Scribd
Upload
195 views

Financial Engineering and Risk Management: Martin Haugh Garud Iyengar

Swaps are contracts that exchange one type of cash flow for another. For example, a plain vanilla interest rate swap exchanges a fixed interest rate payment for a floating interest rate payment. Swaps allow companies to leverage their strengths in different markets. For instance, two companies could swap their borrowing rates so that each pays a rate closer to their relative strength. Financial intermediaries also facilitate swaps by constructing contracts that allow them to earn a small profit from the difference in rates.

Uploaded by

Alejandro Sanhueza
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PDF, TXT or read online on Scribd
195 views

Financial Engineering and Risk Management: Martin Haugh Garud Iyengar

Swaps are contracts that exchange one type of cash flow for another. For example, a plain vanilla interest rate swap exchanges a fixed interest rate payment for a floating interest rate payment. Swaps allow companies to leverage their strengths in different markets. For instance, two companies could swap their borrowing rates so that each pays a rate closer to their relative strength. Financial intermediaries also facilitate swaps by constructing contracts that allow them to earn a small profit from the difference in rates.

Uploaded by

Alejandro Sanhueza
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 5

Financial Engineering and Risk Management

Swaps

Martin Haugh

Garud Iyengar

Columbia University Industrial Engineering and Operations Research

Swaps
Denition. Swaps are contracts that transform one kind of cash ow into another. Example. Plain vanilla swap: xed interest rate vs oating interest rates Commodity swaps: exchange oating price for a xed price. e.g. gold swaps, oil swaps. Currency swaps Why swaps? Change the nature of cash ows Leverage strengths in dierent markets

Example of leveraging strengths


Two companies Company A B Fixed 4.0% 5.2% Floating LIBOR + 0.3% LIBOR + 1.0%

Company A is better in both but relatively weaker in the oating rate market Company A Borrows in xed market at 4.0% Swap with B: pays LIBOR and receives 3.95% Company B B borrow in the oating market at LIBOR + 1.0% Swap with A: pays 3.95% and receives LIBOR Eective rates: A: 4% + 3.95% LIBOR = (LIBOR + 0.05%) B: LIBOR 1% + LIBOR 3.95% = 4.95% Both gain!
3

Role of nancial intermediaries


Same two companies Company A B Fixed 4.0% 5.2% Floating LIBOR + 0.3% LIBOR + 1.0%

Financial intermediary that constructs the swap. Company A Borrows in xed market at 4.0% Swap with Intermediary: pays LIBOR and receives 3.93% Company B B borrow in the oating market at LIBOR + 1.0% Swap with Intermediary: pays 3.97% and receives LIBOR Financial intermediary makes 0.04% or 4 basis points. Why? Compensation for taking on counterparty risk and providing a service
4

Pricing interest rate swaps


rt = oating (unknown) interest rate at time t Cash ows at time t = 1, . . . , T Company A (long): receives Nrt 1 and pays NX Company B (short): receives NX and pays Nrt 1 Value of swap to company A N (r0 , . . . , rT 1 ) = Cash ow of oating rate bond - Face value. Therefore, value of swap to company A
T

VA = N 1 d (0, T ) NX
t =1

d (0, t )

Set X so that VA = 0, i.e. X= 1 d (0, T )


T t =1

d (0, t )
5

You might also like