EC3011- Introduction to Financial Derivatives

Swaps

Burcu Kapar
City University, London

Spring Term-2014

Forward rate agreement (FRA)

Forward rate agreement (FRA)

Forward Rate Agreement is an over-the-counter agreement that a certain
interest rate will apply to either borrowing or lending a certain principal
during a specified future period of time.
The assumption underlying the contract is that the borrowing or lending
normally be done at LIBOR.

Forward rate agreement (FRA)

Forward rate agreement (FRA)

Suppose that the agreement takes place at time t, on the interest rate RK (t) to
a loan with principal M, during a specified future period [T1 , T2 ]. Define:
R(t, T1 ) and R(t, T2 ): Spot rates observed at time t < T1 for maturity T1
and maturity T2 .
R(T1 , T2 ): Spot rate observed at time t = T1 for maturity T2
RF (t, T1 , T2 ): Forward rate observed at time t for the period [T1 , T2 ]:

RF (t, T1 , T2 ) =

R(t, T2 )(T2 t) R(t, T1 )(T1 t)

.
T2 T1

Forward rate agreement (FRA)

Forward rate agreement (FRA)

Imagine that at time T1 you borrow an amount M at the rate RK (t) and
reinvest it at the spot rate prevailing at T1 for the period [T1 , T2 ], i.e.
R(T1 , T2 ). At T2 you repay the amount borrowed at the rate RK (t).
The cash flow at T2 is:
V(T2 ) = M[eRK (t)(T2 T1 ) + eR(T1 ,T2 ))(T2 T1 ) ]
The value at time t0 > t is
0

V(t0 ) = M[eRK (t)(T2 T1 ) + eR(T1 ,T2 ))(T2 T1 ) ]eR(t ,T2 )(T2 t )

The FRA is equivalent to an agreement where the future spot rate is
exchanged for a predetermined rate.

Forward rate agreement (FRA)

Forward rate agreement (FRA)

Now imagine you lend an amount M at t = T1 and get back, at time t = T2 ,
at the agreed interest RK (t).
The cash flow in this case is:
Cash flow:
t = T1 : M
t = T2 : MeRK (t)(T2 T1 )

Forward rate agreement (FRA)

Forward rate agreement (FRA)

The present value of this contract is:
V(t) = MeR(t,T1 )(T1 t) + MeRK (t)(T2 T1 ) eR(t,T2 )(T2 t)
By choosing RK (t) so that V(t) = 0 (it does not cost anything to enter a FRA
agreement) we obtain:
MeR(t,T1 )(T1 t) = MeRK (t)(T2 T1 ) eR(t,T2 )(T2 t)
Hence
R(t, T1 )(T1 t) = RK (t)(T2 T1 ) R(t, T2 )(T2 t)
or
RK (t) =

R(t, T2 )(T2 t) R(t, T1 )(T1 t)

= RF (t, T1 , T2 )
T2 T1

Forward rate agreement (FRA)

Forward rate agreement (FRA)

At a generic time t0 , the value of a contract entered at time t for a rate
RK (t) 6= RK (t0 ) for the party paying RK (t), is
0

V(t0 ) = M[eRF (t ,T1 ,T2 )(T2 T1 ) eRK (t)(T2 T1 ) ]eR(t,T2 )(T2 t )

and for the party receiving RK (t)
0

V(t0 ) = M[ eRK (t)(T2 T1 ) eRF (t ,T1 ,T2 )(T2 T1 ) ]eR(t ,T2 )(T2 t )
Comparing with previous expression
0

V(t0 ) = M[eRK (t)(T2 T1 ) eR(T1 ,T2 ))(T2 T1 ) ]eR(t ,T2 )(T2 t )

we derive that we can price a FRA by assuming that the forward rate is
certain to be realized.

Forward rate agreement (FRA)

Forward rate agreement (FRA)

Take again expression
0

V(t0 ) = M[eRK (t)(T2 T1 ) eRF (t ,T1 ,T2 ))(T2 T1 ) ]eR(t ,T2 )(T2 t )
By assuming that RK and RF are compounded with frequency equal to
T2 T1 we would get
0

V(t0 ) = M[RK (t) RF (t0 , T1 , T2 )](T2 T1 )eR(t ,T2 )(T2 t )

Remember rates are annual. We have used formula
erc n = (1 +

rm mn
)
m

with n = T2 T1 (period) and m = 1/(T2 T1 ).

