Swaps

Swaps
A swap is a financial transaction in which two counterparties agree to
exchange streams of payments over time.
A swap is an agreement between two parties to exchange sequences
of cash flows for a set period of time.
All swaps involve exchange of a series of periodic payments
between two parties, usually through an intermediary which is
normally a large financial institution which keeps
a Swap
Book.
Swaps are customized contracts traded in the OTC market. Firms and
financial institutions are the major players in the swaps market.
Since swaps are OTC products, the risk of a counterparty defaulting
is quite high and this is one of the major drawbacks of swap related
product.

Swaps
The market primarily consist of financial institutions and corporations who
use the swap market to hedge more efficiently their liabilities and assets.
Many institutions create synthetic fixed- or floating-rate assets or liabilities
with better rates than the rates obtained on direct liabilities and assets.
A swap is an exchange of cash flows, CFs. It is a legal
arrangement between two parties to exchange specific
payments.
In case of Plain Vanilla type of interest rate swap there would be exchange
of cash flow for conversion of floating interest rate to fixed interest rate for a
notional principal.
Thus, there would be swap of floating and fixed interest rate payments.
Since swaps are customized contract products, interest payments may be made
annually, quarterly, monthly, or at any other interval determined by both the
parties.

Swaps: Types
There are four types of swaps:
1. Interest Rate Swaps: Exchange of fixed-rate
payments for floating-rate payments
2. Currency Swaps: Exchange of liabilities in
different currencies
3. Cross-Currency Swaps: Combination of
Interest rate and Currency swap
4. Credit Default Swaps: Exchange of premium
payments for default protection

Plain Vanilla Interest Rate Swaps:

Terms
1. Parties to a swap are called counterparties. There are two
2.
3.
4.
5.

parties:
Fixed-Rate Payer
Floating-Rate Payer
Rates:
Fixed rate is usually a T-note rate plus basis points.
Floating rate is a benchmark rate: LIBOR
Reset Frequency: Semiannual
Principal: No exchange of principal
Notional Principal (NP): Interest is applied to a notional
principal; the NP is used for calculating the swap payments.
Trade Date: It is the date on which the interest rate swap
contract signed.
Effective Date: It is the date on which the interest rate swap
contract is operationalised. On this date onward the interest
payment is estimated.

Example
July 31, 2010, Company A and Company B enters into
a 3 year swap with the following terms:
Company A pays to Company B an amount equal to
5.50%(fixed interest rate) every 6 month on a notional
principal of $ 10Mn.
Company B pays to Company A an amount equal to 6
month LIBOR on the same notional principal.
Effective date March 1st and Sept 1st every year.
Decide the pay off for both the parties.

Plain Vanilla Interest Rate Swap:

Example

Interest Rate Swap: Point

Points:
If LIBOR > 5.5%, then fixed payer
receives the interest differential.
If LIBOR < 5.5%, then floating payer
receives the interest differential.

Interest Rate Swaps

Fundamental Use
One of the important uses of swaps is in
creating a synthetic fixed- or floating-rate
liability or asset that yields a better rate
than a conventional or direct one:
Synthetic
fixed-rate
investments
Synthetic
floating-rate
investments

loans
loans

and
and

Swaps as Bond Positions

Swaps can be viewed as a combination of a
fixed-rate bond and flexible-rate note (FRN).
A fixed-rate payer position is equivalent
to
Buying a FRN paying the LIBOR
Shorting a fixed-rate bond at the swaps
fixed rate.

A floating-rate payer position is equivalent to

Shorting a FRN at the LIBOR
Buying a fixed-rate bond at the swap fixed rate

Swaps as Bond Positions

From the previous example, the fixed-rate
payers swaps CFs can be replicated by:
Fixed Rate Payers
Selling at par a 3-year bond, paying a 5.5%
fixed rate and a principal of $100Mn.
Purchasing a 3-year, $100Mn FRN with the
rate reset every six months at the LIBOR.

Floating Rate Payers

Selling a 3-year, $100Mn FRN paying the
LIBOR
Purchasing 3-year, $100Mn, 5.5% fixedrate bond at par

Size Problem: Multiple

Counterparties

Party A wanted to convert its 5.75%

fixed interest carrying exposure
$50,000,000 through a swap deal.
The swap dealer matched the same
with two floating for fixed swaps with
Libor payment semi-annually.

