Interest Rate and Currency Swaps

Keith C.
Brown, CFA
University of Texas, Austin
Donald J Smith
Boston University
Interest Rate and Currency Swaps:

A Tutorial
The Research Foundation of

The Institute of Chartered Financial Analysts
Interest Rate and Currency Swaps:
A Tutorial
978-0-943205-81-6
Mission
The Research Foundation's mission is to identify,
fund, and publish research that is relevant to the
CFA@ Body of Knowledge and useful for AIMR
member investment practitioners and investors.
Core CFA
Body of
Knowledge
The Research Foundation of

The Institute of Chartered Financial Analysts
P. 0. Box 3668
Charlottesville, Virginia 22903
U.S.A.
Telephone: 804/98@3644
Fax: 804/98@3634
Table of Contents
Acknowledgments ...................................... viii

Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix
Chapter 1. Overview of the Swap Market . . . . . . . . . . . . . . . . . . . I

Chapter 2. Economic Interpretations of a Swap Contract . . . . . . . 19
Chapter 3. Swap Applications. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Chapter 4. Pricing Interest Rate and Currency Swaps . . . . . . . . . 61
Chapter 5. The Risks in Swap Contracting . . . . . . . . . . . . . . . . . . 83
Chapter 6. Swap Design Variations and Extensions . . . . . . . . . . . 103
Appendix: Calculation of the Macaulay Duration Statistic . . . . . . 123
Selected Swap References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Glossary of Swap Terminology ............................ 131
Acknowledgments
This project began in 1986 when, as full-time consultants to Manufacturers Hanover

Trust Company, we first recognized the impact interest rate and currency swaps were
having on corporate finance and institutional investment. We have been fortunate to
have had opportunities to follow closely the development of these markets and to work
with a number of market professionals. We owe a great debt of gratitude to our many
colleagues at Manufacturers Hanover, Chemical Bank, and Texas Commerce Bank. In
pa~icular,we would like to thank Barbara Luttich, Gary Hickerson, and Mike
Fitzgerald, as well as Tom McCaskill, Tom Kennedy, Tom Geggatt, and Eileen Green,
who provided the platform for developing much of the material contained in this
volume.
We would also like to thank Gary Gastineau for his support and guidance in the
formative stages of this project. In fact, his invaluable Dictionary of Financial Risk
Management provided us with a considerable amount of the motivation needed to
create the glossary that appears at the end of the tutorial.
Lastly, we would like to thank the Research Foundation of the Institute of Chartered
Financial Analysts for its solicitation and generous funding of our work. We appreciate
the efforts of Katy Sherrerd and her sta£fin helping to bring this project to fruition and
for recognizing the important role that swap contracting plays in today's financial
markets.
Keith C. Brown, CFA

Donald J. Smith
viii
Foreword
Derivatives tend to provoke some colorful emotions among people who don't know
much about them. Some turn white with fear, others red with anger (witness the
reactions of the citizens of Orange County, California). In practice, a little knowledge
goes a long way toward tempering these reactions.
This tutorial provides more than a little knowledge about two particularly useful
forms of derivatives-interest rate and currency swaps. Both are widely used by
corporations and investors for risk-management purposes in a world in which the
volatility of both interest rates and exchange rates has increased markedly. The
number of interest rate swap contracts in 1993 was seven times the number in 1987;
the number of currency swaps was five times as great. Surely, these numbers alone are
testimony to the need for such instruments. In financial products, as in others, demand
does indeed elicit innovation and supply.
Keith Brown and Don Smith, with this tutorial, have created an invaluable resource
for those wishing-or needing-to know more about swaps. The authors steer readers
gently through the complexities of and possible variations on these instruments,
providing stepby-step instructions and "real-life" examples of how to use them. The
exercises (and solutions) after each chapter permit readers to learn by doing, as well
as by reading. Another feature readers will find useful is a comprehensive current
bibliography of other books, journal articles, and papers relating to the subject of
swaps.
The Research Foundation is pleased to present this second entry in its tutorial
series. We believe it is a useful addition to the literature on swaps and, like the
instruments themselves, meets a real demand for such products in the field of
derivatives. The authors should be commended for the thoroughness and comprehen-
siveness of this work.
Katrina F. Sherrerd, CFA

Executive Director
Research Foundation of the
Institute of Chartered Financial Analysts
Chapter 1. Overview of the Swap Market
Many innovative financial products have ap- an exchange of a fixed interest rate for LIBOR
peared (and disappeared) during the past couple (the London Interbank Offered Rate). Each set-
of decades. With the benefit of hindsight, it is tlement period, the two rates are compared and
now clear that one of the most important and the difference (times the transaction's notional
lasting innovations developed in this era is the principao is paid by one counterparty to the
over-the-counter swap contract. The interest other. A typical currency swap is an exchange of
rate and currency swap markets have become a fixed interest rate, say 8 percent in Canadian
enormous in the sheer number and size of dollars, for U.S. dollar LIBOR. An important
transactions and participants. Perhaps the most difference is that an interest rate swap does not
telling statement of impact is that swaps have involve an exchange of principal (hence the
attained "commodity status." These days, finan- term "notional" principal), whereas actual prin-
cial analysts routinely consider the effects of cipal amounts are usually traded at the inception
"swapping" into or out of a particular interest and maturity of a currency swap.
rate or currency exposure. Although our pri-
mary focus is on interest rate and currency
swaps, we show that the same contract design Historical Development of the
can be used to manage equity and commodity Swap Market
price risks as well. Swap contracting as we know it today is a
Broken down to its essential nature, a swap fairly recent phenomenon. The first swap agree-
contract is quite straightforward. Two counter- ment was negotiated in 1981 by Salomon Broth-
parties agree to a periodic exchange of cash ers on behalf of the World Bank and IBM and
flows for a set length of time based on a speci- involved an exchange of cash flows denomi-
fied amount of principal. Both cash flows in an nated in Swiss francs and deutschemarks. The
interest rate swap are denominated in the same first standard fixed-for-floatinginterest rate swap
currency; in a currency swap (sometimes called in the United States was executed in 1982 with
a cross-currency swap), the cash flows are ex- the Student Loan Marketing Association ("Sallie
pressed in different monetary units. In either Mae") as a counterparty.
type of contract, one of the cash flow streams These transactions raise two questions: First,
typically is based on a fixed interest rate set at given that firms have borrowed money from one
the inception of the deal, and the other is another (thereby creating interest rates) and
referenced to an index that varies over time. A have traded across national borders in different
standard, or "plain vanilla," interest rate swap is currencies (thereby creating foreign exchange
Interest Rate and Currency Swaps: A Tutorial
rates) for hundreds of years, why have we had of the swap markets that was spurred by these
interest rate and currency swaps for only a short events has been remarkable. Table 1.1presents
period of time? Second, why did the interest rate annual statistics on total dollar volume and
swap, which is the simpler of the two contracts number of contracts for interest rate and cur-
by virtue of having no foreign exchange compo- rency swaps. Also reported is average size of an
nent, develop after the currency swap? outstanding contract in each market. Several
The defining factor behind the timing of the aspects of these data are revealing. First, from
development of the swap markets is summa- 1987 (the first year for which this information
rized in a single word: volatility. In particular, was gathered in a systematic manner) to 1993,
what matters is the volatility of interest rates outstanding principal in the entire swap industry
(particularly in the United States) and exchange increased from less than $1trillion to more than
rates. Two recent events significantly reshaped $7 trillion. This growth is especially striking
the volatility of these two variables. The first was given that the volume prior to 1981 was effec-
the suspension in August 1971 of the Bretton tively zero. Second, interest rate swap activity is
Woods worldwide system of maintaining fixed substantially greater than that for currency
exchange rates linked to a gold standard. There- swaps. In 1993, for instance, total notional prin-
after, exchange rates throughout the world were cipal of interest rate swaps was seven times that
effectively allowed to float to market-determined for currency swaps. Third, the rate of expansion
levels (albeit with frequent central bank inter- in the two markets over this time frame d i e r s ;
vention). The second catalyzing event occurred the outstanding principal of interest rate agree-
in October 1979, when the U.S. Federal Reserve ments grew at an average annual rate of 44.36
Board of Governors, led by its chairman Paul percent compared with 30.43 percent for cur-
Volcker, in an attempt to reduce the inflation rency contracts. Finally, although the size of the
rate, elected to change its operating target to typical currency swap deal appears to have
focus on bank reserve growth rates rather than fluctuated around the $27 million mark for some
the level of short-term interest rates. time, interest rate swap transactions have been
The effect of each of these events on rate getting steadily larger in scale.
volatility is displayed rather emphatically in The primary users of swap agreements are
Figure 1.1. The top panel shows how the first corporate and institutional managers seeking to
difference (i.e., the current minus the previous hedge their underlying operating statement and
rate) of the monthly series of Japanese yen/U.S. balance sheet exposures to adverse movements
dollar exchange rates has evolved since January in interest rates or foreign exchange rates. In
1960. The most striking feature is the virtual fact, according to a 1991 survey of firms' chief
break in the constancy of the pattern that oc- financial officers by Institzktional Investor, three-
curred in the latter part of 1971, following the quarters of the firms with revenues of at least $3
breakdown of the Bretton Woods agreement. billion had used swaps at some point. Cited
The lower panel illustrates how the Federal motivations for using swaps included a corpo-
Reserve's policy change increased the volatility rate treasurer trying to keep the funding cost of
of the ten-year, constant-maturity 1J.S. Treasury a floating-rate debt issue from getting too high,
series in late 1979. When these charts are taken another treasurer protecting the home-currency
together, the answers to the questions about the revenue generated by product sold overseas, an
evolution of the swap markets become evident. insurance company executive attempting to
First, although corporations always had been align the interest rate sensitivities of the firm's
exposed to interest and exchange rates, the assets and liabilities, and a portfolio manager
financial instruments to hedge those risks only trying to execute a tactical asset allocation strat-
became available when volatility reached a level egy in a cost-effective way. Notice that these
at which market making would be profitable. motivations do not involve the pursuit of finan-
Second, volatility in the markets for foreign cial arbitrage. This omission is notable because
exchange increased well before the volatility of many swaps in the early years of the market
domestic interest rates increased. aimed to lower the end user's cost of borrowed
By any standard of measurement, the growth funds by attaching the swap to a newly issued
Figure 1.1 Volatility in the Exchange Rate and Interest Rate Markets
First Diflerence of Monthly YenlDollar Exchange Rate Series
First Difference of 10-Year (Constant-Maturity) U.S. Treasury Yield Series
Data Source: Federal Reserve System.
bond. The swap market, however, could not ally agreeable. The essential variables in a swap
have grown as large and as rapidly as it has if it contract include the level of the fixed rate, the
had to rely largely on continuing inefficiency in manner in which the variable reference rate is to
the capital market, an inefficiency that permits be determined, the scale of the transaction (i.e.,
the new-issue arbitrage opportunity. the notional principal), the currency of the cash
A key element to the swap market's success flows, the dates of the settlement payments, and
has been the flexibility of the contract itself. the events that define default. Although plain
Because each swap is negotiated in the over-the- vanilla terms of agreement have emerged, un-
counter market, there is no limit on the terms or conventional "structured" swaps also can be
conditions that can be written into the contract, transacted. This feature distinguishes swaps
assuming that the two parties find them mutu- from exchange-traded futures contracts, which
I Growth of the Interest Rate

Table I. ward collateralized arrangements has devel-
and Currency Swap Markets oped.
These two aspects of interest rate and cur-
Total Notional Average rency swaps-customization and credit risk-
Principal (USD Contract explain why commercial banks have played
equivalent, Total Size such a major role in the development of the
Year-End in millions) ContlOacts($millions) market. At first, banks acted as brokers to the
Interest Rate Swaps market, putting the corporate end users together
1987 $ 682,888 34,127 $20.01 and collecting an arrangement fee. Banks even-
1988 1,010,203 49,560 20.38 tually stepped in as intermediaries to the trans-
1989 1,539,320 75,223 20.46 actions and served as the counterparties to the
1990 2,311,544 102,349 22.58 end users. This arrangement facilitated growth
1991 3,065,065 127,690 24.00 of the swap market because commercial banks,
1992 3,850,806 151,545 25.41
1993 6,177,352 236,126 26.16 more than any other institution in the economy,
have the human and financial capital to assess
Currency Swaps and manage credit risk. Moreover, many mon-
1987 ey-center banks saw swaps as a natural replace-
1988 ment to the business they were losing as their
1989 best corporate customers accessed capital mar-
1990 kets to raise funds directly instead of indirectly
1991 via bank loans, a phenomenon dubbed "disinter-
1992 mediation." Over-the-counter derivatives, such
1993 as swaps, offered a means of "reintermediation"
Note: The currency swap total is adjusted for double- between commercial banks and corporations.
counting of contracts. Table 1.2 lists the biggest swap and derivatives
Source: The International Swaps and Derivatives Associa-
tion.
houses worldwide. Note that commercial banks
are not just market makers; they also tend to be
heavy end users of swap contracts to manage
their own balance sheet exposures.
have standardized terms. In fact, one of the main Another interpretation of the role of commer-
reasons for the extraordinary development of cial banks in the swap market is as an interme-
the swap market has been the extent to which diary between the futures industry and corpo-
the inherent flexibility of the co:ntract allows rate risk managers. Many swap contracts
corporate risk managers to custorrlize solutions compete directly with exchange-traded futures,
to their hedging needs. as in the case of a plain vanilla interest rate swap
Over-the-counter swaps d 8 e r from ex- exchanging a fixed rate for LIBOR versus a strip
change-traded futures contracts in another fun- of Eurodollar futures contracts. Because the
damental way. The daily mark-to-market valua- swap can be customized to the specific needs of
tion and settlement procedures of a futures the end user, in particular with regard to the
exchange limit credit risk dramatically. Given exact settlement dates, it can minimize the basis
that gains and losses are realized daily, no risk that remains even after executing the
unrealized value builds up over the lifetime of hedge. Many corporate end users prefer a more
the futures contract as it does on a. swap. Thus, exact hedge undertaken with a bank counter-
a swap contract is necessarily a risky instrument party rather than structuring the hedge itself
in that default by the counterparty could lead to with futures contracts, even if it costs a little
significant economic loss (although the amount more and entails bearing the bank's credit risk.
of notional principal can be a very deceptive The bank, in turn, can lay off the risk it assumes
measure of the extent of risk). Both counterpar- when entering the swap with the corporation by
ties to the swap bear this credit risk. Moreover, using the futures contracts themselves. In effect,
swaps have tended to be unsecured obligations, the bank intermediary acquires a futures posi-
although in recent years, a growing trend to- tion with its attendant daily mark-to-market set-
Table 1.2 Outstanding Notional ter Agreement documents for interest rate and
Principal of Leading currency swaps that spell out precisely, among
Derivatives Dealers, 1993 other aspects, the language of the deal, how
agreements need to be confirmed, what happens
in the event of a counterparty default, and how
Financial Institution
the parties to the transaction should treat the
Chemical Bank $2,416 swap for tax purposes.
Bankers Trust 1,982
Citicorp 1,981
J.P. Morgan 1,660 Interest Rate Swaps: Basic
Union Bank of Switzerland
Swiss Bank
Product Design and Market
Societe Generale Conventions
Mitsubishi Bank At first glance, swap market terminology can
Credit Lyonnais be a confusing blend of banking, capital market,
Chase Manhattan and futures market vocabulary. Several conven-
Credit Suisse
tions, however, have emerged to standardize the
Salomon
BankAmerica language necessary to negotiate and understand
Banque Indosuez swap transactions. Figure 1.2 illustrates several
Merrill Lynch of these conventions for a plain vanilla, U.S.-
Goldman Sachs dollar-denominated interest rate swap agree-
Barclays 751 ment. The two counterparties have arranged to
Paibas 742 make periodic exchanges of cash flows based on
National Westminster 577 a common notional principal and two separate
Royal Bank of Canada 554
interest rates, one that remains fixed for the life
Note: German and most Japanese banks do not disclose of the agreement and one that is reset (ime.,
derivative position sizes.
Source: Fortune, March 7 , 1994. "floats") according to changing market condi-
tions. The two parties to the transaction are
referred to as the p a y a d (Counterparty A) and
tkment procedures and passes it on to the mceive-fxed (Counterparty B) sides of the deal.
corporation as a contract that settles up only
periodically. In fact, the growth of trading activ-
ity in futures contracts has been just as dramatic
as that of the swap market in recent years, which Figure 1.2 Swap NIarket Pricing
indicates that the over-the-counter swap market Mechanics
and futures exchanges complement one another At Origination
as much as they compete.
Negotiate Terms of the Transaction
An important institutional presence in the (Including Notional Principal, Maturity, etc.)
swap market is the International Swaps and
No Exchange of Cash Flows
Derivatives Association (ISDA) . This organiza-
tion, which was originally known as the Interna-
tional Swap Dealers Association, is an industry On Each Settlement Date
trade group that provides its members with
Floating Reference Rate
many services, ranging from periodic surveys of (e.g., Six-Month LIBOR)
trends in the market to advocacy on regulatory
4
issues. Easily the most important contribution Counterparty A Counterparty B
ISDA has made to the growth of the industry
was to create a set of standardized terminology
Swap Fixed Rate =
and conditions that has governed virtually every
Treasury Swap
market transaction since 1987. Specifically, Note + Spread
ISDA developed (and continues to update) Mas- Yield
No exchange of cash flows takes place at origi- pays the fixed rate and the offer side when it
nation of the swap. receives the fixed rate.
The fixed-rate payer is sometimes said to Table 1.3 lists a representative set of quoted
have "bought" the swap or, equivalently, taken fixed rates on swaps based on six-month LIBOR.
the long position, which would then leave the Two aspects of this table are noteworthy. First,
fixed-rate receiver as the "seller,'kr short posi- as the swap maturity lengthens, the absolute
tion. In fact, nothing is actually bought or sold, level of the swap spread tends to rise. This
because at inception, the swap is neither an phenomenon suggests that the swap spread has
asset nor a liability. Each party has entered a a separate term structure from the usual matu-
zero-sum contract that might, ark.! probably will, rity term structure built into the Treasury yield
take on positive value to one side; if it does, the curve. Second, across the entire list of swap
other side will have a corresponding amount of maturities-which is representative of the ten-
negative value. The expressions "buy" and "sell" ors commonly available in the market-the bid-
arise from interpreting the floating reference ask differential on the swap spread quote never
rate as the commodity that the two counterpar- exceeds 4 basis points. This differential repre-
ties are trading; the swap's fixed rate is the price sents the market maker's profit margin on a pair
for this recurring transaction. That is, Counter- of "matched" deals (i.e., simultaneously exe-
party B can be viewed as having agreed to sell cuted pay-fixed and receive-fixed transactions
the reference rate on each settlement date for having the same notional principal and settle
the fixed rate agreed upon at the outset. ment dates), so apparently the plain vanilla
Notice also that the floating-rate side of the segment of the swap market is quite competi-
transaction is quotedflat; any modification to the tive. These bid-ask spreads were much wider in
price of the swap typically is negotiated as an the formative years of the swap market.
Figure 1.3 illustrates a matched pair of five-year
adjustment to the fixed rate. For example, a
agreements using these quotes, with Counter-
market maker might set a lower pay-fixed rate
party C now serving the role of the second
when transacting with a weaker counterparty
corporate end user.
than with a stronger one; the receive-fixed side Several important standards govern the pro-
is LIBOR flat in each case. The reference rate on cess for calculating the periodic settlement pay-
the swap can be any mutually agreeable index ments. The most important is that settlements
(e.g., LIBOR, the prime rate, a commercial are made on a net basis; that is, although
paper index, or the average of certificate of Figures 1.2 and 1.3 suggest that two cash flows
deposit rates). Nevertheless, a recent ISDA sur- will change hands each settlement period on
vey reported that about 90 percent of the U.S.-
dollar-based contracts used either three- or six-
month LIBOR as the floating rate. Table 1.3 Representative Quotes for
Another important convention shown in Plain Vanilla Interest Rate
Figure 1.2 is that the fixed-rate side of the Swaps Based on Six-Month
contract is broken down into two components: a LIBOR
Treasury note yield and a swap spread. The Bid Ask Effective
particular Treasury note yield selected depends Swap Treasury Swap Swap Fixed Swap
on the maturity, or tenor, of the swap. The usual Maturity Yield Spread Spread Rate
practice is to use the yield of the on-the-run (i.e., (years) (%I (bps) (bps) (%)
the most recently issued) security maturing
closest to the swap's final settlement date. A
convenient facet of these conventions is that the
market maker's quoted price for the agreement
is reduced to the swap spread, because all
market participants can monitor the current
Treasury yield. In fact, a market maker usually
quotes two swap spreads-the bid side when it Source: Chemical Securities, Inc.
6
Chapter 1, Overview of the Swap Market
Figure 1.3 A Matched Pair of Five-Year Swap Transactions