Forward rate agreement (FRA)

Example: Forward Rate Agreement

Suppose that a company enters into an FRA that specifies it will receive a
fixed rate of 4% on a principal of $ 1 million for a 3 month period starting in
3 years. If 3 month LIBOR proves to be 4.5% for the 3 month period. (All
interest rates are quarterly compounding).
What is the cash flow to the lender at the 3.25 year point?
What is the cash flow to the lender at the 3 year point?

Forward rate agreement (FRA)

Solution to Example: Forward Rate Agreement

T2 = 3.25years, T = 3years, RK = 4%, R(T1 , T2 ) = 4.5%
Cash flow to the lender at the 3.25 year point
V(T2 ) = M[(RK (t) R(T1 , T2 ))(T2 T1 )]
V(3.25) = [$1million (0.04 0.045) (3.25 3.00)]
V(3.25) = $1.250
Cash flow to the lender at the 3 year point
V(3) =

V(3.25)
(1+(R(T1 ,T2 )(T2 T1 ))
$1250
1+(4.5%0.25)

V(3) =
V(3) = $1.236.09

Forward rate agreement (FRA)

Example: Forward Rate Agreement

Year(n)
1
2
3
4
5

Zero rate for an

n-year investment (%
per annum)
3.0
4.0
4.6
5.0
5.3

Forward rate for nth

year (% per annum)
5.0
5.8
6.2
6.5

Suppose that continuously compounded LIBOR zero and forward rates are
as in the table above. Consider an FRA where we will receive a rate of 6%
measured with annual compounding on a principal of $1 million between the
end of year 1 and the end of year 2. What is the value of the FRA at time 0?

Forward rate agreement (FRA)

Solution to Example: Forward Rate Agreement

t0 = 0year, T = 1year, T2 = 2year, T = 1year
RK = 6%
RF (T1 , T2 ) = 5%with continuous compounding
RF (T1 , T2 ) = 5.127% with annual compounding
R(T1 , T2 ) = 4%with continuous compounding
0

V(t0 ) = [M(RK (t) RF (t0 , T1 , T2 ))(T2 T1 )]eR(t ,T2 )(T2 t )

V(0) = [$1million(6% 5.127%)(2 1)]e4%(20)
V(0) = $805.800

Floating rate bonds

Floating rate bonds

Floating rate bonds are bonds whose coupons are paid at fixed dates
t1 , t2 tN , which are known in advance, but the coupon rate is reset
periodically, with rates tied to a representative interest rate index such as
LIBOR, FED Funds Rate, Treasury Bill Rates etc.
The value of the coupon payment is
c(ti+1 ) = Mrs (ti , ti+1 )/2
with rs the floating spot rates (semiannually compounded).
At t = tN (immediately after Nth coupon payment)
B(tN ) = M

Floating rate bonds

Proof
At t = tN1 (immediately after (N-1)th coupon payment)
B(tN1 ) =

M(1 + rs (tN1 , tN )/2

B(tN ) + c(tN )
=
=M
1 + rs (tN1 , tN )/2
1 + rs (tN1 , tN )/2

At t = tN2 (immediately after (N-2)th coupon payment)

B(tN2 ) =

B(tN1 ) + c(tN1 )
=
1 + rs (tN2 , tN1 )/2

M + c(tN1 )
M(1 + rs (tN2 , tN1 )/2
=
=M
1 + rs (tN2 , tN1 )/2
1 + rs (tN2 , tN1 )/2
Hence immediately after the coupon payment the bonds is worth par.

Floating rate bonds

Value of the Bond between Two Payments Date

In between two payments date, the bond value is calculated by discounting
the value of the bond at the next payment date.
This is equal to the face value (bond value immediately after coupon
payment) plus the coupon payment, i.e.
ti1 < t < ti
Bfloat (t ) = B(ti )erc (t
[M + c(ti )]e

rc (t ,ti )(ti t )

,ti )(ti t )

= M[1 + rs (ti1 , ti )/2]erc (t

We assumed rc (t , ti+1 ) is continuously compounded.