Swap Market
Structure
Fixed Rate Payer

Party A
NP $50m

Party B
NP $25m
Floating Rate Payer

Fixed Rate Payer

Swap Bank
Floating Rate Payer

Floating Rate Payer

Fixed Rate Payer

Party C
NP $25m

13

Swap Market Price

Quotes

Swap spread: Swap dealers usually quote two

different swap spreads
One for deals in which they pay the fixed rate
One in which they receive the fixed rate
Swap spread of 80/86 dealer buys at 80bps over
T-note yield and sells at 86 over T-note yield.
Take the fixed payers position at a fixed rate
equal to 80 bps over the T-note yield and
Take the floating payers position, receiving
86 bps above the T-note yield.

14

Swap Market Price Quotes

Swap Bank Quote Offerings
Example:

Swap Rate = (Bid Rate + Ask Rate)/2

15

Swap Valuation
At origination, most plain vanilla swaps have an
economic value of zero. This means that neither
counterparty is required to pay the other to
induce that party into the agreement.
An economic value of zero requires that the
swaps underlying bond positions trade at par
par value swap.
If this were not the case, then one of the
counterparties would need to compensate the
other. In this case, the economic value of the
swap is not zero. Such a swap is referred to as an
off-market swap
In general, the value of an existing swap is equal
to the value of replacing the swapreplacement
swap.

Swap Valuation
Formally, the
values of the
fixed and floating
swap positions
are:

where:

SV

fix

K P KS

NP
P t
t 1 (1 K )

S
P

K
fl
SV
NP
P t
t 1 (1 K )
M

KS = Fixed rate on the existing swap

KP = Fixed rate on current par-value swap
SVfix = Swap value of the fixed position on
the existing swap
SVfl = Swap value of the floating position on
the existing swap

17

Advantages of Swaps
Company rating generally plays vital role in case of
market borrowing.
A good rating reduced the cost of borrowing
significantly.
It may also happen that a company may be good in
getting funds at lower floating rate and another
company may be getting fund at lower fixed rate.
Hence there are many possibilities for arrangement
of interest rate swaps.

Comparative Advantage
Swaps are often used by corporations
and financial institutions to take
advantage of arbitrage opportunities
resulting
from
capital-market
inefficiencies.
To see this consider the following case.

19

Comparative Advantage
Case:
ABC Inc. is a large conglomerate that is
working on raising $300,000,000 with a 5-year
loan to finance the acquisition of a
communications company.
Based on a BBB credit rating on its debt, ABC
can borrow 5-year funds at either
A 9.5% fixed a spread of 250 bp over a 5-year T-note
yield
Or
A floating rate set equal to LIBOR + 75

ABC prefers a fixed-rate loan.

20

Comparative Advantage
Suppose:
The treasurer of ABC contacts his investment banker
for suggestions on how to obtain a lower rate.
The investment banker knows the XYZ Development
Company is looking for 5-year funding to finance its
$300,000,000 shopping mall development.
Given its AA credit rating, XYZ could borrow for 5
years at either
A fixed rate of 8.5% (150 bp over T-note)
Or
A floating rate set equal to the LIBOR + 25 bp
The XYZ company prefers a floating-rate loan.
21

Comparative Advantage
Fixed Rate
ABC
9.5%
XYZ
8.5%
Credit Spread
100 bp

Floating Rate
LIBOR 75 bp
LIBOR 25 bp
50 bp

preference
Fixed
Floating

22

Comparative Advantage
The Investment banker realizes there is a
comparative advantage.
XYZ has an absolute advantage in both the
fixed and floating market because of its lower
quality rating, but it has a relative advantage
in the fixed market where it gets 100 bp less
than ABC.
ABC has a relative advantage (or relatively
less disadvantage) in the floating-rate market
where it only pays 50 bp more than XYZ.

23

Comparative Advantage
Thus, it appears that investors/lenders in the
fixed-rate market assess the difference
between the two creditors to be worth 100
bps, whereas investors/lenders in the floatingrate market assess the difference to be 50
bps.
Arbitrage
opportunities
exist
comparative advantage exist.

whenever

In this case, each firm can borrow in the

market where it has a comparative advantage
and then swap loans or have the investment
banker set up a swap.
24

Comparative Advantage
Note:
The swap wont work if the two companies
pass their respective costs. That is:
ABC swaps floating rate at LIBOR + 75bp
for 9.5% fixed
XYZ swaps 8.5% fixed for floating at LIBOR
+ 25bp
Typically,
the
companies
divide
the
differences in credit risk, with the most
creditworthy company taking the most
savings.

25

Comparative Advantage
Given total savings of 50 bp (100 bp on fixed
50bp float), suppose the investment banker
arranges an 8.5%/LIBOR swap with a NP of
$300,000,000 in which ABC takes the fixed-rate
position and XYZ takes the floating-rate payer
position.

