Chapter 7

Swaps

Options, Futures, and Other Derivatives, 8th Edition,

Copyright John C. Hull 2012

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

Options, Futures, and Other Derivatives, 8th Edition,

Copyright John C. Hull 2012

An Example of a Plain Vanilla Interest

Rate Swap
An agreement by Microsoft to receive 6month 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 that could
occur (Day count conventions are not
considered)
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Copyright John C. Hull 2012

One Possible Outcome for Cash

Flows to Microsoft (Table 7.1, page 150)
Date

LIBOR

Floating Cash
Flow

Fixed Cash
Flow

Net Cash
Flow

Mar 5,
2012

4.20%

Sep 5, 2012 4.80%

+2.10

2.50

0.40

Mar 5,
2013

5.30%

+2.40

2.50

0.10

Sep 5, 2013 5.50%

+2.65

2.50

+ 0.15

Mar 5,
2014

5.60%

+2.75

2.50

+0.25

Sep 5, 2014 5.90%

+2.80

2.50

+0.30

Options, Futures, and +2.95

Other Derivatives, 8th2.50
Edition,
Copyright John C. Hull 2012

+0.45

Mar 5,
2015

Typical Uses of an Interest 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

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Copyright John C. Hull 2012

Intel and Microsoft (MS)

Transform a Liability (Figure 7.2, page 151)
5%
5.2%

Intel

MS
LIBOR+0.1%
LIBOR

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Copyright John C. Hull 2012

Financial Institution is Involved

(Figure 7.4, page 152)

4.985%
5.2%

Intel
LIBOR

5.015%

F.I.

MS
LIBOR

LIBOR+0.1
%

Financial Institution has two offsetting

swaps
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Copyright John C. Hull 2012

Intel and Microsoft (MS) Transform an

Asset (Figure 7.3, page 152)
5%
4.7%

Intel

MS

LIBOR-0.2%
LIBOR
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Financial Institution is Involved

(See Figure 7.5, page 153)

4.985%

5.015%
4.7%

Intel

F.I.

MS

LIBOR-0.2%
LIBOR

LIBOR

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Copyright John C. Hull 2012

Quotes By a Swap Market Maker

(Table 7.3, page 154)
Maturity
2 years

Bid (%)
6.03

Offer (%)
6.06

Swap Rate (%)

6.045

3 years

6.21

6.24

6.225

4 years

6.35

6.39

6.370

5 years

6.47

6.51

6.490

7 years

6.65

6.68

6.665

10 years

6.83

6.87

6.850

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10

Day Count
A day count convention is specified for for
fixed and floating payment
For example, LIBOR is likely to be actual/360
in the US because LIBOR is a money market
rate

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11

Confirmations
Confirmations specify the terms of a
transaction
The International Swaps and Derivatives has
developed Master Agreements that can be
used to cover all agreements between two
counterparties
Governments now require central clearing to
be used for most standardized derivatives
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12

The Comparative Advantage Argument

(Table 7.4, page 156)
AAACorp wants to borrow floating
BBBCorp wants to borrow fixed

Fixed

Floating

AAACorp

4.0%

6 month LIBOR 0.1%

BBBCorp

5.2%

6 month LIBOR + 0.6%

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13

The Swap (Figure 7.6, page 157)

4.35%
4%
AAACorp

BBBCorp
LIBOR+0.6%
LIBOR

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The Swap when a Financial

Institution is Involved (Figure 7.7, page 157)
4.33%

4.37%

4%
AAACorp

LIBOR

F.I
.

BBBCorp
LIBOR+0.6%
LIBOR

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Criticism of the Comparative

Advantage Argument
The 4.0% and 5.2% rates available to AAACorp
and BBBCorp in fixed rate markets are 5-year
rates
The LIBOR0.1% and LIBOR+0.6% rates
available in the floating rate market are sixmonth rates
BBBCorps fixed rate depends on the spread
above LIBOR it borrows at in the future
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16

The Nature of Swap Rates

Six-month LIBOR is a short-term AA borrowing
rate
The 5-year swap rate has a risk corresponding to
the situation where 10 six-month loans are made
to AA borrowers at LIBOR
This is because the lender can enter into a swap
where income from the LIBOR loans is
exchanged for the 5-year swap rate
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17

Using Swap Rates to Bootstrap the

LIBOR/Swap Zero Curve
Consider a new swap where the fixed rate is the
swap rate
When principals are added to both sides on the final
payment date the swap is the exchange of a fixed
rate bond for a floating rate bond
The floating-rate rate bond is worth par. The swap is
worth zero. The fixed-rate bond must therefore also
be worth par
This shows that swap rates define par yield bonds
that can be used to bootstrap the LIBOR (or
LIBOR/swap) zero curve
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Example of Bootstrapping the

LIBOR/Swap Curve (Example 7.1, page 160)
6-month, 12-month, and 18-month
LIBOR/swap rates are 4%, 4.5%, and 4.8%
with continuous compounding.
Two-year swap rate is 5% (semiannual)

2.5e 0.040.5 2.5e 0.0451.0 2.5e 0.0481.5

2 R
102.5e
100
The 2-year LIBOR/swap rate, R, is 4.953%
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19

Valuation of an Interest Rate Swap

Initially interest rate swaps are worth close
to zero
At later times they can be valued as the
difference between the value of a fixed-rate
bond and the value of a floating-rate bond
Alternatively, they can be valued as a
portfolio of forward rate agreements (FRAs)

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Valuation in Terms of Bonds

The fixed rate bond is valued in the usual way
The floating rate bond is valued by noting that
it is worth par immediately after the next
payment date

