Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

A Brief Introduction on Swaps

UQ Business School

March 12, 2018

Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Introduction

Interest Rate Swaps

Total Return Swaps

Credit Default Swaps

Longevity Swaps

Summary
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Things we will cover

This week, we will cover the topic of swaps.

1. Interest Rate Swaps (part 1)
2. Equity Swaps
3. Credit Default Swaps
Next week, we will extend and examine
1. Interest Rate Swaps (part 2)
2. Currency Swaps
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

What is a Swap?

Let’s swap cashflows!

A swap is an agreement to exchange a series of cash flows on
periodic dates in the future.
1. Does not require payment by either party at initiation (except
currency swaps)
2. OTC (off the counter) and non-standard
3. Regulated by the International Swaps and Derivatives
Association
4. Default risk are comparatively higher
It’s a useful tool for structuring products, and often used by
investment managers.
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Interest Rate Swaps

Interest Rate Swap

An agreement to exchange fixed rate for floating (variable)

rate over the tenor (life) of the swap
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Interest Rate Swaps

Interest Rate Swap Example

Suppose I lend you $100 at 4% pa fixed rate and you lend

me $100 at variable (i.e., floating) rate for 3 years. Interest
is paid semi-annually.

1. Thus we have an interest rate swap with a tenor of 3 yrs

2. Both loan amounts are equal, hence it is pointless to
exchange $100.
3. It is also pointless to exchange the full interest amount every
6 mths. Only the party with the larger payment liability pays
the difference. Example: If the floating rate is 6% pa, I pay
you $1. If the floating rate is 3% pa, you pay me $0.50
4. In the above, you are the fixed rate payer (i.e., payer) and I
am the fixed rate receiver (i.e., receiver). As a fixed rate
receiver, I pay floating rate
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Why do we use interest rate swaps? (Liabilities)

Transforming Liabilities

Interest Rate Swaps are used to transform liabilities

1. Suppose company A borrowed at LIBOR floating rate + a

margin of 50 bps. Company A already has many variable rate
borrowings and wanted to convert the above into fixed rate
borrowing.
2. Suppose company B has just issued an 8% coupon bond, in
addition to other fixed rate borrowings. Company B wanted
to convert the above to variable rate borrowing.
3. Hence, companies A and B can do an interest rate swap. Lets
assume the fixed swap rate is 6%.
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Why do we use interest rate swaps? (Liabilities)

1. Company A converts variable to fixed liabilities

2. Company B converts fixed to variable liabilities
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Why do we use interest rate swaps? (Assets)

Transforming Assets

Interest Rate Swaps are used to transform assets

1. Suppose company F holds floating rate notes issued in

Australia. Thus, it receives BBSW minus 30 bps margin.
BBSW (Bank Bill Swap Rate) is analogous to LIBOR; it is the
reference rate at which variable rates in Australia are set
upon. Company F wanted to convert its cash inflow into fixed
amount.
2. Suppose company V holds 5.8% fixed coupon bonds and
wanted to convert its cash inflow into variable amount
3. Thus, companies F and V can do an interest rate swap. Lets
assume the fixed swap rate is 6%
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Why do we use interest rate swaps? (Assets)

1. Company F converts variable to fixed cash inflows

2. Company V converts fixed to variable cash inflows
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Why do we use interest rate swaps? (Assets)

1. Usually, companies F and V wont directly transact the interest

rate swap. They will do this through a financial intermediary
(FI)
2. In the example below, FI earns a 4 bps spread but each of F
and V receives 2 bps less.
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Why do we use interest rate swaps? (Speculation)

If you predict that the yield will increase (price will decrease) in the
future, you can try to speculate on your prediction by:
1. Sell bond futures (sell high now, close out by buy low later), or
2. Enter into an interest rate swap as a fixed-rate payer (pay
fixed, receive floating)
It can be shown (later) that if yield increases, the fixed coupon
bond will trade at discount. The effect is such that the swap has a
positive value to fixed rate payer
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Why do we use interest rate swaps? (Hedging)