Six-Month Six-Month
LIBOR LIBOR
f 4
Counterparty B
Counterparty A (the swap dealer) Counterparty C
> >
each deal, in reality, the counterparty owing the one period to another if the settlement periods
larger of the two amounts will simply pay the themselves have different numbers of days.
difference. Second, the fixed and floating rates Note, however, that fixed-rate payments based
specified in the swap agreement might not be on a 30/360 day count will not vary at all. Finally,
directly comparable. For instance, the fixed rate the reference rate used to settle at date t is
typically is a semiannually compounded rate actually determined one period in arrears (i.e.,
quoted on a bond basis (consistent with a at date t - 1). This convention, which matches
quoted Treasury yield). The day-count conven- the usual practice for determining interest pay-
tion for the swap fixed rate used for partial-year ments in the floating-rate note and bank loan
cash flows typically is either "actua1/365" or markets, ensures that both cash flows will al-
"30/360." In contrast, U.S. dollar LIBOR is a ways be known one full settlement period in
money-market rate based on a 360-day year; its advance. With these definitions, the net settle-
partial-year cash flows are calculated on an ment obligation is defined in a straightforward
"actua1/360" basis. Assuming an actua1/365 day manner as the difference between the fixed-rate
count for the fixed-rate payment, the formulas and floating-rate payments.
for the settlement calculations under these con- Table 1.4 demonstrates the settlement date
ditions are as follows: cash flows from the perspective of the fixed-rate
payer in the five-year swap illustrated in
(Fixed-rate payment), = (Swap fixed rate) Figure 1.3. Specifically, assume that after the
initial agreement was negotiated, the terms of
(Numb;w;f days
1 the transaction were confirmed as follows:
Origination date: September 30, 1994

x (Notional principal) Maturity date: September 30, 1999
and Notional principal: U.S. $30 million
Fixed-rate payer: Counterparty A
(Floating-rate payment), = (Reference rate) ,-, Swap fixed rate: 7.56 percent (semiannu-
al, actual/365 bond basis)
(Numbf;; days
i Fixed-rate receiver: Counterparty B (the
swap dealer)
Floating rate: Six-month LIBOR (money-
x (Notional principal),
market basis)
where the subscript denotes the settlement pe- Settlement dates: September 30th and
riod date. Notice three important features of March 30th of each year
these equations. First, the principal involved in LIBOR determination: Determined in ad-
the interest rate swap transaction is never ex- vance, paid in arrears
changed; it is notional (or hypothetical) in the
sense that it is used only as a scale factor to The third column of Table 1.4 lists an assumed
translate a percentage rate into a cash amount. path that the six-month spot LIBOR follows over
Second, the fixed-rate payment might vary from the course of the contract. As the fixed-rate
Table 1.4 Settlement Cash Flows for the Fixed Payer on a Five-Year Interest Rate
Swap
Fixed-Rate Floating-Rate Counterparty A's
Settlement Number Assumed Payment Receipt Net Payment
Date of Days Current LIBOR (Counterparty A) (Counterparty B) (Receipt)
payer, Counterparty A makes (receives) the net plain vanilla currency swap is assumed to ex-
settlement payment whenever the day-count- change a fixed rate in the foreign currency for
adjusted level of LIBOR is less than (exceeds) U.S. dollar LIBOR. This structure is shown in
the swap fixed rate of 7.56 percent. This net Figure 1.4.
settlement amount is shown in the last column Notice in this diagram that two distinct types
of the table as the difference between the coun- of exchanges take place: principal on both orig-
terparties' cash flows. ination and maturity, and coupon interest on all
of the settlement dates. Customarily, both prin-
Currency Swaps: Basic Product cipal exchanges are executed at the spot foreign
Design and Market Conventions exchange (FX)rate prevailing at the initiation
Two factors make the cross-currency swap date, regardless of subsequent market EX rates.
agreement a more difficult transaction to ana- Furthermore, as in the interest rate swap, the
lyze than the single-currency agreement consid- floating-rate side of the coupon exchanges in the
ered above. First, because the associated cash standard currency swap is usually quoted flat.
flows are denominated in different monetary Thus, the dollar cash flow paid by Counterparty
units, the principal amounts are usually ex- E on each settlement date is determined by
changed at the origination and maturity dates of multiplying the relevant LIBOR (which would
the contract. Second, because two currencies once again have been determined at the previ-
are involved, the interest rates defining the ous settlement date) by the U.S. dollar principal
transaction can be expressed on either a fixed- amount, adjusted by the day-count factor. The
rate or a floating-rate basis in either or both periodic cash flow that Counterparty D is obli-
currencies. Assuming that the U.S. dollar is one gated to pay is simply the product of the quoted
of the currencies involved in the deal, this leaves fixed rate and the foreign-currency-based princi-
the following four possibilities: (1) a fixed rate in pal amount. Because the cash flows differ in
the foreign currency versus a fixed rate in U.S. denomination, currency swaps do not settle on a
dollars, (2) a fixed rate in the foreign currency net basis.
versus a floating rate in U.S. dollars, (3) a Table 1.5 lists a representative set of quotes
floating rate in the foreign currency versus a for various maturities and the main international
fixed rate in U.S. dollars, or (4) a floating rate in currencies. For comparative purposes, quotes
the foreign currency versus a floating rate in for plain vanilla U.S. dollar interest rate swaps
U.S. dollars. Although all of these formats are are presented in the last row of the table. These
used in practice, the predominant quotation rates represent the fixed foreign interest rates
convention in the market is the second; that is, a that a market maker would receive for payment
Figure 1.4 A Basic Currency Swap principal in dollars). Notice that in each market,
Transaction the swap yield curve is upward sloping.
At Originafion To see how these rate conventions translate
into cash flows, suppose Counterparty D has
Foreign Currency agreed to pay the dealer (Counterparty E) 8.65
Principal percent on the four-year sterling swap. Assume
further that the transaction has the following
Counterparty D Counterparty E
characteristics:
U.S. Dollar
Principal Origination date: November 15, 1994
Maturity date: November 15, 1998
Notional principal: GBP 20 million and
On Each Settlement Date (Including Maturity) USD 34.4 million
Fixed-rate payer: Counterparty D
Foreign Currency Swap fixed rate: 8.65 percent in pounds
Fixed-Coupon Rate
sterling (semiannual bond basis)
Counterparty D Counterparty E Fixed-rate receiver: Counterparty E (the
swap dealer)
U.S. Dollar Floating rate: Six-month LIBOR in U.S.
LIBOR
dollars (money-market basis)
Settlement dates: November 15th and
-
May 15th of each year
At Maturity LIBOR determination: Determined in ad-
Foreign Currency
vance, paid in arrears
Principal
r-----l The initial and ultimate principal exchanges are
Counterparty D Counterparty E based on the dollar/pound spot exchange rate of
4 USD 1.72/GBP that is assumed to have pre-
U.S. Dollar L
Principal
vailed at the swap origination date. With the
preceding customs, the pound-denominated
coupon settlement payments are computed as
of U.S. dollar LIBOR. For instance, on a four- [0.0865 x (Number of days/365) x GBP 20
year contract, a corporate counterparty would million], and the dollar-based cash flows are
have to pay the currency swap dealer 4.12 determined by [LIBOR x (Number of days/
percent in Japanese yen (times the principal in 360) x USD 34.4 million]. These amounts are
yen) to receive U.S. dollar LIBOR (times the shown in Table 1.6 from the perspective of
Counterparty D (i.e., the fixed-rate payer).
Table 1.S Representative Quotes for Although the plain vanilla form of a currency
Plain Vanilla Currency swap is of the fixed foreign currency/floating
Swaps Based on Six-Month dollar variety, that is not always the most useful
U.S. Dollar LIBOR for Two-, way to package cash flows in order to satisfy a
Three, and Four-Year corporate end user. For instance, what if Coun-
Maturities terparty D in the previous example had wanted
to receive a fixed rate in U.S. dollars, instead of
Currency 2 Years 3 Years 4 Years LIBOR, in exchange for fixed sterling payments?
Yen 3.27% 3.78% 4.12% Fortunately, the standard fixed/floating cur-
Sterling 8.13 8.55 8.65 rency swap can easily be repackaged by com-
Swiss franc 5.07 5.24 5.38 bining it with a floating/fixed U.S. dollar interest
Deutschemark 6.43 6.92 7.21 rate swap. This objective can be accomplished
U.S. dollar 7.79 7.97 8.08 by negotiating the following two transactions
Source: Chemical Securities, Inc. with the swap market maker:
Interest Rate and Currency Swaps: 12 Tutorial
Table 1.6 Settlement Cash Flows for the Fixed-Payer on a Four-Year, British
Pound Sterling Currency Swap
Number Assumed Fixed-Rate Floating-Rate
Settlement Date of Days Current LIBOR Payment (millions) Receipt (millions)
- - - - - -
Initial Exchange of Principal

11/15/94 USD 34.400 GBP 20.000
Coupon Exchanges
5/ 15/95 GBP 0.858 USD 0.994
11/15/95 0.872 1.055
5/15/96 0.863 1.087
11/15/96 0.872 1.178
5/15/97 0.858 1.254
11/15/97 0.872 1.187
5/15/98 0.858 1.167
Final Coupon and Principal Exchange
11/15/98 GBP 0.872 USD 0.967
and GBP 20.000 and USD 34.400
Receive dollar LIBOR in. exchange for Recent Trends in the Use of Swap
paying the sterling given rate of 8.65 Contracts
percent, and In recent years, swap contracting has ex-
pay dollar LIBOR in exchange for receiv- panded into new markets, as well as into new
ing a dollar fured rate, assumed to be 8.04 versions of the basic product. For instance, it is
percent. now possible to trade both interest rate and
currency swaps that are denominated in more
than 18 different currencies. New nonplain va-
Because the second of these swaps involves only nilla swap designs and related products include
dollar-based cash flows, physical exchange of prin-
cipal is required only for the first transaction.
Figure 1.5 illustrates the sequence of cash flow Oflmayket swaps, which set the fixed rate
exchanges that will occur on the settlement dates. to be something other than the prevailing
As a practical matter, if both of these trans- "at-market" level in order to create an
actions were executed simultaneously with the initial payment at the origination of the
same market maker, the corporate end user agreement;
Varying notional principal swaps, in which
(Counterparty D) would not undertake two sep-
the size of the deal either expands or
arate transactions. Rather, to minimize the req-
contracts from one settlement date to the
uisite documentation and bookkeeping, the next according to a predetermined sched-
swap intermediary in this case would undoubt- ule;
edly offer the counterparty a direct, blended Indexed amortizing rate swaps, in which
quote of "receive U.S. dollar 8.04 percent, pay the notional principal varies in response
sterling 8.65 percent," leaving LIBOR out alto- to changes in some market index (such
gether. Moreover, using U.S. dollar LIBOR as as the level of LIBOR) during the agree-
the base facilitates computation of the full range ment;
of fixed/fixed nondollar swaps--for instance, a Entry and exit options on swaps (known as
fixed rate in Swiss francs versus a fixed rate in swaptions), which give the holder the
deutschemarks. These fked/fixed swaps were right, but not the obligation, to get either
once known as CIRCUS swaps, which stood for into or out of a swap at prearranged
"combined interest rate and currency swaps." terms;
Figure 1.5 Creating a U.S. Dollar, British Pound Sterling FixedlFixed Currency
Swap (Settlement Date Payments)
Pay Fixed SterlinglReceive Dollar LIBOR
Counterparty E
Counterparty D (swap market maker)
LIBOR
Receive Fixed DollarlPay Dollar LIBOX
-
U.S. Dollar 8.04%
Counterparty E
___)
U.S. Dollar
LIBOR
Net Transaction: Pay Fixed SterlinglReceive Fixed Dollar
Sterling 8.65%
>
Counterparty E
4
U.S. Dollar 8.04%
e Basis swaps, calling for the exchange of and receive-fixed sides of the swap con-
two different floating rates (e.g., LIBOR tract itself;
vs. prime); Collars, corridors, and participation agree-
"Di#"swaps, which can be thought of as ments, which are combinations of caps
cross-currency basis swaps in that the and floors; and
cash flows are linked to floating rates in Equity and commodity swaps, which define
different countries but are denominated one of the cash flows of the swap in terms
in the same base currency; of the return to an equity (e.g., Standard
Cap and floor agreements, which are the & Poor's 500) or a commodity (e.g., West
respective option analogs to the pay-fixed Texas Intermediate Oil) index.
We will discuss these innovations in subsequent be centered on the currencies of the Western
chapters. European countries, including the European
To get a better idea of the range of the swap Currency Unit basket. Transactions in Canadian
industry, consider Table 1.7, which is based on a dollars and in currencies of Pacific Rim coun-
recent ISDA market survey. The table shows the tries (Australia, New Zealand, and Hong Kong)
total outstanding notional principal for both in- account for a relatively small part of these
terest rate and currency swaps of all varieties at markets.
year-end 1993. Also shown are the percentages Growth in the market for over-the-counter
of the various total outstanding volumes repre- interest rate option products has paralleled that
sented by each currency. These figures, which of the swap industry. Table 1.8 summarizes an
are listed in rank order by currency for interest ISDA report on the use of caps, floors, combina-
rate swap contracts, show clearly that although tion agreements (i.e., collars, corridors, and
U.S. dollar transactions are easily the largest participations), and swaptions as of year-end
single presence in either product market, they 1992. The display lists the number of contracts
are far from dominant. Indeed, roughly two- transacted (both long and short), as well as the
thirds of the deals in each group are negotiated total notional principal of dollar-denominated
in a nondollar currency. In particular, about one agreements. Perhaps most notable is the small
in five transactions across the two markets is size of the interest rate option market relative to
denominated in Japanese yen, with another 20 the swap market itself. Recall from Table 1.1that
percent coming from a combination of deals total interest rate swap volume for 1992 was in
done in Swiss francs, German deutschemarks, excess of $3.85 trillion with 151,545 contracts
or British pounds. In fact, if the US.-dollar- and traded; the dollar-denominated portion of the
Japanese-yen-based activity were removed, the market exceeded $1.76 trillion in 52,258 con-
vast majority of swap activity in the world would tracts. In this light, the market for over-the-
Table 1.7 Swap Activity by Currency as of Year-End 1993

Interest Rate Swaps Currency Swaps
Dollar Equivalent Percent of Dollar Equivalent Percent of
Currency (millions) Total (millions) Total
U.S. dollar
Japanese yen
Deutschemark
French franc
British sterling
Swiss franc
Italian lira
Euro currency unit
Australian dollar
Canadian dollar
Dutch guilder
Spanish peseta
Swedish krona
Belgium franc
Hong Kong dollar
Danish krone
New Zealand dollar
0ther currencies
Total
- -
Note: The currency swap total is unadjusted for double-counting of contracts.

Source: International Swaps and Derivatives Association.
Table 1.8 Cap, Floor, Combination, and Swaption Activity as of Year-End 1992
Combination
Activity Caps Floors Options Swaptions Total
Transaction Volume
Number of contracts bought
Number of contracts sold
Total
U.S. Dollar Notional Principal

(millions)
Long positions $ 81,450 $25,341 $ 3,932 $16,193 $126,916
Short positions 150,446 36,904 9,789 15,139 212,278
Total $231,896 $62,245 $13,721 $31,332 $339,194
Note: Positions have been adjusted for double-counting of contracts.
Source: International Swaps and Derivatives Association.
counter interest rate option products was fall), measured in either dollar or contract vol-
roughly one-tenth the size of the whole interest ume. Although the distribution of long and short
rate swap market, and the total number of option positions is largely a function of interest rate
contracts traded represented only about one- expectations that prevailed at the time, the prev-
fifth of the volume in swaps. Notice also that cap alence of caps is consistent with the notion that
agreements, which protect the contract's holder these contracts are used extensively by liability
against rising interest rates, were more popular managers seeking protection against increases
than floor contracts (which pay off when rates in their borrowing costs.
Exercises
Exercise 1.1: With the interest rate swap quotations shown in Table 1.3, use a
box-and-arrow diagram to illustrate a matched set of seven-year, plain vanilla interest
swap transactions from a dealer's point of view (i.e., the simultaneous acquisition of
pay-fixed and receive-fixed transactions having the same notional principal and
settlement dates). Also, calculate the swap dealer's profit on each settlement date,
assuming a notional principal of $25 million and, for simplicity, settlement dates that
are exactly 182.5 days apart.
Solution: With bid and offer fixed rates for the seven-year deals quoted at 7.77 percent
and 7.81 percent, respectively, the transaction can be illustrated as in Figure E-1.1.
Notice that, barring default by one of the corporate counterparties, the dealer is not
concerned with the actual level of LIBOR on any settlement date. If LIBOR is greater
(less) than 7.81 percent, the dealer will make (receive) the net settlement payment to
Firm X but receive (make) a payment from Firm Y when LIBOR is greater (less) than
7.77 percent. Thus, on every settlement date, the dealer will receive the difference
between the bid and offer fixed rates prorated to the appropriate number of days in the
settlement period and scaled to the notional principal amount. In this case, the
calculation is given by
Thus, the dealer will receive $5,000 every six months for the next seven years from this
pair of transactions.
Figure E-1.1 A Matched Set of Seven-

Year Swaps
Six-Month LIBOR Six-Month LIBOR
Financial 4
Firm Y
-) Institution
7.81% 7.77%
Exercise 1.2: Using the interest rate swap quotations listed in Table 1.3, calculate the
swap cash flows from the standpoint of the fmed-rate receiver on a three-year swap
with a notional principal of $40 million. (Assume the relevant part of the settlement
date pattern and the realized LIBOR path shown in Table 1.4 for the five-year
agreement. Also, calculate fixed-rate payments on an actual/365 day-count conven-
tion.)
Solution: Given that no principal is exchanged at the origination of a plain vanilla
interest rate swap on September 30,1994, the first settlement will take place on March
30, 1995. As the fixed-rate receiver, the counterparty in question will calculate the
following gross cash flows on this date:
Floating-rate payment = (0.0550) x (g) x ($40,000,000) = $1,106,111
and
Fixed-rate receipt = (0.0714) x

(;::)
-- x ($40,000,000) = $1,416,263.
Thus, the net receipt due the receive-fixed counterparty is $310,152 (i.e., $1,416,263 -
$1,106,111). Notice that the value for six-month LIBOR used in the floating-rate
calculation is determined by the September 30, 1994, value of that rate; the swap fixed
rate is 7.14 percent, the bid side of the dealer's three-year quote. The complete list of
settlement cash flows is given in Table E-1.I.
Table E- 1.1 Settlement Cash Flows, Fixed-Rate Receiver

- - - - - - - - - -
Fixed-Rate
Settlement Number Assumed Fixed-Rate Floating-Rate Receiver's Net
Date of Days Current LIBOR Receipt Payment Receipt (Payment)
Exercise 1.3: As a swap dealer, you have just been contacted by a prospective
corporate counterparty who wishes to do a three-year "fixed/fixed" yen/sterling
currency swap. In particular, the corporation needs to pay a fixed interest rate in
Japanese yen and to receive a fixed rate in British pounds. Your current spot FX and
three-year currency swap quotes (versus six-month U.S. dollar LIBOR) are as follows:
Japanese Yen British Pound

Spot Exchange Rate JPY 127.47/USD USD 1.82/GBP
Currency Swap Bid 4.85% 9.83%
Offer 4.92% 9.93%
These quotes imply that you would be willing to pay 4.85 percent in yen to receive U.S.
dollar LIBOR, but you would need to receive 4.92 percent in yen when paying LIBOR.
Your bid-offer spread is 7 basis points in yen. Note that the bid-offer spread is h-igher
in sterling because each basis point is not worth as much, given that sterling would be
at a forward discount to yen.
(a) Describe the sequence of transactions necessary to construct this swap from the
counterparty's perspective, including your quotes for both of the fxed rates.
(b) Construct a table similar to Table 1.6 summarizing the cash flow exchanges on
each exchange date, again adopting the end-user's viewpoint. In this analysis, assume
that the deal is to be scaled to a transaction size of USD 25 million and that the number
of days in the settlement payments alternates between 182 and 183, starting with 183
days between the origination date and the first settlement date.
Solution: First of all, recognize that at the current exchange rates, USD 25 million
translates into JPY 3,186,750,000 (the product of USD 25,000,000 and.JPY 127.47/USD)
and GBP 13,736,264 (USD 25,000,000 divided by USD 1.82/GBP). These become the
principal amounts governing the transaction. Then:
(a) The desired swap could be accomplished by combining the following currency
swaps:
Pay 4.92 percent Japanese yen, receive U.S. dollar LIBOR, and
receive 9.83 percent British sterling, pay U.S. dollar LIBOR.