,ti )(ti t )

Swaps

Swaps
Swap is an agreement between two companies to exchange cash the flows in
the future.
The agreement defines the dates when the cash flow to be paid and the way
in which they are calculated.
Types of Swaps
Interest Rates Swaps
Currency Swaps

Swaps

Interest Rate Swaps

Interest rate swaps are typically agreement to exchange a fixed rate payment
on a given principal for a floating rate payment on the same principal.
The floating rate is chosen equal to the spot rate at the beginning of each
subsequent period.
The principal is never exchanged.
Frequency is in general chosen as semiannual.

Swaps

Interest Rate Swaps-Illustration

Consider a 3 year swap initiated on May 1, 2005 between Microsoft and
Intel. Microsoft agrees to pay to Intel an interest rate of 5% per annum on a
notional principal of $100 million and in return Intel agrees to pay Microsoft
the 6-month LIBOR rate on the same notional principal. Microsoft is the
fixed rate payer and Intel is the floating rate payer. Payments are to be
exchanged every 6 months and that 5% interest rate is quoted with
semiannual compounding.

Swaps

Interest Rate Swaps-Illustration

Note: J. Hull (2006), Options, Futures, and Other Derivatives, sixth edition, Prentice-Hall.

Swaps

Interest Rate Swaps-Illustration

Cash Flow to Microsoft

Date
May. 1, 2005
Nov. 1, 2005
May. 1, 2006
Nov. 1, 2006
May. 1, 2007
Nov. 1, 2007
May. 1, 2008

Six-Month
LIBOR
rate(%)
4.20
4.80
5.30
5.50
5.60
5.90

Floating Cash
Flow received

Fixed Cash
Flow Paid

Net Cash
Flow

+2.10
+2.40
+2.65
+2.75
+2.80
+2.95

-2.5
-2.5
-2.5
-2.5
-2.5
-2.5

-0.40
-0.10
0.15
0.25
0.30
0.45

Swaps

Interest Rate Swaps-Illustration

First Payments
First exchange of payments on November 1, 2005.
Microsoft would pay Intel:$100million 0.5 5% = $2.5million
Intel would pay Micorsoft interest on the $100 million principal at the 6
month LIBOR rate prevailing 6 months prior to November 1, 2005 that is, on
May 1, 2005.
6 month LIBOR rate on May 1, 2005 is 4.2%.
Intel pays Microsoft:$100million 0.5 %4.2 = $2.1million

Swaps

Using the Swap to Transform a Liability

For Microsoft, the swap can be used to transform a floating-rate loan into a
fixed-rate loan.
Suppose that Microsoft has arranged to borrow $100 million at LIBOR plus
10 basis points (LIBOR + 0.1%)
Microsoft has three sets of cash flows after entering the swap:
It pays LIBOR plus 0.1%to its outside lenders.
It receives LIBOR under the terms of the swap.
It pays 5% under the terms of the swap.
Thus, for Microsoft, the swap has the effect of transforming borrowings at a
floating rae of LIBOR plus 10 basis points into the borrowings at a fixed rate
of 5.1% as depicted in the Figure in the next slide.

Swaps

Using the Swap to Transform a Liability-Illustration

Note: J. Hull (2006), Options, Futures, and Other Derivatives, sixth edition, Prentice-Hall.

Swaps

Using the Swap to Transform a Liability

For Intel, the swap can be used to transform a fixed-rate loan into a
floating-rate loan.
Suppose that Intel has a 3 year $100 million loan outstanding on which it
pays 5.2%.
Intel has three sets of cash flows after entering the swap:
It pays 5.2% to its outside lenders.
It pays LIBOR under the terms of the swap.
It receives 5% under the terms of the swap.
Thus, for Intel, the swap has the effect of transforming borrowings at a fixed
rate of 5.2% into borrowing at a floating rate of LIBOR plus 20 basis points
as depicted in the Figure in the previous slide.

Swaps

Role of Financial Intermediary

Financial intermediary such as a bank or other financial institution is the
party that arranges a swap between two parties.
Interest rate swaps are usually structured so that the financial institution
earns about 3 or 4 basis points on a pair of offsetting transactions.
Financial intermediary has two seperate contracts with the parties in the
swap.
If one of the companies defaults, the financial institution has to honor its
agreement with the other company.

