Swaps

Financial Derivatives Finance 206/717

Philipp ILLEDITSCH

Fall 2012

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Introduction

What are Swaps? Commodity Swaps Interest Rate Swaps

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Denition

A swap is an agreement between two parties to exchange cash ows at future dates according to certain rules

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Swaps
Forward or futures are used to lock in price at one future date
e.g. price of oil one year from today

What if you want to lock in prices at dierent dates? Option 1:

buy strip of futures contracts

Option 2:
enter into swap agreement

Swap is just sequence of forward/futures contracts, combined with borrowing and lending

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Commodity Swaps Example

Utility Inc is going to buy
100,000 barrels of oil 1 year from today 100,000 barrels of oil 2 years from today

Current forward/futures prices:

F0,1 = $100/barrel F0,2 = $105/barrel

We will need interest rates:

1-year cont. comp. risk-free rate is 6% 2-year cont. comp. risk-free rate is 6.5%

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Commodity Swaps Example cont.

Swap agreement:
sign agreement with counter-party to buy 100,000 barrels in both year 1 and year 2, for price $X /barrel

What is swap price X ?

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Pricing Swap
What are cash ows from swap (in $100, 000)?
long swap Year 0 0 Year 1 S1 X Year 2 S2 X

How can we synthesize swap?

Year 0 Long 1-year forwards Long 2-year forwards Borrow at 1-year risk-free rate Invest at 2-year risk-free rate Year 1 S1 F0,1 X e 0 ,1 2r0,2 X e X e 0 ,1 2r0,2 X e
r r

Year 2 S2 F0,2

F0 , 1 F0 , 2 F0 , 1 F0 , 2

F0,1 X F0 , 2 X S1 X S2 X

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Swap Price
No-arbitrage implies
(F0,1 X ) e r0,1 (F0,2 X ) e 2r0,2 = 0 i.e., X e r0,1 + e 2r0,2 = F0,1 e r0,1 + F0,2 e 2r0,2

Substituting in for forward prices and interest rates

X = 100e .06 + 105e 2.065 = $102.4125 e .06 + e 2.065

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In General
Suppose forward prices of oil are F0,t Then price per barrel of swap covering periods t1 , t2 , . . . , tn is X =
n r0,ti ti F0,ti i =1 e n r0,ti ti i =1 e

i.e. it is price at which PV of swap payments

n

Xe r0,ti ti
i =1

is equal to PV of payments under strip of forward agreements

n

e r0,ti ti F0,ti
i =1
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Swap Embeds Loan

To extent to which forward prices predict spot prices, Utility Inc expects to pay above spot price at date 1, and below spot price at date 2 That is, there is loan hidden in swap price Of course, spot prices might turn out to be dierent But Utility Inc can use swap to construct pure loan How?

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Value of Swap
Value of swap is zero initially Value may change because
futures prices may change interest rates may change swap payments are made

What is value of swap at any time t ?

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Interest Rate Swaps

We will look at plain vanilla interest rates swaps These swaps are an agreement for the exchange of oating rate interest payments and xed rate interest rate payments As of Dec 2011, the Bank of International Settlements estimates a worldwide notional amount outstanding of 403 trillion USD, and a market value of 18 trillion USD

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Example
Suppose BlueChip borrows $1M in a oating rate loan in October 2010, which they expect to repay in 3 years
e.g. they take 1-year loan for $1M , which they plan to roll-over or they take 3-year oating rate loan

In either case, we assume that BlueChip pays interest of rLIBOR + 0.25%

(note: not continuously compounded)

To hedge interest rate exposure, BlueChip can use swap

agrees to pay amount equal to $1M (rx rLIBOR ) to counter-party say LB (large bank)

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Example cont.

BlueChips resulting net payment is $1M (rLIBOR + 0.25%) + $1M (rx rLIBOR ) = $1M (rx + 0.25%) They have converted 3-year oating-rate loan into a 3-year xed rate loan

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Example cont.
12-month LIBOR rates turn out to be: Oct 2010 Oct 2011 Oct 2012 6% 5% 8%

i.e. if you take 12-month $1,000 loan in Oct 2010 at LIBOR, you must repay (1 + 6%) $1, 000 in Oct 2011.

