Swaps

1
Nature of Swaps

A swap is an agreement to exchange

cash flows at specified future times
according to certain specified rules

2
 Swaps
A forward contract is a type of swap.
You enter into a forward contract to buy 100
shares @ 1000, after one year.
Outflow 1,00,000 Inflow 100S where
S is the price after one year.
Swaps lead to series of cash flows being
exchanged between B & S.

3
Characteristics of Swaps contract
 Multiple payments
◦ Forwards is a single payment swap
 Has zero value at initiation
◦ No cash flow at t0, except for currency swap
 CF exchanged on settlement date, aka payment date.
 Time between settlement date is settlement period
 Practice of netting on settlement date, except for currency
swaps.
 Generally settled in cash. No physical delivery.
 Has a termination date, of final payment.
 Predominantly OTC markets traded – hence customized.
 Can be terminated, with the counterparty if the terms allow, or
sell to another party or enter into an offsetting contract.

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Example of a Plain Vanilla Fixed-
Floating IRS

Company A and bank B contract on

April 1, 2012 an IRS whereby
company A will pay 5% fixed rate of
interest semi-annually for 2 1/2-years
on a notional principal of $100 million
and bank B will pay 6-months LIBOR
rate of interest.

5
Example of a Plain Vanilla Fixed-
Floating IRS

5% fixed rate
A B

LIBOR floating rate

6
 Interest Payments
(in million, ignoring day count conventions)

Date 6-m Payment Payment Net Pmt.

LIBOR A to B B to A A to B

1 Apr,12 4.80
1 Oct,12 5.00 2.50 2.40 +0.10
1 Apr,13 5.20 2.50 2.50 0.00
1 Oct,13 5.40 2.50 2.60 - 0.10
1 Apr,14 5.00 2.50 2.70 - 0.20
1 Oct,15 2.50 2.50 0.00
B. B. Chakrabarti: bbc@iimcal.ac.in 7
Swap

5% fixed

B A
LIBOR

Principal of $100 m is notional. It is not exchanged (since both

payments are in same currency)

Six exchange of payments between the two parties.

Fixed payment is always $2.5 m
Floating payment is fixed 6 m in advance.

In a swap, one side remits the difference to the other side.

A is long floating rate bond and short on fixed rate bond.

B is long on fixed rate bond and short on floating rate bond.

8
Swap Quotes
 Market makers quote bid and offer fixed
rates against LIBOR. Swap rate is the
average of the bid and offer fixed rates.

 Suppose the rates are: bid = 6.02% and

offer = 6.08%. Then swap rate = 6.05%.
 Bid rate means that market maker will pay
fixed 6.02% and receive LIBOR.
 Offer rate means that market maker will
receive fixed 6.08% and pay LIBOR.

B. B. Chakrabarti: bbc@iimcal.ac.in 9
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

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Convert a liability
 For MS, swaps can be used to convert a floating
rate liability to fixed rate liability.
 MS has borrowed 100m @ LIBOR + 10 bps.
 After swap, the cash flows of MS are
◦ Pay LIBOR+0.1% to outside lenders
◦ Pay 5% to Intel
◦ Receive LIBOR from Intel.
5% fixed
5.2% fixed LIBOR+0.1%
Intel Microsoft
LIBOR

◦ Effective interest rate for MS  5.1% fixed.

◦ Why should Intel enter into swap deal?
◦ To convert a fixed rate liability to floating rate. If Intel had a
100m fixed loan @ 5.2%, it has now become a floater with
LIBOR+20bps

11
Convert an Asset using Swaps
 For MS, swaps can be used to convert a fixed rate
asset to floating rate asset.
 MS owns 100m bonds @ 4.8% p.a.
 After swap, the cash flows of MS are
◦ Receive 4.8% on the bond
◦ Pay 5% to Intel
◦ Receive LIBOR from Intel.
5% fixed
LI BOR -0.2% Fixed 4.8%
Intel Microsoft
LIBOR

◦ Effective interest rate for MS  LIBOR-0.2% floating.

