RM Module 3.1

RISK MANAGEMENT USING
SWAPS
Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore
An Introduction to Swaps
A swap is a contract calling for an exchange of payments, on one or more dates, determined by the difference in two prices
A swap provides a means to hedge a stream of risky payments

A single-payment swap is equivalent to a forward contract
An Introduction to Swaps
A swap is an agreement between counter-parties to exchange cash flows at specified future times according to pre-specified conditions. A swap is equivalent to a coupon-bearing asset plus a coupon-bearing liability. The coupons might be fixed or floating. A swap is equivalent to a portfolio, or strip of forward contracts--each with a different maturity date, and each with the same forward price.
Meaning of Swaps
Swaps involve exchange of one set of financial obligations with another, e.g. fixed rate of interests with floating rate of interest, one currency obligation to another, a floating price of a commodity to fixed price etc.
History of Swaps
First currency swap was engineered in London in 1979, but the next deal structured by Salomon Brothers in 1981 in London involving organizations of the stature of World bank and IBM, not only ended the 2-year obscurity but also gave credibility to the instrument, so necessary for its extremely fast growth.
History of Swaps
First Interest rate swap was engineered in London in 1981and was introduced in the US in 1982 by Student Loan Marketing Association (Sallie Mae). Commodity swaps were first engineered in 1986 by Chase Manhattan Bank.
Purpose of a Swap
Reduce cost of capital Manage risk Exploit economies of scale Arbitrage across capital markets Enter new markets Create synthetic instruments
An Example of a Commodity Swap

An industrial producer, IP Inc., needs to buy 100,000 barrels of oil 1 year from today and 2 years from today The forward prices for deliver in 1 year and 2 years are $20 and $21/barrel The 1- and 2-year zero-coupon bond yields are 6% and 6.5%
An Example of a Commodity Swap (contd)

IP can guarantee the cost of buying oil for the next 2 years by entering into long forward contracts for 100,000 barrels in each of the next 2 years. The PV of this cost per barrel is
$20 $21 $37.383 2 106 1065 . .
Thus, IP could pay an oil supplier $37.383, and the supplier would commit to delivering one barrel in each of the next two years A prepaid swap is a single payment today for multiple deliveries of oil in the future
An Example of a Commodity Swap (contd)

With a prepaid swap, the buyer might worry about the resulting credit risk. Therefore, a better solution is to defer payments until the oil is delivered, while still fixing the total price. Any payment stream with a PV of $37.383 is acceptable. Typically, a swap will call for equal payments in each year
For example, the payment per year per barrel, x, will have to be $20.483 to satisfy the following equation
x x $37.383 2 106 1065 . .
We then say that the 2-year swap price is $20.483
Physical Versus Financial Settlement

Physical settlement of the swap
Physical Versus Financial Settlement (contd)

Financial settlement of the swap
The oil buyer, IP, pays the swap counterparty the difference between $20.483 and the spot price, and the oil buyer then buys oil at the spot price If the spot price of oil is greater than $20.483, then the swap counterparty pays the buyer the difference

Whatever the market price of oil, the net cost to the buyer is the swap price, $20.483
Spot price Swap price Spot price = Swap price Swap Payment Spot Purchase of Oil
Note that 100,000 is the notional amount of the swap, meaning that 100,000 barrels is used to determine the magnitude of the payments when the swap is settled financially

The results for the buyer are the same whether the swap is settled physically or financially. In both cases, the net cost to the oil buyer is $20.483

Swaps are nothing more than forward contracts coupled with borrowing and lending money
Consider the swap price of $20.483/barrel. Relative to the forward curve price of $20 in 1 year and $21 in 2 years, we are overpaying by $0.483 in the first year, and we are underpaying by $0.517 in the second year
Thus, by entering into the swap, we are lending the counterparty money for 1 year. The interest rate on this loan is
Given 1- and 2-year zero-coupon bond yields of 6% and 6.5%, 7% is the 1-year implied forward yield from year 1 to year 2
0.517 / 0.4831 7%
If the deal is priced fairly, the interest rate on this loan should be the implied forward interest rate
The Swap Counterparty

