2 Nature of Swaps Two popular swaps A swap is an agreement to exchange cash flows at specified future times according to certain specified rulesTwo popular swapsplain vanilla interest rate swapsfixed-for-fixed currency swaps
3 7.1 Mechanics of interest rate swaps “plain vanilla” interest rate swapsIn this swap a company agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. In return, in receives interest at a floating rate on the same notional principal for the same period of time.floating rateThe floating rate in most interest rate swap agreements is the London Interbank Offered Rate (LIBOR).
4 An Example of a “Plain Vanilla” Interest Rate Swap Consider a hypothetical 3-year swap initiated on March 5,2007,between Microsoft and Intel.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
5 Cash Flows to Microsoft Received:0.5*0.042*100million = 2.1millionPaid:0.5*0.05*100million = 2.5million
7 Typical Uses of an Interest Rate Swap Converting a liability fromfixed rate to floating ratefloating rate to fixed rateLIBOR+0.1%→ 5.1%5.2%→ LIBOR+0.2%
8 Typical Uses of an Interest Rate Swap Converting a investment fromfixed rate to floating ratefloating rate to fixed rate4.7%→ LIBOR- 0.3%LIBOR- 0.2%→ 4.8%
9 Role of financial institution Converting a investment from
10 Role of financial institution Converting a investment from
11 Market makersMany large financial institutions act as market makers for swap. They are prepared to enter swap without having an offsetting swap with another counterparty.Market makers must carefully quantify and hedge the risks they are taking.Bonds ,FRA ,interest rate futures are example of the instruments that they can be used for hedging by swap market makers.
12 Consider a new swap :fixed rate = current swap rateWe can reasonably assume that the value of this swap is zero.
13 7.2 Day count issuesA LIBOR-based floating-rate cash flow on a swap payment date is calculated as:LRn/360(L : principal ,R : relevant LIBOR rate n : the number of day since the last payment date)
14 7.3 ConfirmationA confirmation is the legal agreement underlying a swap and is signed by representatives.International Swap and Derivatives Association (ISDA) in New York.The confirmation specifies that the following business day convention is to be used and that the US calendar determines which days are business days and which are holiday.
16 7.4 The comparative-advantage argument An explanation commonly put forward to explain the popularity of swaps concerns comparative advantage.AAA Corp wants to borrow floatingBBB Corp wants to borrow fixed
18 SwapAAA Corp : gain 0.23%BBB Corp : gain 0.23%FI : 0.04%Total :0.5%
19 Criticism of the Comparative Advantage Argument The 4.0% and 5.2% rates available to AAA Corp and BBB Corp in fixed rate markets are 5-year rates.The LIBOR−0.1% and LIBOR+0.6% rates available in the floating rate market are six-month rates.BBB Corp’s fixed rate depends on the spread above LIBOR it borrows at in the future.
20 7.5 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.
21 7.6 Determining LIBOR/Swap zero rates 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.
23 7.6 Valuation of interest rate swaps Interest rate swaps can be valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bondAlternatively, they can be valued as a portfolio of forward rate agreements (FRAs)
24 Valuation in Terms of Bonds Form a point of view of the floating-rate payerThe 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.
37 Swaps & ForwardsA swap can be regarded as a convenient way of packaging forward contracts.Although the swap contract is usually worth zero at the outset, each of the underlying forward contracts are not worth zero.
38 7.10 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?38