◦ Why should Intel enter into swap deal?
◦ To convert a floating rate asset to fixed rate asset. If Intel
had a 100m floating rate bonds @ LIBOR-0.2% it has now
become a fixed with 4.8%

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 Financial Institution is Involved
(liability)

4.985% fixed 5.015% fixed

5.2% fixed LIBOR+0.1%
Intel FI Microsoft
LIBOR LIBOR

Financial Institution has two offsetting swaps with MS and Intel. FI

makes a profit of 3 bps
MS interest rate is 5.115% instead of 5.1%
Intel interest rate is LIBOR+0.215% instead of LIBOR+0.2%

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 Financial Institution is Involved
(asset)

4.985% fixed 5.015% fixed

LI BOR -0.2% Fixed 4.8%
Intel FI Microsoft
LIBOR LIBOR

Financial Institution has two offsetting swaps with MS and Intel. FI

makes a profit of 3 bps
MS makes LIBOR--0.215% instead of LIBOR-0.2%
Intel makes 4.785% instead of 4.8%

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Quotes By a Swap Market Maker

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

2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850

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 The Comparative Advantage Argument
 Two companies want to borrow 100m.
 One is AAA rated and other BBB rated.
 Rate is higher for BBB for both fixed and
floating (due to its poor rating)
 AAACorp wants to borrow floating, BBBCorp fixed
 Diff between fixed rate > Diff in floating rate. (1.2>0.7). This can be
used for creating a swap deal.
 BBB has comparative adv in floating. AAA in fixed.

Fixed Floating

AAACorp 10.0% 6-month LIBOR + 0.30%

BBBCorp 11.2% 6-month LIBOR + 1.0%
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 The Comparative Advantage Argument
• AAA borrows fixed@10%, BBB floating @
LIBOR+1%

• AAA’s loan is now LIBOR+0.05%. Saves 25 bps

• BBB’s loan is now 10.95% Saves 25 bps
Fixed 9.95%
Fixed 10% LIBOR+1%
AAA BBB
LIBOR

Fixed 9.935 Fixed 9.965

Fixed 10% LIBOR+1%
AAA FI BBB
LIBOR LIBOR

• AAA’s loan is now LIBOR+0.065% Saves 23.5 bps

• BBB’s loan is now 10.965% Saves 23.5 bps
FI makes 3 bps
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Criticism of the Comparative
Advantage Argument
 Why should there be spread differential
between the two companies?
 The fixed 10.0% and 11.2% rates available
are 5-year rates
 The floating rates are six month rates
 Lender has the option of changing the rate
every six months/ even refuse to roll over if
credit worthiness declines.
 BBB’s fixed rate depends on the spread
above LIBOR it borrows at in the future
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 The Nature of Swap Rates
 Six-month LIBOR is a short-term AA
borrowing rate
 The 5-year swap rate has a risk
corresponding to the situation where 10 six-
month 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

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 Valuation of an Interest Rate
Swap
 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
 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

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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
15-months are 10%, 10.5%, and 11% (cont
comp)
 6-month LIBOR on last payment date was
10.2% (s.a. compounding)

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Valuation Using Bonds

Time Bfix cash Bfl cash Disc PV PV

flow flow factor Bfix Bfl
0.25 4.0 105.100 0.9753 3.901 102.505
0.75 4.0 0.9243 3.697
1.25 104.0 0.8715 90.640
Total 98.238 102.505

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Currency Swap
Exchange principal and interest in one
currency with another.
Principal exchanged at the beginning
and at end.

