Chapter 7 Swaps

Options, Futures, and Other Derivatives
Tenth Edition
Chapter 7
Swaps
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Nature of Swaps
A swap is an agreement to exchange cash flows at specified
future times according to certain specified rules
OTC
An Example of a “Plain Vanilla” Interest

Rate Swap
Variable rate (SOFR)
• An agreement by Apple to receive 6-month LIBOR & pay a fixed rate

of 3% per annum every 6 months for 3 years on a notional principal
of $100 millionTrade is done using realised rate not forward rate Notional amount = Does not change
hands. Very specific to interest rate
swap.
• Next slide illustrates cash flows that could occur (Day count
conventions are not considered)
3.0%
Citi Apple
Cash Flows to Apple LIBOR
FLOATING FIXED Net

LIBOR Cash Flow Cash Flow Cash Flow
Date Rate ($ ($ Millions) ($ Millions) ($ Millions)
Millions)
2.2% Blank
Mar. 8, 2016 Look at the past 6 months realized rate.
Blank
2.8% +1.10 –1.50 –0.40

Sept. 8, 2016 Apple will pay 0.4 to
2.2/2*100 mn 3/2*100 mn CITI
3.3% +1.40 –1.50 –0.10
Mar. 8, 2017
3.5% +1.65 –1.50 +0.15

Sept. 8, 2017
3.6% +1.75 –1.50 +0.25

Mar. 8, 2018
3.9% +1.80 –1.50 +0.30

Sept. 8, 2018
Mar. 8, 2019 3.4% +1.95 –1.50 +0.45
Typical Uses of an Interest Rate Swap
Net Interest payamnet
• Converting a liability from -3.2% +2.97% - VR( variable rate
-VR -0.23%
-(VR +0.23%)
– fixed rate to floating rate

2.97% This part is not swap
Citi Intel 3.2%

LIBOR
– floating rate to fixed rate

Net Interest Payment
- VR + 0.1% +VR - 3%
3.0% LIBOR+0.1% 2.9 %
Citi Apple
LIBOR
Typical Uses of an Interest Rate Swap
• Converting an investment from
– fixed rate to floating rate This part is investment
3.0%
Citi Apple 2.7%
LIBOR Given 100 mn investment
– floating rate to fixed rate 2.7% -3% +VR

VR - 0.3%
2.97%
LIBOR−0.2%
Citi Intel
LIBOR
Quotes By a Swap Market Maker (Table 7.3, page 161)
Bank =
Average of BID and offer
Market maker is buying SOFAR ....and pay us 2.55% Market maker is selling SOFAR and receive 2.58% from us
Maturity Bid (%) Offer (%) Swap Rate (%)

2 years 2.55 2.58 2.565
3 years 2.97 3.00 2.985
4 years 3.15 3.19 3.170
5 years 3.26 3.30 3.280
7 years 3.40 3.44 3.420
10 years 3.48 3.52 3.500
Day Count In swaps we will calculate on basis of days and not months...as in swaps the amount is huge
• A day count convention is specified for fixed and floating payments

• For example, LIBOR is likely to be actual/360 in the U.S. because
LIBOR is a money market rate
Confirmations (Legal Agreement)

• Confirmations specify the terms of a transaction
• The International Swaps and Derivatives has developed Master
Agreements that can be used to cover all agreements between two
counterparties
• CCPs are used for most standard swaps between two financial
institutions
CCP = Central clearing party. If u want u can use a CCP not a mandatory requirement
The Comparative Advantage Argument
(Table 7.4, page 163) what it asnwers .... Why the firms enter into swap??
Different firms have different competitive advantage in different market. This is based on the argument that
floating rates dont change. This will be true only if the rating does not change. Hence it only works for one
period
• AAACorp wants to borrow floating Borrower in Fixed
If AAA borrowes in fixed it will pay 1.2% more less than 0.7% in floating
• BBBCorp wants to borrow fixed Borrower in Floating
B Fixed Floating
AAACorp 4.00% 6-month LIBOR − 0.1%