The result is a pay 4.92 percent yen, receive 9.83 percent sterling swap, which
represents your offer swap rate in yen and your bid rate in sterling.
(b) After swapping principal amounts at the origination date, the cash flow exchanges
on first settlement date from the counterparty's standpoint are calculated as follows:
Yen payment = (0.0492) x /El X (JPY 3,186,750,000)= JPY 78,608,828
and
Pound receipt = (0.0983) x (El x ((GBP 13,736,264) = GBP 686,390.
The full set of cash exchanges, which will be known at the inception of the deal, is
shown in Table E-1.2.
Table D l.2 Cash Flow Exchanges, Counterparty

Settlement Days in Payments Receipts
Date Settlement (millions) (millions)
Initial GBP 13.736 JPY 3,186.75
1 JPY 78.61 GBP 0.69
2 78.18 0.68
3 78.61 0.69
4 78.18 0.68
5 78.61 0.69
Final JPY 3,186.75 GBP 13.736
and JPY 78.18 and GBP 0.68
Exercise 1.4: Suppose that on September 30, 1994, the treasurer for Company X
wishes to restructure the coupon payments of one of her outstanding debt issues. The
bond in question is scheduled to pay semiannual interest on September 30th and
March 30th each year until September 30, 1999, and has a coupon rate of 8 percent
with a face value of $35 million. On the same day, the treasurer for Company Y wants
to restructure the interest payments on his $50 million, four-year, floating-rate note
having a coupon reset each September 30th and March 30th to a reference rate of
LIBOR flat. The maturity of this floating-rate bond is September 30, 1998.
(a) Using the representative plain vanilla interest rate swap quotes in Table 1.3,
describe how both treasurers, working with a market maker, can use a swap
agreement to alter synthetically their current cash flow obligations. Specifically,
assume that Company X wishes to wind up with floating-rate exposure and Company
Y desires fixed-rate debt.
(b) Assuming that the market maker negotiates these swap transactions simulta-
neously, will they represent a matched book? If not, describe two remaining sources
of market exposure that the dealer still faces.
Solution: Although the timing of the coupon payments for the two companies is
comparable, the terms of the swaps they seek are not. Specifically, Company X needs
a five-year, receive-fixed swap for a notional principal of $35 million and Company Y
desires a four-year, pay-fixed, $50 million deal.
(a) Company X could synthetically alter its fixed-rate payments by entering into a
receive-fixed swap, accepting the market maker's five-year bid quote of 7.53 percent.
The transaction is shown in Figure E-1.2.
Figure E-1.2 Company X's Synthetic

Debt Conversion
Six-Month LIBOR
Company X 1/ Marzrzaker
Pay 8%
Coupons
To calculate the resulting synthetic floating rate that Company X will be obligated to
pay, recall that in the U.S. dollar market, LIBOR is quoted on a 360-day basis, but the
swap fixed rate, which is linked to Treasury yields, is on a 365day basis. Adjusting for this
discrepancy so that the net cost of funds is expressed on a money-market basis, we have
Fixed-rate debt coupon payment = (8.00%) x (360/365) = 7.89%

Swap:
LIBOR payment = LIBOR
Fixed receipt = (7.53%) x (360/365) = (7.43%)
Net cost of funds = LIBOR + 0.46%.
The treasurer at Company X can expect her semiannual interest cost to be 46 basis
points higher than the level of six-month LIBOR set one period in arrears. Similarly,
taking the offered side of the four-year market, the pay-fixed swap necessary to convert
Company Ys' floating-rate debt and the resulting synthetic fixed-rate funding cost (on
a 365-day basis) is shown in Figure E-1.3. The result is a net funding cost for Company
Y of [(LIBOR) X (365/360)] + (7.45%) - [(LIBOR) X (365/360)] = 7.45%.
Figure E-1.3 Company Y's Synthetic

Debt Conversion
Six-Month LIBOR
Company Y
Market Maker
Pay LIBOR
Coupons
(b) Although this arrangement may appear to be a matched set of transactions, the
market maker has two distinct interest rate exposures. First, the swaps are different in
maturity by one year, so the dealer is left with an unhedged commitment to pay the
fixed rate of 7.53 percent to Company X in Year 5. If LIBOR during this period is less
than 7.53 percent, the dealer will have to make a net settlement payment with no
compensating cash inflow on the other side. Second, during the four years common to
both swaps, the contracts are written for different notional principal amounts. One way
to see the problem this arrangement creates is to split the $50 million swap with
Company Y into: (1) a $35 million swap to match the transaction with Company X and
(2) an unhedged residual deal of $15 million. If LIBOR exceeds 7.45 percent during the
first four years, the market maker would have to pay out on this unmatched portion
with no offsetting inflow. Figure E-1.4 depicts these two exposures.
Figure E-1.4 Market Maker's Swap Exposures

Years 1 4
$35 million
LIBOR
Company Y
LIBOR
Company X
swap
lrket Maker
y 7.45%
I
$35 million
7.53% 1
Company Y
LIBOR
$15 million
Year 5
I
I I
7.53%
I
Market Maker
Swap I
I l l
Company Y
$35 million
Chapter 2. Economic Interpretations of a
Swap Contract
Although interest rate and currency swaps are 30/360. Therefore, the adjustment to the rate
inherently simple financial contracts specifying differential is 0.5 regardless of the actual num-
a periodic exchange of cash flows, they can be ber of days in the semiannual period.) The
interpreted several ways: as a pair of capital sequence of settlement cash flows on the swap
market transactions, as a sequence of forward contract will be the same, barring default, as if
contracts, and as a pair of options contracts. the firm (1) had issued a $100 million, five-year
These interpretations demonstrate that swaps floating-rate note (FRN) that pays LIBOR flat
serve to integrate financial markets by connect- each period, in arrears, and (2) used those funds
ing the cash, futures, and options markets for to purchase a five-year, $100 million fuced-rate
fixed-income securities. note that has a coupon rate of 8 percent (paid
semiannually at a rate of 4 percent per period).
A Swap as a Pair of Capital Market FRNs first appeared in the financial market-
Transactions place in the 1970s in response to rising interest
rates brought on by higher levels of inflation. In
Consider a plain vanilla interest rate swap in
general, FRNs pay a coupon referenced to a
which a firm receives a fixed rate of 8 percent for
five years and pays six-month LIBOR. Settle- money-market rate such as LIBOR plus (or
ment is on a net basis in arrears, and the minus) a margin that reflects the credit quality
notional principal is $100 million. LIBOR is of the issuer, its degree of marketability, and its
determined at the start of each period according tax status. The idea is that because the coupon
to the method spelled out in the documentation payment will adjust each period to reflect fully
(e.g., which banks will be surveyed and how current market conditions, price changes will be
their offered rates will be averaged). Then, at quite limited compared with fixed-rate bonds of
the end of the period, the firm pays its counter- equivalent maturity. In fact, the market price
party the difference between LIBOR and 8 per- would be expected to be par value at the time
cent (times 0.5, times $100 million) if LIBOR the coupon is reset and to differ from par only if
exceeds 8 percent and receives the difference if the margin is no longer sufficient (e.g., if the
LIBOR is less than 8 percent. (This calculation issuer has been downgraded or the liquidity of
assumes, for simplicity, that the day-count con- the security has eroded). The FRN considered
vention on both the fixed rate and LIBOR is here can be viewed as a sequence of six-month
19
Interest Rate and Cuwmcv Swufis: A Tutorial
Eurodollar time deposits that pay a coupon rate ment exchange is known in advance, but the
set at LIBOR flat. remainder will depend on future levels of
The combination of buying a fured-rate note LIBOR Given that the market prices of the FRN
funded by issuing an FRN is illustrated in and the fixed-rate note are equal, the swap
Figure 2.1. Notice that the cash inflows (above coupon of 8 percent must be the "at-market"
the time line) and outflows (below the time line) rate. If the prices of the fixed- and floating-rate
for the principal at origination and at maturity notes differ, implying an initial net payment from
are assumed to offset each other fully in the two one counterparty to the other, the swap rate
capital market transactions. The remaining cou- would be an "off-market" transaction.
pon payments are the same as an interest rate Figure 2.1 once again highlights the fact that
swap exchanging 8 percent fixed for floating- a plain vanilla interest rate swap entails neither
rate LIBOR. The floating flows are portrayed as an initial exchange of principal nor any at matu-
a sequence of shaded boxes of varying sizes, rity. Such an exchange would not add any value,
and the fixed-rate flows are all the same size. only additional credit risk. Recall, however, that
Note that the initial floating flow is in fact fixed, currency swaps do involve exchange of princi-
because it is set at the current level of LIBOR, pal. Consider a firm that receives a fixed rate of
which is observed in the spot market for Euro- 8 percent based on a principal of $100 million in
dollar time deposits. Therefore, the initial settle- U.S. dollars and pays a fixed rate of 10 percent
Figure 2.1 Interpreting a Plain Vanilla R d e F i x e d Internst Rate Swap as a Pair

of Capital Market Transactions
--
- - -- - - - - - - ---
Chapter 2. Economic Interpretations of a Swap Contract
based on 160 million deutschemarks. This swap note and selling the initial deutschemark pro-
would have an initial exchange and later a ceeds for dollars in the spot FX market. These
re-exchange of principal, typically using the ini- hypothetical transactions are depicted in
tial spot market rate (here assumed to be DEM Figure 2.2. Note that the coupon payments are
l.GO/USD) for both transactions. This swap can assumed to be annual, following the convention
be interpreted as the purchase of the fixed-rate in the Eurobond market of paying coupon inter-
dollar note funded by issuing the deutschemark est only once a year.
F i r e 2.2 Gapital Market Interpretation of a Currency Swap
I I DES.1 I f ) Million ~ 1
These two examples raise an interesting The interpretation of a swap as a combination

question: If the cash flows on a swap contract of bonds is particularly useful in calculating its
can be fully replicated by capital market trans- mark-to-mtirket (MTM) value. Usually, the value
actions, why does a swap market; need to exist? of a swap is determined from the fixed rate on a
Tne answer is found not so much in theory as in replacement swap having the same terms (such
practice-swaps turn out to be a particularly as the remaining time to maturity and the credit
efficient way to transform the nature of assets risk of the counterparty) as the original agree-
and liabilities. That the same transformation ment. Consider, for example, the status of the
could be done by buying one type of bond and swap illustrated in the bottom panel of Figure
selling another is an important theoretical con- 2.1, assuming that a year has passed and the
cept but not an alternative likely to make the current market fixed rate on a new four-year,
short list of a corporate treasurer facing an receive-fixed interest rate swap is 7 percent. The
actual risk-management problem. swap would have a positive MTM value to the
Using a combination of capital market instru- firm because it has a contract to receive an
"above-market" fixed rate of 8 percent for pay-
ments presents an obvious practical problem:
ment of LIBOR. This calculation is a straightfor-
buying and selling bonds that have the exact
ward exercise in bond mathematics: What is the
same payment dates. A swap contract avoids this present value of the annuity represented by the
problem and also has some other unambiguous eight remaining 4 percent periodic cash flows,
advantages. compared with an annuity of 3.5 percent, now
that the discount rate has fallen to 3.5 percent
Lower transaction costs: Issuing debt can per period? This solution is as follows:
be expensive because of the costs of Swap MTM value =
underwriting and registration, whereas
swaps trade at rather tight bid-offer
spreads (5-10 basis points or less). More-
over, a swap can be unwound much more
quickly and at less expense than buying
back publicly issued debt.
Less credit risk: A swap is an executory The swap, which started out at a value of zero,
contract, meaning that one need perform has become an asset to the fixed-rate receiver
only if the counterparty performs. That with an MTM value of $3,436,978.l
reduces the credit risk to the difference in Now suppose that trading volume in the swap
the present value of the lost receipts and market is dramatically reduced for some reason.
the present value of the payments that no In such a case, realistic market quotations on
longer would have to be made. The de- replacement swaps might be difficult to. obtain.
fault on a bond would not entail that Nevertheless, the MTM value of the receive-
offset, so the ultimate loss could be as fixed swap could be estimated as the difference
much as the present value of the lost between the market value of the hypothetical
coupons, as well as the lost principal. fixed-rate bond less the value of the FRN. As
No change in debt-equity ratios: The swap long as there is trading in bonds having similar
is an ofibalance-sheet instrument, whereas coupon rates, maturities, and credit ratings as
the issuance of a bond raises leverage the counterparties to the swap, a reasonable
ratios even if the bond that is issued
merely finances the purchase of an Swap dealers typically mark the swap portfolio to the
equally valued bond. midpoint of the bid-offer spread, thereby using the same
e Anonymity: A swap allows a firm to repo- rate to value either a pay-fixed or receive-fixed position.
When calculating loss on event of default of the counter-
sition its balance sheet quickly and qui- party, however, the dealer would use the market bid rate
etly, without alerting its competitors to its on a receivefmed swap that has gone into default and the
strategy (at least within a reporting period). offer rate on a pay-fixed swap.
approximation to the MTM value can be ob- duration is divided by 1plus the periodic yield)
tained. Even in the best of circumstances, how- could be used to ascertain the impact of the
ever, the values from the replacement swap and contract on the firm's overall exposure to inter-
from the bond market should differ because of est rate risk, as measured by the gap between
differences in the treatment of swaps and bonds the duration of assets and liabilities. In general,
in bankruptcy. entering a plain vanilla interest rate swap has
Another application of the capital market one of the following effects: (1) Receiving the
interpretation to an interest rate swap is to fixed rate on a swap shortens the duration of
calculate the sensitivity of the MTM value to liabilities (or lengthens the duration of assets) in
changes in swap fixed rates, as summarized by order to gain when market rates fall (i.e., a
the swap's duration statistic.2 The duration of receive-fixed swap has a positive implied dura-
the receive-fixed swap in the example above can tion), or (2) paying the fxed rate on a swap
be estimated as the duration of the 8 percent, lengthens the duration of liabilities (or shortens
five-year note held long minus the implied dura- the duration of assets) in order to gain when
tion of the FRN that was issued. The implied market rates rise (i.e., a pay-fixed swap has a
duration of an FRN is the remaining time in the negative implied duration statistic).
coupon period expressed as a fraction of a year, The notion of duration is much more difficult
which follows from interpreting duration as an to extend to a currency swap than to an interest
elasticity. Immediately before the rate reset rate swap because more than one yield is in-
date, the percentage change in the price would volved. The MTM value on a plain vanilla inter-
be zero for any percentage change in the interest rate swap depends fundamentally on just one
est rate, because the FRN is assumed to reset to variable-the fixed rate on the replacement
par value. After reset, the note is equivalent to a swap. The MTM value on a currency swap
time deposit having a maturity equal to the time depends on three variables-the interest rate in
until the next reset date. Suppose that the each of the two currencies and the spot market
counterparties to our swap are both Aaa-rated exchange rate. Consider again the receive-
firms and that the 8 percent, fixed-rate note and USD/pay-DEM currency swap outlined earlier.
the FRN at LIBOR flat are priced in the market The MTM value after a year would be the
at par value. Under these circumstances, the present value of the dollar inflows less the
duration of the fixed-rate bond would be calcu- present value of the deutschemark outflows
lated as 4.2 years and the implied duration of the converted to dollars at the spot market ex-
FRN as 0.5 years, so the implied duration of the change rate. Those present values can be ob-
swap is 3.7 years. tained from the domestic bond market in each
The duration statistic for the swap (or, better, currency, based on yields to maturity for bonds
the modif;ied duration whereby the Macaulay having the same coupon rates, remaining term
to maturity, and credit ratings of the counterpar-
ties. A summary statistic such as duration, how-
The duration statistic of a bond can be interpreted ever, is generally not applicable because of the
several ways: the price elasticity given a change in the yield less-than-perfect correlation between interest
to maturity, the weighted average time to maturity rates in different currencies.
whereby the weights are the shares of market value
represented by each cash flow, a zero-coupon-bond-equiv-
alent risk factor (in that a ten-year coupon bond having a A Swap as a Series of Forward
duration of eight years would have almost the same price
sensitivity as an eight-year, zero-coupon bond). Key limita-
Contracts
tions of the commonly used Macaulay duration statistic, Now consider a two-year quarterly settle-
named for Frederick Macaulay, who first developed it in ment swap whereby a firm pays a fixed rate of 6
1938, are the underlying assumption of a parallel shift to a percent and receives three-month LIBOR. Even
flat yield curve and interaction between the level of interest though the actual settlements will be on a net
rates and credit risk premiums. Nonetheless, it is a widely
used summary statistic for the impact of interest rate basis, the gross inflows and oufflows can be
changes on asset valuations. See the appendix for a more pictured as in Figure 2.3. The swap appears to
detailed discussion. be a sequence of three-month forward contracts,
23
Interat rot^ attd Csswmcy Swaps: A Tsltorial
Figure 2.3 Cash Flows on Quarterly just like on an interest rate swap by multiplying
Settlement, Pay-Fixed the rate differential by the fraction of the year
Interest Rate Swap spanned by the transaction (e.g., 1/4 for a
threemonth contract) and by the notional prin-
cipal. The in-advance settlement amount is cal-
culated as the present value of the in-arrears
amount, using the prorated level of the realized
LIBOR as the discount rate.
Suppose that the market maker buys a 3 X 6
FRA from Company ABC at its bid rate of 4.81
percent and, at the same time, sells a 3 x 6 FRA
Month to Company XYZ at its offer rate of 4.85 percent,
each for a notional principal of $10 million. As in
each one an exchange of 6 percent for three- the swap market, "buy" and "sell" are awkward
month LIBOR (times 1/4, times the notional yet commonly used words when describing FRA
principal). In the market for interest rate risk- transactions. Given that the FRA has an initial
management products, such contracts are called value of zero and therefore is neither an asset
forward rate agreements (FRAs). An FRA is nor a liability, it cannot be bought or sold;
merely a one-date swap, and a swap can be instead, one simply enters a contract that s u b
viewed as a series of FRAs. sequently may have a positive or negative value.
The FRA's name indicates the time frame of Nevertheless, recalling that LIBOR can be inter-
the reference rate: A 3 x 6 FRA means a preted as the "commodity," the fixed rate is then
contract on three-month LIBOR, three months the price paid or received in exchange for
forward; a 12 x 18 FRA means a contract on LIBOR The transactions are displayed in
six-month LIBOR, one year forward. FRA mar- Figure 2.4.
ket makers quote a bid-offer spread on a rate Now suppose that three-month LIBOR is 5.00
basis. For example, suppose that the FRA rates percent on the rate determination date in Month
for three-month LIBOR shown in Table 2.1 3. If the contract specified settlement in arrears
prevail in the market at date zero, with current at Month 6, ABC would be obligated to pay the
LIBOR assumed to be 4.50 percent. On a 3 X 6 market maker $4,750, calculated as 5.00 percent
FRA, the market maker is prepared to pay a less 4.81 percent, times 1/4 (assuming that
fixed rate of 4.81 percent for receipt of three- there are 90 days between Months 3 and 6 and
month LIBOR and to receive a fixed rate of 4.85 that LIBOR is quoted on a 360-day basis), times
percent for payment of LIBOR In either case, no $10 million. If settled in advance, the Month 3
payment will take place until LIBOR is revealed payment would be
in Month 3. Net settlement can then be made in
arrears at Month 6 or in advance at Month 3. If
in arrears, the settlement flow will be calculated
Similarly, the payment from the market maker
Table 2.1. Indicative Bid-Offer Quotes to XYZ would be $3,750.00 in Month 6 or
on Three-Month Forward $3,703.70 in Month 3. The market maker is fully
Rate Agreements
Figure 2.4 3 x 6 FRAs Transacted at
Period Bid Offer the Market Maker's Bid and
Offer Rates
Three-Month LIBOR Three-Month LIBOR
in Month 3 in Month 3
Company
FRA Company
Market
ABC Maker XYZ
-Bid Rate ~
Offer Rate
hedged from interest rate risk by having the FRAs. Settlement payments (and the buildup
matched FRAs; its spread of 4 basis points of value that creates credit risk) would be zero
compensates it for the inevitable credit risk and on a series of on-market FRAs but not on a plain
its transaction costs. vanilla interest rate swap. The payer of the fixed
Now reconsider the firm that entered the rate in an upwardly sloped yield curve environ-
two-year, pay-fixed swap at 6 percent. In lieu of ment takes on more default risk than the coun-
the swap, the firm could have bought a se- terpart~because the fixed-rate payer would have
quence of FRAs-the 3 x 6,6 x 9, and so forth. outflows at first and then anticipate later inflows
From Table 2.1, the rates on those FRAs are the in return.
market maker's offers-4.85 percent, 5.24 per- Why does the plain vanilla variety of swap
cent, 5.68 percent, and so on out to the 21 x 24 contract have the same fixed rate each period
at 7.40 percent. The key point is that compared instead of the sequence of fixed rates corre-
with the interest rate swap, the sequence of sponding to the series of comparable FRAs? The
FRAs would have a known, but different, fixed answer lies in the history of swaps, however
rate for each period. A plain vanilla swap not brief that history may be. The first wave of
only has a known fixed rate but also that rate is interest rate swaps in the early 1980s comprised
the same for each settlement period. Because mostly new-issue arbitrage transactions. The
LIBOR is the same for either alternative, the swaps were attached to newly launched bonds to
fixed rate on the swap must be some sort of create synthetic instruments at what were
average of the FRA rates. Chapter 4 will demon- deemed to be lower "all-in" costs of funds than
strate that the swap fixed rate is indeed such an were available by directly issuing the desired
average in the sense that the present values of type of liability. Inasmuch as this was done
the cash flows represented by the various FRA typically with a traditional fixed-income bond,
rates and the single swap rate must be equal in the swap was designed to provide a fixed pay-
a market free from arbitrage opportunities. ment each period to offset exactly the coupon
The significance of this interpretation is that flow on the bond. More recently, swaps have
a swap now can be viewed as a series of off- been used widely in financial restructurings that
market FRAs whenever the swap yield curve is might need a known, but not necessarily con-
not completely flat. Suppose the time path of stant, fixed rate for each future time period. Had
FRAs is upward sloping, as in the example that been the primary application in the early
above. Each individual "on-market" FRA would years, the plain vanilla swap instrument of today
have an initial value of zero. Likewise, the inter- might have come to be described as a sequence
est rate swap has an initial value of zero, but of on-market rather than off-market FRAs.
some of its individual settlement dates, as off- To see how this "series of forward contracts"
market FRAs, have positive, and others nega- interpretation applies to currency swaps, return
tive, initial values. With this yield curve sce- to the deal portrayed in Figure 2.2. The firm
nario, the first few settlement dates on the receives dollars based on an 8 percent interest
pay-fixed swap will have negative value because rate and a principal of USD 100 million and pays
the firm is paying an above-market fixed rate for deutschemarks based on a 10 percent interest
receipt of LIBOR. The last few swap payment rate and a principal of DEM 160 million. Looking
dates will then have positive values compared at each settlement date in isolation, the entire
with the on-market FRAs because the firm is currency swap appears to be a portfolio of FX
paying a below-market fixed rate. forward contracts-an initial spot market EX
This interpretation demonstrates that the trade at the going rate of DEM l.GO/USD, then
credit risk inherent in a swap agreement results four EX forwards each at DEM 2.00/USD, and
from its structural design of applying the same finally in Year 5, a much larger FX forward at
fixed rate to all settlement periods, as well as DEM 1.6296/USD. Notice that the last transac-
from the random nature of interest rates. As- tion is a weighted average of the coupon and the
sume for a moment that LIBOR follows a path principal exchanges; that is, 1.6296 = (8/108 x
that is completely anticipated by the market and 2.00) + (100/108 x 1.60).
that those anticipations track the time path of A fixed/fixed currency swap such as this one
25
can also be described as a series of off-market currency swap and the series of FX forwards.
. FX forward contracts (except when the interest The credit risk, however, would not be identical.
rate differential between the currencies is zero). Because of its structural design of applying the
To see this requires the series of on-market EX same off-market rate to each coupon exchange,
forward rates. These rates can be obtained from the currency swap has more credit risk than
the interest rate parity condition whereby the would the series of FX forwards. This firm's
forward exchange rate equals the spot rate counterparty has a favorable trade on each of
times the ratio of (1 plus) the yields in each the first four dates, trades that it would not likely
currency. Suppose that the yield curves in dol- default on (as long as the dollar is worth fewer
lars and deutschemarks are flat at 8 percent and than 2 deutschemarks). As with interest rate
10 percent, respectively. Then the EX forward swaps, this particular design can be traced to the
rates consistent with interest rate parity can be early years of the swap market, when currency
obtained from the following equation: swaps were used in new-issue arbitrages based
on coupon-bearing bonds.
(Forward DEM/USD) = (Spot DEM/USD)
A Swap as a Pair sf Option