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Valution of Floating-Rate Bond

Value = PV
of L+k* at t*
Value =
L+k*
0
Valuation
Date

Value = L

t*
First Pmt
Date
Floating
Pmt =k*

Second
Pmt Date

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Copyright John C. Hull 2012

Maturity
Date

22

Example
Pay six-month LIBOR, receive 8% (s.a.
compounding) on a principal of $100 million
Remaining life 1.25 years
LIBOR rates for 3-months, 9-months and 15months are 10%, 10.5%, and 11% (cont
comp)
6-month LIBOR on last payment date was
10.2% (s.a. compounding)
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Valuation Using Bonds (page 161)

Time Bfix cash
flow

Bfl cash
flow

0.25

4.0

0.75

4.0

1.25

104.0

Total

Disc
factor

PV
Bfix

PV
Bfl

105.100 0.9753

3.901

102.50
5

0.9243

3.697

0.8715 90.640
98.238 102.50
5

Swap value = 98.238 102.505 = 4.267

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Valuation in Terms of FRAs

Each exchange of payments in an interest
rate swap is an FRA
The FRAs can be valued on the
assumption that todays forward rates are
realized

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Valuation of Example Using FRAs

(page 163)
Time

Fixed
cash
flow

Floating
cash
flow

Net Cash
Flow

Disc
factor

PV
Bfl

0.25

4.0

-5.100

-1.100

0.9753

-1.073

0.75

4.0

-5.522

-1.522

0.9243

-1.407

1.25

4.0

-6.051

-2.051

0.8715

-1.787

Total

-4.267

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Overnight Indexed Swaps

Fixed rate for a period is exchanged for the
geometric average of the overnight rates
Should OIS rate equal the LIBOR rate? A
bank can
Borrow $100 million in the overnight market,
rolling forward for 3 months
Enter into an OIS swap to convert this to the 3month OIS rate
Lend the funds to another bank at LIBOR for 3
months
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Overnight Indexed Swaps continued

...but it bears the credit risk of another bank in
this arrangement
The OIS rate is now regarded as a better proxy
for the short-term risk-free rate than LIBOR
The excess of LIBOR over the OIS rate is the
LIBOR-OIS spread. It is usually about 10 basis
points but spiked at an all time high of 364 basis
points in October 2008
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An Example of a Currency Swap

An agreement to pay 5% on a sterling
principal of 10,000,000 & receive 6% on
a US$ principal of $18,000,000 every year
for 5 years

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Exchange of Principal
In an interest rate swap the principal is not
exchanged
In a currency swap the principal is usually
exchanged at the beginning and the end of
the swaps life

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The Cash Flows (Table 7.7, page 166)

Date

Dollar Cash
Flows
(millions)

Sterling cash
flow
(millions)

Feb 1, 2011

-18.0

+10.0

Feb 1, 2012

+1.08

0.50

Feb 1, 2012

+1.08

0.50

Feb 1, 2014

+1.08

0.50

Feb 1, 2015

+1.08

0.50

Feb 1, 2016

+19.08

10.50

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Copyright John C. Hull 2012

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Typical Uses of a
Currency Swap
Convert a liability in one currency to
a liability in another currency
Convert an investment in one
currency to an investment in
another currency

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Comparative Advantage May Be

Real Because of Taxes

General Electric wants to borrow AUD

Quantas wants to borrow USD
Cost after adjusting for the differential impact
of taxes
USD

AUD

General Electric

5.0%

7.6%

Quantas

7.0%

8.0%

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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

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Example
All Japanese LIBOR/swap rates are 4%
All USD LIBOR/swap rates are 9%
5% is received in yen; 8% is paid in dollars.
Payments are made annually
Principals are $10 million and 1,200 million
yen
Swap will last for 3 more years
Current exchange rate is 110 yen per dollar
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Valuation in Terms of Bonds (Table 7.9,

page 169)
Time

Cash Flows
($)

PV ($)

Cash flows
(yen)

PV (yen)

0.8

0.731
1

60

57.65

0.8

0.668
2

60

55.39

0.8

0.610
7

60

53.22

10.0

7.633
1,200
Value of Swap = 1230.55/1108 9.6439 = 1.5430
Total

9.643
9
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1,064.30
1,230.55

36

Valuation in Terms of Forwards

(Table 7.10, page 170)
Time $ cash
flow

Yen cash Forward

flow
Exch
rate

Yen cash
flow in $

Net
Cash
Flow

Present
value

-0.8

60

0.009557

0.5734

0.2266

-0.2071

-0.8

60

0.010047

0.6028

0.1972

-0.1647

-0.8

60

0.010562

0.6337

0.1663

-0.1269

-10.0

1200

0.010562

12.6746

+2.674
6

2.0417

Total

1.5430

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Swaps & Forwards

A swap can be regarded as a convenient
way of packaging forward contracts
Although the swap contract is usually
worth close to zero at the outset, each of
the underlying forward contracts are not
worth zero

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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
Some swaps are more likely to lead to credit risk exposure than
others
What is the situation if early forward rates have a positive value?
What is the situation when the early forward rates have a negative
value?

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Other Types of Swaps

Floating-for-floating interest rate swaps,
amortizing swaps, step up swaps, forward
swaps, constant maturity swaps,
compounding swaps, LIBOR-in-arrears
swaps, accrual swaps, diff swaps, cross
currency interest rate swaps, equity swaps,
extendable swaps, puttable swaps,
swaptions, commodity swaps, volatility
swaps..
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