a = 1.2 b = 0.7
BBBCorp 5.20% 6-month LIBOR + 0.6%
4.35%
4% LIBOR+0.6%
AAACorp BBBCorp
LIBOR
0.04%
4.33% 4.37%
4% AAACorp LIBOR+0.6%
F.I. BBBCorp
LIBOR LIBOR
F.I 2018,
Copyright © = financial institution
2015, 2012 Pearson Education, Inc. All Rights Reserved
Criticism of the Comparative Advantage
Argument
• The 4.0% and 5.2% rates available to AAACorp and BBBCorp in fixed
rate markets are 5-year rates
• The LIBOR−0.1% and LIBOR+0.6% rates available in the floating
rate market are six-month rates
• BBBCorp’s fixed rate depends on the spread above LIBOR it borrows
at in the future
Valuation of an Interest Rate Swap
• Initially interest rate swaps are worth close to zero
• At later times they can be valued as a portfolio of forward rate
agreements (FRAs) Valuation = PV of Future cash flow
• The procedure is to
– Calculate LIBOR forward rates
– Calculate the swap cash flows that will occur if LIBOR forward
rates are realized
– Discount these swap cash flows at OIS rates
Example 7.1 (page 166) Exam question
• Swap involves paying 3% per annum and receiving LIBOR

every six months on $100 million
• Swap has 15 months remaining (exchanges in 3, 9, and 15 months)
• LIBOR rate applicable to exchange in 3 months was determined 3
months ago and is 2.9%
• Forward LIBOR rates for 3-9 month period and 9-15 month periods
are 3.429% and 3.734%, respectively
• OIS zero rates for maturities of 3, 9, and 15 months are 2.8%, 3.2%,
and 3.4%, respectively these are annual rates
OIS = Overnight index swap rate
Considered risk free rates. use this to discount the cashflow
Though Libor rates are given at an interval of 3 months still we are dividing the rates by 2 to calculate cashflow for 6
months?? As they have mentioned LIBOR received every six months
0.03/2*100 0.029/2*100 0.03429/2*100
Calculations ($ million) -0.05*e^-0.028*3/12
Time Fixed cash Floating Net cash Discount PV of net

(yrs) flow cash flow flow factor cash flow
0.25 −1.5000 +1.4500 −0.0500 0.9930 −0.0497
0.75 −1.5000 +1.7145 +0.2145 0.9763 +0.2094
1.25 −1.5000 +1.8672 +0.3672 0.9584 +0.3519
Blank Blank Blank Blank Blank +0.5117
0.2145*e^-0.032*9/12
Value of swap is $0.5117 million
Bootstrapping LIBOR forward rates:
Example 7.2
• 6,12,18, and 24 month OIS rates are 3.8%, 4.3%, 4.6%,and 4.75%
respectively with cont. comp.
Annual rate Sa = Semi annual compounding
• 6-month LIBOR rate is 4% (sa comp.)
• Suppose forward LIBOR rates for 6-12 and 12-18 months have
already been calculated as 5% and 5.5%,respectively (sa comp)
• The two year swap rate is 5% Swap rate is Fixed Rate p.a. Always P.a unless otherwise
mentioned
• The next step is to calculate the LIBOR forward rate, F, for the18-24
month period.
Swap is constructed at T0
Bootstrapping LIBOR forward rates:
Calculations
• A 2-year swap where 5% is paid and LIBOR is received on $100 is
worth zero.
• Value of first three exchanges are
0.5×(0.04− 0.05)×100×e−0.038×0.5 = −0.4906
0.5×(0.05 − 0.05)×100×e−0.043×1.0 = 0
0.5×(0.055 − 0.05)×100×e−0.046×1.5 = +0.2333
• The value of the fourth payment must be +0.2573 so that the total
value is zero
0.5×(F−0.05)×100×e−0.0475×2.0 = 0.2573
F = 0.05566 or 5.566% per annum
An Example of a Fixed-for-Fixed
Currency Swap beginning
In currency swap Notional amount exchanges hands at the
and the end of 3 years. This is the biggest difference in
Interest and currency rate swaps.
Coverting liability/ Investment from one currency to another
Five year agreement by BP to
• Pay 3% on a US dollar principal of $15,000,000
• Receive 4% on a sterling principal of £10,000,000
• 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
Dollars 3.0%
Barclays BP
Sterling 4.0%
• 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
The Cash Flows
Bp's Perspective
Dollar Cash Flows Sterling cash flow

Date (millions) (millions)
0 Feb 1, 2016 +15.00 −10.00
1 Feb 1, 2017 −0.45 +0.40
2 Feb 1, 2018 −0.45 +0.40
3 Feb 1, 2019 −0.45 +0.40
4 Feb 1, 2020 −0.45 +0.40
5
Feb 1, 2021 −15.45 +10.40
-15 -0.45 10 +0.4
3% * 15 mn
Comparative Advantage May Be Real
Because of Taxes
US based company
• General Electric wants to borrow AUD Borrow USD
Australian based co.
• Qantas wants to borrow USD Borrow AUD
Borrowing costs after adjusting for the differential impact of taxes could
be:
Blank USD AUD
General Electric 5.0% 7.6%

a = 2% b =0.4%
Qantas 7.0% 8.0%
GE = will pay 2 % less in USd market and will pay 0.4 % less in AUD market. It has
competitive advantage in USd market
Qantas = will pay 2% more in USD market and 0.4 % more in AUD market. It has
compettitive advantage in AUD market
Examples 7.3 and 7.4 Swap was constructed 2 years ago
Risk free rate or discount rate rf = 1.5 %

