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Swaps
6.2
Nature of Swaps
A swap is an agreement to
exchange cash flows at specified
future times according to certain
specified rules
6.3
6.4
FIXED
Net
Date
Rate
Mar.1, 1998
4.2%
Sept. 1, 1998
4.8%
+2.10
2.50
0.40
Mar.1, 1999
5.3%
+2.40
2.50
0.10
Sept. 1, 1999
5.5%
+2.65
2.50
+0.15
Mar.1, 2000
5.6%
+2.75
2.50
+0.25
Sept. 1, 2000
5.9%
+2.80
2.50
+0.30
Mar.1, 2001
6.4%
+2.95
2.50
+0.45
6.5
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
Intel
MS
LIBOR+0.1%
LIBOR
6.6
6.7
5.015%
F.I.
Intel
LIBOR
MS
LIBOR
LIBOR+0.1%
Intel
MS
LIBOR-0.25%
LIBOR
6.8
6.9
5.015%
F.I.
Intel
MS
LIBOR-0.25%
LIBOR
LIBOR
4.7
%
6.10
Fixed
Floating
AAACorp
10.00%
BBBCorp
11.20%
6.11
6.12
Swap Design
Design the swap so AAAs
borrowing rate equals the
comparative disadvantage (CD)
rate minus the gain:
LIBOR + .3 - .25
Do the same thing for BBB
BBBs rate with swap:
11.2 - .25
Now, draw the diagram
6.13
AAA
BBB
LIBOR+1%
LIBOR
6.14
Then gain:
G = (1.2 - .7 - .04)/2 = .23%
AAAs rate with swap:
LIBOR + .3 - .23 = LIBOR + .07
BBBs rate with swap:
11.2 - .23 = 10.97%
Draw swap diagram
6.15
AAA
9.97%
F.I.
BBB
LIBOR+1%
LIBOR
LIBOR
6.16
6.17
6.18
Swap Valuation
Fixed Receive: Vswap = Vfixed Vfloating
Fixed Pay: Vswap = Vfloating - Vfixed
The fixed rate stream is valued as an
annuity
The floating rate stream is valued by
noting that it is worth par immediately
after the next payment date
6.19
6.20
6.21
Swap Valuation
The floating rate instrument is worth:
Vfloating = M M/(1+y/2)2T
The fixed rate stream is worth:
Vfixed
= (C/2)(Annuity Factor)
So for Fixed Receive Swap:
Vswap = (C/2)
(Annuity Factor) - M
+M/(1+y/2)2T
6.22
Swap Valuation
The swap is structured such that initial value is zero to
either party
Set Vswap = 0
Rearrange terms:
M=(C/2)(Annuity Factor) + M/
(1+y/2)2T
The left-hand side is the present value of a bond at y
Since the bond is selling at par, CR = C/M = y
For the swap to have zero value the fixed rate must
equal the yield to maturity on a par bond
The swap rate is the coupon rate on a LIBOR bond
that causes it to be worth par
6.23
Example
Zero coupon LIBOR curve is 5%, 6%,
and 7% for one, two, and three years
What is the swap rate on a three year
interest rate swap?
Assume payments are annual and
yields are compounded annually
Solve for LIBOR par yield
M = CRxM(d1 + d2 + d3) + Md3
6.24
Example Continued
Solution:
1
1
3
1
.
07
CR
6.91%
1
1
1
2
1.05 1.06 1.073
6.25
6.26
6.27
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
6.28
6.29
Years ------millions-----0
15.00 +10.00
+1.20 1.10
1
2
+1.20 1.10
3
+1.20 1.10
4
+1.20 1.10
5
+16.20 -11.10
6.30
Typical Uses of a
Currency Swap
Conversion from Conversion from
a liability in one
an investment in
currency to a
one currency to
liability in
an investment in
another currency
another currency
6.31
AUD
12.6%
Qantas
13.0%
7.0%
6.32
Comparative Advantage
GM has absolute advantage in both markets
But GM has comparative advantage in dollars
Qantas has comparative advantage in
Australian dollars
So GM should borrow dollars and Qantas
Australian dollars
Then swap cash flows to earn gain from
comparative advantage
6.33
Comparative Advantage
Gain per party:
G = (2 - .4)/2 = .8%
GMs rate with swap:
12. 6 - .8 = AUD 11.8%
Qantas rate with swap:
7 - .8 = USD 6.2%
6.34
USD 5%
USD 5%
GM
Qantas
AUD 11.8%
AUD 13%
6.35
USD 6.2%
USD 5%
GM
Qantas
AUD 13.0%
AUD 13%
6.36
6.37
GM
USD 6.3%
F.I.
Q
AUD 13%
AUD11.9%
AUD 13%
6.38
6.39
6.40
6.41
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