Contracts
for t = 1,2, 3, 4, and 5. The numerical values of A well-known result in options pricing theory
those on-market FX forward rates are given in is put-call-fo~wa~d payity, the proposition that a
the last column of Table 2.2. combination of buying a call option and writing
The firm that is buying dollars via the cur- a put option on the same commodity for the
rency swap and paying deutschemarks has un- same strike price and expiration date is equiva-
favorable trades on the first four dates and then lent to a long forward position. The forward
a favorable one on the fifth. The firm is paying 2 price is assumed to be the same as the mutual
deutschemarks for every dollar on the swap strike price on the options, and the delivery date
contract, but only 1.6296 to 1.7219 deutsche- is assumed to match the expiration date. The
marks per dollar would have been. needed in the equivalence is in terms of the ultimate payoff. If
explicit EX forward market. Balancing that, how- the market price for the commodity at the time
ever, is the final purchase at DEM 1.6296/USD of delivery exceeds the preagreed purchase
on the full amount, including the principal, price, the gain on the forward contract is the
whereas the on-market FX forward would have same as on the in-the-money call option. Like-
been at DEM 1.7537/USD. The dollar receipts wise, if the market price is below the contractual
would be the same; the difference is in the price, the loss on the forward equals the loss on
amount and timing of the deutschemark pay- the in-the-money put option that has been writ-
ments. Notice the present value of the deutsche- ten. (Note that the expressions "in the money"
mark outflows would be equivalent for both the and "out of the money" refer to the perspective
of the option holder; the writer of an option loses
Table 2.2 Forward Rates Implied by when the contract is in the money to its owner.)
Interest Rate Parity and the An analogous proposition is cap-flooy-su~ap
Currency Swap parity, a result that is not really all that surpris-
ing given that an interest rate swap has already
Implicit Interest been interpreted as a series of forward con-
Date of USD Off-Market Rate Parity tracts. Interest rate cap and floor agreements are
Exchange Amount FX Forwards FX Forwards multiperiod interest rate option contracts, each
bear) (millions) (DEM/USD) (DEM/USD) contract corresponding to a different settlement
period. A cap agreement is a series of cash
settlement interest rate options, typically based
on LIBOR. The writer of the cap, in return for an
option premium that is usually paid at origina-
tion, is obliged to pay the difference between
LIBOR and the strike, or cap, rate (times the Figure 2.5 Payoff Diagrams for Buying
fraction of the year, times the notional princi- and Writing an Interest Rate
pal), whenever that difference is positive. The Cap and Floor
writer of a floor agreement makes settlement Gains Gains
payments only when LIBOR is below the floor
rate. No payment is made if LIBOR is above the
floor or below the cap. As with FRAs, settlement
can be either in advance or in arrears, although
the latter is more common given that these
contracts are typically used to hedge exposure
to floating-rate bank loans and notes (which Losses
I
Losses
themselves typically settle in arrears). Gains Gains
Before interpreting an interest rate swap as a
combination of caps and floors, it is useful to
I I
describe these lnultiperiod option contracts in 1 8% LIBOR 1 4% LIBOR
more detail. For example, consider a three-year,
semiannual settlement, 8 percent cap on six- 8%Cap 4% Floor
month U.S. dollar LIBOR. The buyer of the cap
Losses Losses
pays the writer an upfront premium, quoted as
a percentage of the notional principal, say, 120
basis points? If the notional principal is $100 not the obligation, to sell to the writer a time
million, the cost of the cap is $1.2 million. deposit having a coupon rate equal to the cap
Suppose that settlement dates are on the 15th of strike rate in the amount of the notional princi-
May and November of each year and that pal of the contract. The owner "exercises" that
LIBOR on one particular May 15th is 9.125 option if current LIBOR exceeds the cap rate,
percent. The holder of the cap will receive thus selling a relatively low-coupon deposit at
settlement in arrears that November in the par value. The proceeds of that sale can then be
amount of $575,000, calculated as (9.125 percent used to buy a time deposit that earns the higher,
- 8 percent) x (184/360) x $100 million, market rate. The gain on those hypothetical
assuming an actua1/360 day-count basis. transactions is equivalent to the payoff on the
The payoff relationships for caps and floors cap agreement. Whether one interprets a cap as
can be pictured using traditional, option-style a call on LIBOR or a put on a time deposit (and,
diagrams. Figure 2.5 portrays an 8 percent cap similarly, a floor as a put on LIBOR or a call on
and a 4 percent floor on LIBOR. Notice that the a time deposit) is purely a matter of semantic
payoff on the cap takes the same form as a preference.
typical call option on a commodity and the floor An interest rate collar is a combination of a
takes the form of a put option. Indeed, following cap and a floor, a long position in one and a short
the convention in which LIBOR is the commod- position in the other. To buy a 4-8 percent
ity, caps are referred to as "calls on LIBOR" and collar on LIBOR is to buy an 8 percent cap and
floors as "puts on LIBOR." Alternatively, a cap to write a 4 percent floor. On a given settlement
agreement on LIBOR is a series of put options date, the buyer will receive cash payments when
on an underlying Eurodollar time deposit. In LIBOR exceeds 8 percent, make payments when
effect, the owner of the option has the right, but LIBOR is below 4 percent, and neither receive
nor pay if LIBOR is at or between 4 percent and
8 percent. Often the motive for a firm to buy a
"n practice, interest rate caps and floors are quoted by collar is to reduce the initial cost of acquiring the
market makers on a volatility basis, for instance, 18.5 protection from higher levels of LIBOR, because
percent bid and 19.5 percent offered. That measure of the up-front receipt from writing the floor can be
volatility (stated as a standard deviation), plus the strike
rate, the current term structure of interest rates, and the used to offset the cost of buying the cap.
time frame for the contract, are then entered into an option A special case of an interest rate collar occurs
pricing model to obtain the actual amount of the premium. when the premiums on the cap and the floor are
equal and therefore fully offset each other. For similar degrees of upside protection, the firm
example, suppose that the premium on a three- might prefer (1)the cap, if IdBOR is expected to
year, 4 percent floor is 120 basis points, match- be low, on balance; (2) the collar, if LIBOR is
ing the premium on the 8 percent cap. The expected to be in a middle range; or (3) the
combination is known as a "zerocost" or "zero- pay-fixed swap, if LIBOR is expected to be high.
premium" collar. A more accurate, but surely Ironically, a risk manager's decisions inevitably
less marketable, name would be a "rate-contin- express a view on market rates, even if the
gent, deferred-cost" collar. The idea is that a cap motive for acquiring the risk-management prod-
agreement alone has a known, fully prepaid cost uct is lack of confidence in the view itself.
for the upside interest rate insurance. The zero- The amortized cost of the cap agreement is
cost collar, however, has an uncertain cost- indicated in Figure 2.6 by the vertical distance
uncertain with respect to both timing and between the cost of funds for the FRN alone and
amount-for the same amount of interest rate the "capped" FRN. The simplest method of
insurance. If LIBOR were to remain at a suffi- spreading the up-front premium over the con-
ciently low level over the lifetime of the contract, tract's lifetime, and also the method most com-
the ultimate cost of the zero-cost collar could far monly used to date for tax and accounting
exceed the cost of the cap. purposes, is straight-line amortization. If the
A firm's choice between a swap, cap, and premium on a three-year cap is 120 basis points,
collar to manage interest rate risk will depend the amortized cost would be 40 basis points a
on a number of factors, including accounting year. This, however, neglects the financing cost
and tax treatment of the various derivatives, of the multiyear insurance. Suppose that the
initial cost and free cash flow, the firm's risk three-year, fixed-rate cost of funds is 6.25 per-
tolerance, and the firm's view on the average cent (assuming semiannual interest payments).
future level for LIBOR. The last factor, the rate Then the amortized cost inclusive of financing
view, is summarized in Figure 2.6. Assume that would be 44.5 basis points, calculated as a
the firm has interest rate exposure from having six-period annuity in which the rate per period is
issued an FRN on which it pays EIBOR + 0.25 3.125 percent and multiplied by 2 to annualize
percent. Suppose further that the firm's revenue the cost per period.
from operations is uncorrelated with actual and Straight-line amortization of the premium,
expected inflation, as well as with short-term whether the financing cost is included or not,
interest rates. Therefore, higher levels of LIBOR neglects the time decay of a typical option. In
could cause financial distress. Notice that for particular, the third year of the cap should be
Figure 2.6 Comparing the Funding Cost of Hedging with a Cap, Collar, and Swap
Floating-Rate Note (FRN)
Cost of
Funds
FRN & Cap
FRN & Collar
FRN &
Pay-Fixed
Swap
Amortized
Cost of Cap
Margin over LIBOR

on the FRN L LIBOR
Lowest Cost
1 Swap of Funds
Calp Collar
more expensive than the second year. Calculat- makes settlement payments whenever LIBOR is
ing the annual incremental cost of a multiyear less than 5 percent will certainly be worth more
option requires a valuation model. Suppose that than one with a strike rate of 4 percent. Keep
a one-year, 8 percent cap on six-month LIBOR tightening the collar, and at some strike rate
would cost only 15 basis points. If LIBOR is common to both the cap and the floor, say 6
initially below 8 percent, the option holder will percent, the combination will be zero-cost. That
definitely not receive any payment in six point, illustrated in Figure 2.7, will be the at-
months. So, the entire value of the one-year, market pay-fixed swap fixed rate.
out-of-the-money cap depends on the next level
of LIBOR If a two-year, 8 percent cap costs 55 Figure 2.7 An Illustration of Capfloor-
basis points, the imputed cost for the second Swap Parity
year would be 40 basis points. Therefore, the
incremental cost for the third year would be 65
basis points.4 I
Now let us return to the interpretation of an
interest rate swap as a combination of a cap and
a floor. Actually, an interest rate swap is just a 8% LIBOR
special case of an interest rate collar. Consider
again the 4-8 percent, zero-cost collar on
LIBOR that was constructed from buying the 8
6% versus LIBOR
percent cap and writing the 4 percent floor. Now Losses
4% Floor
tighten the collar by lowering the cap rate down
to 7 percent. The up-front premium must go
up-an insurance policy providing protection To summarize, buying a 6 percent cap and
whenever LIBOR exceeds 7 percent has to cost writing a 6 percent floor on LIBOR is equivalent
more than a policy that pays off only when in terms of settlement cash flows to an interest
LIBOR gets above 8 percent. Suppose that pre- rate swap paying a fixed rate of 6 percent and
mium is 200 basis points (times the notional receiving LIBOR. When LIBOR is above 6 per-
principal). To attain a zero initial cost, the floor cent, the net settlement receipt on the swap is
that is written must generate 200 basis points in the same as the receipt on the in-the-money cap
premium as well. That condition will require a that is owned. When LIBOR is below 6 percent,
higher floor rate-a contract whereby the writer the net settlement payment on the swap is the
same as the payment on the in-the-money floor
that has been written. Similarly, writing a cap
* The Emerging Issues Task Force (EITF) of the Finan- and buying a floor at the same strike rate is the
cial Accounting Standards Board (FASB) has been working same as a receive-fixed interest rate swap. Note
on the problem of amortizing the upfront premium on a that the capfloor combination at the same
multiyear option contract. At the time of this writing, the
EITF appears likely to recommend moving to option-based strike always has the same payoffs as a swap
methods for amortization. The problem is an intriguing contract. If this common strike rate is not set
one: How much of the total cost of the 8 percent, three-year equal to the market swap rate, however, it will
cap should be assigned to the initial year? So far, we have be equivalent to an off-market swap. When the
seen three possible answers-40 basis points, 44.5 basis combination also nets to a zero initial cost, the
points, and 15 basis points. Another candidate is 65 basis
points! Suppose that financial market conditions (specifi-
common strike rate matches the at-market swap
cally, the term structures of interest rates and implied coupon.
volatilities) remain unchanged for a year. Because of time Swap-cap-floor parity can be used to test the
decay, the value of the now two-year cap agreement will internal consistency of credit risk and valuation
decline from 120 to 55 basis points. The issue then is when models for swaps vis-a-vis options contracts. For
to assign the 65-basis-point time premium. We will not example, because selling a cap and buying a
suggest an answer, only advise readers to stay current with
the accounting literature because a steady stream of im- floor at the same strike rate can offer the same
portant rulings is likely as FASB catches up to develop cash flows as a receive-fixed swap, the projected
ments in risk management and derivatives. credit risk on the swap must be comparable to
29
the credit risk on the floor agreement. (Note pay-fixed swap, its all-in synthetic floating rate
that a firm bears the counterparty's credit risk would be LIBOR plus 2 percent over the tenor of
on bought options and not on written options the swap; the 2 percent is the difference be-
because only in the former case is the firm tween the 8 percent received on the underlying
relying on the other party's future performance.) bond and the 6 percent paid on the swap. If the
Any difference in the assigned credit risk be- firm chose the off-market, 8 percent, pay-fixed
tween the swap and the option combination swap, its synthetic floating rate would be LIBOR
would have to be explained by some difference flat, supplemented by a lump-sum receipt at the
in documentation and legal rulings and prece- initiation of the swap. Notice that this strategy
dents. Another implication of this parity relation- effectively "monetizes" the unrealized apprecia-
ship is that option pricing models, which have tion of the underlying bond, converting that
attained a considerable level of theoretical so- appreciation to cash without having to sell the
phistication, can be used in the valuation of swap bond. The difference in results is illustrated in
contracts. Figure 2.8, in which the shaded boxes represent
Whenever a firm analyzes an interest rate the off-market adjustments to the plain vanilla
swap contract, it should work through the alter- agreement.
natives of structuring the transaction as a cap/ In general, the payer of an above-market
floor package with the same counterparty or fixed rate receives an up-front payment; the
splitting the transaction into its component o p payer of a below-market fixed rate makes the
tions and booking those separately with differ- initial payment. Calculating the amount of the
ent counterparties. It should ask whether one lumpsum initial receipt on the off-market swap
structure has any advantages over the other in is straightforward in theory but more difficult in
terms of taxation, accounting, and pricing. The practice. It will be the present value of a 2
two alternatives generate the same net settle- percent annuity (times the notional principal,
ment cash flows, but that does not: always trans- adjusted for the day-count basis). The valuation
late to the same after-tax funding cost or the issue is to select the discount rate (or rates)
same bottom-line accounting results. used in determining the present value. Suppose
that 6.25 percent is the firm's three-year, fixed-
rate cost of funds for a semiannual payment,
Interpreting an Off-Market Interest fully amortizing bank loan. Calculated as the
Rate Swap present value of a six-period annuity of 1percent
Suppose the at-market terms on three-year, per period discounted at 3.125 percent per six-
semiannual settlement interest rate swaps re- month period, we have
quire a firm to pay a fixed rate of 6 percent for
receipt of six-month LIBOR. If the firm instead is
willing to pay a fixed rate of 8 percent on what
would be an off-market swap, it clearly should
receive something in return. For example, as-
sume that the firm is seeking to transform a or 5.395 percent of the swap's notional principal.
fixed-rate bond holding bearing a coupon rate of Finally, notice that there is no particular reason
8 percent to a synthetic floating-rate asset, be- to expect that the swap futed rate is the firm's
cause its view is that short-term rates will be own fixed-rate cost of funds, given that the swap
rising higher and faster than generally antici- is set against LIBOR flat and the firm might not
pated by market participants, perhaps even lead- be able to issue a par-value FRN at that level.
ing to an inverted yield curve. One strategy, of Another conceptual problem is how to ac-
course, would be simply to sell the bond and count properly for the lump-sum receipt. Notice
invest its proceeds in FRNs. Suppose, however, that the off-market swap in the lower panel of
that the firm is unwilling for some reason to Figure 2.8 appears to be a combination of an
divest itself of the bond and instead wants to on-market swap, which would have an initial
restructure its asset portfolio using derivatives. economic value of zero, and a loan contract. The
If the firm entered an at-market 6 percent lump-sum receipt would be the proceeds of the
Chapter 2. Economic interpretations of a Swap Contmd
Figure 2.8 Settlement Flows for an At- ing for an off-market swap. First, consider the
Market and Off-Market capital market interpretation. An on-market
lnterest Rate Swap swap is analogous to owning an FRN that pays
LIBOR and issuing an equally valued, fixed-rate
Plain Vanilla, Pay-Fixed Swap at the Market Rate of 6 %
note that pays a fixed coupon rate of 6 percent.
The off-market swap is interpreted as owning
the same FRN at LIBOR but issuing a more
~ ~1i IIiCUi!
S r k - h l ~tlt highly valued fixed-rate note bearing the 8 per-
cent coupon rate. The difference in the initial
market values of the FRN and the 8 percent
bond is the cash the fixed payer receives on the
off-market swap, which is pictured in the upper
panel of Figure 2.9.
This capital market interpretation suggests
L - that the up-front cash received could be ac-
counted for in the same manner as the premium
on a newly issued, high-coupon bond. Upon
entering the off-market swap, the fixed payer
would debit cash and credit some liability ac-
count on the balance sheet (call it the swap
premium). That premium would be amortized
over the life of the swap as a deduction to
Off-Market, Pay-Fixed Swap at the Rate of 8% interest expense. This approach attains essen-
tially the same result as the loan approach. The
amount of the initial lumpsum paynient is
spread out over the swap's lifetime as an offset
Figure 2.9 Interpretingan Off-Market