Swaps

The Comparative Advantage Argument

Borrowing rates that provides a basis for the comparative-advantage
argument

AAA Corp
BBB Corp

Fixed
4.0%
5.2%

Floating
LIBOR-0.1%
LIBOR+0.6%

AAACorp has a comparative advantage argument in the fixed-rate market

and BBBCorp has a comparative advantage in floating-rate market.
AAACorp borrows fixed-rate funds at 4% per annum and BBBCorp borrows
floating-rate funds at LIBOR+1% per annum. The they enter into a swap
agreement to ensure that AAACorp ends up with floating rate funds and
BBBCorp ends up with fixed-rate funds as depicted in the next figures for
two cases: without a financial intermediary and with a financial intermediary.

Swaps

Interest Rate Swaps-Illustration

Note: J. Hull (2006), Options, Futures, and Other Derivatives, sixth edition, Prentice-Hall.

Swaps

Interest Rate Swaps-Illustration

Note: J. Hull (2006), Options, Futures, and Other Derivatives, sixth edition, Prentice-Hall.

Swaps

Valuation of Interest Rate Swaps

An interest rate swap is worth zero or close to zero when it is first initiated.
After it has been existence for some time, its value may become positive or
negative.
Two valuation approaches:
Regarding the swap as the difference in the value of fixed and floating
rate bonds
Regarding the swap as a portfolio of FRAs

Swaps

Valuation in Terms of Bonds

From the point of view of the floating-rate payer, a swap can be regarded as
a long position in a fixed-rate bond and a short position in a floating rate
bond. Hence;
V(t) = Bfix (t) Bfloat (t)
From the point of view of the fixed-rate payer, a swap can be regarded as a
long position in a floating-rate bond and a short position in a fixed rate bond.
Hence;
V(t) = Bfloat (t) Bfix (t)

Swaps

Valuation in Terms of Bonds

Assume N semiannual periods and spot rates rc is continuously compounded.
The fixed bond is valued in the usual way.
is the fixed rate in the swap (like a coupon rate in the fixed bonds) ,
If R

Bfix (t) =

N
X
i=1

rc (t,ti )(ti t)

M(R/2)e
+ Merc (t,tN )(tN t)

Swaps

Valuation in Terms of Bonds

The floating rate leg is valued by remembering that a floating bond is worth
par immediately after the next payment date. If ti1 < t < ti
Bfloat (t ) = (M + c(ti ))erc (t

,ti )(ti t )

rs (ti1 , ti )
2
To convert from continuous compounding to semiannual compounding
c(ti ) = M

rs (t1 , t2 ) = 2(e(rc (t1 ,t2 )/2 1)

Swaps

Example: Interest Rate Swaps

Suppose that a financial institution has agreed to pay 6 month LIBOR and
receive 8% per annum (with semiannual compounding) on a notional
principal of $ 100 million. The swap has a remaining life of 1.25 years. The
LIBOR rates with continuous compounding for 3 month, 9 month and 15
month maturities are 10%, 10.5% and 11%, respectively. The 6 month
LIBOR rate at the last payment date was 10.2%(with semi-annual
compounding).
What is the value of the swap paying fixed rate?
What is the value of the swap paying floating rate

Swaps

Example: Interest Rate Swaps

Bfix (t) =

N
X

rc (t,ti )(ti t)

M(R/2)e
+ Merc (t,tN )(tN t)

i=1

Bfix (t) =

1.25
X

100 (8%/2)erc (t,ti )(ti t) + $100erc (t,tN )(tN t)

i=0.25

Bfix (t) = 4 erc (0,0.25)(0.250) + 4 erc (0,0.75)(0.750) + 4 erc (0,1.25)(1.250)

+ 100 * erc (0,1.25)(1.250)
Bfix (t) = 4 e0.100.25 + 4 e0.1050.75 + 4 e0.111.25 + 100 e0.111.25
Bfix (t) = $98.238million

Swaps

Example: Interest Rate Swaps

rs (ti1 , ti )
2
%10.2
c(ti ) = $100
2
c(ti ) = $5.1

c(ti ) = M

Bfloat (t ) = (M + c(ti ))erc (t

,ti )(ti t )