The swap counterparty is a dealer, who is, in effect, a broker between buyer and seller The fixed price paid by the buyer usually exceeds the fixed price received by the seller. This price difference is a bid-ask spread, and is the dealers fee The dealer bears the credit risk of both parties, but is not exposed to price risk
The Swap Counterparty (contd)

The situation where the dealer matches the buyer and seller is called a back-to-back transaction or matched book transaction
The Swap Counterparty (contd)

Alternatively, the dealer can serve as counterparty and hedge the transaction by entering into long forward or futures contracts
Note that the net cash flow for the hedged dealer is a loan, where the dealer receives cash in year 1 and repays it in year 2 Thus, the dealer also has interest rate exposure (which can be hedged by using Eurodollar contracts or forward rate agreements)
The Market Value of a Swap

The market value of a swap is zero at interception
Once the swap is struck, its market value will generally no longer be zero because
the forward prices for oil and interest rates will change over time, and even if prices do not change, the market value of swaps will change over time due to the implicit borrowing and lending.
A buyer wishing to exit the swap could enter into an offsetting swap with the original counterparty or whomever offers the best price The market value of the swap is the difference in the PV of payments between the original and new swap rates
Rate Conventions
Interest rate swaps and currency swaps are together known as Rate Swaps.
Swaps are most often tied to LIBOR.
It is quoted actual over 360, as though the year is of 360 days. This raises the effective rate for a period and has compounding effect. Bond equivalent yields are quoted on actual over 365 days. For comparison, adjustments can be made by multiplication of a rate differential by 365/360 or by 360/365.
Cash Market Transactions

Swaps are used in conjunction with following basic cash market transactions: Obtain actuals from cash market Make/receive payments to/from cash market Supply actuals to cash market
CASH MARKET TRANSACTIONS

.
Principal
Debt market (Floating Rate) Debt Market (Fixed Rate)
Principal
Counterparty A
Swap Dealer
Counterparty B
SWAP
Initial Exchange of Notionals

(Optional)
Notionals Notionals
Counterparty A
Notional
Swap Dealer
Counterparty B
Notionals
Periodic Usage or Purchase Payments (Required)

Fixed Price
Counterparty A
Floating Price
Swap Dealer
Fixed Price
Counterparty B
Floating Price
Re-exchange of Notionals
.
(Optional)
Notionals
Counterparty A
Notionals
Swap Dealer
Notionals
Counterparty B
Notionals
Using Swaps to Manage Risk

Swaps can be used to lower borrowing costs and generate higher investment returns. Swaps can be used to transform floating rate assets into fixed rate assets, and vice versa. Swaps can transform floating rate liabilities into fixed rate liabilities, and vice versa. Swaps can transform the currency behind any asset or liability into a different currency.
Swapping to Lower Borrowing Costs

Two firms can enter into a plain vanilla swap to exploit their comparative advantages regarding quality spread differentials. For example: Firm B is a low-rated, risky, firm. It can borrow at a fixed rate of 8%, or at a floating rate of LIBOR + 75bp. Potential counter-party, Firm A, can borrow at a fixed rate of 7%, or at a floating rate of LIBOR +25bp.

Suppose Firm B wishes to borrow at a fixed rate, and Firm A wishes to borrow at a variable rate. Although B faces higher rates in both markets, it has a comparative advantage in the floating rate market. It is paying only 50bp more in the floating rate market, but it must pay 100bp more in the fixed rate market. Firm A has a comparative advantage in the fixed rate market because Firm A is paying 100 bp less there, compared to 50 bp less in the floating rate market.
Swapping to Lower Borrowing Costs...