An agreement to pay 5% on a sterling

principal of £10,000,000 & receive 6% on
a US$ principal of $18,000,000 every
year for 5 years

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Exchange of Principal
Fixed 6% on USD 18m

IBM BP
Fixed 5% on GBP 10m

 Called fixed for fixed currency swap

 Initially, IBM pays $18m to BP and
receive £10m.
 IBM receives $1.08m and pay £0.5m
 End, IBM receives $18m from BP and
pay £10m.
 In an interest rate swap the principal is not exchanged. In a currency
swap the principal is usually exchanged at the beginning and the end of
the swap’s life
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The Cash Flows of IBM
Dollars Pounds
$ £
Year ------millions------
2008 –18.00 +10.00
2009 +1.08 –0.50
2010 +1.08 –0.50
2011 +1.08 –0.50
2012 +1.08 –0.50
2013 +19.08 −10.50

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 Typical Uses of a Currency Swap
 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
Fixed 6% on
Fixed 6% on
USD 18m
USD 18m
IBM BP
Fixed 5% on
GBP 10m
 IBM wants to swap its $18m borrowing @6% to £10m @ 5%
(change liability). Fixed 6% on
Fixed 5% on
USD 18m
GBP 10m
IBM BP
Fixed 5% on
GBP 10m

 IBM has invested £10m in UK @ 5%. But feels USD will

strengthen and wants income in USD.

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Comparative Advantage Arguments for
Currency Swaps
GE wants to borrow AUD (20m), Qantas wants to borrow USD
(12m).
GE has comparative adv in USD and Qantas in AUD. Spread
between GE and Q in USD and AUD are not same. Hence
swap possible.
Reason: Tax advantage if GE borrows in USD than AUD.

USD AUD

GE 5.0% 7.6%

Qantas 7.0% 8.0%

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 The Comparative Advantage Argument
• GE borrows USD 12m @ 5% fixed, Qantas borrows AUD 20m
@ 8%.

• GE’s loan is now AUD 6.9% Saves 70 bps

• Qantas’ loan is now USD 6.3% Saves 70 bps
• FI makes 20 bps
• Each year FI makes 1.3% on 12m = USD 156,000 and incurs a
loss of 1.1% on 20m = AUD 220,000.
• FI can minimize the forex risk on AUD by buying AUD 220,000
in forward market for the life of the swap.

USD 5% USD 6.3

USD @5% AUD 8%
GE FI Qantas
AUD 6.9% AUD 8%

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 The Comparative Advantage Argument
• Why not other options……
like
USD 5% USD 5.2
USD @5% AUD 8%
GE FI Qantas
AUD 6.9% AUD 6.9%

USD 6.1% USD 6.3

USD @5% AUD 8%
GE FI Qantas
AUD 8% AUD 8%

• GE/Q are exposed to forex risk.

• First  Qantas pays 1.1% in AUD and 5.2% in USD.
• Second  GE pays AUD 8% and receives USD 1.1%
• Ideally FI should take the forex risk (for the 0.2% charges?)

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 Valuation of Currency Swaps
USD 5%
Like interest rate swaps, currency
GE
swaps can be valued as the
AUD 6.9%
difference between 2 bonds.
GE bought a USD 5% bond and sold AUD 6.9%
bond.
V swap = Bd-sBf where Bd is the value of the bond in domestic
currency, Bf is the value of the bond in foreign currency and s is the
exchange rate.
GBP 6%

GE
V swap = sBf- Bd USD 5.5%

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Example
 All Japanese LIBOR/swap rates are 4%
 All USD LIBOR/swap rates are 9%
 A FI has structured a swap wherein 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

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

V swap = 1230.55/110 – 9.644

= 1.543 million USD.

If the FI is paying yen and receiving USD, what is the value of the
swap?

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 Swaps & Forwards
 A swap can be regarded as a convenient
way of packaging forward contracts
 Although the swap contract is usually
worth zero at the outset, each of the
underlying forward contracts are not
worth zero

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 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
 Some swaps are more likely to lead to credit risk
exposure than others
 What is the situation if early forward rates have a
positive value?
 What is the situation when the early forward rates
have a negative value?

