Swaps and their ApplicationsSwaps and their Applications

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Overview of SwapsOverview of Swaps SwapsSwaps – – ObligatesObligates two parties to exchange some two parties to exchange some

specified specified cash flowscash flows at specified at specified intervalsintervals over a over a specified specified time periodtime period. Like futures contracts, swaps . Like futures contracts, swaps can be viewed as can be viewed as a portfolio of forward contractsa portfolio of forward contracts..

Key Features:Key Features: Credit risk is two-sided but a swap is Credit risk is two-sided but a swap is less riskyless risky than a forward than a forward

(and (and moremore risky than futures) because a swap reduces the risky than futures) because a swap reduces the “performance period”“performance period” (the time interval between cash (the time interval between cash payments) but does payments) but does notnot require posting a margin. require posting a margin.

Swaps can be Swaps can be tailored exactlytailored exactly to customer needs and can be to customer needs and can be arranged for arranged for longer time periodslonger time periods than futures and forwards than futures and forwards (e.g., 1-5 years vs. 1-2 years for forwards/futures).(e.g., 1-5 years vs. 1-2 years for forwards/futures).

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Basic Components of a Swap Basic Components of a Swap ContractContract

Swaps can be created for all types of financial assets Swaps can be created for all types of financial assets and commodities. and commodities.

Swaps have experienced explosive growth since the Swaps have experienced explosive growth since the early 1980s due to the ability to early 1980s due to the ability to custom-tailor payoffs custom-tailor payoffs over relatively long time periodsover relatively long time periods. .

Notional PrincipalNotional Principal is used to define the magnitude of is used to define the magnitude of cash flows but this principal is cash flows but this principal is nevernever exchanged. exchanged.

Payments are Payments are nettednetted at pre-specified at pre-specified settlement datessettlement dates over the life of the swap.over the life of the swap.

A A difference checkdifference check is sent to one of the two parties at is sent to one of the two parties at each settlement date (reduces credit risk).each settlement date (reduces credit risk).

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Types of SwapsTypes of Swaps Interest Rate Swaps:Interest Rate Swaps: The most common swap is based on The most common swap is based on

swapping fixed versus floating interest payments. Also, swapping fixed versus floating interest payments. Also, can create can create basis swapsbasis swaps and and cross-currency swapscross-currency swaps..

Currency Swaps:Currency Swaps: Enables two parties to exchange Enables two parties to exchange currencies at pre-specified dates over the life of the swap.currencies at pre-specified dates over the life of the swap.

Commodity Swaps:Commodity Swaps: Can receive or pay floating or fixed Can receive or pay floating or fixed prices for commodities such as oil and natural gas.prices for commodities such as oil and natural gas.

Equity SwapsEquity Swaps: Can exchange the return on a stock (or : Can exchange the return on a stock (or stock index) for the return on another asset (e.g., LIBOR).stock index) for the return on another asset (e.g., LIBOR).

Credit Default Swaps:Credit Default Swaps: Enables to exchange cash flows Enables to exchange cash flows depending on changes in a borrower’s credit rating.depending on changes in a borrower’s credit rating.

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Example of Motivation for SwapsExample of Motivation for Swaps Swaps can allow Swaps can allow bothboth parties to achieve lower parties to achieve lower

financing costs.financing costs. Example:Example:

AAA can borrow at fixed rate AAA can borrow at fixed rate (10.8%)(10.8%) and swap with and swap with BBB in order to pay floating rate BBB in order to pay floating rate (L-0.1%).(L-0.1%). Both Both parties can then parties can then split the split the 7070 bps savings bps savings (120-50 bps). (120-50 bps).

Borrower:Borrower: AAAAAA BBBBBB

Fixed RateFixed Rate 10.8%10.8% 12.0%12.0%

Floating RateFloating Rate LIBOR + LIBOR + 0.25%0.25%

LIBOR + LIBOR + 0.75%0.75%

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Alternative Swap Example Alternative Swap Example (‘Hi’ / AAA swaps floating for fixed (‘Hi’ / AAA swaps floating for fixed rate):rate):

Reduce borrowing costs by using interest Reduce borrowing costs by using interest rate swaps.rate swaps.

Example: Two firms with different credit Example: Two firms with different credit ratings, Hi and Lo:ratings, Hi and Lo:

HiHi can borrow fixed at can borrow fixed at 11.011.0%% and and floating at LIBOR + floating at LIBOR + 1.01.0%.%.

LoLo can borrow fixed at can borrow fixed at 11.411.4%% and and floating at LIBOR + floating at LIBOR + 1.51.5%.%.

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HiHi wants wants fixedfixed rate, but it will rate, but it will issue floatingissue floating and and “swap”“swap” with Lo. with Lo. LoLo wants wants floatingfloating rate, but it will rate, but it will issue fixed and swap with Hi. Lo also makes issue fixed and swap with Hi. Lo also makes “side payment”“side payment” of 0.45% to Hi. of 0.45% to Hi.

Hi Lo

CF to lender

-(LIBOR+1%) -11.40%

CF Hi to Lo -11.40% +11.40%

CF Lo to Hi +(LIBOR+1%) -(LIBOR+1%)

CF Lo to Hi +0.45% -0.45%

Net CF -10.95% -(LIBOR+1.45%)

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Rationales for why Swap Rationales for why Swap “Savings” Exist“Savings” Exist

Comparative AdvantageComparative Advantage – predicts savings should disappear – predicts savings should disappear (but they don’t!).(but they don’t!).

Under-priced Credit RiskUnder-priced Credit Risk – again, predicts savings disappear as – again, predicts savings disappear as market corrects under-pricing.market corrects under-pricing.