Bfloat (t ) = ($100 + $5.1)erc (0,0.25)(0.250)

Bfloat (t ) = $105.1 e0.100.25
Bfloat (t ) = $102.505million

Swaps

Example: Interest Rate Swaps

The value of the swap for the party paying fixed rate
V(t) = Bfloat (t) Bfix (t)
V(t) = $102.505 $98.238
V(t) = $4.267million
The value of the swap for the party paying floating rate
V(t) = Bfix (t) Bfloat (t)
V(t) = $98.238 $102.505
V(t) = $ 4.267million

Swaps

Valuation in Terms of FRAs

A swap can be characterized as a portfolio of forward rate agreements. The
FRA can be valued on the assumption that todays forward rates are realized.
The procedure is as follows:
Use the LIBOR/swap zero curve to calculate forward rates for each of
the LIBOR rates that will determine swap cash flows
Calculate swap cash flows on the assumption that the LIBOR rates will
equal the forward rates
Discount these swap cash flows (using theLIBOR/swap zero curve) to
obtain the swap value

Swaps

Valuation in Terms of FRAs

Assume continuously compounded spot rate, and semiannually compounded
fixed and forward rate.
V(t) =

N
X
M
i=1

where
fc (t, t1 , t2 ) =

fs (t, ti1 , ti )]erc (t,ti )(ti t)

[R

rc (t, t2 )(t2 t) rc (t, t1 )(t1 t)

t2 t1

Swaps

Example: Interest Rate Swaps

Suppose that a financial institution has agreed to pay 6 month LIBOR and
receive 8% per annum (with semiannual compounding) on a notional
principal of $ 100 million. The swap has a remaining life of 1.25 years. The
LIBOR rates with continuous compounding for 3 month, 9 month and 15
month maturities are 10%, 10.5% and 11%, respectively. The 6 month
LIBOR rate at the last payment date was 10.2%(with semi-annual
compounding).
What is the value of the swap paying fixed rate?
What is the value of the swap paying floating rate

Swaps

Example: Interest Rate Swaps

The first exchange of payments is known at the time of the swap is
negotiated.
The other two exchanges can be regraded as FRAs.
The exchange on 9th month is a FRA where interest at 8% is exchanged for
forward rate corresponding for the period between 3 and 9 month.
The exchange on 15th month is a FRA where interest at 8% is exchanged for
forward rate corresponding for the period between 9 and 15 month.

Swaps

Example: Interest Rate Swaps

fc (0, 0.25, 0.75) =

rc (0, 0.75)(0.75 0) rc (0, 0.25)(0.25 0)

0.75 0.25

fc (0, 0.25, 0.75) =

10.5% (0.75 0) 10% (0.25 0)

0.75 0.25

fc (0, 0.25, 0.75) = 10.75%

To convert from continuous compounding to semiannual compounding
fc (0, 0.25, 0.75) = 2(efc (0,0.25,0.75)/2 1)
fc (0, 0.25, 0.75) = 2(e(10.75%/2 1)
fc (0, 0.25, 0.75) = 11.044%

Swaps

Example: Interest Rate Swaps

fc (0, 0.75, 1.25) =

rc (0, 1.25)(1.25 0) rc (0, 0.75)(0.75 0)

1.25 0.75

fc (0, 0.75, 1.25) =

11% (1.25 0) 10.5% (0.75 0)

1.25 0.75

fc (0, 0.75, 1.25) = 11.75%

To convert from continuous compounding to semiannual compounding
fc (0, 0.75, 1.25) = 2(e11.75%/2 1)
fc (0, 0.75, 1.25) = 12.10%

Swaps

Example: Interest Rate Swaps

V(t) =

N
X
M
i=1

fs (t, ti1 , ti )]erc (t,ti )(ti t)

[R

The value of the swap for the party paying floating-rate

V(t) =

$100
$100
[8% 10.2%]e0.100.25 +
[8% 11.0.44%]e0.10.50.75 +
2
2
$100
[8% 12.1%]e0.111.25
2
V(t) = $ 4.267million

Swaps

Currency Swaps
Currency swaps are typically agreement to pay a fixed rate on a principal in
a given currency and receive a payment at a fixed rate on a principal in a
different currency.
Principal is exchanged at the beginning and at the end of the life of the swap.
The fixed rate is chosen so that the value of the swap is zero when first
initiated.