ABC

Floating Rate LIBOR

Fixed Rate 8.5%

Swap Bank

Floating Rate LIBOR

XYZ

Fixed Rate 8.5%

26

Example
Jan 1, 2010, Company A and Company B enters into a 10-year
interest rate swap with the following terms:
Company A pays Company B an amount equal to 11%(fixed
interest rate) per annum on a notional principal of $200,000 .
Company B pays Company A an amount equal to one-year
LIBOR + 4% per annum on a notional principal of $200,000
Decide the pay off for both the parties.

Answer
Diagram below indicates the cash flows between the parties, which occur annually.

Fixed Rate: 11%

Company A

Company B

Floating Rate: LIBOR+4%

Answer
As on Jan 1, 2011:
Company A will pay to Company B
$200,000 * 11% = $22,000

Let us assume as on Jan 1, 2011, one-year LIBOR is

6.50%. Therefore, Company B will pay Company A
$200,000 * (6.50% + 4%) = $21,000.

The settlement takes place through the net payment, that

is Company A would pay
US$ 1000 to Company B.
At no point does the principal change hands, which is
why it is referred to as a "notional" amount.
If LIBOR in Jan 2012 becomes 7.15%, then Company B
would pay to Company A at the rate 11.25% and
Company A would pay Company B at the rate of 11%. In
this case Company A would be profitable.

Synthetic Swap:
Fixed -Loans and Deposits
A Libor linked floating rate deposits of
$100mn was accepted by a bank for a
period of 3-year.
On the same
deposits, the bank has created a
5.50% semi-annual interest payment
3- year loan. Using the synthetic swap
concept estimate the minimum Yield
on the fixed rate loan, if the floating
rate deposits convert to fixed rates.

Synthetic Swap:
Fixed -Loans and Deposits

Currency Swaps

Foreign Currency Swap

The first currency swap transaction took place in 1982 between

the World Bank and IBM.
A plain vanilla currency swap involves exchanging principal
and fixed interest payments on a loan in one currency for
principal and fixed interest payments on a similar loan in
another currency.
The parties to a currency swap will exchange principal amounts
at the beginning and end of the swap.
Currency swaps are generally resorted to by parties who need a
different currency for financing assets but can raise resources in
a different currency, in a different market on more competitive
terms and with comparative advantage.
Because of their market share and pre-dominant position, a
company may be better known in one market and can raise
resources at lower cost

Steps involves in Currency Swap Transactions

Exchange of equivalent amounts of
different currencies.
Exchange
of
periodic
interest
payments during the life of swap.
Re-exchange of principal amount at a
pre-determined rate on the maturity
of swap.

Example
A Japanese Company wanted to raise US$ loan but it
is not getting good response in US market. At the
same time, a US based company wanted to set up a
manufacturing plant in Japan is not getting Japanese
Yen at competitive rate in Japan. US-based Company
can raise US$ at 5.5% from US market and the
Japanese Company can raise Yen loan at 3.75% from
Japanese market.
Illustrate with diagram the transaction of Currency
Swap between the two Companies.

Answer
These companies can raise resources in their respective markets and
then exchange those currencies to fund their requirements and this
can be accomplished through a Currency Swap.
The principal can be swapped as per the following diagram.

Answer
The regular interest payment can take place as per following
diagram.

Example
Company A, a U.S. firm, and Company B, a
European firm, have 5 years debt exposures
equivalent to $50 million. As on January 1, 2010, the
exchange rate is $1.25 per euro. The dollardenominated interest rate is 7.25%, and the eurodenominated interest rate is 4.5%. Arrange a
Currency Swap and decide the payment after one year
if, the exchange rate is $1.40 per euro as on Jan 1,
2011.

Answer
Company A, the U.S. firm, and Company B, the
European firm, need to enter into a five-year currency
swap for $50 million. First the principal will be
exchanged.
Since the exchange rate, at the time of swap arrangement,
is $1.25 per euro, Company A pays $50 million, and
Company B pays Euro 40 million (50/1.25).
Company A will borrow from US market US$50 at a rate
of 7.25% and Company B would borrow from Euro
market Euro 40 million at the rate of 4.5%. This satisfies
each company's need for funds denominated in another
currency, which is nothing but currency swap.