Interest Rate Swap
A Capital Markef In t ~ g e t a t i o n
At-Market, Pay-Fixed Off-Market, Pay-Fixed

Interest Rate Swap Interest Kate Swap
Note at 8%
loan; the series of incremental fixed payments in

excess of 6 percent represents the level-pay-
ment, fully amortized repayment schedule, in-
cluding both principal redemption and interest.
Viewed in this way, the debit to cash corre- An Options Interpretation
sponding to the initial receipt is balanced by the
credit to a loan liability. That loan would be At-Market, Pay-Fixed Off-Market, Pay-Fixed
written down each year by the portion of the 2 lnterest Rate Swap Interest Rate Swap
Cap on
percent that is principal; the remainder would be LIBOR at Floor on
interest expense. 8%Strike LIBOR at
Tne various interpretations of a swap contact
can shed some additional light on the account- ---
to the amount of interest paid. What can matter proach also is essentially the same as the loan
is how the loan or swap premium is amor- method because an increase to interest income
tized-on a straight-line or compound-interest has the same ultimate effect as a reduction in
basis. The difference is especially important for interest expense.
tax purposes. The key point is that the various interpreta-
Second, consider the interpretation of the tions of an off-market interest rate swap unam-
swap as a pair of options. The on-market, pay- biguously imply that the initial cash receipt to
fixed at 6 percent swap is equivalent to buying a the payer of the above-market rate should be
6 percent interest rate cap on LIBOR and writing amortized over the lifetime of the contract.
a 6 percent floor. The premiums on the cap and Nevertheless, for a time in the 1980s, Internal
floor must be equal because the combination Revenue Service (IRS) regulations required the
generates a swap with no initial payment. The fixed-rate payer to book the initial cash receipt
off-market swap, however, at a fixed rate of 8 as income in the initial accounting period. This
percent is equivalent to buying a less expensive requirement led to a number of tax-driven, off-
8 percent cap and writing a more expensive 8 market swap deals, usually to inject some "in-
percent floor. Raising the strike rate on an come" into the balance sheet to capture the
interest rate cap lowers its cost; raising the value of tax-loss carryforwards (or foreign tax
strike rate on a floor increases its cost. The net credits) that were about to expire worthless
outcome is an initial receipt of cash correspond- because of the lack of taxable income. The IRS
ing to the difference in premiu.ms. This ap- eventually ruled in 1989 that the lumpsum,
proach is illustrated in the lower panel of up-front proceeds on an exchange contract such
Figure 2.9. Notice that the initial cash received as a swap must be amortized over the life of the
for agreeing to pay the above-market fixed rate swap. Later, in 1991, the IRS further clarified its
should be the same in both panels-5.395 per- position to rule that initial proceeds that are
cent of the notional principal in this example. material (say, greater than 40 percent of the
That is, the difference in the values of the bonds notional principal) must be booked using the
and the values of the options is the same, loan approach. Smaller sizes of initial proceeds
regardless of the volatility assumptions used to (say, 10-40 percent) must be amortized, while
value the caps and the floors. even smaller amounts (say, less than 10 per-
This interpretation suggests that the up-front cent) can be fully booked as interest income.
cash received could be accounted for in the
same manner as the premiums on caps and
floors that compose the swap. In general, the Summary of Economic
premium is amortized over the lifetime of the interpretations of Swap Contracts
option, typically on a straight-lime basis, al- Our objective in interpreting a plain vanilla
though as discussed previously, recently there swap in various ways is to demonstrate that
has been a movement to amortize over time swap contracts help integrate financial markets.
according to the incremental value for each year An interest rate or currency swap can be easily
that is derived from an option pricing model. described as a pair of capital market transac-
Also, a major difference in the accounting for tions, each having a different coupon-reset fre-
purchased and written options is that the former quency or a different currency denomination (or
may qualify for accrual (hedge) accounting and both). Although this interpretation misses the
the latter must be marked to market. Neverthe- treatment of swaps in bankruptcy, it does pro-
less, suppose that both premiums on the long vide a few useful applications. The capital mar-
position in the cap and the short position in the ket approach indicates how swaps can be valued
floor are amortized in the same manner. Then using bond prices, quite a practical concept if
the net difference in the two is the amount trading in the swap market were to slow
credited to interest income (because the pre- appreciably or was not active to begin with, as
mium on the floor that is written exceeds the in the case of an emerging market. This
premium on the cap that is bought). This ap- approach also indicates how to place a dura-
tion value on a swap, even when the swap is is very useful from an analytic perspective be-
initially neither an asset nor a liability to its cause all of the power of option pricing models
end user. can be applied to swap contracts.
The forward market interpretation is useful These interpretations can be used to get
in understanding some of the aspects of credit some insight into the valuation of a nonplain
risk on a swap. When the term structure of vanilla swap such as an off-market interest rate
interest rates is not flat, and when interest rate swap. Paying an above-market fixed rate is
differentials across currencies are not zero, in- shown to be the same in terms of cash flows as
terest rate and currency swaps can be described buying an FRN at LIBOR flat and hnding the
as off-market series of forward contracts. That purchase by issuing a high-coupon bond having
concept introduces an asymmetry of risk expo- a market price higher than the FRN. The same
sure between the two counterparties. Typically, can be said for buying an out-of-the-moneyinter-
a sequence of actual forwards will have less est rate cap and writing an in-the-money floor
credit risk because of the structural design of agreement. The initial proceeds of the off-mar-
assigning a single fixed rate to all settlement ket swap would be the same as the difference
periods on a plain vanilla swap. between the market values of the FRN and
The options market interpretation is an ex- fixed-rate note and between the embedded cap
tension to the well-known put- call-forward par- that is owned and the floor that is written. The
ity condition. With swaps, the result is that same patterns would hold for receiving the fixed
paying a fixed rate on a swap is the same as rate on a swap, which is comparable to buying
buying a cap and writing a floor. In the same a fixed-rate bond and issuing the FRN or
manner, receiving a &xed rate is the same as buying a floor and writing a cap at the same
selling a cap and buying a floor. This connection strike rate.
Exercises
Exercise 2.1: Suppose that you work in the back office derivatives operations of a
regional commercial bank. Each day, the scheduled cash flows on a number of
transactions need to be finalized as the reference rate is determined. Your job is to
confirm the calculations, advise the counterparties of their scheduled receipts or
payments, and pass that information on to the bank's accounting and cash-
management departments. The calculations are usually done by computer, but
yours is down for the day. Assume that the current date is March 15th and the
three-month LIBOR is determined to be 6.125 percent (it was set two business days
prior). Note that there are 92 days between March 15th and June 15th. Work out
the obligations on the following transactions:
(a) A 3 x 6 FRA with Company ABC: The bank pays a fixed rate of 5.87 percent and
receives three-month LIBOR on a notional principal of $7.8 million. Both rates are
on an actua1/360 day-count basis, and settlement is in arrears.
(b) A 3 x 6 FRA with Company DEF: The bank receives a fixed rate of 5.91 percent
and pays three-month LIBOR on a notional principal of $12 million. Both rates are
on an actual/360 day-count basis and settlement is in advance.
(c) A quarterly settlement interest rate swap with Company GHI: The bank receives a
fixed rate of 6.77 percent and pays three-month LIBOR on a notional principal of $20
million. The fixed rate is on a 30/360 basis, the floating rate is on an actua1/360 basis,
and settlement is in arrears.
(d) A quarterly settlement interest rate cap sold to Company ABC on three-month
LIBOR at a strike rate of 6 percent for a notional principal of $15 million. The strike
rate is on an actua1/360 biasis, and settlement is in arrears.
(e) A quarterly settlement interest rate floor sold to pension fund XYZ on
three-month LIBOR at a strike rate of 6 percent for a notional principal of $50
million. The strike rate is on an actua1/360 basis, and settlement is in arrears.
Solution:
(a) The bank is scheduled to receive $5,083.00 from ABC on June 15th.
(b) The bank is scheduled to pay $6,491.72 to DEF on March 15th.
(c) The bank is scheduled to receive $25,444.44 from GHI on June 15th.
X $20,000,000 = $25,444.44.
360 360
(d) The bank is scheduled to pay $4,791.67 to ABC on June 15th.
(e) No payment. The interest rate floor is out of the money because LIBOR is greater
than the floor strike rate.
Banks often put their derivatives transactions in a master agreement that provides for
settlement netting to minimize credit risk. For example, if the FRA and interest rate cap
transactions with ABC are under one master agreement, the bank would be scheduled
to receive the net amount of the two settlement flows. Because the bank receives
$5,083.00 on (a) and pays $4,791.67 on (d), the net payment from ABC to the bank
would be $291.33 on June 15th.
Exercise 2.2: Suppose that the grid shown in Table E-2.1 represents movements in
the swap yield curve over a five-year time period. The percentages are the fixed rates
on annual settlement swaps against one-year LIBOR. For example, the fixed rate on a
three-year swap entered in Year 1would be 6.41 percent. A three-year swap transacted
in Year 2 will have a higher fixed rate, namely 7.78 percent.
Calculate the sequence of mark-to-market values on a five-year swap that is entered
in Year 1. Follow this swap to its maturity, calculating its market value for each year.
Use the swap fixed rate as the discount factor in present value calculations and assume
a notional principal of $25 million.
Table E-2.1 Movements in the Swap Yield Curve

Tenor
(years) Year 1 Year 2 Year 3 Year 4 Year 5
One 5.10% 6.75% 8.50% 7.35% 6.75%
Two 5.82 7.23 8.21 7.70 7.41
Three 6.41 7.78 8.50 8.41 7.90
Four 6.87 8.10 8.66 8.90 8.31
Five 7.20 8.19 8.74 9.25 8.66
Solution: The key point is that the replacement swap for each year is the one with a
maturity that matches the remaining tenor on the swap being valued.
Year 1: MTM Value = 0
(0.0810 - 0.0720) X $25 million

Year 2: MTM Value = 2 - - = $743,573
t-1
(1.0810)
3
(0.0850 - 0.0720) X $25 million
Year 3: MTM Value = --
= $830,057
t=l
(1.0850)
(0.0770 - 0.0720) X $25 million

Year 4: MTM Value = --
= $223,828
t= 1
(1.0770)
(0.0720 - 0.0675) x $25 million

Year 5: MTM Value = = -$105,386.
1.0675
Notice that the MTM value reached a maximum in the third year. This pattern is
typical because two offsetting factors are at work: (1)The longer the swap has been in
existence, the greater the likely difference between the current market rate and the
Interest Rate a d Cilnency Swaps: A Tutorial
Figure E-2.1 Converting a Dollar Bond with a Currency Swap

Buy a 5% Fixed-Coupon, JPY 5 Billion, Five-Year Bond
Fl
IPY 5.15 Billion
lssue a 10% Fixed-Coupon, USD 40 Million,Five-Year Bond
Gross Cash Flows on a "Pay USD, Receive JPY" FixedlFixed Currency Swap
II'Y 5.21;Rillion
Fl
fixed rate on the swap, and (2) the longer the swap has been in existence, the fewer
the number of remaining settlement dates. The former factor tends to increase, and the
latter to decrease, the MTM value of the swap. Also note that when the swap has a
positive value, such as during the first four years, the firm is concerned with the credit
risk of the counterparty. If the counterparty were to default, that MTM value would be
the amount of loss at that point.
Exercise 2.3: As the treasurer of a Japanese automobile manufacturer, you are
concerned about the foreign exchange exposure associated with the dollar-based
revenues the firm generates by selling cars in the United States. One way to hedge this
36
balance sheet exposure is to incur an offsetting amount of dollar-denominated

liabilities. Accordingly, you are considering converting one of your yen-denominated
bonds into frxed-rate, synthetic, dollar-denominated debt with a fured/frxed currency
swap.
The issue that you are thinking of converting has a five-year maturity with a 5
percent coupon paid annually in arrears. The face value of the note is JPY 5 billion. A
discussion with a swap market maker reveals that a fixed rate of 5 percent in yen could
be swapped for a fixed rate of 10 percent in U.S. dollars. Also, the rate at which the
principal flows would be exchanged at origination and maturity is the current FX spot
rate of JPY 125/USD.
(a) Describe how the currency swap that you will require can be interpreted as a pair
of bond transactions. Indicate specifically which bond would be bought and which
would be sold.
(b) Calculate the five-year sequence of forward exchange rates implicit in this currency
swap transaction, as well as the analogous series of forward rates implied by the
interest rate parity condition.
Solution: The currency swap needed is one in which the manufacturer will receive yen
and pay dollars. Moreover, the currency swap will be an exchange of fixed rates. At the
current exchange rate, JPY 5 billion is equivalent to USD 40 million (JPY 5 billion +
JPY 125/USD), and the annual coupon exchanges would be for JPY 250 million and
USD 4 million.
(a) The five-year capital market transactions replicating the swap would be
Buy a yen-denominated bond with a 5 percent coupon and face value of JPY 5
billion, and
sell a dollar-denominated bond with a 10 percent coupon and face value of USD
40 million.
The result of these approaches is shown graphically in Figure E-2.1. Notice that when
this swap is coupled with the existing short position in the five-year yen bond, the net
effect will be to convert the yen-denominated obligation into dollar-denominated debt.
(b) The spot and forward exchange rates built into the currency swap are as shown in
Table E-2.2. The exchanges in Years 1 through 4 are calculated as JPY 250 million
divided by USD 4 million; the fifth-year transaction is a composite of USD 4 million at
JPY 62.5/USD and USD 40 million at JPY 125/USD. The given rate of JPY 119.318/
USD is the weighted average: JPY 62.5 (4/44) + JPY 125 (40/44).
Table E-2.2 FX Forward Implied by Interest Rate Parity
Year Transaction Type Rate WPY/USD)

Spot FX trade
One-year FX forward
Two-year FX forward
Three-year FX forward
Four-year FX forward
Five-year FX forward
Interest Rate and Currency Swaps: t l Tutorial
The farward rates implied by interest rate parity are the following:
Spot FX Trade = JPY 125/USD
One-year FX forward = UPY 125/USD) x 1'' +

+
0'05)]
0.
= JPY 119.318/USD
[((I + 0.05)j2]
Two-year FX forward = UPY 125/USD) x = JPY 113.895/USD
+
Three-year FX forward = UPY 125/USD) x [((I + 0'05))3] = JPY 108.718/USI)

+ 0.
Four-year FX forward = UPY 125/USD) x [((I + o'051)4] = JPY 103.776/USD

0. +
Five-year FX forward =: UPY 125/USD) x = JPY 99.059/USD.
Thus, from your point of view, as the payer of U.S. dollars and receiver of Japanese yen
on the swap, you will be getting: (1) the spot exchange rate at Year 0, (2) a favorable
exchange rate in Years 1 through 4, and (3) an unfavorable exchange at Year 5.
Exercise 2.4: The treasurer of a British brewery is planning to enter an at-market,
plain vanilla, three-year, quarterly settlement interest rate swap to pay a fixed rate of 8
percent and to receive three-month sterling LIBOR. First, he decides to check various
cap-floor combinations to see if any might be preferable. A market maker in British
pound sterling over-the-counter options presents the treasurer with the following price
list (in basis points) for three-year, quarterly settlement caps and floors:
Interest Rate Caps Interest Rate Floors

Strike Rate BUY Sell BUY Sell
7% 582 597 320 335
8 398 413 401 416
9 2051 220 502 517
The basis point prices when multiplied by the notional principal give the actual
purchase or sale price in pounds sterling. These quotes are from the perspective of the
market maker, not the firm. That is, the treasurer could buy a 9 percent cap from the
market maker for 220 basis points or sell one for 205 basis points. The strike rates are
quoted on a 365-day basis, as is sterling LIBOK.
In financial analysis of this sort, the treasurer assumes that the three-year cost of
funds on fully amortizing debt would be about 8.20 percent (for quarterly payments).
Should another structure be considered in lieu of the plain vanilla swap?
Solution: The key is to recognize that the combination of buying the cap and writing
a floor at the same strike rate generates the same settlement cash flows as a pay-fured
swap. The fixed rate on the swap would equal the strike rate on the cap and floor.
Consider first the 8 percent cap-floor combination. The treasurer could buy the cap
for 413 basis points (the market maker's offer) and sell the floor for 401 basis points
(the market maker's bid). The net is an up-front outflow of 12 basis points (times the
notional principal). Because the 8 percent pay-fixed swap would not entail an initial
payment, the 8 percent cap-floor combination can be rejected.
Consider next the 7 percent cap-floor combination. The treasurer could buy the cap
for 597 basis points and sell the floor for 320 basis points, resulting in a net up-front
outflow of 277 basis points. The fixed rate on the synthetic swap would be 7 percent,
however, not 8 percent. The attraction of the cap-floor alternative turns on the trade-off
of a present value of 277 basis points versus a three-year annuity of 100 basis points
(actually a 12-period annuity of 25 basis points per quarterly period). Using the
three-year fixed rate of 8.20 percent, the present value of the savings is 263.57 basis
points; that is,
Because the 263.57 basis points is less than the up-front cost of 277 basis points, the
7 percent cap-floor combination can be rejected as well.
Consider finally the 9 percent cap-floor combination. The treasurer could buy the
cap for 220 basis points and sell the floor for 502 basis points, resulting in a net up-front
inflow of 282 basis points. The fured rate on the synthetic swap would be 9 percent.
Because the initial receipt exceeds the present value of the higher swap coupon (i.e.,
282 9 263.57), this combination should be considered. Is it definitely better? Perhaps
so in terms of cash flow and the time value of money, but the treasurer would also have
to consider the tax and accounting treatment of the difference in the options premiums
to confirm the benefit.
Chapter 3. Swap Applications
In recent years, swap contracts have become an stance, a firm whose credit quality forces it to
important and popular way for corporations to finance long-term asset acquisitions with short-
repackage their asset and liability cash flows. term bank loans must be concerned with rising
This chapter considers several applications that domestic interest rates. Also, a U.S.-based man-
demonstrate three general reasons for the pop ufacturer with substantial overseas sales (and
ularity of swaps. First, swaps are a cost-effective hence foreign currency receipts) is exposed to a
way to transform a firm's existing risk profile. If strengthening U.S. dollar. When a corporation is
a company's operating structure leaves it ex- in such a situation, it must either accept the
posed to adverse movements in domestic inter- exposure as part of its general risk-management
est or foreign exchange rates, swaps can be strategy (i.e., speculation) or attempt to remove
efficient mechanisms for synthetically altering the exposure from its balance sheet by hedging.
the balance sheet accounts in order to close these Within the hedging alternative, the company
sensitivity gaps. Second, swaps are used widely in again has two choices: It can formally restructure its
the process of issuing new semities to obtain a balance sheet accounts by, say, rehancing short-
cheaper borrowing cost or enhance investor return. tern,floating-rate debt with a new long-term, fixed-
These applications, which often rely on an end user's rate issue; or it can implement the desired change
specific market view or an apparent arbitrage across artificially by using swaps as an off-balancesheet
different hancial product markets, represent the restructuring tool. This section details three exarn-
essence of what has come to be called structured ples of how this latter approach works.
jnance. Finally, the swap contract can be an expedi-
ent means for a corporate manager to exploit Balance Sheet Gap Management. Con-
information about the firm that the capital market sider the risk-management problem faced by
does not possess (i.e., asymmetric infomation). Company FNC, a financial services corporation
This role of swaps will be particularly useful when whose stylized balance sheet is presented in
the information in question involves an evaluation Table 3.1. Although a substantial amount of the
of the firm's relative creditworthiness. funding for this firm comes from debt on which
the coupon resets periodically, the majority of its
assets are held in long-term investments. The
Risk-Management Applications potential problem with this sensitivity mismatch
In the quest to achieve a profitable operating , is that interest rate changes will affect the
structure, a corporation often finds itself with an market value of FNC's assets and liabilities to
unintended exposure to financial risk. For in- different degrees; therefore, its net worth is
Interest Rate and Currency Swaps: rl Tutorial
Table 3.1 Company FNC's Balance individual positions determining the weighting
Sheet and Assetkiability scheme. Also, the duration of the liabilities is
Durations scaled by a measure of the firm's leverage, thus
adjusting for the fact that any firm with a positive
Market Duration net worth has more assets than liabilities.1 The
Item Value (years) asset and liability duration figures calculations
Assets for FNC Company are as follows:
Cash (noninterest bearing
account) !j 100
5-year term loans, valued at par
to yield 10% 400
10-year amortizing mortgages
valued at par to yield 10% 500
+ 1,000
x 1.73 = 4.03 years,
Total and
Liabilities
5-year, floating-rate note with
annual reset to LIBOR
(current LIBOR = 8%) 5; 600 = 3.00 years.
7-year, zero-coupon bond issued
to yield 8% 300
Thus, the duration gap calculation for FNC is
Total
Net worth $; 100