• All Japanese interest rates are 1.5% per annum (cont. comp.)
• All USD interest rates are 2.5% per annum (cont. comp.) r =2.5 %
• 3% is received in yen; 4% 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
Spot exchange rate = 1/110 yen $ /Y
Exchange rates are always mentioned in terms of $ hence we had to convert it
Valuation in Terms of Forward Rates
0.009182*36 0.3306 -0.4
Dollar Yen
Cash Cash Forward Dollar Value of Net Cash Present
Time Flow Flow Rate Yen Cash Flow Flow Value
1 −0.4 +36 0.009182 0.3306 −0.0694 −0.0677
2 −0.4 +36 0.009275 0.3339 −0.0661 −0.0629
3 −10.4 +1236 0.009368 11.5786 +1.1786 +1.0934
Total Blank Blank Blank Blank Blank +0.9629
1/110 e^0.025 -0.015 *1 -0.0694*e^-0.025*1

1/110 e^ 0.025 -0.015*2
1/110 e^ 0.025 -0.015*3
Valuation in Terms of Bonds
Fixed for fixed currency swaps can be valued either using forward
rates or as the difference between 2 bonds.
Cash flows
Cash Flows PV (millions of PV (millions
Time ($ millions) ($ millions) yen) of yen)
1 0.4 0.3901 36 35.46
2 0.4 0.3805 36 34.94
3 10.4 9.6485 1,236 1,181.61
Total Blank 10.4191 Blank 1,252.01
Value = 1,252.01/110−10.4191 = +0.9629 millions of dollars
Other Currency Swaps
• Fixed-for-floating: A floating interest rate in one currency is
exchanged for a fixed rate in another currency.
• Floating-for-floating: A floating interest rate in one currency is
exchanged for a floating rate in another currency.
Credit Default Swaps: A Quick First
Look
• Notional principal (e.g., $100 million) and maturity (e.g., 5 yrs)
specified
• Protection buyer pays a fixed rate (e.g., 150 bp) on the notional
principal (the CDS spread)
• If the reference entity (a country or company) defaults protection
seller buys bonds issued by the reference entity for their face value
and the spread payments stop. Total face value of bonds bought
equals notional principal

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Options, Futures, and Other Derivatives

An Example of a “Plain Vanilla” Interest

• An agreement by Apple to receive 6-month LIBOR & pay a fixed rate

FLOATING FIXED Net

2.8% +1.10 –1.50 –0.40

3.5% +1.65 –1.50 +0.15

3.6% +1.75 –1.50 +0.25

3.9% +1.80 –1.50 +0.30

Mar. 8, 2019 3.4% +1.95 –1.50 +0.45

– fixed rate to floating rate

Citi Intel 3.2%

– floating rate to fixed rate

– floating rate to fixed rate 2.7% -3% +VR

Maturity Bid (%) Offer (%) Swap Rate (%)

• A day count convention is specified for fixed and floating payments

Confirmations (Legal Agreement)

• BBBCorp wants to borrow fixed Borrower in Floating

AAACorp 4.00% 6-month LIBOR − 0.1%

BBBCorp 5.20% 6-month LIBOR + 0.6%

• Swap involves paying 3% per annum and receiving LIBOR

Calculations ($ million) -0.05*e^-0.028*3/12

Time Fixed cash Floating Net cash Discount PV of net

Dollar Cash Flows Sterling cash flow

General Electric 5.0% 7.6%

Risk free rate or discount rate rf = 1.5 %

• 3% is received in yen; 4% is paid in dollars. Payments are made

2 −0.4 +36 0.009275 0.3339 −0.0661 −0.0629

3 −10.4 +1236 0.009368 11.5786 +1.1786 +1.0934

Total Blank Blank Blank Blank Blank +0.9629

1/110 e^0.025 -0.015 *1 -0.0694*e^-0.025*1

Value = 1,252.01/110−10.4191 = +0.9629 millions of dollars

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Calculations ($ million) -0.05e^-0.0283/12

1/110 e^0.025 -0.015 1 -0.0694e^-0.025*1