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Swaps
Two parties exchange recurring payments (most
commonly)
the feature of recurring payments distinguishes a swap from a forward contract but, some swaps involve only a single exchange
(Thus, in practice its a swap if it is written up on swap documentation. That is, its a swap if its called a swap.)
Basic facts
Payments based on indices:
interest rates (most common) currency prices (actually an exchange of currencies) commodity prices equity prices or returns
Notional Amount: Trade Date: Effective Date: Termination Date: Fixed Amounts: Fixed Rate Payor: Fixed Rate Payor Paryment Dates:
LEU
Each January 15, April 15, July 15 and October 15 starting with April 15, 1989; subject to adjustment in accordance with the Following Day Banking Convention.
10.05%, 30/360
(First page would be a cover letter; in addition, a swap with any but the simplest features might include a few pages of definitions of the terms which appear in the confirmation.)
Each January 15, April 15, July 15 and October 15 starting with April 15, 1989; subject to adjustment in accordance with the Follow ing Banking D ay Convention.*
Floating Rate for Initial Calculation Period: Floating Rate Option: Designated Maturity: Adjustment to Floating Rate Option:
*While this swap uses the Following Banking Day Convention, the use of the Modified Following Banking Day Convention is more common. With payment dates in the middle of the month, the difference between these two conventions is not relevant.
Effective date:
date begin accruing interest; analogous to settlement date
Payment dates:
dates when payments are exchanged*
Reset dates:
dates when LIBOR quotes are observed note that LIBOR is observed at the beginning of the period due to this, the floating rate for the initial calculation period is known on the trade date, and included in the confirmation
Following Banking Day Convention means that if the specified payment date is a weekend or a holiday, payment is made on the next business day.
Relevant dates
Trade date Reset date for second payment Effective (value) date First payment date Reset date for third payment Second payment date Reset date for final payment Eleventh payment date Termination and final payment date
1/18/89
1/20/89
4/13/89
4/17/89
7/13/89
7/17/89
10/11/91
10/15/91
1/15/92
Remarks: 4/15/89 is a Saturday, so the payment is made on Monday 4/17/89 7/15/89 is a Saturday, so the payment is made on Monday 7/17/89 10/13/91 is a Sunday, so the reset date is Friday 10/11/91
Second payment is based on LIBOR quoted 3 months and 2 (business) days earlier Floating Rate for Initial calculation Period is known on the trade date, and thus included in the confirmation
In 30/360, when counting days you pretend that each month has 30 days
Payment conventions
What if the payment date specified in the contract is a weekend or holiday? Need to consider two issues:
When is the payment date? If the payment date is adjusted, do we also adjust the amount of interest paid?
Adjusted: shift payment date and change the interest accrual (that is, change the amount of the payment)
payment = (182/360)0.06N Most commonly, but not always, swap payments are adjusted. Swap payments might be unadjusted if the swap is intended to exactly hedge an underlying bond on which payments are unadjusted.
Changes in notional amount reflect fact that: (a) LEU borrowed $75 million (b) repaid $5 million on 15 Jan 1990 (c) Repaid $10 million on 15 Jan 1991 (d) Repaid the remaining $60 million on 15 Jan 1992
It is crucial to understand that the cash flow on say 7/17/89 is based on LIBOR observed on 4/13/89, ., cash flow on 1/15/92 is based on LIBOR observed on 10/11/91.
Note that this column reflects the adjustment To floating rate option, that is the floating Rate is divided by 0.97
In an ideal world, dealer would do another swap (of same size) in which it:
Pays 9.95% Receives 3-month LIBOR
Dealer gross profit is 0.10% or 10 basis points Exactly offsetting swaps only rarely (if ever) occur
Steps in Dealing
Negotiate terms by telephone
convention is LIBOR flat as a result, dealer quotes the fixed rate fixed rate is chosen so that the swap has value 0 on the trade date
Fax confirmation (this is what you have) Exchange signed ISDA Master Agreement
ISDA master defines terms, contains detailed provisions
Swap quotes
Hypothetical Indicative U.S. Dollar Interest Rate Swap Quotes Maturity /tenor 2Y 3Y 4Y 5Y 7Y 10Y Spread over Treasury yield if dealer pays fixed 25 basis points 28 basis points 30 basis points 30 basis points 33 basis points 37 basis points Spread over Treasury yield if dealer receives fixed 27 basis points 30 basis points 34 basis points 35 basis points 38 basis points 42 basis points
For each maturity/tenor, the spread would be added to the yield on the current Treasury note of the same maturity. For example, if the dealer pays fixed on a 5 year swap, the fixed rate of the swap would be equal to the yield on the 5 year note plus 30 basis. If the dealer pays floating and receives fixed, the fixed rate of the swap would be equal to the yield on the 5 year note plus 35 basis points.
Interest payment: LIBOR 0.25 $200 Million LIBOR currently is 7% Company exposed to risk of increases in LIBOR
0 0% -2 5% 10% 15%
-8 3-mo. LIBOR
Fixed-Rate Payer
Pay 7.00% Fixed Rate 0.25 Notional Principal
Fixed-Rate Receiver
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0 0% 5% 10% 15%
-2
-4 3-mo. LIBOR
0 0% 5% 10% 15%
-2
-4
-6 3-mo. LIBOR
Here:
cash flows are from perspective of counterparty who is receiving floating, paying fixed rt(t, t+0.25) is a floating interest rate observed at time t, for a deposit/loan from time t to time t + 0.25 7% is the fixed rate we ignore notional principal (notional = $1) and the details of day-counts
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0.25( 0.07)
0.25( 0.07)
...
[1 + 0.25(0.07)]
Here the end-user has hedged cash flows (interest expense) by swapping from floating to fixed
0.25[0.07r0(0, 0.25)]
0.25[0.07r0.25(0.25, 0.5)]
...
0.25[0.07rT-0.25(T0.25, T)]
0.25r0(0, 0.25)
0.25r0.25(0.25, 0.5)
...
[1 + 0.25rT-0.25(T0.25, T)]
Which is hedging?
Swapping from floating to fixed creates a synthetic fixed-rate bond Swapping from fixed to floating creates a synthetic floating-rate bond Which is less risky:
a fixed rate bond?; or a floating rate bond?
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Which is hedging?
Swapping from floating to fixed:
reduces the variability of interest expense increases the variability of the value of the (synthetic) bond
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2-year swap
$1,500,000
$1,000,000
$0 0 1 2 3 4 5
Fixed payments
-$500,000
5-year swap
$1,500,000
Fixed payments
$1,000,000
$0 0 -$500,000 1 2 3 4 5
-$1,000,000
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$1,000,000
Fixed payments
$500,000 Swap payments
$0 0 -$500,000 1 2 3 4 5
-$1,000,000
$1,000,000
Fixed payments
$0 0 -$500,000 1 2 3 4 5
-$1,000,000
0.5[0.0712r0(0, 0.5)]
...
0.5[0.0712r1.5(1.5, 2.0)]
...
0.5[0.0712r2(2, 2.5)]
...
...
0.5[r1.5(1.5, 2.0)0.0591]
0.5[0.07120.0591]
...
0.5[0.07120.0591]
...
0.5[0.0712r2(2, 2.5)]
...
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Gibson has shifted income from years 3 through 5 into years 1 and 2.
Other swaps
Ordinary (plain-vanilla) swap: swap fixed for floating Basis swap: swap one floating rate for another Currency swaps: the two legs are denominated in different currencies
Both, either, or neither legs may be fixed In a currency swap, principals typically are exchanged
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