Swaps

Currency swaps
1 is the fixed rate on the principal in the first currency and R
2 is the
Assume R
fixed rate on the principal in the second currency semiannually compounded
with N semiannual payments to exchange.
Currency swaps can be valued in two ways.
Valuation in terms of bonds
Valuation in terms of FRAs

Swaps

Valuation in Terms of Bonds

Currency swaps can be valued as the difference between the value of two
fixed-rate bonds. Denote Q1,2 the exchange rate between the two currency
(Q converts from currency 2 into currency 1). Assume r1 and r2 are the spot
rates in the two countries continuously compounded. The fixed bonds are
valued in the usual way.
B1 (t) =

N
X

M1

i=1

R1 r1 (t,ti )(ti t)
e
+ M1 er1 (t,tN )(tN t)
2

in units of the first currency, and

B2 (t) =

N
X
i=1

M2

R2 r2 (t,ti )(ti t)
e
+ M2 er2 (t,tN )(tN t)
2

in units of the second currency. So the value of the swap expressed in the
first currency is
V(t) = B1 (t) Q1,2 (t)B2 (t)

Swaps

Example-Currency Swaps
The term structure of LIBOR/swap interest rates is flat in both Japan and the
United States. The Japanese rate is 4% per annum and the US rate is 9% per
annum (both with continuous compounding). A financial institution has
entered into a currency swap in which it receives 5% per annum in yen and
pays 8% per annum in dollars once a year. The principals in two currencies
are $ 10 million and 1.200 million yen. The swap will last for another 3
years and the current exchange rate is 110 yen=$1.
What is the value of the swap paying dollars?
What is the value of the swap paying yen?

Swaps

Example-Currency Swaps

B1 (t) =

N
X

M1 Rer1 (t,ti )(ti t) +M1 er1 (t,tN )(tN t)

i=1

B1 (t) = 0.8er(0,1)(10) +0.8er(0,2)(20) +0.8er(0,3)(30) +10er(0,3)(30)

B1 (t) = 0.8e0.09(10) +0.8e0.09(20) +0.8e0.09(30) +10e0.09(30)

B1 (t) = $9.64million

Swaps

Example-Currency Swaps

B2 (t) =

N
X

M1 Rer1 (t,ti )(ti t) +M1 er1 (t,tN )(tN t)

i=1

B2 (t) = 60er(0,1)(10) +60er(0,2)(20) +60er(0,3)(30) +1200er(0,3)(30)

02
B2 (t) = 60e0.04(10) +60e0.04(20) +60e0.04(30) +1200e0.04(30)

B2 (t) = 1230.55yen

Swaps

Example-Currency Swaps

V(t) = B1 (t) Q1,2 (t)B2 (t)

V(t) = $9.64 (1/110) 1230.55

V(t) = $1.54

Swaps

Valuation in Terms of FRAs

Each exchange of payments in an interest rate swap is an FRA. The FRA can
be valued on the assumption that todays forward exchange rates are realized
where
F(t, ti ) = Q1,2 (t)e(r1 (t,ti )r2 (t,ti ))(ti t)
The value of the swap expressed in the currency of first country is
V(t) =

N
X
1
i=1

1 F(t, ti )M2 R
2 ]er1 (t,ti )(ti t)
[M1 R

Swaps

Example-Currency Swaps
The term structure of LIBOR/swap interest rates is flat in both Japan and the
United States. The Japanese rate is 4% per annum and the US rate is 9% oer
annum (both with continuous compounding). A financial institution has
entered into a currency swap in which it receives 5% per annum in yen and
pays 8% per annum in dollars once a year. The principals in two currencies
are $ 10 million and 1.200 million yen. The swap will last for another 3
years and the current exchange rate is 110 yen=$1.
What is the value of the swap paying dollars?
What is the value of the swap paying yen?

