Company

BA’s net position is to borrow at £11%

A saves £.6%

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Company A

Swap

Bank

$8% £12%

$8%

£11% £12%

$9.4%

$ £


Company B 10.0% 12.0%

Company

BB’s net position is to borrow at $9.4%

B saves $.6%

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A is the more credit-worthy of the two firms.

Comparative Advantage as the Basis for Swaps

$ £


Company B 10.0% 12.0%

A has a comparative advantage in borrowing in dollars.B has a comparative advantage in borrowing in pounds.

A pays 2% less to borrow in dollars than BA pays .4% less to borrow in pounds than B:

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B has a comparative advantage in borrowing in £.


$ £


Company B 10.0% 12.0%

B pays 2% more to borrow in dollars than A

B pays only .4% more to borrow in pounds than A:

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A has a comparative advantage in borrowing in dollars.

B has a comparative advantage in borrowing in pounds.

If they borrow according to their comparative advantage and then swap, there will be gains for both parties.


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Swap Market Quotations

• They make a market in “plain vanilla” swaps and provide quotes for these.

• Since the swap banks are dealers for these swaps, there is a bid-ask spread.

• For example, 6.60 — 6.85 means the swap bank will pay fixed-rate DM payments at 6.60% against receiving dollar LIBOR or it will receive fixed-rate DM payments at 6.85% against receiving dollar LIBOR.

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Variations of Basic Currency and Interest Rate Swaps

• Currency Swaps– fixed for fixed – fixed for floating– floating for floating– amortizing

• Interest Rate Swaps – zero-for floating– floating for floating

• For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit.

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Risks of Interest Rate and Currency Swaps

• Interest Rate Risk– Interest rates might move against the swap bank

after it has only half of a swap on the books, or if it has an un hedged position.

• Basis Risk– If the floating rates of the two counterparties are

not pegged to the same index.• Exchange rate Risk– In the example of a currency swap given earlier, the

swap bank would be worse off if the pound appreciated.

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Risks of Interest Rate and Currency Swaps (continued)

• Credit Risk– This is the major risk faced by a swap dealer—the risk

that a counter party will default on its end of the swap.• Mismatch Risk– It’s hard to find a counterparty that wants to borrow

the right amount of money for the right amount of time.

• Sovereign Risk– The risk that a country will impose exchange rate

restrictions that will interfere with performance on the swap.

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Pricing a Swap

• A swap is a derivative security so it can be priced in terms of the underlying assets:

• How to:– Plain vanilla fixed for floating swap gets valued just

like a bond.– Currency swap gets valued just like a nest of

currency futures.

Swaps 10-1. Definitions In a swap, two counterparties agree to a contractual arrangement where in...

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