1. Chapter 6 Swaps (part2)
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

2. 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
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

3. 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 swap’s life
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

4. The Cash Flows (Table 7.7, page 166)
Date
Dollar Cash Flows
(millions)
Sterling cash flow
Feb 1, 2011
-18.0
+10.0
Feb 1, 2012
+1.08
−0.50
Feb 1, 2014
Feb 1, 2015
Feb 1, 2016
+19.08
−10.50
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

5. 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
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

6. 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%
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

7. Comparative Advantage May Be Real Because of Taxes
Assume that GE wants to borrow 20 million AUD and Qantas wants to borrow 15 million USD and the current exchange rate is 0.75 USD/AUD.
USD 5.0%
USD 6.3%
General
Electric
Financial
institution
Qantas
Airways
AUD 8.0%
USD 5.0%
AUD 6.9%
AUD 8.0%
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

8. 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
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

9. 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
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

10. Valuation in Terms of Bonds (Table 7.9, page 169)
Time
Cash Flows ($)
PV ($)
Cash flows (yen)
PV (yen) 1
0.8
0.7311 60
57.65 2
0.6682
55.39 3
0.6107
53.22
10.0
7.6338
1,200
1,064.30
Total
9.6439
1,230.55
Value of Swap = /110 − =
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

11. Valuation in Terms of Forwards (Table 7.10, page 170)
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

12. Valuation in Terms of Forwards (Table 7.10, page 170)
Time
$ cash
flow
Yen cash flow
Forward Exch rate
Yen cash flow in $
Net Cash Flow
Present value 1
-0.8 60
0.5734 2
0.6028 3
0.6337
-10.0
1200
2.0417
Total
1.5430
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012

13. 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……..
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012