Fixed at 7.1%
Firm B
THE SWAP
Floating at LIBOR
Firm A
pays floating LIBOR + 75bp borrows NP at a variable rate
pays fixed rate of 7%
borrows NP at a fixed rate
Capital Market
Net result: Firm B has borrowed at a fixed rate of 7.85%, and Firm A has borrowed at a floating rate equal to LIBOR - 10bp. Both counter-parties to this swap have lowered their interest expense by swapping.
Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore 29

The gains to these types of swaps (that lower borrowing costs) have diminished in recent years, but judging from surveys on derivatives usage, the gains still exist. These swaps are done with swap dealers (intermediaries); firms dont do them between themselves.
7.12% fixed
Firm B
Floating LIBOR
Swap
7.08% fixed
Firm
Floating LIBOR
Dealer
Using a Swap to Transform Liabilities: Party A is hedging against rising interest rates; Party B will then benefit from falling interest rates
A has an existing floating rate loan LIBOR 5%
The Swap
LIBOR
6% B has an existing fixed rate loan
The result (with the swap) is that A will be paying 5% fixed. B will be paying LIBOR + 100 bp.
Using a Swap to Transform Assets:

Party A is locking in a fixed rate of return; Party B will benefit from rising interest rates
A owns an existing floating rate bond
LIBOR A
5% The Swap LIBOR B 6%

B owns an existing fixed coupon bond
The result (with the swap) is that A will be receiving 5% fixed. B will be receiving LIBOR + 100 bp.
Using a Currency Swap to Hedge Against an increase in the Price of a Foreign Currency Transform a liability in one currency into a liability in another currency. Transform an expense (cost) in one currency into a another currency.
Before the swap, this U.S. firm loses if the $/ exchange rate rises. $
Using a Currency Swap to Hedge Against a Decrease in the Price of a Foreign Currency Transform an investment in one currency into an asset in another currency. Transform a revenue in one currency into a another currency.
Before the swap, this U.S. firm loses if the $/ exchange rate falls.
Comparative Advantage for Currency Swaps

Two firms can enter into a currency swap to exploit their comparative advantages regarding borrowing in different countries. That is, suppose:
Firm B can borrow in $ at 8.0%, or in at 6.0%. Firm A can borrow in $ at 6.5% or in at 5.2%.
If A wants to borrow , and B wants to borrow $, then they may be able to save on their borrowing costs if each borrows in the market in which they have a comparative advantage, and then swapping into their preferred currencies for their liabilities.
Using Commodity Swaps: Examples

An airline wants to lock in the price it pays for x gallons of jet fuel per quarter. In each of the next N years, the airline will agree to pay a fixed price and receive the floating price. A gold producer wants to lock in the price it receives for z oz. of gold each month.
In each of the next M years, the gold producer will agree to pay a floating price and receive a fixed price.
Using Equity Swaps: Examples

A bearish portfolio manager might agree to pay, each month, the monthly rate of return on a portfolio of stocks, and receive a floating rate of return linked to LIBOR (divided by 12), receive a fixed payment. Note if the portfolio of stocks declines in value, the portfolio manager actually receives two cash flows!
Basic Types of Swap

Interest Rate Swaps Currency Swaps Commodity Swaps
Interest Rate Swap

A, desirous of 10-yr fixed rate debt (available at 11.25% s.a.) has access to cheap floating rate financing (LIBOR + 50bp). B, desirous of a 10-yr floating rate financing (available at LIBOR) has access to cheaper fixed rate financing (10.25% s.a.).
A dealer available can be a floating rate payer or receiver at LIBOR and a fixed rate payer at 10.40% s.a. and receiver at 10.50% s.a.
Interest Rate Swap

.
CASH MARKET TRANSACTIONS Principal

Principal
Counterparty A
Swap Dealer
Counterparty B
SWAP
Interest Rate Swap

.

Debt market (Floating Rate) 6-M LIBOR +50bps Debt Market (Fixed Rate)
10.25% (sa)
10.50% (sa)
Counterparty A
6-M LIBOR
Swap Dealer
10.40% (sa)
Counterparty B
6-M LIBOR
SWAP
Interest Rate Swap

.
CASH MARKET TRANSACTIONS Principal

Principal
Counterparty A
Swap Dealer
Counterparty B
SWAP
A Plain Vanilla Interest Rate Swap

Party B agrees to pay a fixed payment and receive a floating payment, from counter-party A. Party B is the fixed rate payer-floating rate receiver (the pay-fixed party).
Party A is the fixed rate receiver-floating rate payer (the receive-fixed party).
Typically, there is no initial exchange of principal (i.e., no cash flow at the initiation of the swap).
A Plain Vanilla Interest Rate Swap...

