RISK MANAGEMENT

Lecture 6

Swaps

Nature of Swaps

A swap is an agreement to exchange cash flows at specified future times according to certain specified rules. Usually the calculation of cash flows involves the future values of one or more market variables. Used for converting a liability/investment from:

fixed rate to floating rate. floating rate to fixed rate.

Mechanics of a Plain Vanilla Interest Rate Swap

Plain Vanilla Swap: In this a company agrees to pay a fixed rate on a notional principal in return of a floating rate from another company on same notional principal for same period. For example: An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million.

Cash Flows to Microsoft

Mar.5, 2001
Sept. 5, 2001

4.2%
4.8%

Mar.5, 2002
Sept. 5, 2002 Mar.5, 2003

5.3%
5.5% 5.6%

+2.40
+2.65 +2.75

2.50
2.50 2.50

0.10
+0.15 +0.25

Sept. 5, 2003
Mar.5, 2004

5.9%
6.4%

+2.80
+2.95

2.50
2.50

+0.30
+0.45

Intel and Microsoft transform a liability

Intel
LIBOR

MS
LIBOR+0.1%

Financial Institution is involved

4.985% 5.2%

5.015%

Intel
LIBOR

F.I.
LIBOR

MS
LIBOR+0.1%

Intel and Microsoft transform an asset

Intel
LIBOR-0.2% LIBOR

MS

Financial Institution is involved

4.985%

5.015% 4.7%

Intel
LIBOR-0.2%
LIBOR

F.I.
LIBOR

MS

The Comparative Advantage Argument

AAACorp wants to borrow floating. BBBCorp wants to borrow fixed.

Fixed AAACorp BBBCorp 10.00% 11.20%

Floating 6-month LIBOR + 0.30% 6-month LIBOR + 1.00%

The Swap

9.95% 10%

AAA
LIBOR

BBB
LIBOR+1%

The Swap when a Financial Institution is Involved

AAA
LIBOR

F.I.
LIBOR

BBB
LIBOR+1%

Criticism of the Comparative Advantage Argument

Why are there different spreads in two markets? Differential exists due to nature of contracts.

The 10.0% and 11.2% rates available to AAACorp and BBBCorp in fixed rate markets are 5-year rates. The LIBOR+0.3% and LIBOR+1% rates available in the floating rate market are six-month rates. Lenders have opportunity to review the rates every six months.

BBBCorps fixed rate depends on the spread above LIBOR it borrows at in the future.

If this increases, BBBCorps fixed rate will go up.

Example: Problem 6.1

A has comparative advantage in fixed rate market but wants to borrow floating. B has comparative advantage in floating rate market but wants to borrow fixed. Difference between spreads = 1.4 0.5 = 0.9% p.a. Bank wants 0.1%. So remaining 0.8% will be shared.

Example: Problem 6.1

12.3% A BANK LIBOR

12 .4% B
LIBOR + 0.6%

12%
LIBOR

Quotes By a Swap Market Maker

Quotes By a Swap Market Maker

The bid is the fixed rate in a contract where market maker will pay fixed and receive floating. The offer is the fixed rate in a contract where market maker will receive fixed and pay floating. Swap Rate: the average of bid and offer rate for a particular maturity.

Valuation of an Interest Rate Swap

At initiation an interest rate swap is worth zero. Interest rate swaps 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). In both cases LIBOR zero rates are used for discounting.

Valuation in terms of bonds

If a company pays fixed and receives floating: Vswap = Bfl - Bfix The fixed rate bond is valued in the usual way. Bfix = ke-riti + Le-rntn The floating rate bond is valued by noting that it is worth par immediately after the next payment date. Bfl = (L + k*)e-r1t1

Valuation in terms of bonds (Example 6.3)

In four months:

0.5*0.12*100 = $6 million will be received. 0.5*.096*100 = $4.8 million will be paid. $6 million will be received & the LIBOR rate prevailing in 4 months time will be paid. 6e-0.1*4/12 + 106e-0.1*10/12 = $103.328 million. (100 + 4.8) e-0.1*4/12 = $101.364 million.

In 6 months:

Value of fixed rate bond:

Value of floating rate bond:

Value of swap to party paying floating = $1.964 million.

Currency Swaps

An agreement in which principal & interest payments in one currency are exchanged for principal & interest payments in another currency. Principal amounts are exchanged at the beginning & end of life of swap. Usually the principal amounts are chosen to be approximately equivalent, using the exchange rate at the initiation of swap.

Uses of a Currency Swap

Conversion from a liability in one currency to a liability in another currency. Conversion from an investment in one currency to an investment in another currency.

Interest rate vs. Currency Swaps

In an interest rate swap the principal is not exchanged. In a currency swap the principal is exchanged at the beginning and the end of the swap.

An example of a Currency Swap

An agreement to pay 11% on a sterling principal of 10,000,000 & receive 8% on a US$ principal of $15,000,000 every year for 5 years.

The Cash Flows

Year 2001 2002 2003 2004 2005 2006

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. In terms of bonds, IBM is long a dollar bond that pays interest at 8% p.a. and short a sterling bond that pays interest at 11% p.a.

Valuation of Currency Swaps

If dollars are received and foreign currency is paid, value of swap is: Vswap = BD S0BF If dollars are paid and foreign currency is received, value of swap is: Vswap = S0BF BD

Comparative Advantage Argument (Example: Problem 6.11)

A has comparative advantage in Canadian dollar fixed rate market but wants to borrow US $ floating rate market. B has comparative advantage in US $ floating rate market but wants to borrow in Canadian fixed rate market. Difference between spreads = 1.5 0.5 = 1% p.a. Bank wants 0.5%. So remaining 0.5% will be shared.

Example: Problem 6.11

C$: 5% A BANK
US$ : LIBOR+0.25%

C$: 6.25% B
US$ : LIBOR+1%

C$: 5%

US$ : LIBOR+1%

Swaps & Forwards

A swap can be regarded as a series of forward contracts. The plain vanilla interest rate swap in our example consisted of 6 FRAs. The fixed for fixed currency swap in our example consisted of a cash transaction & 5 forward contracts.

Swaps & Forwards

The value of the swap is the sum of the values of the forward contracts underlying the swap. Swaps are normally at the money initially. This means that it costs nothing to enter into a swap. It does not mean that each forward contract underlying a swap is at the money initially.

Credit Risk in Swaps

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 value of contract is positive. If value is negative and counterparty gets into financial difficulties:

Company could have a windfall gain.

Potential losses from defaults on currency swaps are greater than on interest rate swaps. Why?

Exchange of principal at end of life of swap.

Market Risk vs. Credit Risk

Market risk arises from the possibility that market variables will move in such a way that value of a swap becomes negative for a company.

Credit risk arises from possibility of a default by counterparty when value of contract is positive.