Suppose you were a liability manager and you have issued/sold a
fixed coupon bond. To hedge the risk of a falling yield (bond price
or value of your liability increases), you can:
1. Buy back the bond, or
2. Enter into an interest rate swap as a fixed-rate receiver
(receive fixed, pay floating).
• It can be shown (later) that if yield decreases, the fixed
coupon bond will trade at premium. The effect is such that
the swap has a positive value to fixed rate receiver. This
positive swap value offsets the increase in your liability, so
zero net effect
• It can be shown (later) that if yield increases, the fixed coupon
bond will trade at discount. The effect is such that the swap
has a negative value to fixed rate receiver. This negative swap
value offsets the decrease in your liabilit, so zero net effect
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Decreasing Duration

Note also that a receive fixed, pay floating swap has the same
effect as decreasing duration. This is because this swap implies
that you issue short-term floating rate notes (thus pay floating
rate) and use the proceeds to buy back long-term bonds (thus
receive fixed rate)
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Pricing a Swap

Pricing a Swap

Calculate a fixed rate whereby market participants are indif-

ferent between paying (receiving) this fixed rate over time or
paying (receiving) a rate that can fluctuate over time.

• Calculate the fixed rate

• Subsequently set the value of the swap to be equal to zero at
origination (because the present value of the two cash flow
streams (floating and fixed) are equal to each other
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Valuing a Swap

Valuing a Swap

Because a swap is equivalent to an asset and a liability, one

can just value each of them to determine the value of the
swap at any moment in time

• At origination (t = 0), a swap has zero value

• As time passes, the value of the swap deviates from zero
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Example: Pricing a Vanilla Interest Rate Swap

Determine a fair fixed rate under the following conditions:

Plain Vanilla Interest Rate Swap

A swap with a tenor of 3 years:

1. The floating leg: 1 year LIBOR
2. The fixed leg: ?? (for you to price)
Assume settlement is yearly.

• The yield curve is: y1 = 5%, y2 = 6%, y3 = 7.5%

• The forward rates should be:
f1 = 5%, f2 = 7.01%, f3 = 10.564%
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Example: Pricing a Vanilla Interest Rate Swap

Determine a fair fixed rate under the following conditions:

Plain Vanilla Interest Rate Swap

A swap with a tenor of 3 years:

1. The floating leg: 1 year LIBOR
2. The fixed leg: ?? (for you to price)
Assume settlement is yearly.

• Use the forward rates as unbiased estimates of expected

future spot rates.
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Example: Pricing a Vanilla Interest Rate Swap

Work out the expected cashflows from the floating leg:

• The forward rates should be:
f1 = 5%, f2 = 7.01%, f3 = 10.564%
Assume the notional principal (NP) is $100. (The NP for both the
fixed leg and the floating leg are the same) The ‘expected’ floating
rate cash flows are:
1. CF1 = NP × f1 = 100 × 5% = 5
2. CF2 = NP × f2 = 100 × 7.01% = 7.01
3. CF3 = NP × f3 = 100 × 10.564% = 10.564
4. CF3 = NP = 100
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Example: Pricing a Vanilla Interest Rate Swap

Valuing the ‘expected’ cash flows at spot rate should yield the NP
(NP = 100)

5 7.01 10.564 100

+ + + = 100
1.05 1.062 1.0753 1.0753

• The the value of the floating rate side of the swap

equals its NP, immediately after a floating payment has
been made. (Remember this)
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Example: Pricing a Vanilla Interest Rate Swap

We know that the value of the swap at origination (t = 0) is set to

zero, thus the fixed rate payments per year (F ) must satify the
following:
F F F 100
+ 2
+ 3
+ = 100
1.05 1.06 1.075 1.0753
Rearranging terms,
1 1 1
F ×{ + 2
+ } = 100 − 80.496
1.05 1.06 1.0753
Thus, the fixed annual payments are:

F = 7.367
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Example: Pricing a Vanilla Interest Rate Swap

Determine a fair fixed rate under the following conditions:

Plain Vanilla Interest Rate Swap

A swap with a tenor of 3 years:

1. The floating leg: 1 year LIBOR
2. The fixed leg: circa 7.367% when we use the forward rates
Assume settlement is yearly.