= 4.03 - I&$( X 3.00 = 1.33years.
The fact that FNC Company's duration gap is

Asset and Liability Duration Calculations: positive means that it is exposed to rising rates;
its net worth is like a long position in a one-year
=
(0.00) +
(E) (E)
---- (4.17) - t ---- (4.73) = 4.03 years
four-month, zero-coupon bond. A negative gap
value, which would occur when shorter term
Dliabiliw
=
(E) I::+:(
- (1.00) -- (7.00) = 3.00 years assets are financed with longer term liabilities,
could be interpreted as equivalent to a short
zero-coupon holding of comparable magnitude,
thereby exposing the firm to falling rates. A
subject to these rate fluctuations. Specifically, as
duration gap of zero implies a hedged position in
interest rates rise, the value of the company's
which assets and liabilities are equally respon-
assets will decline by more than the value of the
sive to future rate movements.
liabilities, thereby shrinking net worth. Said
Unless FNC wants to hold this exposure (and
differently, because the company is "short fund-
in so doing speculate on falling rates), it will
ed," a rate increase will cause its :Sundingcost to
attempt to set its duration gap to zero. One way
rise before it can reinvest the asset base at a
to accomplish this task would be to restructure
more profitable level.
One approach to measuring this asset/liabil-
ity sensitivity imbalance that is particularly effec- ' As reviewed in the appendix, the duration statistic is
tive for financial firms is duration gap. Duration often used in the context of linking percentage changes in
gap is usually computed as follows: interest rates with the resulting percentage change in
position value. Thus, with different levels of assets and
(Total liabilities) liabilities, simply matching asset and liability durations
Dgap = Dasset -
--
Total assets Dliability . would still leave the firm exposed on a dollar basis. Also,
notice that although the maturity of the mortgage portfolio
In this calculation, the durations of the asset and is twice as long as that of the loan portfolio, the two durations
are only about a half-year apart because the former cash flow
liability portfolios from the balance sheet are structure amortizes the principal and the latter does not,
obtained as weighted averages of the respective thereby shifting the weights associated with the payment
accounts, with the relative market values of the dates in the duration calculation closer to the present.
its balance sheet by changing the existing ac-

counts. In general, the treasurer for FNC would
either have to shorten asset duration, lengthen
liability duration, or some combination of the
two. Formal balance sheet restructuring, how-
ever, is not usually the most sensible approach.
+ ti:]
---
- $402.
(4.31) + e:~1
--- (7.0) = O.OO
years,
or Psw -
Beyond the obvious costs of attempting to buy A clear advantage of the swap-based ap-
or sell what may be illiquid instruments, the proach to hedging is that it does not require
more compelling reason for this statement can FNC to liquidate any existing position or create
be seen by assuming FNC tries to close its any new one. Another interesting aspect of this
duration gap by selling some of its loan portfolio synthetic risk-management solution is that if the
and holding the proceeds in cash. Recognizing treasurer had instead wanted to shorten the
that the average duration for the blended loan firm's asset duration, he or she would have used
portfolios is 4.48 years [calculated as (400/900) the same swap. That is, an asset swap designed to
x 4.17 + (500/900) x 4.731, the amount needed convert some of the existing fixed-rate loans to
to be held in cash, w,,, is found by solving have a floating-rate coupon would also be of the
pay-fixed variety. This result is illustrated gen-
erally in Figure 3.1.
Using Forward (i.e., Deferred Start)
- /GI X 3.00 = 0.00 years, Swaps. Another benefit of using swaps to
control financial risks is that they allow the
corporation to tailor a solution to its unique view
or was, = 40 percent (of $1,000). The remaining of the world. For example, when confronted by
level of income-producing assets would be only the balance sheet shown in Table 3.11, suppose
$600, an amount not even sufficient to service FNC's managers decide that (1)they are willing
the firm's existing debt. Thus, its interest rate to bear the exposure during the first two years
exposure would be solved, but Company FNC of the FRN's life, based on the view that LIBOR
would then be operating at a loss, which of would not rise (and might even fall) during that
course would also reduce its net worth. time, but (2) they want to fix their funding cost
The important point of the preceding analysis in Years 3 through 5. Although a formal restruc-
is that a firm is best served by selecting the turing of the existing debt issues to effect this
balance sheet structure that makes the most blend of speculation and hedging would be
sense for the operating efficiency of the organi- prohibitively expensive, it is quite simple to
zation and then hedging any attendant expo- achieve in the swap market. Specifically, FNC
sures some other way. To see how FNC could would require a three-year, pay-fixed swap that
although negotiated today, would not start until
have eliminated its rate exposure synthetically,
the end of Year 2. This sort of arrangement is
suppose that the treasurer had decided to con-
known as a forward swap.
vert sonae of its annual-reset FRN with a five- Figure 3.2 shows the net effect of combining
year, pay-fixed swap. Assuming for simplicity a current position in a five-year, annual-reset
that the swap fixed rate is 8 percent, the portion FRN with a three-year, pay-fixed swap with a
of the "floater" position equivalent to the swap's two-year deferred start date. The first thing to
notional principal is effectively transformed into notice is that the fixed rate on the forward swap
an 8 percent, fixed-rate bond. Valued at par, (arbitrarily chosen to be 8.50 percent for this
such a bond would have a duration of 4.31 years. example) is not the same as the fixed rate on the
Thus, to determine the dollar value of the FRN five-year swap commencing immediately (8 per-
liability that would have to be swapped, the cent). In general, the rate on the forward swap
treasurer needs to solve for the notional princi- will differ from that on the plain swap any time
pal on the required pay-fixed swap, p,, in the the implied floating-rate yield curve is not flat,
following formula: because the swap fixed rate should be an aver-
Figure 3.1 C h h g a Positive Duration Gap Balance Sheet Position Synthetically

Convertin'g a Floating-Ra te Liability with a Pay-Fixed Swap
LIBOR
Company FNC Swap Dealer

>
Fixed Rate
Pay LIBOR
on FRN
* 7
Bondholders
Converting a Fixed-Rate Asset with a Pay-Fixed Swap
Fixed Rate
Receive Fixed-
Rate Coupon
age of the relevant segment of the implied once the forward swap becomes effective at the
forward rate curve. Thus, in an upward- or beginning of the third year, the company will
downward-sloping yield curve environment, again be hedged against the adverse economic
swaps starting at different points in time will conditions the management fears. Notice in
have different fixed rates.2 calculating the duration gap for those three
The top panel of Figure 3.2 indicates that years, we assumed that the fixed rate on a new
without the swap in the first two years, FNC three-year plain vanilla swap was the same 8.50
retains its positive duration gap and, therefore, percent that prevailed in the forward swap
is exposed to rising rates. Of course, this risk is market two years prior. With this assumption,
exactly the one that the firm's management is the swapped floater would be valued at par and
willing to assume. The lower panel shows that have a duration of 2.77 years and the zero-
coupon liability's duration would be equal to its
five-year maturity. Also, assuming no substan-
A more formal analysis of how foward swaps should be tive changes in the relative allocations on either
priced in an efficient market is presented in the next side of the balance sheet, the durations for what
chapter. are now three- and eight-year loan and mortgage
Figure 3.2 Converting a Floating-Rate Liability with a Forward Swap

Years 1 and 2
Swap Dealer
Pay LIBOR
on FRN
Bondholders
Duration Gap = (4.03) - (-)

900
1000
(3.00) = 1.33 years
Interest Rate Exposure: Rising Rates
Years 3 through 5
LIBOR
CI
Pay LIBOR
on FRN
Bondholders
Duration Gap = (2.61) - [(z) (E) (E)

(E) (1.0) + (2.77) + (5.011 = 0.00 years
Interest Rate Exposure: None

portfolios are 2.74 and 3.48, respectively. If, for become more expensive (in Swiss francs) as the
simplicity, the amortized mortgage principal is years pass.
held in cash, the asset duration would be 2.61 To hedge this new exposure, the treasurer of
years (calculated as [(166/1000) x 01 + [(400/ Company SND can do several things. First, he
1000) x 2.741 + [(434/1000) x: 3.481). Thus, can try to sell enough of the firm's domestic
using a procedure similar to that shown in the currency in the FX forward and futures markets
preceding example, the notional principal on the to guarantee the acquisition of the requisite
forward swap would have to be $288 to ensure French francs for prices fixed in Swiss francs at
that the duration gap at the beginning of Year 3 today's levels. This approach amounts to an
will be zero. attempt to convert the denomination of a future
income statement item while otherwise leaving
Matching Foreign-Currency-Denomi- the company's balance sheet untouched. A po-
nated Assets and Liabilities. Company tential problem with this solution, however, is
SND is a Swiss consumer nondurables manufac- that liquidity and contract availability in the
turer that, to date, has produced and sold its over-the-counter and exchange-traded FX for-
products entirely within Switzerland. As a con- ward markets may not be sufficient to support
sequence, all of its accounting statement entries such activity.
have been denominated in Swiss francs (CHF) A second basic approach to hedging that
with the result that any risk-management prob- SND could adopt would be to "rebalance" a
lems SND's treasurer faced were attributable portion of its asset and liability accounts. Specif-
largely to fluctuating Swiss interest rates. Re- ically, assume in this case that the company can
cently, however, two changes have taken place. sell some of its current holdings in Swiss-franc-
First, SND has begun importing materials denominated interest-bearing assets and pur-
needed for its production process from France. chase an equivalent number of French bonds in
SND's new supply contract with the French order to create a three-year French franc reve-
nue stream that would match the FRF 5 million
parts producer runs for three years and will
liability. Finally, as the physical conversion of
result in SND having an annual French-franc-
assets suggested by the second hedging
denominated (FRF) account payable of FRF 5
scheme is likely to come at the expense of
million. Of course, this foreign currency liability
extremely high transaction costs, a third alter-
creates a new source of economic risk for native would be to implement this conversion
SND-namely, the possibility that the Swiss synthetically in the currency swap market.
franc will depreciate relative to the French cur- To see how the synthetic adjustment might
rency thereby making the obligation increas- be carried out, suppose that Company SND
ingly expensive in terms of its domestic mone- currently holds in its security portfolio a three-
tary unit. year bond priced at a par value of CHF 60 million
The second recent change at SND is that, and paying a fixed annual coupon of 7.50 per-
because of increasingly tight operating margins cent. Under the present conditions in the for-
during the past few years, the treasurer has just eign exchange market, Swiss francs can be
received a mandate from senior management to converted into French francs at the rate of CHF
operate the treasury unit as a profit center. That 0.25/FRF and the 7.50 percent Swiss franc cou-
is to say, he will now be allowed to take a limited pon could be swapped for a French franc fixed
number of positions implementing his view on rate of 6.60 percent in a three-year transaction.
future domestic and foreign exchange rate With these prices, notice that SND will have to
movements. In this context, the treasurer be- hold only the equivalent of FRF 75.76 million
lieves the inflation rate in France will be consid- face value in bonds to generate the necessary
erably lower than that in Switzerland in the near FRF 5 million cash flow (FRF 75.76 x 0.0660).
future and, accordingly, the relative value of the Thus, the company will have to convert only
French franc will strengthen compared with the CHF 18.94 million (or FRF 75.76 million x CHF
Swiss franc. He recognizes that if this forecast is 0.25/FRF) of its existing bond holding to imple-
correct, the firm's recent supply contract will ment the necessary change. This means that
its continuing existence; after all, arbitrage is a tive funding advantage in the market in which it
strategy that "corrects" the pricing discrepan- wishes to issue debt, each company can benefit
cies it seeks to exploit. Thus, a more plausible from issuing debt in the market in which it does
explanation of price discrepancies than arbi- have an advantage and then swapping coupon
trage is that two apparently cotnparable cash obligations to obtain the desired funding struc-
flow patterns-one "natural" and one trans- ture.
formed with the use of a swap-have important, To understand these potential gains, suppose
if subtle, differences that participants in the that the two treasurers negotiate a swap directly
market recognize when pricing them. Said dif- with one another, deciding to split any "arbi-
ferently, when evaluating swapdriven deals, it is trage" gains equally. Accordingly, after Firm
extremely important to look beneath the surface AAA issues five-year, fixed-rate debt and Firm
to see where the hidden risks may lie. This BBB issues a five-year FRN, they agree to a
caution can be illustrated by considering nu- swap with the following terms:
ances of what is regarded as the standard swap Notional Principal: U.S. $25 million
story involving credit risk arbitrage. Fixed-Rate Payer: Counterparty BBB
Swap Fixed Rate: (T + 0.40)% (semian-
Classical Interest Rate Swap Arbi- nual actua1/365 bond
trage. Suppose that two corporate borrowers basis)
each seek five-year funding in the amount of $25 Fixed-Rate Receiver Counterparty AAA
million dollars. The treasurer at Firm AAA, the Floating Rate: &month LIBOR
stronger credit, prefers to issue floating-rate (money-market ba-
debt because of his belief that short-term inter- sis)
est rates will fall as the Federal Reserve Board
eases its monetary policy in an attempt to bol- where T represents the T-bond yield. These
ster the sluggish economy. His counterpart at bond and swap transactions are shown in
Firm BBB, the weaker credit, prefers issuing Figure 3.4.
fured-rate debt to match the interest rate insen- The net, synthetic funding cost for each
sitivity of the company's net operating revenues. company can be calculated as
Their respective costs of funds for par-value, AAA's funding cost (money-market basis) =
semiannual payment fixed- and floating-rate
debt issues are as follows:
Firm Fixed-Rate Debt Cost Floating-Rate Debt Cost
AAA
BBB
5-year T-bond yield
+ 25 basis points
5-year T-bond yield
+ 85 basis points
-
LIBOR
LIBOR
--
-I- 30 basis points I)::;(
X - = LIBOR- 0.15%.
BBB's funding cost (actua1/365 bond basis) =

Quality
spread
60 basis points 30 basis points
In this example, AAA has an absolute advan-

(LIBOR + 0.30%) x rs) + [(T + 0.40%)
tage in both markets, reflecting its stronger
credit standing, but it has a relative advantage
only in the fixed-rate market, where its spread
over the weaker name is worth 60 basis points.
- LIBOR X -
1;:91 = T + 0.70%.
Thus, both counterparties appear to have ob-

Conversely, although Firm BBB pays a higher tained superior financing by using the swap
funding cost in both markets, it has a relative agreement to take advantage of the 30-basis-
advantage in issuing floating-rate debt, because point quality spread discrepancy in the fixed-
it is penalized only 30 basis points for its weaker and variable-rate bond markets. By issuing in
credit standing. This quality spread differential their respective markets of comparative advan-
creates an apparent opportunity for credit risk tage and then restructuring their coupon obliga-
arbitrage based on the principle of comparative tions with the swap, each firm enjoys a gain in
advantage. Because neither firm enjoys a rela- the form of a funding cost that is 15 basis points
Figure 3.4 The Credit Arbitrage Swap Illustrated

Interest Rate Swap
7' + 40 bps
4
Firm AAA Firm BBB
>
LIBOR
Issue Fixed- LIBOR

Rate Debt T + 25 bps + Issue Floating-
30 bps Rate Debt
1
Bondholders
less than through a direct issue in their markets short, then, the funding scheme involving the
of choice. swap is riskier for both counterparties than the
Before determining whether these gains r e p respective desired direct issues. Consequently,
resent a legitimate arbitrage situation, another the swaprelated funding cost should be lower to
important point must be considered. Notice that account for this increased exposure. Further,
Firm AAA has used the swapdriven deal to although the terms of the swap contract depend
acquire sub-LIBOR financing when a direct- largely on the negotiating skills of the two
issue FRN would have required coupons of counterparties, it is reasonable to assume that
LIBOR flat. These two structures are not directly the higher-rated credit will be able to command
comparable, however. To see why, recognize a larger percentage of the quality spread differ-
that although Firm AAA's swaprelated funding ential. The critical point is that the existence of
cost depends critically on its counterparty's arbitrage cannot be evaluated fully until after all
promise to make the net settlement payment relevant swap risks-including liquidity, legal,
whenever LIBOR is less than T + 0.40 percent, taxation, and accounting, as well as default
the direct-issue cost embeds no such depen- risk-are regarded in their proper context. We
dency (i.e., Firm AAA does not have to worry examine these sources of uncertainty more thor-
about its bondholders defaulting on any promis- oughly in Chapter 5.
es). What would happen, for instance, if on a
settlement date, LIBOR is actually less than T + Arbitrage with Currency Swaps. Keep
0.40 percent and Firm BBB defaults on its ing these caveats about credit risk in mind, the
obligation to make the net settlement payment preceding arbitrage example can be extended in
on the swap? In such a case, Firm AAA's funding two ways. First, swaps can be used to transform
cost would be the fixed-rate coupon it issued a company's comparative advantage across dif-
rather than the LIBOR-based coupon it desired; ferent currencies. Second, as we saw earlier,
that its swap counterparty defaults in no way asset swaps can also be used to convert revenue
relieves Firm AAA of the obligation to repay its streams in search of a superior investment re-
bondholders. turn.
Similarly, Firm BBB's swapdriven funding Suppose that a U.S.-based pension fund is
cost of T + 0.70 percent is only truly fixed to the seeking a fixed-rate, seven-year bond invest-
extent that Firm AAA honors its contractual ment with a face value of USD 10 million.
obligations. If AAA should default on a settle- Assume further that the effective annual yield to
ment date when LIBOR exceeds T + 0.40 per- maturity on direct-purchase bonds that satisfy
cent, BBB would still be forced to pay LIBOR + the fund's maturity and credit quality policy
0.30 percent under adverse circumstances. In constraints is 8.00 percent. Because this fund is
not restricted from using derivatives or making and the coupon rate in the swap market (9.42
international investments, the manager thinks percent). Notice, however, that simply adding
that she may be able to increase the net yield by this &basis-point differential directly onto 8.00
purchasing a foreign-pay bond and swapping the percent in calculating the manager's all-in yield
cash flows into dollars. would be incorrect because these two items are
One specific transaction that she is contem- denominated in different currencies. Said differ-
plating is the purchase of a Eurosterling bond ently, a basis point in dollars is generally not the
issued by a British company. 'The particular same as a basis point expressed in a foreign
security that she has been offered pays an currency. In this case, 1basis point in sterling is
annual sterling coupon of 9.50 percent and has equal to 0.95 basis points in dollars? Conse-
an otherwise comparable set of characteristics quently, the effective yield on the swapped Euro-
(i.e., duration and default rating). From a swap sterling issue is 8.076 percent.
dealer, she has also obtained the following pric- Whether the difference between 8.076 per-
es: (1) USD 1.40/GBP for the spot exchange of cent and the direct-purchase yield of 8.00 per-
dollars and pounds, and (2) a bid-offer quote of cent represents an arbitrage once again is sub-
9.35-9.42 percent on a seven-year sterling cur- ject to debate. As before, the central issue is
rency swap versus the payment or receipt of 8.00 whether a swapped bond purchase is truly as
percent in U.S. dollars. With these terms, a USD good as the direct purchase. In either circum-
10 million investment would be equivalent to stance, the fund manager will have to worry
GBP 7.143 million and, accepting the offer side about default on the part of the issuer, but only
of the dealer's swap quotes, the manager would in the former case will she also have to worry
make annual payments of GBP 0.673 million about her swap counterparty defaulting when-
(calculated as GBP 7.143 x 0.0942) in exchange ever the pound depreciates in value relative to
for receiving USD 0.800 million. The combined the dollar. Further, inasmuch as the currency
cash flows from the swapped Eurosterling bond
are shown in Table 3.2.
One way to interpret the apparent arbitrage This value can be derived by discounting a seven-year
in this example is to note that the fund manager annuity of 1basis point in sterling at the rate of 9.50 percent
has been able to exploit the swap market to and then reannuitizing that amount in dollars at 8.00
receive the same USD 800,000 annual coupons percent. That is, the dollar value of 1basis point in sterling
she would have gotten with the direct dollar- is the solution to the following equation:
denominated issue plus an additional GBP 6,000.
This incremental sterling-denominated sum was
the result of the discrepancy between the cou-
pon rate in the Eurobond market (9.50 percent)
Table 3.2 Asset Arbitrage with a Currency Swap