Different Cash FlowsDifferent Cash Flows – interest rate swaps don’t have call – interest rate swaps don’t have call provisions, so “savings” are really the cost of the issuer’s provisions, so “savings” are really the cost of the issuer’s option to call fixed rate debt (most plausible reason).option to call fixed rate debt (most plausible reason).

Different Information SetsDifferent Information Sets – insiders can signal their beliefs – insiders can signal their beliefs about the true value of the firm.about the true value of the firm.

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Rationales for why Swap Rationales for why Swap “Savings” Exist “Savings” Exist (cont.)(cont.) Different Taxation and RegulationDifferent Taxation and Regulation – can explain certain – can explain certain

transactions but should disappear as governments close transactions but should disappear as governments close loopholes.loopholes.

Exposure ManagementExposure Management – more firms are actively managing – more firms are actively managing their financial price risks and therefore swaps have grown in their financial price risks and therefore swaps have grown in line with this trend.line with this trend.

Synthetic InstrumentsSynthetic Instruments – as more issuers create synthetic – as more issuers create synthetic instruments (or hybrids), more swaps are needed.instruments (or hybrids), more swaps are needed.

LiquidityLiquidity – lower B-A spreads attract more investors and – lower B-A spreads attract more investors and improves the liquidity of the market.improves the liquidity of the market.

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Pricing and Valuing a SwapPricing and Valuing a Swap AA Swap Swap can be decomposed intocan be decomposed into a portfolio of a portfolio of

forward contracts (or short term loans).forward contracts (or short term loans).

At origination,At origination, bothboth types of loans/forwardstypes of loans/forwards (fixed (fixed and floating rate) and floating rate) have anhave an E(NPV) = 0. E(NPV) = 0.

A swap isA swap is a combination of long position a combination of long position in one type in one type of loan (e.g., long a fixed rate) andof loan (e.g., long a fixed rate) and a short position a short position in the other type (short a floating rate). in the other type (short a floating rate).

ThreeThree yield curves ( yield curves (spot zero-coupon, forward zero-spot zero-coupon, forward zero-coupon, and spot par bondcoupon, and spot par bond) are used to price the ) are used to price the expected cash flows from a swap.expected cash flows from a swap.

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Applications of SwapsApplications of Swaps Types of Users:Types of Users:

Non-financial CorporationsNon-financial Corporations Financial Companies (CB’s, IB’s, Brokers, Insurance)Financial Companies (CB’s, IB’s, Brokers, Insurance) Institutional Investors (Pension funds, Mutual funds)Institutional Investors (Pension funds, Mutual funds) Governments (Federal and Municipal)Governments (Federal and Municipal)

Usually used to Modify Debt Obligations:Usually used to Modify Debt Obligations: Match Interest Sensitivity of AssetsMatch Interest Sensitivity of Assets Reduce Funding CostsReduce Funding Costs Enhance Yield on InvestmentsEnhance Yield on Investments Increase Debt CapacityIncrease Debt Capacity Protect Value of Investments from Interest Rate RiskProtect Value of Investments from Interest Rate Risk

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Applications of Swaps Applications of Swaps (cont.)(cont.)

Also used to Modify Cash Flows:Also used to Modify Cash Flows: Reduce Volatility of CF’s to IR, FX, Commodity, Equity Price Reduce Volatility of CF’s to IR, FX, Commodity, Equity Price

MovementsMovements Hedge on Inflows (Income, Receivables) Hedge on Inflows (Income, Receivables) Hedge on Outflows (Cost of Goods Sold, Operating Expenses)Hedge on Outflows (Cost of Goods Sold, Operating Expenses) ““Macro Hedge” of Both Inflows and Outflows (e.g., A/L Mgmt.)Macro Hedge” of Both Inflows and Outflows (e.g., A/L Mgmt.)

Can also be used to Create Synthetic Instruments:Can also be used to Create Synthetic Instruments: Inverse Floating Rate NotesInverse Floating Rate Notes Adjustable-rate Preferred StockAdjustable-rate Preferred Stock Synthesize Long-Dated Forward Contracts (can be cheaper)Synthesize Long-Dated Forward Contracts (can be cheaper)

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FX Rate Risk and SwapsFX Rate Risk and Swaps Typical Usage:Typical Usage:

Firm borrows in one currency where interest rates are Firm borrows in one currency where interest rates are lower and then swaps cash flows into lower and then swaps cash flows into home/base home/base currencycurrency..

Hedge Hedge transaction exposurestransaction exposures rather than “macro rather than “macro hedges”.hedges”.

Common Examples:Common Examples: Company managing Foreign Inflows or Outflows (e.g., Company managing Foreign Inflows or Outflows (e.g.,

Import/Export businessImport/Export business).). Governments borrowing in international capital Governments borrowing in international capital

markets.markets. To access long-term fixed rate capital in To access long-term fixed rate capital in “exotic” “exotic”

currenciescurrencies (e.g., McDonalds borrowing in New (e.g., McDonalds borrowing in New Zealand).Zealand).

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Credit Default Swaps Credit Default Swaps – – InfiniteInfinite LeverageLeverage

Does not usually own reference asset

Going “long”

Benefits when reference asset price INCREASES, max at Par

Tends to own reference asset

Hedging or going “short”

Benefits when reference asset price DECREASES

Protection SellerProtection Buyer

Payment upon Default of Reference Asset

Premium Payments

Reference Asset can be a MBS, CDO, Bond, or Loan

Like an Like an insurance contractinsurance contract that pays in the event of default. that pays in the event of default. FASB requires mark-to-market valuation.FASB requires mark-to-market valuation. Collateral CallCollateral Call - Protection Buyers can call for - Protection Buyers can call for partialpartial payment if default event payment if default event

is likely. Determined by mark-to-market value.is likely. Determined by mark-to-market value.