If BlueChips swap agreement species annual payments,

and uses xed rate of 7.2%, then loan interest payments and swap payments made by BlueChip to LB are:

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Net Payments

Oct Interest payments 2010 2011 2012 2013

Swap payments/receipts

Total

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Net Payments
Oct Interest payments 2010 0 2011 $1M (6% + 0.25%) = $62, 500 2012 $1M (5% + 0.25%) = $52, 500 2013 $1M (8% + 0.25%) = $82, 500 Swap payments/receipts Total 0 0 $1M (7.2% 6%) = $12, 000 $1M (7.2% 5%) = $22, 000 $1M (7.2% 8%) = $8, 000

$74, 500 $74, 500 $74, 500

Floating rate used here is the one 12-months prior to payment date
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Fixed-Rate and Floating Rate Payers

BlueChip is xed rate payer LB is oating rate payer Why would somebody prefer xed over oating payments? Why would somebody prefer oating over xed payments?

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Swap PricingBack to Example

BlueChip entered into swap agreement with LB in October 2010 Swap agreement required BlueChip to pay $1M (rx rLIBOR ) for three years Let rLIBOR t ,t +1 denote LIBOR rate from date t to date t + 1 What is cash ow of Blue Chipss swap position?
2010 2011 2012 2013

swap

$1M rLIBOR10,11 rx

$1M rLIBOR11,12 rx

$1M rLIBOR12,13 rx

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Pricing Swap
We could do this just as before with commodities e.g. LBs cash ow in Oct 2012 is $1M rx rLIBOR11,12
where rLIBOR11,12 is 12-month LIBOR rate from Oct 2011 to Oct 2012

LB could hedge oating rate, rLIBOR

by locking in forward rate; e.g. using FRA or Eurodollar futures

We could then take the present value of certain cash ows and nd the value of rx such that the net present value is zero ...

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Easier Way to Determine Price

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Easier Way to Determine Price

Cash ows of LBs swap position are
2010 2011 2012 2013

LBs swap

$1M rx rLIBOR10,11 $1M rx

$1M rx rLIBOR11,12 $1M rx

$1M rx rLIBOR12,13 $1M rx +$1M

buy a xed rate bond

0
x B2010

sell a oating rate bond

0
oat +B2010

$1M rLIBOR10,11

$1M rLIBOR11,12

$1M rLIBOR12,13 $1M

x Let B2010 denote price of xed rate coupon bond in Oct 2010 that matures in Oct 2013 oat Let B2010 denote price of oating rate coupon bond in Oct 2010 that matures in Oct 2013 oat x No arbitrage implies that B2010 = B2010

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Easier Way to Determine Price

Net cash ows would be same if:
BlueChip pays LB $1M rx in Oct 2011, 2012, 2013
and in Oct 2013 pays LB principal $1M

LB pays BlueChip $1M rLIBOR in Oct 2011, 2012, 2013

and in Oct 2013 pays BlueChip principal $1M

That is:
BlueChip sells LB bond that has face value of $1M , and pays coupon rate of rx LB sells BlueChip bond that has face value of $1M , and pays coupon rate equal to LIBOR rate
x oat Choose rx such that B2010 = B2010
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oat What is B2010 ?

What is price of bond that pays oating rate (LIBOR) as coupon?
Bond that is paying oating rate is just worth par value

Back to example
oat = $1M Price at maturity is equal to face value; i.e. B2013 oat ? What is B2012

oat B2012 =

$1M rLIBOR12,13 + $1M = $1M 1 + rLIBOR12,13

oat ? What is B2011

oat $1M rLIBOR11,12 + B2012 = $1M 1 + rLIBOR11,12

oat B2011 =

oat ? What is B2010

oat $1M rLIBOR10,11 + B2011 = $1M 1 + rLIBOR10,11

oat B2010 =

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What is rx?
x oat rx is coupon rate such that B2010 = B2010 = $1M

Suppose yield curve in 2010 is:

r0,1 = 6% r0,2 = 6.5% r0,3 = 7%

We have

$1Mrx e 0.06 + $1Mrx e 0.0652 + ($1Mrx + $1M ) e 0.073 = $1M Solving for rx : rx = e 0.06 1 e 0.073 = 7.2% + e 0.0652 + e 0.073

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In General

rx is par value coupon rate i.e. rate such that

T

e t r0,t $1M rx + e T r0,T $1M = $1M

t =1

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Market Value of Swap

Swap has value of zero when it is issued But not at subsequent dates What is value of swap at any time t?

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