(cash flows in millions)
Bond Currency Swap

Year Receipts
- - - - -
Receipt
- - -
Payment Net Cash Flow
-GBP 7.143 GBP 7.143 USD 10.000 -USD 10.000
0.679 0.800 0.673 IJSD 0.800 + GBP 0.006
0.679 0.800 0,673 0.800 + 0.006
0.679 0.800 0.673 6.800 + 0.006
0.679 0.800 0.673 0.800 + 0.006
0.679 0.800 0.673 0.800 -t 0.006
0.679 0.800 0.673 0.800 + 0.006
0.679 0.800 0.673 0.800 + 0.006
and GBP 7.143 USD 10.000 GBP 7.143 USD 10.000
swap requires a physical exchange of principal, The treasurer for DEF knows that each of these
this default exposure is greater than it would floaters could be converted into a synthetic
have been on a single-currency interest rate fixed-rate issue with the appropriate position in
swap, in which the principal is notional. If the an interest rate swap. Accordingly, he contacts a
swap counterparty in this example is also the swap dealer who provides the following actual/
bond dealer that sold the manager the Euroster- 365 swap fixed-rate quotes for dollar-denomi-
ling issue, the dealer will probably be able to nated, seven-year, plain vanilla agreements
hold the bond as collateral, thereby reducing its against six-month LIBOR:
credit exposure to the pension fund. Dealer's Bid Rate: T + 85 basis points
Structured Finance Applications. Gen- Dealer's Ofer Rate: T + 95 basis points
erally speaking, structured finance can be At the time these quotes were obtained, the
viewed as a form of financial market intermedi- seven-year Treasury yield was 8.25 percent,
ation in which the disparate wants and needs of leaving a bid-offer swap fixed-rate quote range
the ultimate sources and uses of capital are of 9.10 percent to 9.20 percent.
mutually satisfied through the creative unbun- As a first step in establishing whether any of
dling and rebundling of cash flows. Of course, these FRNs has the potential to generate a
derivatives play a special role in the repackaging superior funding cost to the direct-issue alterna-
process, and swaps are a prominent feature of tive of 9.50 percent, the treasurer charts the
the financial engineer's tool kit. The role that the nature of the swap agreement that would be
intermediary plays in these situations is to en- required to convert each into synthetic fixed-
sure that the patterns of cash flows the issuer rate debt. These diagrams are presented in
wants to pay can be reorganized to match the Figure 3.5. The next step is to compute the net
pattern of cash flows that the investor wants to synthetic fixed-rate cost of funds implied by all
receive and, at the same time, to provide suffi- three of the structures.
cient financial incentive for everyone to partici- For the traditional FRN, this calculation is as
pate in the deal. follows:
As a straightforward example of this process,
suppose that Corporation DEF seeks $50 million
in seven-year, fxed-rate funding. Because this
firm has several outstanding fixed-rate debt is-
sues in this maturity range, investors have little (9.2W) - LIBORX
appetite for any more at the present time. As a
consequence, DEF would have to pay a coupon As in an earlier example, the coupon cash flows
of 9.50 percent on a par-value bond, which is a of the $50 million traditional floater are trans-
little high by historical standards, given the formed with a $50 million pay-fixed swap, result-
company's present credit grade. Several institu- ing in a net funding cost of 9.453 percent,
tional investors, however, have expressed an slightly below the target of 9.50 percent. Recall,
interest in taking positions in any of three differ- however, that this comparison cannot be made
ent types of floating-rate structures, each of directly until the cost of a potential default by the
which pays semiannual interest linked to swap counterparty is included in the synthetic
LIBOR. The coupon resetting formulas for the rate. Also, although impossible to quantify in the
three FRNs, which are functions of the relative present case, the treasurer would also need to
demand for each innovation, are quoted on an consider the myriad "back office" costs associ-
actua1/360 money-market basis as follows: ated with the swap-based alternative (e.g.,
o Traditional FRN: Six-Month LIBOR + account,ing, documentation, and settlement cal-
0.25% culations). Thu-s, although the "traditional float-
Reverse (or 'BulZ'Y FRN: 18.40%- Six- er/pay-fixed swap" combination cannot be dis-
Month LIBOR missed as a possibility, it is unlikely to provide a
Bear FRN: (2 x Six-Month LIBOR) - compelling structure from DEF's point of view
9.10% once all of the ancillary costs are included.
Figure 3.5 Charting the Structured ments. Thus, because the LIBOR exposure built
Finance Alternatives into the reverse floater is opposite that of the
traditional FRN, the opposite swap is required.
Converting a Traditional FRN
As shown in the calculation below, the synthetic
- LIBOR
,
fixed rate associated with this structure is 9.556
percent:
l";"r=c 9.20%
Swap Dealer
(18.40% L 1 B O R ) x
LIBOR + 25 bps
l- 7
I
Bondholders
+ [LIBOR X
:
-
]
- 9.10% = 9.556%.
This percentage is in excess of the 9.50 percent

direct-issue benchmark even before swap de-
Converting a Reverse F RN fault risk concerns are taken into account.
Although the treasurer would not agree to
LIBOR this "reverse FRN/receive-fixed swap" deal any-
DEF Swap Dealer
way, the actual synthetic funding cost of the
-4 structure is even worse than it appears to be.
9.10% Notice that the funding cost on this combination
18.40%- LIBOR is only fixed if LIBOR is less than or equal to
v 18.40 percent, because the coupon on the floater
Bondholders would be zero on any settlement date when
LIBOR exceeds 18.40 percent (i.e., DEF can
never expect an interest payment from its bond-
Converting a Bear FRN holders). Thus, given that the reverse floater
has effectively capped the benefits to the issuer
2 x LIBOR at the point where LIBOR equals 18.40 percent,
4 the treasurer will have to purchase an offsetting
DEF seven-year, semiannual settlement cap agree-
2 x 9.20%
ment (with a strike rate set at 18.40 percent) to
protect against having to make too large a swap
2 x LIBOR - 9.10%
payment in a period of extremely high market
v rates. Although such a cap would not be partic-
Bondholders
ularly expensive under the presumed condi-
tions, it would not be free, and its amortized cost
The restructuring of the reverse FRN, illus- would raise the overall synthetic fixed-rate fund-
trated in the center panel of Figure 3.5, is by its ing expense even more.
nature a more involved process. First of all, Finally, the bear FRN (so called because the
notice that, from DEFs perspective, a $50 mil- note appreciates in value as LIBOR rises,
lion, receive-fixed swap will now be required. thereby creating a negative-duration asset) illus-
The best way to see why the firm would want to trated in the bottom panel of Figure 3.5 also has
pay the floating rate on a swap in order to a few unique nuances embedded in it that make
convert this type of floating-rate debt issue is to its conversion to a synthetic fixed-rate issue
interpret the reverse FRN coupon (18.40 per- somewhat problematic. Like the reverse floater,
cent - LIBOR) as being equivalent to (1) a this instrument's coupon can be decomposed
payment of 18.40 percent and (2) the receipt of into two parts: (1) a payment of twice the
LIBOR. The net effect is that the coupon pay- prevailing LIBOR and (2) a fixed-rate receipt of
ment will decline as LIBOR increases, thereby 9.10 percent. Consequently, to neutralize the
exacerbating the price decline that fixed-income floating-rate portion of the coupon payment, two
securities typically suffer in rising rate environ- pay-fixed, $50 million swaps (or one with a
notional principal of $100 million) are needed. Asymmetric Information and Firm
Further, like both of the other swap-related Credit Quality
structures, this deal involves the additional de-
The preceding applications have stressed
fault exposure to the swap dealer, but now this
how swap contracting is useful in managing
exposure is twice as great because of a doubling
undesirable economic exposures and repackag-
of the notional principal. Lastly, notice that the
ing cash flows to exploit windows of funding or
funding cost on the "bear FRN/pay-fixed swap"
investment opportunity. In a final general appli-
combination is only fixed for LIBOR above 4.55
cation, the swap product can also be adapted to
percent (i.e., 9.10/2). For LIBOR beneath this
help a manager make a choice of funding struc-
floor level, the coupon on the floater once again
tures to take advantage of his or her superior
remains zero, and so Corporation DEF would
knowledge of the firm's true financial condition.
need to supplement this structure with an inter-
In particular, if a corporate treasurer faced with
est rate floor agreement having a notional prin-
the decision of funding in either the short- or
cipal of $100 million and a strike rate of 4.55
long-term debt markets has private (asymmet-
percent.
ric) information as to the improving or deterio-
The bear floater/swap package generates an
rating credit quality of the company, the swap
attractive synthetic fixed rate of 9.174 percent,
can be an effective way to repackage the debt
as shown in the following calculation:
obligations accordingly.
To see how this process unfolds, consider
(2 X LIBOR - 9.10%) X
(E)
--
the following scenario.5 Suppose that the chief
financial oEcer at Company IMP holds two
x (g)]]
+
i
2 x 9.20% - LIHOR
This rate is more than 30 basis points beneath

= 9.174%.
beliefs as she considers the details of the firm's
proposed debt financing program. First, she is
quite concerned about the possibility that short-
term interest rates will increase steadily and is
the direct-issue target rate to absorb the amor- therefore naturally reluctant to commit to a
tized cost of the floor and the default and various variable-rate structure. Second, based on her
other risks on the swap transaction. If after knowledge of changes planned for the internal
amortizing these costs and risks into the syn- operating structure of the organization, the
thetic fxed rate, DEF finds it can fund for less credit quality of the company will improve sub-
than 9.50 percent, it should do so. All parties to stantially in the near future. Given that the
the transaction would be satisfied: Corporation capital market has not yet recognized these
DEF would obtain superior synthetic fixed-rate improvements, she is also concerned about lock-
funding, the investors would be able to acquire ing in long-term, fixed-rate funding with a direct
debt issued by DEF in a desired coupon pack- placement, even though this strategy would help
age, and the swap dealer would make his or her to mitigate her perceived economic exposure.
spread on the agreement with DEF (and, possi- To simplify the analysis, assume that the
bly, fees for placing the underlying debt). Of CFO has two financing choices: (1) borrow in a
course, the crucial elements in making this series of short-term commitments at market
transaction work are having motivated end us- interest rates prevailing in the money market on
ers and an intermediary with the ability to each rollover date; or (2) lock in long-term
transform the cash flows cheaply and effectively
with swap and option contracts?
360)] = (1/2) [0.25 percent x (36513' 60) 1 + (112') [18.40
percent x (365/360)] = 9.4545 percent. Notice that al-
An interesting addendum to this example is that Corpo- though this scheme would avoid the additional credit risk
ration DEF could also obtain $50 million of synthetic associated with any of the swap-based solutions, it would
fixed-rate funding without accessing the swap market at all still require the purchase of a cap agreement (with a
by issuing traditional and reverse floaters in two $25 million notional principal of $25 million) to protect against LIBOR
tranches. The resulting synthetic funding cost on such a rising too high on the reverse FRN. Of course, the pur-
structure would be (1/2) [(LIBOR + 0.25 percent) x chase of the cap would entail credit risk.
(365/360)] + (1/2) [(18.40 percent - LIBOR) x (365/ This example was adapted from Titman (1992).
financing at the known fixed bond rate available Figure 3.6 Exploiting Asymmetric
now. Recognizing that any funding cost can be Information about Company
expressed as the relevant Treasury yield plus a Credit Quality
credit adjustment, these rates can be written: Improving Credit Quality
Long-term funding rate = TL + BS
Short-term funding rate = ps + L@s
The tilde (") denotes a variable rate component, Company 4 Swap
and MSand BS represent the credit adjustments IMP Dealer
in the short-term money and long-term bond TL + SS

markets, respectively. T +K
The important point to recognize from this
design is that the long-term funding strategy
Bondholder
locks in both the pure rate and credit spread
components whereas the short-term format lets
both components adjust to changing market
circumstances. Unfortunately, neither of these - -
Net Cost of Funds = (is + MS) - tTL + SS - (TS+ LS)I
direct-issue structures meets the needs of the - -
CFO, who would like to lock in the Treasury rate = TL + SS- (LS-MS)
while letting the firm-specific risk premium de-
cline as the company's balance sheet strength-
ens. At this point, the swap agreement becomes Declining Credit Quality
useful. Recalling the earlier convcmtions in quot-
ing plain vanilla interest rate swaps, we have
Swap fixed rate = TL + SS
Swap floating rate = LIBOR = ps + LS
Company
Dealer
SS is the swap spread and LIBOR has been TL + SS

broken down into the short-term #Treasuryyield
plus an appropriate floating-rate spread (the
T~: + B
1
so-called "TED" spread).
The top panel of Figure 3.6 illustrates what
will happen if Company IMP adopts the short-
term rollover borrowing strategy and then
LA Bondholder
swaps into a fixed rate. Notice that the net cost

of this combination is TL + SS -- (Ls - MS). Net Cost of Funds = (TL+ BS) + [is + - (TL + SS)]
This conversion has accomplished two things. = + is- (SS-BS)

First, the CFO has no general yield curve expo-
sure because a fixed, long-term base rate of (TL
+ SS) has been established. Second, although at the same time he expects interest rates to fall.
she is exposed to an increased level of general Once again, neither of the two direct-issue fund-
risk aversion in the short-term credit markets ing schemes produces a simultaneous attain-
(an increase in tS),she is now in a position to ment of the implied objectives. A swapbased
benefit from any improvement in firm credit strategy can, however. Assuming that DCL has
quality that results in a lower level of MS. Tnus, the same market-determined credit rating as
by repackaging the short-term funding alterna- IMP at the present time, the lower panel of
tive with a pay-fixed swap, she has been able to Figure 3.6 shows that both of the treasurer's
achieve both of her goals. goals can be satisfied by issuing a long-term
Conversely, suppose the treasurer of Com- bond and converting the fixed-rate liability into
pany DCL has private information strongly sug- floating-rate payments. The net funding cost, Ts
gesting that his firm's credit quality will decline + LS - (SS - BS), ensures that the treasurer
54
will be able to take advantage of falling rnarket sequence of cash flows so as to align othenvise-
rates while having locked in his credit spread at conflicting goals among market participants.
what he feels to be an overly generous assess- That is, rather than serve as investment or
ment by the capital market. funding vehicles in themselves, interest rate and
currency swaps add value through their ability
Summary of Swap Applications to transform other securities into a more desir-
As the market for interest rate and currency able format. This ability was true whether the
swaps has matured, industry participants have ultimate goal was managing unwanted economic
become increasingly comfortable with how exposure, attempting to exploit an apparent pric-
these derivative products function. One by-prod- ing inefficiency across the various product mar-
uct of this rising level of comfort has been a kets, or taking advantage of private information.
more substantial appreciation for how swap con- In evaluating the benefits from any swap-based
tracts can be used to help a firm better achieve strategy, however, two aspects must always be
its financial objectives. In this chapter, we pre- considered. First, the swap will have its own
sented three broad reasons why the swap mar- market-driven price, which can at times diverge
ket has grown to its current stature. A common from a level consistent with other market prices.
theme running through each set of examples is Second, swaps inevitably entail some type of
that these agreements provide a cost-effective default risk, which makes credit assessment of
way of repackaging an existing or proposed the agreement itself a critical concern.
Interest Rate and Currency Swaps: tl Tutorial
Exercises
Exercise 3.1: Table E-3.1 presents the asset and liability structure for a hypothetical
financial corporation. Assume that all asset and liability positions are valued at par.
(Thus, the yields on the nonamortizing loan portfolio and futed-rate debt issue are 10
percent and 8 percent, respectively.)
Table E-3.1 A Hypothetical Balance Sheet

Market
Item Value Duration
Assets
Cash $ 200 0.00
10-year, 10%business loan 800 4.17
Total
Liabilities
&year E'RN (annual coupon
reset at LIBOR)
6-year, 8%coupon bond
Total $ 850
(a) After first obtaining the average duration of the asset and liability portfolios,
calculate the duration gap for this bank and use this concept to describe the nature of
the bank's interest rate exposure.
(b) Suppose that the firm attempted to eliminate this risk by formally restructuring
some of the balance sheet accounts. In order to achieve a "zero-gap" position by
altering the asset base, how much (in dollars) of the loan portfolio will have to be sold
off and held in cash? Describe the practical and economic limitations of solving the rate
exposure problem in this manner.
(c) Suppose that instead of formally restructuring the balance sheet, the bank
considers lengthening the duration of its liabilities synthetically by converting a portion
of its FRN position with a six-year, pay-fixed interest rate swap. If the fixed rate on this swap
is 8 percent, how much of the floater position would have to be swapped?
Solution: (a) The asset and liability durations are as follows:
D, =
1,000
X (0.00) + /GI X (4.17) = 3.34 years
and
D,i,iliv = (8 X (1.00) +
350
X (5.00) = 2.65 years.
These durations, in turn, produce the following duration gap statistic:
D,, = (3.34) - / - ~ ~ X ~(2.65)

o )= 1 0 9 years.
As noted earlier, a positive duration gap value suggests that this financial corporation
is exposed to rising interest rates; it is short funded, meaning that its average liability
will have to be refinanced before its average asset can be reinvested.
(b) Assuming that the level and structure of the liability side of the balance sheet do
not change, the percentage of assets that must be invested in cash (w,,,~) to close the
duration gap is given by:
D, +
= [fiomh)(O.0O) (1 - wmh)(4.17)]- (rn)
850
2.65X = 0.00years,
or w,,, = 46 percent. That is, the cash account must be increased by $260,from $200
to $460. Beyond the obvious expense and logistical difficulties of liquidating a portion
of what is likely to be a privately placed portfolio, this sort of physical transforn~ation
has a more fundamental economic flaw. Specifically, notice that before the restructur-
ing, the firm was generating positive net interest income from its operations. For
instance, assuming that LIBOR = 5.5 percent and that the cash account generates no
income, revenues net of debt service were (800) x (0.10) - [(500) x (0.055) + (350)
x (0.08)] = $24.50. After the shift, however, this same figure would be (540) x (0.10)
- [(500) x (0.055) + (350) x (0.08)] = -$1.50. Even if the cash-equivalent account
is assumed to earn some nominal return, the fact remains that formally restructuring
the balance sheet to solve an interest rate risk-management problem takes this firm
away from its main business (i.e., making and servicing loans) and, consequently, is an
inferior solution.
(c) If the six-year floater is combined with a six-year, pay 8 percent fixed swap, the
result will be a synthetic six-year, 8 percent fxed bond, which would have the same
five-year duration as the actual fixed-rate issue already on the balance sheet. With the
original asset accounts intact, the principal value of the floater position that would have
to be converted to lengthen liability duration by a sufficient amount is determined as
the solution to
850 350 + Psw
D- = (3.34) - (l,OOo)
x [j500850
-Psw)(l.O) + (----)(5.0)]
850 = 0.00 years.
In this instance, p,, = $273, which becomes the notional principal on the swap.
Exercise 3.2: The chief financial offrcer of a large British retail store chain is
considering issuing a five-year "geared reverse floater." The geared reverse floater
would have a coupon-reset formula of 30 percent minus 2.5 times six-month (GBP)
LIBOR, subject to a minimum coupon rate of 0 percent if LIBOR were to exceed 12
percent. The five-year, semiannual payment GBP 100 million floating-rate note can be
issued at par value. The CFO intends to use derivative instruments to convert the
geared reverse floater into synthetic fixed-rate funding. The following quotes for
five-year, semiannual settlement interest rate swaps and caps on six-month GBP
LIBOR are obtained from a market maker in derivative products:
Interest Rate Swaps: The firm can pay a fixed rate of 8.16 percent and receive
LIBOR, or the firm can receive a fixed rate of 8.10 percent and pay LIBOR.
Interest Rate Caps: With a strike rate of 12 percent, the firm buys the cap at 150
basis points and writes the cap at 130 basis points. The premium on the cap is
quoted as a percentage of the notional principal.
Indicate the specific combination of transactions that provides a synthetic fmed-rate
liability. Calculate the all-in cost of funds. Assume that GBP LIBOR, the coupon rate on
the geared reverse floater, the swap fixed rate, and the strike rate on the caps are all
stated on a semiannual bond basis.
Interest Rate and Currency Swaps:A. Tutorial
Solution: The British retailing firm would issue the geared reverse floater, enter two
and one-half swaps (each for GBP 100 million or, more likely, one swap for notional
amount of GBP 250 million) to receive the fixed rate of 8.10 percent, and buy two and
one-half caps at a strike rate of 12 percent (or, just one for GBP 250 million). The caps
on LIBOR assure a fixed rate if LIBOR were to rise above 12 percent. If LIBOR 5 12
percent, the interest expense on the I;RN and the swaps will be (30 percent - 2.5 x
LIBOR) + (2.5 x LIBOR - 2.5 x 8.10 percent) = 9.75 percent. But if LIBOR > 12
percent, the expense without the caps would be (2.5 x LIBOR - 2.5 x 8.10 percent)
> 9.75 percent. The cost of the caps, 375 basis points (2.5 x 150 bps each) raises the
fixed rate cost of funds above 9.75 percent. Paying this premium at the time of
origination would lower the net sale proceeds from the geared reverse floater to 96.25
percent of par.
The semiannual, all-in fixed cost of funds is 10.74 percent, calculated as the solution
to
Note that 9.75 percent is the synthetic fixed coupon rate; the all-in cost exceeds that in
the same manner that the yield on a discount bond always exceeds its coupon rate.
Exercise 3.3: A Spanish pension fund is considering buying a five-year, floating-rate
note named "El Oso Gran.de." El Oso Grande would have a coupon-reset formula of
three times six-month (Spanish peseta) LIBOR minus 24 percent, subject to a
minimum coupon rate of 0 percent if peseta LIBOR were to fall below 8 percent.
Currently, six-month peseta LIBOR is 11.20 percent, so the initial coupon would be
based on a rate of 9.60 percent. The five-year, semiannual payment, 100 million peseta
floating-rate note can be bought at par value. The pension fund intends to use
derivative instruments to convert El Oso Grande into a synthetic fixed-rate asset.
Quotes for five-year, semiannual settlement interest rate swaps, caps, and floors on
six-month Spanish peseta LIBOR, shown below, are obtained from a Madrid commer-
cial bank specializing in derivative products.
Interest Rate Swaps: The pension fund can pay a fixed rate of 13.50 percent and
receive six-month peseta LIBOR, or the fund can receive a fixed rate of 13.35
percent and pay six-month peseta LIBOR.
Interest Rate Caps: With a strike rate of 24 percent, the fund buys the cap at 125
basis points and writes the cap at 90 basis points.
Interest Rate Floors: With a strike rate of 8 percent, the fund buys the floor at 175
basis points and writes the floor at 140 basis points.
(Recall that the premiums on the caps and floors are quoted as a percentage of the
notional principal.) Indicate the specific combination of transactions that provides a
synthetic fixed-rate asset to the pension fund. Calculate the all-in fixed rate of return.
Assume that Spanish peseta LIBOR, the coupon rate on El Oso Grande, the swap fixed
rate, and the strike rate on the caps and floors are all stated on a semiannual bond
basis.
Solution: The Spanish pension fund would buy El Oso Grande, enter three swaps
(each for a notional principal equal to the par value of the FRN or, equivalently, one
swap with three times the notional value) to receive the fixed rate of 13.35 percent and
write three floors at a strike rate of 8 percent (or, again, one with three times the
notional amount).
The role of the floors is to create a fixed-rate asset even when LIBOR is less than
8 percent. Neglecting the floors, if LIBOR 2 8 percent, the return will be (3 x LIBOR
- 24 percent) + (3 x 13.35 percent - 3 x LLBOR). The LIBOR flows net out by
design, and the return is 16.05 percent. If LIBOR < 8 percent, the return will be (3 x
13.35 percent - 3 x LIBOR) > 16.05 percent. Writing the floors in effect sells off the
potential for a higher return if LIBOR is low. The receipt of 420 basis points (3 x 140
basis points for each floor) raises the fixed rate of return above 16.05 percent.
The net cost of the position is only 95.8 percent of par, the cost of the FRN less the
premium received on writing the floors. So the all-in, semiannual fixed rate of return
is 17.34 percent, calculated as
Exercise 3.4: The corporate treasurer of BCD Corporation is considering a financially