On 1/3/08, an agreement is struck wherein for the next 3 years, every six months, company B receives from company A, a payment on a notional principal of $100 million, based on 6-M LIBOR. Company B makes a fixed payment on the same notional principal to company A, based on a rate of 5% per annum. Define Define
R as the fixed rate.

~ R as the variable (floating) rate.
Define NP as the notional principal. Note that 6-month LIBOR at origination is R0 = 4.20%. The next two slides illustrate the cash flows.
~ ~ ~ R0 R1 R 2 R 3
0
Multiply each R by NP times #days between payments over 360 (or use a 365-day year)
R R
R R
Each actual payment (difference check) equals the difference between the interest rates times NP times #days between payments over 360, or #days/365. The time t variable cash flow is typically based on the time t-1 floating interest rate.
Thus, the first floating cash flow, based on the rate, R0, is known: it is 4.20%.
All subsequent floating cash flows are random variables as of time zero (but always known one period in advance).
The Cash Flows to Company B

---------Millions of Dollars---------
LIBOR FLOATING Date Mar.1, 2008 Sept. 1, 2008 Mar.1, 2009

Sept. 1, 2009
FIXED
Net
Rate 4.2% 4.6% 5.1%

5.5%
Cash Flow Cash Flow Cash Flow +2.10 +2.30

+2.55
2.50 2.50
2.50
0.40 0.20
+0.05
Mar.1, 2010
Sept. 1, 2010 Mar.1, 2011
5.6%
4.9% 4.4%
+2.75
+2.80 +2.45
2.50
2.50 2.50
+0.25
+0.30 - 0.05
A Closer Look at the Cash Flows on September 1, 2008

Floating Payment:
Based on the 6-month LIBOR rate that existed on March 1, 2008: 4.20%. ($100,000,000)(0.042)(1/2) = +$2,100,000.
Fixed Payment:
Based on 5% rate. ($100,000,000)(0.05)(1/2) = -$2,500,000.
Net Cash Flow: -$400,000.

Quoting Plain Vanilla Swaps

Typically, the floating index, e.g. LIBOR, is bought or sold flat. If you buy LIBOR (pay-fixed), you pay a spread over the most recently issued Treasury with the same maturity as the swap (the asked swap spread). If you receive fixed (sell LIBOR) then you receive the Treasury rate plus the bid swap spread, which is smaller than the asked swap spread. Example: For a 5-year swap, a dealer might quote 20 (bid) and 24 (asked). Suppose the yield midpoint of the most recently issued 5-year Tnote is 5.40%. Then, the pay-fixed party will pay 5.64%, and receive LIBOR.
Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore 48
Typical Uses of an Interest Rate Swap

To convert a liability from: a fixed rate to floating rate. a floating rate to fixed rate.
To convert an investment (asset) from: a fixed rate to floating rate. a floating rate to fixed rate.
Other Interest Rate Swap Structures

Off market swaps: The fixed rate may be away from the market; an initial payment will have to be negotiated. Amortizing swap: varying NP according to a predetermined schedule. Index amortizing swap: The NP, or term of the swap, varies according to some randomly changing interest rate index. Basis swap: The two interest rates both float (e.g., LIBOR and the prime rate; or 2-year Treasury rate and 10-year Treasury rate). Forward swap: The first cash flow takes place in the far future, long after the terms of the swap have been negotiated.
Currency Swaps
There are four types of basic currency swaps: fixed for fixed. fixed for floating. floating for fixed. floating for floating. N.B.: It is the interest rates that are fixed or floating. Typically, the NP is exchanged at the swaps initiation and termination dates.
Typical Uses of a Currency Swap

To convert a liability in one currency into a liability in another currency. To convert an investment (asset) in one currency to an investment in another currency.
Currency Swap
A, needing floating rate dollars, can borrow euros at 9.0% fixed and dollars at 1-yr LIBOR floating. B, needing fixed rate euros, can borrow euros at 10.1% fixed and dollars at 1-yr LIBOR floating. Swap dealer can pay 9.45% fixed on euros against dollar LIBOR and dollar LIBOR against 9.55% fixed on euros.
Currency Swap
.

