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Chapter 7

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

Nature of Swaps

A swap is an agreement to exchange cash flows at specified future times according to certain specified rules

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

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

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

(See Table 7.1, page 159

---------Millions of Dollars--------LIBOR FLOATING Date Rate FIXED Net Cash Flow Cash Flow Cash Flow +2.10 2.50 0.40

Mar.5, 2010

Sept. 5, 2010

4.2%

4.8%

Mar.5, 2011

Sept. 5, 2011 Mar.5, 2012

5.3%

5.5% 5.6%

+2.40

+2.65 +2.75

2.50

2.50 2.50

0.10

+0.15 +0.25

Sept. 5, 2012

Mar.5, 2013

5.9%

6.4%

+2.80

+2.95

2.50

2.50

+0.30

+0.45

4

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

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

5

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

(Figure 7.2, page 160)

5% 5.2%

Intel

LIBOR

MS

LIBOR+0.1%

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

(Figure 7.4, page 162)

4.985% 5.2%

5.015%

Intel

LIBOR

F.I.

LIBOR

MS

LIBOR+0.1%

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

(Figure 7.3, page 161)

5% 4.7%

Intel

LIBOR-0.2% LIBOR

MS

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

(See Figure 7.5, page 163)

4.985%

5.015% 4.7%

Intel

LIBOR-0.2%

LIBOR

F.I.

LIBOR

MS

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

(Table 7.3, page 163) Maturity Bid (%) Offer (%) Swap Rate (%)

2 years

3 years 4 years 5 years 7 years 10 years

6.03

6.21 6.35 6.47 6.65 6.83

6.06

6.24 6.39 6.51 6.68 6.87

6.045

6.225 6.370 6.490 6.665 6.850

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

10

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

11

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

12

(Figure 7.7, page 167)

4.33% 4%

4.37%

AAA

LIBOR

F.I.

LIBOR

BBB

LIBOR+0.6%

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

13

The 4.0% and 5.2% rates available to AAACorp and BBBCorp in fixed rate markets are 5-year rates The LIBOR0.1% and LIBOR+0.6% rates available in the floating rate market are sixmonth rates BBBCorps fixed rate depends on the spread above LIBOR it borrows at in the future

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

14

Six-month LIBOR is a short-term AA borrowing rate The 5-year swap rate has a risk corresponding to the situation where 10 sixmonth 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

15

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

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 (See Example 7.2 on page 169.)

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

16

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 Alternatively, they can be valued as a portfolio of forward rate agreements (FRAs)

17

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

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

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

18

Value = PV of L+k* at t* Value = L+k* 0 Valuation Date t* First Pmt Date Floating Pmt =k* Second Pmt Date

Value = L

Maturity Date

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

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Example

Pay six-month LIBOR, receive 8% (s.a. compounding) on a principal of $100 million Remaining life 1.25 years LIBOR rates for 3-months, 9-months and 15months are 10%, 10.5%, and 11% (cont comp) 6-month LIBOR on last payment date was 10.2% (s.a. compounding)

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

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PV fixed PV floating Bond Bond 3.901 102.5045 3.697 90.64 98.238 102.505

21

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

Each exchange of payments in an interest rate swap is an FRA The FRAs can be valued on the assumption that todays forward rates are realized

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

22

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

23

An agreement to pay 5% on a sterling principal of 10,000,000 & receive 6% on a US$ principal of $15,000,000 every year for 5 years

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

24

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

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

25

Dollars Pounds $ ------millions-----18.00 +10.00 +1.08 0.5 +1.08 0.5 +1.08 0.5 +1.08 0.5 +19.08 10.5

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

26

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

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

27

Comparative Advantage Arguments for Currency Swaps (Table 7.6, page 176)

General Electric wants to borrow AUD Qantas wants to borrow USD

USD

General Motors Qantas 5.0% 7.0%

AUD

7.6% 8.0%

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

28

Like interest rate swaps, currency swaps can be valued either as the difference between 2 bonds or as a portfolio of forward contracts (See Examples 7.6 and 7.7)

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

29

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, 7th Ed, Ch 7, Copyright John C. Hull 2010

30

Time 1 2 3 3 Total Cash Flows ($) 0.8 0.8 0.8 10.0 PV ($) 0.7311 0.6682 0.6107 7.6338 9.6439 Cash flows (yen) 60 60 60 1,200 PV (yen) 57.65 55.39 53.22 1,064.30 1,230.55

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

31

Time $ cash flow

-0.8 -0.8 -0.8 -10.0

60 60 60 1200

0.009557 0.010047 0.010562 0.010562

0.5734 0.6028 0.6337 12.6746

-0.2266 -0.1972 -0.1663 +2.6746

Present value

-0.2071 -0.1647 -0.1269 2.0417 1.5430

1 2 3 3 Total

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

32

A swap can be regarded as a convenient way of packaging forward contracts When a swap is initiated the swap has zero value, but typically some forwards have a positive value and some have a negative value

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

33

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

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

34

Amortizing/ step up Compounding swap Constant maturity swap LIBOR-in-arrears swap Accrual swap Equity swap

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

35

Cross currency interest rate swap Floating-for-floating currency swap Diff swap Commodity swap Variance swap

Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright John C. Hull 2010

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