Answer

Answer
Periodic Interest Payment
Company A would mobilize US$ at a cost of 7.25%
annually and Company B would mobilizes Euro at a
cost of 4.5% annually. Since both of them exchange
their currencies, cost of borrowing would be also be
exchanged by them.
Company A would bear the Euro cost of borrowing
and Company B would bear the US$ cost of bearing.
US$ annual borrowing cost: US$ 50 million @7.25%
: US$ 3.625million
Euro annual borrowing cost Euro 40 million @ 4.5%
: Euro 1.80 million.

Answer
As on Jan 1, 2011, exchange rate is US$ 1.40 per Euro and
hence Euro 1.80 million is equivalent to US$ 2.52 million.
Hence the interest payment would be :
Company A would pay US$ 2.52 million to Company B
Company B would pay US$3.625 million to Company A
Hence the net US$ 1.105 million would be paid by
Company B to Company A
At the end of the swap of period both the parties reexchange the original principal amounts.
These principal payments are unaffected by exchange rates
at the time.

Jan 1, 2012, Company A and Company B enters into a

10-year interest rate swap with the following terms:
Company A pays Company B an amount equal to 9%
(fixed interest rate) per annum on a notional principal
of Rs. 10 lakh .
Company B pays Company A an amount equal to oneyear LIBOR + 3.50% per annum on a notional
principal of Rs.10 lakh.
Decide the pay off for both the parties.

Examples
Using following information, estimate the WACC
for IBM in US$
Out of total debt of US$100 million, it has $50 million
US$ yield 8% and US$ 50 million is Yen-denominated
debt yield 2% in Yen.
Debt represent 25% of IBMs Capital and effective tax
shield of IBM is 33%
Risk-free rate in US$ is 6% while in Yen it is 2%
IBMs equity portfolio beta is 0.85
Global Market Risk-premium is 4%

Solution

For estimating WACC for IBM in US$ we need to find out the cost of
yen-denominated debt in US$, given that its yield in Yen is 2%. The
return on Yen-denominated debt to a US investor is equal to the debts
yield in Yen plus the % change in the foreign exchange price of the
Yen.
Cost of Yen-denominated debt in US$
= Cost of Yen debt in Yen + % change FX value of Yen
K d = Kd + E(x $/)
As per Unbiased Interest Rate Parity Hypothesis, the expected change
in foreign currency value is the risk-free interest differential between
the two countries.
Hence, % change FX value of Yen against US$
= Risk-free rate in US( 6%) less Risk-free interest rate in Yen (2%) = 4%
Cost of Yen-denominated debt in US$ = Kd + E(x $/) = 2%+ 4% =6%

Solution
Estimation of IBMs Cost of Debt Capital
Kd = Cost of US$ Debt *Weight + Cost of Yen Debt *Weight
= 8% *50% + 6%*50% =7%
Estimation of IBMs Cost of Equity Capital
Ri = Rf + iUS (RUS Rf) where
Global Market Risk-premium : 4% Risk-free interest rate in US: 6%
Equity betas: IBM: 0.85
RIBM = 6% + 0.85 *4% = 9.40%
Estimation of IBMs WACC
Kw = WdKd(1-t)+WsKs Where
Kd : Before tax cost of debt : 7%
Ks : cost of equity : 9.40%
t : Effective corporate tax rate: 33%
Wd : weight for debt capital : 25%
Ws : Weight for equity capital: 75%
Kw = 25%*7%*(1-33%) +75%*9.40% =8.22%

Credit Default Swaps

It is a financial agreement that the seller of
the CDS will compensate the buyer in the
event of a loan default or other credit event.
The buyer of the CDS makes a series of
payments, known as CDS fee or spread to
the seller and in exchange receives a payoff
if the loan defaults.
A default is often referred to as a "credit
event" and it includes events as failure to
pay, restructuring and bankruptcy, or even a
drop in the borrower's credit rating.

Credit Default Swaps

CDS contracts on sovereign obligations also
usually include as credit events repudiation,
moratorium and restructuring.
Size of CDSs are in the $10$20million range
with maturities between 1yr and 10 yr.
The payoff is generally the principal amount
of the loan.
The compensation for the buyer of CDS is the
face value of the loan.
In the event of default, the seller takes
possession of the defaulted loan.

Credit Default Swaps

Anyone can purchase a CDS, even buyers
who do not hold the loan instrument.
CDS contracts outstanding auction in the
market and anybody can purchase it.
CDSs are not traded on an exchange and
there is no required reporting of
transactions to a government agency.
Recent financial crisis expose the lack of
transparency of CDS market and it became
a concern to regulators as it increased the
systemic risk.