9%
Debt market (Euro) Debt Market ($)

LIBOR
9.45%
Counterparty A
LIBOR
Swap Dealer
9.55%
Counterparty B
LIBOR
SWAP
An Example of a Fixed for Fixed Currency Swap

An agreement to pay 1% on a Japanese Yen principal of 1,040,000,000 and receive 5% on a US dollar principal of $10,000,000 every year for 3 years. In a currency swap, unlike in an interest rate swap, the principal is exchanged at the beginning and at the end of the swap.
Note that in currency swaps, the direction of the cash flows at time zero is the opposite of the direction of the subsequent cash flows in the swap (see the next slide).
Cash Flows in a Fixed-for-Fixed Currency Swap
At origination:
$10,000,000
Party A
1,040,000,000
Party B
At each annual settlement date:

Party A $500,000 10,400,000 Party B
At maturity:
Party A
$10,000,000 Party B 1,040,000,000

56
Cash Flows in a Fixed-for-Floating Currency Swap

On the origination date:
The fixed rate payer pays $10,000,000 to the fixed rate receiver. The fixed rate receiver pays 1,040,000,000 to the fixed rate payer.
Fixed rate payer (Floating rate Receiver)
$10,000,000 Fixed rate Receiver (Floating Rate Payer) 1,040,000,000
57
Calculating Subsequent Cash Flows for this Fixed-for-Floating Currency Swap

Tenor is three years. NP1 = 1,040,000,000 yen, and r1 = 1% fixed in yen. NP2 = $10,000,000, and r2 = 6 month $-LIBOR (floating). Settlement dates are every 6 months, beginning 6 months hence. On the origination date, 6 month LIBOR is 5.5%. Assume that subsequently, 6 mo. LIBOR is: Time 6 mo. LIBOR 0.5 5.25% 1.0 5.50% 1.5 6.00% 2.0 6.20% 2.5 6.44%
All Cash Flows for this Fixed-forFloating Currency Swap

6-mo. time 0.0 0.5 1.0 1.5 2.0 2.5 3.0 Fixed rate LIBOR Payment 5.50% $10MM 5.25% 5.2MM 5.50% 5.2MM 6.00% 5.2MM 6.20% 5.2MM 6.44% 5.2MM ---5.2MM 1,040MM Floating rate Payment 1,040MM $275,000 $262,5001 $275,000 $300,000 $310,000 $322,000 $10MM
N.B. The time t floating cash flow is determined using the time t-1 floating rate. 1 Time 1.0 floating rate payment is (0.0525/2)($10,000,000) = $262,500.
Credit Risk: Currency Swaps Note that there is greater credit risk with a currency swap when there will be a final exchange of principal.
This means that there is a higher probability of a large buildup in value, giving one of the counter-parties (the one who is losing) the incentive to default.
Credit Risk
No credit risk exists when a swap is first created.
The credit risk in a swap is greater when there is an exchange of principal amounts at termination.
Only the winning party (for whom the swap is an asset) faces credit risk. This risk is the risk that the counter-party will default. Many vehicles exist to manage credit risk: Collateral (or collateral triggers) Netting agreements Credit derivatives Marking to market
Other Currency Swap Structures

See the different interest rate swap structures presented earlier. They all apply to currency swaps, too. Index differential swaps, or diff swaps: The cash flows are based on two floating rates in different countries, but they are applied to the NP of one of the currencies. For example, pay -based LIBOR, and receive $based LIBOR, on a NP of $20MM. All payments are in $.
Commodity Swap
A crude oil producer wants to fix a price to be received for 5 years on production of 8000 barrels p.m. He agrees to pay average of preceding month price to swap dealer against a receipt of $68.20/barrel. An oil refiner wants to fix the price he pays for oil for 5 years on his average need of 12000 barrels. He agrees to pay $68.40 against market price of $69.50/barrel for an average price of preceding month.
Commodity Swap
.