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Other Types of Swaps
 Notional principal is an increasing
function of time  step up swap
 Used by construction companies that
want increasing amount over time in
floating rate and want to swap with fixed
rate.

 Decreasing function of time 

amortization swap.
 Used by companies with fixed rate
borrowing with defined prepayment
schedule. Want to swap with floating
rate.

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 Compounding swaps
 Only one payment for both fixed and floating interests. At the
end of the life of swap.
Fixed amounts
Fixed-rate payer Microsoft
Fixed-rate notional principal USD
100 million
Fixed rate 6% per annum
Fixed-rate day count convention
Actual/365
Fixed-rate payment date 11-
January-2021
Fixed-rate compounding Applicable
at 6.3%
Fixed-rate compounding dates
Each 11-July and 11-January
commencing 11-July-2016 up to
and including 11-July-2020
Floating amounts
Floating-rate payer: Citibank
Floating-rate notional principal:
USD 100 million
Floating rate: USD 6-month
LIBOR plus 20 basis points
Floating-rate day count
convention: Actual/360
Floating-rate payment date: 11-
January-2021
Floating-rate compounding
Applicable at LIBOR
plus 10 basis points
Floating-rate compounding
dates: Each 11-July and 11-
January commencing 11-July-
2016 up to and including 11-
July-2020
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Currency swap
 Fixed for Fixed
 Floating for floating: Floating in USD
(LIBOR+x bps) is swapped with
Floating in GBP (LIBOR+y bps).
 Cross currency swap: Floating rate in
USD is swapped with Fixed rate in
GBP

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Equity swap
Return from
Equity Index

AA
Fixed or floating rate

◦ Party paying fixed rate payment may also

have to make a variable payment based on
equity return
◦ Payment is known at the end of the
settlement period
◦ Rate of return may include both dividend and
capital gain (in IRS and currency swap,
capital gain is usually not paid)
 Helps fund managers to increase or
decrease exposure to equities without
selling.
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1. Companies X and Y have been offered the following rates per annum on a
$ 5 m, 10 year investment.
Co X requires fixed rate investment, Y floating rate Inv. Design a
swap that will net a bank acting as Intermediary 0.2% p.a and will
appear equally attractive to X & Y.
Fixed Floating

X 8% LIBOR

Y 8.8% LIBOR

8.3% fixed 8.8% fixed

LI BOR Fixed 8.8%
X FI Y
LIBOR LIBOR+0.3%

Return to X = LIBOR+8.3%-LIBOR = 8.3%

Return to Y = 8.8%+LIBOR+0.3%-8.8% = LIBOR + 0.3%

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2. Companies A and B face the following interest rates. A
wants to borrow USD @ floating rate while B wants CAD
@ fixed rate. The FI arranging swap needs 50 bps
spread. If the swap is to be equally attractive to A and B,
what rates of Interest will A and B end up paying?
A B

USD (floating) LIBOR+0.5% LIBOR+1%

CAD (fixed) 5% 6.5%

CAD 5% fix CAD 6.25% fix

CAD @5% fix USD LIBOR+1%

A FI B
USD LIBOR+0.25% USD LIBOR+1%

40
3. A FI has agreed to pay you 8% fixed p.a and
receive 6m LIBOR on a notional principal of
$100m. The swap has a remaining life of 1.25
years. The LIBOR rates with continuous
compounding for 3m, 9m, 15m are 10%,
10.5% and 11%. The 6m LIBOR rate at the last
payment date was 10.2%. Find the value of
swap.
8% fixed

A
LIBOR floating rate

 Vswap = Bfix-Bfl

 Bfix = 4*exp(-0.10*.25)+4*exp(-0.105*0.75)+
4*exp(-0.11*1.25)+100*exp(0.11*1.25) = 98.24

 Bfl = (100+5.1)*exp(-0.1*.25) = 102.505.

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