Credit Default Swaps

The "spread" of a CDS is the annual amount the
protection buyer must pay the protection seller
over the length of the contract, expressed as a
percentage of the loan amount.
For example, if the CDS spread of 50bps , then
an investor buying $10million worth of
protection must pay $50,000 to the CDS seller.
Payments are usually made on a quarterly
basis, in advance. These payments continue
until either the CDS contract expires or loan
defaulted.

Average Cumulative Default

Rate (%)
1970-2010

Table Interpretation
Moodys Credit rating of Baa has a 0.181% of
defaulting at the end of 1st year, 0.581% of chance
of defaulting at the end of 2nd year and so on.
Probability of Baa would default during 2 nd year is
0.581%-0.181%.
Probability of Caa would default during 3rd year is
39.709%-30.204%. It is an unconditional probability.
Probability of Caa would survive until the end of 2nd
year is 100-(39.709%+30.204%).
Probability of Caa would default during 3rd year
with condition it has not defaulted in the earlier
years is {Probability of default during 3rd year/
Probability of survive till 2nd year }. (39.709%30.204%)/(100%-30.204%)

Table Interpretation
The conditional probability for a shorttime period is known as hazard rate or
default intensity. Probability of default
at the end of t year is {1- exp(-t)},
where is the average hazard rate
between the time 0 and t.
Credit Default Spread (CDS), recovery
rate and hazard rate are linked in the
following manner:
= CDS spread/ (1-Recovery Rate)

Problem
Suppose the hazard rate is 1.5% per
year and it remains constant. What is
probability it would be defaulted by
the end of 1st year, 2nd year, 3rd year
and
4th
year.
Estimate
the
unconditional probability that it would
be defaulted during 4th year. What is
the probability that it would be
defaulted in the 4th year with condition
that it has not defaulted earlier.

Solution

Defaulted by the end of

1st year : 1- exp(-1.5%*1)=0.0149
2nd year: 1- exp(-1.5%*2)=0.0296
3rd year : 1- exp(-1.5%*3)=0.0440
4th year: 1- exp(-1.5%*4)=0.0582
5th year: 1- exp(-1.5%*5)=0.0723
Default during the 4th year:0.05820.0440=0.0142
Unconditional probability that it has
defaulted in the 4th year and not defaulted
earlier : 0.0142/(1-0.0440)

CDS Deal : Practical Calculation

Basic Features

One year term

Premium is c% (e.g., .02 or 2%)
Notional value is N (e.g., $10,000,000)
Premiums paid quarterly at times t1, t2, t3, t4.
Default, if occurs, it happens at one of these
times.
Quarterly premium payment = Nc/4 paid at
the end of the quarter. (Nc/4=$50,000)
Recovery rate is R (e.g., .50 or 50%).
If defaults, payment would be N(1-R)

CDS Deal : Practical

Calculation
Basic Features
Probabilities of no default looking ahead
from time t=0 are P1, P2, P3, P4. These
depend on the credit rating of CDS
Purchaser.
Discount rates for computing present
values of cash flows to be received 1, 2, 3,
and 4 periods in the future, 1, 2, 3, 4.

CDS Deal : How the Contract Ends

Time t0
Time t1

Time t2

Time t3

Time t4

Joint Probabilities Contract Ends

Default@ T2
Prob(Default at T1)
=P(D1)

Prob(Default at T2|ND1)
=P(D2|ND1)

Prob(Not Default at T1)

=P(ND1)

Prob(Not Default at T2|ND1)

=P(ND1)

P(Default at T2 and Not Default at T1) = P(D2|ND1)P(ND1) = P1(1-P2)

PV of Cash Flows

Sum = Expected PDV of

Premium Payments

Sum to obtain Expected Present

Discounted Value of Default Payment

Expected Present Value

Price Decision
Notional value is N
The probabilities p1, p2, p3, p4,
The discount rates, 1, 2, 3, 4
The recovery rate, R
All known.
Set PV = 0.
The only unknown is c, which is the price.

There is a Solution
PV 0 implies

4(1 R )

(1 p1)1
p1(1 p 2)
2

p1 p 2(1 p3)3

p1 p 2 p3(1 p 4) 4
p1(1 p 2)1

p1 p 2(1 p3)( )

1
2

p1 p 2 p3(1 p 4)(1 2 3 )

p1 p 2 p3 p 4(1 2 3 4 )

CDS Deal : Problematic Aspect

There is no reserves creation to ensure
payment, if actual default happens.
No regulations to define what actually
constitute credit events.
Proper valuation of underlying mortgage
assets.
Sudden rating migration lead to
increase in CDS spread and conversion
of even good mortgage assets into toxic
assets.