Spot Oil Market
Spot Price
Actuals
Spot Price
Actuals
$68.20/barrel
Counterparty A
Oil Producer
Spot Price (average)
Swap Dealer
$68.40/barrel
Counterparty B
Spot Price (average)
SWAP
Refiner
Why a Swap Dealer?

If A and B attempted a swap with each other directly, it would have failed due to different requirements. Swap dealer can be a fixed-rate payer on 4000 barrels and till such time he can hedge in futures.
Commodity Swaps
Equivalent to a strip of forward contracts on a commodity. Define NP in terms of the commodity; e.g., 10,000 oz. of gold. The NP is not exchanged.
Define Pfixed as the fixed price.

Payments are made by comparing the actual price of the commodity on the settlement date (or an average price over the period, or the actual price one period earlier) to the fixed price.
Commodity Swaps: an Example

A gold mining firm wants to fix the price it will receive for the gold it will mine over the next 3 years. A gold user wants to fix the price it will have to pay for the gold it needs for the next 3 years. NP = 10,000 oz. Pfixed = $320/oz. Settlement is semi-annual, based on average price of gold during the past six months.
Commodity Swaps: an Example...

Subsequently: Avg. gold price during past pd. $305 $330 $368 $402 $348 $300 Producer pays (-) or receives (+) +$150,000 -$100,000 -$480,000 -$820,000 -$280,000 +$200,000
Time 0.5 1.0 1.5 2.0 2.5 3.0
Swaption
When a firm doesnt want a swap now but can lock-in the terms of swap now by buying an option on swap called Swaption.

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RISK MANAGEMENT USING

A swap provides a means to hedge a stream of risky payments

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

An Example of a Commodity Swap

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

An Example of a Commodity Swap (contd)

An Example of a Commodity Swap (contd)

x x $37.383 2 106 1065 . .

We then say that the 2-year swap price is $20.483

Physical Versus Financial Settlement

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

Physical Versus Financial Settlement (contd)

Physical Versus Financial Settlement (contd)

Physical Versus Financial Settlement (contd)

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

Physical Versus Financial Settlement (contd)

The Swap Counterparty

The Swap Counterparty (contd)

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

The Swap Counterparty (contd)

The Market Value of a Swap

Cash Market Transactions

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

CASH MARKET TRANSACTIONS

Debt market (Floating Rate) Debt Market (Fixed Rate)

Initial Exchange of Notionals

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

Periodic Usage or Purchase Payments (Required)

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

Using Swaps to Manage Risk

Swapping to Lower Borrowing Costs

Swapping to Lower Borrowing Costs

Swapping to Lower Borrowing Costs...

pays floating LIBOR + 75bp borrows NP at a variable rate

pays fixed rate of 7%

borrows NP at a fixed rate

Swapping to Lower Borrowing Costs

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

6% B has an existing fixed rate loan

Using a Swap to Transform Assets:

5% The Swap LIBOR B 6%

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

Comparative Advantage for Currency Swaps

Using Commodity Swaps: Examples

Using Equity Swaps: Examples

Basic Types of Swap

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

Interest Rate Swap

Interest Rate Swap

CASH MARKET TRANSACTIONS Principal

Interest Rate Swap

CASH MARKET TRANSACTIONS

Interest Rate Swap

CASH MARKET TRANSACTIONS Principal

A Plain Vanilla Interest Rate Swap

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore

A Plain Vanilla Interest Rate Swap...

R as the fixed rate.

Dr.R.Duraipandian, Professor, Dept. of MBA, PESSE, Bangalore