Swaps

Example-Currency Swaps
Q1,2 = 1/110dolar per yen
F(t, t1 ) = Q1,2 (t)e(r1 (t,ti )r2 (t,ti ))(ti t)
F(0, 1) = Q1,2 (t)e(r1 (0,1)r2 (0,1))(10)
F(0, 1) = 1/110 e(9%4%)(10)
F(0, 1) = 0.009557
F(0, 2) = Q1,2 (t)e(r1 (0,2)r2 (0,2))(20)
F(0, 2) = 1/110 e(9%4%)(20)
F(0, 2) = 0.010047
F(0, 3) = Q1,2 (t)e(r1 (0,3)r2 (0,3))(30)
F(0, 3) = 1/110 e(9%4%)(30)
F(0, 3) = 0.010562

Swaps

Example-Currency Swaps
The value of the swap for the party paying yen
V(t) =

N
X
1
i=1

1 F(t, ti )M2 R
2 ]er1 (t,ti )(ti t)
[M1 R

V(t) = [$10 0.08 0.009557 1200 0.05]e0.091 +

[$10 0.08 0.010047 1200 0.05]e0.092 +
[$10 0.08 0.010562 1200 0.05]e0.093 + [$10 0.010562 1200]e0.093
V(t) = $ 1.54million
The value of the swap for the party paying dollars
V(t) = $1.54million

Swaps

Exercise Book 7.3

A $100 million interest rate swap has a remaining life of 10 months. Under
the terms of the swap; 6-month LIBOR is exchanged for 12% per annum
(compounded semiannually). The average of the bid-offer rate being
exchanged for 6-month LIBOR in swaps of all maturities is currently 10%
per annum with continuous compounding. The 6-month LIBOR rate was
9.6% per annum 2 months ago.
a) What is the current value of the swap to the party paying floating?
b) What is its value to the party paying fixed?

Swaps

Exercise Book 7.5

A currency swap has a remaining life of 15 months. It involves exchanging
interest at 10% on 20million for interest at 6% on $30 million once a year.
The term structure of interest rates in both the United Kingdom and the
United States is currently flat, and if the swap were negotiated today, the
interest rates exchanged would be 4% in dollars and 7% in sterling. All
interest are quoted with annual compounding. The current exchange rate
(dollars per pound sterling) is 1.6500.
a) What is the value of the swap to the party paying sterling?
b) What is the value of the swap to the party paying dollars?

Swaps

Exercise Book 7.11

Companies A and B face the following interest rates (adjusted for the
differential impact of taxes):
US dollars(floating rate)
Canadian dollars (fixed rate)

Company A
LIBOR+0.5%
5.0%

Company B
LIBOR+1.0%
6.5%

Assume that A wants to borrow US dollars at a floating rate of interest and B

wants to borrow Canadian dollars at a fixed rate of interest. A financial
institution is planning to arrange a swap and requires a 50 basis point spread.
If the swap is appear equally attractive to A and B, what rates of interest will
A and B end up paying?

Swaps

Exercise Book 7.19

The LIBOR zero curve is flat at 5% (continuously compounded) out to 1.5
years. Swap rates for 2 and 3 year semiannual pay swaps are 5.4% and 5.6%
respectively.(Assume that the 2.5 year swap rate is the average of the 2 and 3
year swap rates)
Estimate the LIBOR zero rates for maturities of 2.0, 2.5 and 3.0 years.

Swaps

Exercise Book 7.21

Under the terms of an interest swap, a financial institution has agreed to pay
10% per annum and to receive 3 month LIBOR in return on a notional
principal pf $ 100 million with payments being exchanged every 3 months.
The swap has a remaining life of 14 months. The average of the bid and
offer fixed rates currently being swapped for 3 month LIBOR is 12% per
annum for all maturities. The 3 month LIBOR rate 1 month ago was 11.8%
per annum. All rates are compounded quarterly.
What is the value of the swap?

Swaps

Exercise Book 7.22

Suppose that the term structure of interest rates is flat in the United States
and Australia. The USD interest rate is 7% per annum and the AUD rate is
9% per annum. The current value of the AUD is 0.62 USD. Under the terms
of a swap agreement, a financial institution pays 8% per annum in AUD and
receives 4% per annum in USD. The principals in the two currencies are $
12 million USD and 20 million AUD. Payments are exchanged every year
with one exchange having just taken place. The swap will last 2 more years.
What is the value of the swap to the financial institutions? Assume all
interest rates are continuously compounded.