• The swap dealer might quote 7.35% to a fixed-rate receiver,

and 7.39% to a fixed-rate payer.
• If interest rates change, the valkue of the swap will change
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Example: Valuing a Swap post Origination

1. If prices or rates subsequently change, the value of the swap

will change. It will become an asset (+ value) for one party,
and a liability (- value) for the other (the party who could
default).
2. But, the valuation method (compute the PV of the
contracted fixed cash flows and of the expected variable cash
flows) remains the same.
3. Also, one can make use of the fact that PV(floating CF) =
NP, immediately after a CF has been swapped.
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Example: Valuing a Swap post Origination

Let’s continue with our existing example.
Plain Vanilla Interest Rate Swap

A swap with a tenor of 3 years:

1. The floating leg: 1 year LIBOR
2. The fixed leg: circa 7.367% when we use the forward rates
Assume settlement is yearly.

• Suppose that 3 months after the origination date (t = 0.25),

the yield curve flattens at 7%. (what happens to our forward
rates?)
• The next floating cash flow is still set at 5.
• Immediately after this payment is paid, PV(remaining floating
payments) = NP = 100
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Example: Valuing a Swap post Origination

Let us value the floating leg:

5 100
Vfloating = 0.75
+ = 99.805
1.07 1.070.75
because Vfloating = PV(next cash flow) + PV(notional principal).
Let us value the fixed leg:
7.367 7.367 107.367
Vfixed = 0.75
+ 1.75
+ = 102.685
1.07 1.07 1.072.75
The swaps value is 102.685 - 99.805 = 2.88
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Valuing Interest Rate Swaps

• Suppose we are the fixed rate payer (we pay fixed rate and
receive floating rate).
• We can replicate this effect using a combination of basic
bonds:
Replicating Swaps with Bonds

1. Issue fixed coupon bond

2. Invest the proceeds in floating rate coupon bond with
the same maturity and payment dates as the above
fixed coupon bond
3. On each interest payment date, we pay fixed coupon
and receive floating rate
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Valuing Interest Rate Swaps

• Replication using notes.

Replicating Swaps with Bonds and Notes

1. Issue fixed coupon bond

2. Invest the proceeds in short-term floating rate notes
(e.g., 6-mth floating rate note) and roll-over
successively until the maturity of the above fixed
coupon bond
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Linear Pricing Rule

Thus, we can value an interest rate swap by aggregating the value
of each of the components in the portfolio:
1. Value a fixed coupon bond
2. Value a floating rate coupon bond with the same maturity
and payment dates as the above fixed coupon bond
This utilizes the concept of linear pricing.
Linear Pricing Rule

Suppose there is no arbitrage. Let there be two cashflows

1. Let the price of cashflow CA be PA
2. Let the price of cashflow CB be PB
Thus the price of cashflow CA + CB must be PA + PB .
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Key things to know about floating rate bonds

Floating Rate Coupon Bonds

Floating rate coupon bond always repriced to par on interest

repayment dates
The floating rate interest is always set in advance, but paid
at the next period
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Key things to know about floating rate bonds

Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Key things to know about floating rate bonds

Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Key things to know about floating rate bonds

Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

More on Interest Rate Swaps ...

Lin will cover more examples on interest rate swaps next week.
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

What is a Total Return Swap (TRS)?

1. Total Return: Interest flows + changes in price of the asset

(final value - starting value)
2. Reference asset of the total return swap can be a corporate
bond, equity, commodity...
3. The receiver is long credit risk of the underlying assets (what
happens when credit spreads rise?)
4. The total return payer is the legal owner of the reference asset
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

What is a Total Return Swap (TRS)?

A more detailed diagram...

1. Hedge funds use TRS to gain exposure on the Reference

Asset without actually holding them
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Example - Index Swaps

Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

What is an Equity Swap?

1. Equity swaps have two legs:

2. Interest rate leg: LIBOR + margin
3. Equity leg: return of a stock or market index
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

What is an Equity Swap?

Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Credit Default Swaps

1. The protection seller receives periodic premiums

2. However, if the credit event occurs, the protect seller is
required to pay the contingent amount.
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Credit Default Swaps

Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Credit Default Swaps

Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Longevity Swaps
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Longevity Swaps
Outline Introduction Interest Rate Swaps Total Return Swaps Credit Default Swaps Longevity Swaps Sum

Summary on Swaps

1. Interest Rate Swaps: Counterparties exchange fixed for

floating rates
2. Currency Swaps: Counterparties exchange the principals on
the effective date, and return them at maturity
3. Equity Swaps: Counterparties exchange an equity position
for another equity, bond or fixed payment position
4. Credit Default Swaps: Counterpartier exchange default risk
for a premium
5. Longevity Swaps: Counterparties exchange