1. 7.1 Swaps Chapter 7

2. 7.2 Nature of Swaps A swap is an agreement to exchange cash flows at specified future times according to certain specified rules

3. 7.3 An Example of a “Plain Vanilla” Interest Rate Swap 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 Next slide illustrates cash flows

4. 7.4 ---------Millions of Dollars--------- LIBORFLOATINGFIXEDNet DateRateCash Flow Mar.1, 19984.2% Sept. 1, 19984.8%+2.10–2.50–0.40 Mar.1, 19995.3%+2.40–2.50–0.10 Sept. 1, 19995.5%+2.65–2.50+0.15 Mar.1, 20005.6%+2.75–2.50+0.25 Sept. 1, 20005.9%+2.80–2.50+0.30 Mar.1, 20016.4%+2.95–2.50+0.45 Cash Flows to Microsoft (See Table 7.1)

5. 7.5 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

6. 7.6 Intel and Microsoft (MS) Transform a Liability (Figure 7.2) IntelMS LIBOR 5% LIBOR+0.1% 5.2%

7. 7.7 Financial Institution is Involved (Figure 7.4) F.I. LIBOR LIBOR+0.1% 4.985% 5.015% 5.2% Intel MS Dealer spread =.03% evenly split

8. 7.8 Intel and Microsoft (MS) Transform an Asset (Figure 7.3) Intel MS LIBOR 5% LIBOR-0.20% 4.7%

9. 7.9 Financial Institution is Involved (See Figure 7.5) Intel F.I.MS LIBOR 4.7% 5.015%4.985% LIBOR-0.20% Dealer spread =.03 %

10. 7.10 The Comparative Advantage Argument (Table 7.4) AAACorp wants to borrow floating BBBCorp wants to borrow fixed FixedFloating AAACorp 4.0%6-month LIBOR + 0.30% BBBCorp 5.2%6-month LIBOR + 1.00%

11. 7.11 The Comparative Advantage Argument AAACorp has absolute advantage in both markets But a comparative advantage in fixed BBBCorp has comparative advantage in floating If AAA borrows fixed, the gain is 1.2% If BBB borrows floating, the gain is reduced by.7% Therefore, we have a net gain of 1.2 -.7 =.5% If the gain is split evenly, we have a gain per party of: G = (1.2 -.7)/2 =.25%

12. 7.12 Swap Design Design the swap so AAA’s borrowing rate equals the comparative disadvantage (CD) rate minus the gain: LIBOR +.3 -.25 Do the same thing for BBB BBB’s rate with swap: 5.2 -.25 = 4.95 Now, draw the diagram

13. 7.13 The Swap (Figure 7.6) AAA BBB LIBOR LIBOR+1% 3.95% 4% The floating rate leg should be LIBOR

14. 7.14 Swap Design with FI Adjust swap gain for dealer spread Suppose dealer spread =.04% Then gain: G = (1.2 -.7 -.04)/2 =.23% AAA’s rate with swap: LIBOR +.3 -.23 = LIBOR +.07 BBB’s rate with swap: 5.2 -.23 = 4.97% Draw swap diagram

15. 7.15 The Swap when a Financial Institution is Involved (Figure 7.7) AAA F.I.BBB 4% LIBOR LIBOR+1% 3.93% 3.97% Check that dealer spread =.04%

16. 7.16 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 LIBOR+0.3% and LIBOR+1% rates available in the floating rate market are six- month rates BBBCorp’s fixed rate depends on the spread above LIBOR it borrows at in the future

17. 7.17 Valuation of an Interest Rate Swap 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

18. 7.18 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

19. 7.19 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

20. 7.20 Exchange of Principal 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

21. 7.21 Three Cash Flow Components t = 0: exchange principal based upon current exchange rates Pay: $18 M Rcv: £ 10 M t = 1, 2, 3, 4, 5: Pay:.05x10 = £.5 M Rcv:.06x18 = $1.08 M t = 5: Pay: £ 10 M Rcv: $ 18 M

22. 7.22 The Cash Flows (Table 7.5) Years DollarsPounds $ ------millions------ 0 –18.00 +10.00 1 +1.08 –.50 2 +1.08 –.50 3 +1.08 –.50 4 +1.08 –.50 5+19.08 -10.50 £

23. 7.23 Typical 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

24. 7.24 Comparative Advantage Arguments for Currency Swaps (Table 7.6) General Electric wants to borrow AUD Qantas wants to borrow USD USDAUD General Motors 5.0% 7.6% Qantas 7.0% 8.0%

25. 7.25 Comparative Advantage GE has absolute advantage in both markets But GE has comparative advantage in dollars Qantas has comparative advantage in Australian dollars So GE should borrow dollars and Qantas Australian dollars Then swap cash flows to earn gain from comparative advantage

26. 7.26 Comparative Advantage Gain per party: G = (2 -.4)/2 =.8% GE’s rate with swap: 7.6 -.8 = AUD 6.8% Qantas’ rate with swap: 7 -.8 = USD 6.2%

27. 7.27 GE Qantas AUD 6.8% USD 5% AUD 8.0% USD 5% Qantas Assumes Exchange Rate Risk

28. 7.28 GM Qantas AUD 8.0% USD 5% AUD 8% USD 6.2% GE Assumes Exchange Rate Risk

29. 7.29 FI Assumes Exchange Rate Risk Adjust swap gain for dealer spread Suppose dealer spread =.2% Then gain: Gain per party: G = (2 -.4 -.2)/2 =.7% GE’s rate with swap: 7. 6 -.7 = AUD 6.9% Qantas’ rate with swap: 7 -.7 = USD 6.3%

30. 7.30 GE F.I.Q USD 5% AUD 6.9% AUD 8% USD 5% USD 6.3% Check that dealer spread =.2% Pay: 13.0 – 11.9 = AUD 1.1% Rcv: 6.3 – 5.0 = USD 1.3% FI Assumes Exchange Rate Risk

31. 7.31 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

32. 7.32 Swaps & Forwards A swap can be regarded as a convenient way of packaging forward contracts The “plain vanilla” interest rate swap in our example consisted of 6 Fraps The “fixed for fixed” currency swap in our example consisted of a cash transaction & 5 forward contracts

33. 7.33 Swaps & Forwards (continued) 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

34. 7.34 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