engineered, synthetic, fixed-rate funding package based on an innovative "collared floater,"
for which investors seem to have great demand in the marketplace. The collared note
would have a coupon-reset formula of six-month LIBOR + 0.50 percent, subject to a
minimum coupon rate of 7.50 percent and a maximum coupon rate of 12.50 percent. The
five-year, semiannual payment $50 million floating-rate note can be issued at par value.
BCD obtains the following quotes for five-year, semiannual settlement interest rate
swaps, caps, and floors on six-month LIBOR from its commercial bank:
Interest Rate Swaps: BCD Corporation can pay a semiannual fixed rate of 8.75
percent and receive LIBOR. It can receive a semiannual fixed rate of 8.65
percent and pay LIBOR.
Interest Rate Cap Premiums (as a percentage of the notional principal):
BCD Bzcys BCD Writes

Strike Rate the Cap the Cap
12.0% 75 bps 65 bps
12.5 60 50
13.0 45 35
Interest Rate Floor Premiums (as a percentage of the notional principal):
BCD Buys BCD Writes

Strike Rate the Floor the Floor
7.0% 90 bps 80 bps
7.5 105 95
8.0 120 110
Indicate the specific combination of transactions that provides a synthetic fixed-rate

cost of funds. Calculate the all-in cost of funds. Note that the coupon rate on the
collared floater and the strike rates on the caps and floors are on a money-market
(360.day) basis. Describe the credit risk that BCD would bear in the synthetic
fixed-rate package. Be exact in identifying the circumstances when credit risk is a
concern.
Solution: BCD could engineer a synthetic fixed rate cost of funds by

issuing the "collared'floater at a coupon of LIBOR + 0.50 percent, subject to a
maximum rate of 12.50 percent and a minimum of 7.50 percent, at par value,
"buying" a par-value swap to pay a fixed rate of 8.75 percent and to receive LIBOR,
writing a cap on LIBOR at a strike rate of 12 percent for a premium of 65 basis
points, and
buying a floor on LIBOR at a strike rate of 7 percent for a premium of 90 basis points.
The funding cost of the collared floater alone is shown in Figure E-3.1, and the payoff
diagrams for the three separate derivative transactions are illustrated in Figure E-3.2.
The semiannual, synthetic fixed coupon rate resulting from these maneuvers is 9.26
percent [8.75 percent + 0.50 percent x (365/360) 1. To find the all-in synthetic funding
cost, recognize that the notional principals on the swap, cap, and floor equal the par
amount of the collared floater. Thus, the capfloor combination, effectively writing a 7
percent to 12 percent collar, requires a net payment of 25 basis points, so the net
proceeds of the security at origination would be 99.75 percent of par. The yield is then
the solution to the following equation:
or 9.32 percent on a semiannual bond basis.

This structure has two sources of credit risk for BCD: (1) on the swap when the
counterparty is in financial distress and replacement swap fixed rates are higher than 8.75
percent; and (2) on the floor when the counterparty is in financial distress and LIBOR is
less than 7 percent, or in fact, when the market premium on a replacement 7 percent floor
exceeds the unamortized portion of the original 90-basis-point purchase price.
Figure E-3.2 Payoff Diagrams for

Figure E-3.1 Funding Cost of Collared Three Derivative
Inflows
1
Floater
7% 12%
LIBOR
Inflows 1 \":
Transactions
a rnr/
LIBOR at 7.0% Enter Pay-Fixed Swap at 8.75%
/ 12.0% LIBOR
7.0% 8.75%
Outflows
12.50% Outflows I/ \ Write a Cap on
LIBOR at 12.0%
Chapter 4. Pricing Interest Rate and
Currency Swaps
As we have seen, a swap's price is its f ~ e rate.

d of the cash flows implied by the forward rates.
The convention on U.S.-dollar-denominated Currency swaps, in turn, will be priced off the
plain vanilla transactions of quoting this fured forward interest rate curves in each denomina-
rate as a premium over the Treasury yield tion, or the forward exchange rate curve.
merely shifts the pricing problem to one of Swap pricing is not the same as swap valua-
determining the appropriate swap spread. For tion. Pricing is the process of setting the fixed
instance, a swap fixed rate of, say, 6.45 percent rate, usually so that the market value of the swap
on a three-year agreement, or equivalently, a is initially zero (i.e., an at-market swap). There-
swap spread of 45 basis points when the three- after, the value of the swap is found by compar-
year Treasury yields 6 percent, is readily observ- ing that fixed rate to the current fixed rate on a
able in the market. The question is why 6.45 swap having the same terms and remaining time
percent (or 45 basis points) is the proper price in to maturity as the original, a process identified
the first place. earlier as mark-to-marketvaluation. In this chap-
Perhaps the simplest yet most revealing ter, we demonstrate that pricing swaps, includ-
statement about interest rate swap pricing is that ing nonplain vanilla structures having forward
although the swap fixed rate is quoted off the start dates and varying levels of notional princi-
Treasury yield curve, it is priced off a forward pal, is a rather straightforward and mechanical
curve. The forward curve in question would be process once the forward curve is available. As a
the sequence of future yields corresponding to practical matter, these forward rates can be
the floating reference rate on the swap. That is, obtained by direct observation, calculation, and
a LIBOR-against-fixed swap would be priced off estimation.
the LIBOR forward curve and a Treasury bill- Direct Observation: There are active over-
against-fixed swap would be priced off the Trea- the-counter markets in forward rate agree-
sury forward curve. Pricing in this context sug- ments and in foreign exchange, as well as in
gests an averaging process; the swap fixed rate exchange-traded futures contracts on various
will be a "present value" average of the forward interest and FX rates. These forward curves
rates. That is, the swap's price will be estab- produce the most exact swap prices because
lished so that the present value of the fixed cash they indicate directly the levels of the floating
flows on the agreement equals the present value reference rate that can be locked in by hedg-
61
ing transactions for the future settlement the same forward curve. At the bid-offer spread
dates on the swap. level, however, participants diverge in the fixed
Calculation: An implied forward curve can rates they ultimately pay or receive.
be inferred from the cash market yield curve,
the sequence of implicit short-term rates ob-
tained by successively extending the maturity in Pricing Interest Rate Swaps Off
the cash market by one period. For instance, if the FRA Curve
the one-year rate is 5 percent and the two-year In Chapter 2, we showed that FRAs are
rate is 6 percent, the implied forward rate be- merely one-date swaps; alternatively, a plain
tween Year 1 and Year 2 must be about 7 vanilla interest rate swap can be divided into a
percent. Arbitrage transactions will drive rates series of off-market FRAs. This fact can be used
along the implied forward curve to be virtually to aid swap pricing. Suppose that the midpoints
identical to those observed when explicit for- (the average of the bid and offer rates) for a
ward contracts are traded; any difference is sequence of FRAs are 5.75 percent for the 3 x 6
because of transaction costs and. limitations on agreement, 6.00 percent for the 6 x 9, and 6.25
short selling in the cash market. percent for the 9 x 12. The current level of
Estimation: Some swaps need to be priced three-month LIBOR is 5.50 percent. These rates
for tenors for which no corresponding delivery are all quoted on an actua1/360 basis, meaning
dates exist in the futures or cash markets. For that in figuring a cash flow, the annual rate is
example, pricing a 12-year interest rate swap on adjusted by the actual number of days in the
LIBOR will be challenging because futures con- quarter divided by 360. For example, the payoff
tracts on U.S. dollar LIBOR currently extend to on a 3 x 6 FRA transacted on June 15th would
10 years and the Eurodollar time deposit market depend on the level of three-month LIBOR
is mostly short term. Consequently, the forward revealed on September 15th compared with the
cunre for LIBOR, at least in this maturity range, FRA fixed rate of 5.75 percent. If LIBOR on
must be estimated off the forward curve for September 15th is 5.50 percent and there are 91
Treasury securities. An estimated forward curve days between September 15th and December
will naturally produce less-exact swap prices 15th, the buyer of the FRA (the payer of the
because the future levels of the floating refer- fixed rate and receiver of the "commodity"
ence rate cannot be secured by hedging. This LIBOR) owes the counterparty on December
inexactness will be impounded in the bid-offer 15th the rate difference (5.75 percent - 5.50
spread for the swaps; other things being equal, a percent) times 91/360 times the notional princi-
short-term swap priced off an observed forward pal or the present value of that amount if settle-
curve would have a tighter bid-offer spread ment is to be accelerated to September. This
than a long-term swap priced off' an estimated directly observed forward curve based on spot
forward curve. LIBOR and the strip of FRAs is pictured in
Regardless of its source, the average of the Figure 4.1.
relevant segment of the forward. curve repre- Now consider a one-year, quarterly settle-
sents the theoretical swap fixed rate, the mid- ment in arrears interest rate swap on three-
point of the bid-offer spread. The midpoint is month LIBOR. The subsequent rates on the
derived first and then adjustments are made for floating-rate leg of the swap that will determine
other factors such as credit risk, capital reserve the settlement payments are, of course, un-
requirements, back-office operations costs, and known at present. Nevertheless, the presence of
necessary profit levels. All of these factors to- the explicit FRA market means that those un-
gether determine the particular fixed rates that a known rates could be locked in at 5.75 percent,
dealer will be willing to pay or receive. This 6.00 percent, and 6.25 percent, respectively. In
point is a key one because it separates market effect, FRAs could be used to completely hedge
risk from default risk in the pricing process. The the uncertainty on the floating-rate side of the
midpoint swap fixed rate for a particular trans- swap. Therefore, because the swap could be
action would be the same for all market partici- effectively reconstructed with a strip of FRAs,
pants because they all can observe or estimate the swap .fixed rate must be tied to that series of
Chapter 4. Pricing Interest Rate and Currency Swaps
-
Figure 4.1 A Directly Obsewed tional principal. The sum of the last four terms is
Forward Curve Based on the present value of the fixed side of the swap,
Spot LIBOR and the where the fraction of the year represented by
Sequence of FRAs each period is 90/360 (or 1/4).
Notice that the discount rates correspond to
the timing of the cash flows. For instance, 2, is
the rate for discounting the cash flows on both
the floating and fixed sides in 6 months and z,,
is the rate for discounting the cash flows in 12
months. These discount rates, too, can be de-
rived from the forward curve. The first discount
rate, z3, is based on current three-month LIBOR,
0 3 6 9 12 15 5.50 percent. The second discount rate, z,, can
be calculated from z3 and the next point on the
Months forward curve, the 3 x 6 fixed rate of 5.75
percent. The third discount rate, z,, can be
shorter term rates to eliminate the possibility of calculated from % and the following point on the
arbitrage. forward curve, the 6 x 9 fixed rate of 6.00
Suppose that the trade date on this one-year percent. This process is known as bootstrapping,
swap is June 15th and that its day-count basis whereby rates are obtained in sequence and at
will be 30/360. Assume that there are 92 days each point the previous calculations are used.
between June 15th and September 15th, 91 days Taking account of the actual number of days
between September 15th and December 15th, in each period, the discount factors obtained
90 days between December 15th and March from bootstrapping would be the following:
15th, and 92 days between March 15th and June
15th. The swap fixed rate (SFR) will be the
solution to the following equation:
5.50% x (921360) x NP
and
SFR x (114) x NP SFR x (114) x NP

-
I + 23 +---
1 + 2(j
Obtaining the discount rates in this manner is
+ SFR x1(114)
+x9
x NP SFR x (114) x NP
+ 1+ 212
not substantively different from any other
method for doing time value of money analysis.
The four terms to the left of the equal sign are What we have done is calculate the sequence of
the present value of the floating side of the swap, zero-coupon rates that corresponds to the ob-
using the cash flows derived from the forward served forward cume-the zero-coupon interest
curve. This amount is calculated as the dis- rates for 3, 6, 9, and 12 months that could be
counted value of the rate times the fraction of secured by the series of shorter terrn forward
the year on an actua1/360 basis times the no- contracts.
The final step in the pricing process is to transaction costs (thereby reducing the bid-
solve for SFR. On a plain vanilla swap, the offer spreads to zero), an arbitrage opportunity
notional principal is constant for all settlement would be present if the swap fixed rate were
dates, so the NP term conveniently drops out other than 5.95 percent. Suppose, for example,
and the equation reduces to: the swap rate is 6.05 percent. Then, the arbitra-
geur would "sell" the swap and "buy" spot
LIBOR and the FRA strip. The former commits
the trader to receive a fixed rate of 6.05 percent
and pay out LIBOR on each settlement date; the
latter commits him or her to receive LIBOR and
pay out successively 5.50 percent, 5.75 percent,
6.00 percent, and 6.25 percent. The exposure to
LIBOR is eliminated and the arbitrage gain is
the difference in present value of cash flows
based on a constant rate of 6.05 percent and the
series of 5.50 percent, 5.75 percent, 6.00 percent,
and 6.25 percent. This series, however, has the
Solving the equation reveals that SFR is 5.9516 same present value as a constant rate of 5.95
percent, which when rounded to the nearest percent. Consequently, the only assumption re-
basis point becomes 5.95 percent. A market
ally needed in the swap pricing process is the
maker in this one-year swap would then set the
presence of traders in the marketplace able to
bid-offer rates around this midpoint. For exam-
exploit mispricing across financial instruments.
ple, the market maker might be willing to pay a
fixed rate of 5.93 percent and receive a fixed rate This present value average is as precise a
of 5.97 percent in exchange for LIBOR. Al- swap price as possible, given the available data.
though a short-term swap such as this one is Worth noting, however, is that a more easily
usually quoted using the fixed rate itself, the calculated approximation for that price typically
quoted price could be converted to a swap is quite accurate. It comes from calculating the
spread. If the one-year Treasury note yield, internal rate of return (IRR) on a par value,
converted to conform to the quarterly basis of step-up coupon bond paying cash flows equal to
the swap rate, were 5.60 percent, the bid swap the forward rates. In this example, the internal
spread would be 33 basis points and the offered rate of return turns out to be 5.9517 percent, the
premium 37 basis points. solution to the following expression:
A significant aspect of this derivation is that it
has avoided the word "expectations." Indeed, (5.50 X 92/360) (5.75 X 91/360)
the midpoint fixed rate of 5.95 percent was 100 =
1 + IRR
+ (1 + I R Q 2
calculated without assuming any particular path
for future levels of LIBOR, let alone the path
along the forward curve. To be precise, we do
not necessarily assume that three-month LIBOR
will be 5.75 percent in three months, 6 percent in
six months, and 6.25 percent in nine months (or Although precise calculations obviously are
any other pattern, for that matter). Rather, this needed when actually transacting in the swap
method of swap pricing is independent of any market, a decent approximation can be quite
theory of the yield curve, in particular, the pure useful when one merely wants to get a sense of
expectations hypothesis that contends that for- the rates at which swaps are (or should be)
ward rates represent unbiased consensus fore- trading. The IRR approximation can be easily
casts of future cash market rates. obtained using a financial calculator; the present
This averaging method of calculating the value average, in contrast, would typically re-
fmed rate on the swap rests only on the assump- quire a computer spreadsheet, especially for
tion of arbitrage-free markets. Neglecting all longer maturity swaps.
64
Pricing Interest Rate Swaps Off the Treasury bond and Eurodollar futures con-
the Eurodollar Futures Curve tracts. The former has a high ratio, suggesting
that it is a more speculative trading contract with
Having just demonstrated that plain vanilla
interest rate swap prices are easily determined participants turning over their positions fre-
given a sequence of rates on FRAs, we now quently. The Eurodollar futures contract has a
consider how those FRA rates themselves are much lower ratio, suggesting that it is more a
derived. Another way an FRA can be interpreted hedging contract whereby participants tend to
is as a customized, over-the-counter Eurodollar be more inclined than T-bond futures investors
futures contract. Despite some logistical differ- to hold their positions until the delivery date
ences between the two, FRAs and Eurodollar nears. The Eurodollar contract is, in fact, com-
futures are functionally equivalent in terms of monly used by FRA and swaps market makers
managing interest rate risk, and so their rates to hedge their books. The success of the con-
must be very close. In fact, in practice, FRAs are tract, as measured by its open interest and
priced off of Eurodollar futures rates. number of delivery dates, parallels the growth of
the over-the-counter swaps market.
The Eurodollar Futures Contract. Be- To see how these instruments can be used as
fore pursuing the relationships between FRAs, hedges, consider the March 1995 contract hav-
futures, and interest rate swaps, some institu- ing a yield of 6.49 percent. This entry means that
tional aspects of the Eurodollar contract traded on October 31st, a borrower or lender was able
at the International Monetary Market (IMM) to lock in a rate of about 6.49 percent for
located at the Chicago Mercantile Exchange three-month LIBOR as of the following March.
(CME) may be worth reviewing. This contract We must be cautious here because daily settle-
has become enormously successful since it was ment cash flows into and out of the margin
launched in the early 1980s. Delivery dates account will take place, generating either gains
follow the March, June, September, December that can be invested or losses that need to be
cycle (the "IMM dates") and now extend ten funded. Therefore, the performance of the
years into the future. The final trading and hedge can vary depending on the particular path
settlement date is the second London business interest rates take up to the delivery date in
day before the third Wednesday of the delivery March. This point-that the payoffs on a futures
month. The contract size is $1 million, and it contract are path dependent-is best illustrated
allows for cash settlement only. The underlying with a numerical example, summarized in
interest rate is three-month (90-day) LIBOR, and Table 4.2.
it is quoted on a 360-day bank add-on basis. Like Suppose a firm owes $10 million on a bank
any futures contract, the Eurodollar rate con- loan that has its interest rate tied to three-month
tract requires participants to post a collateral LIBOR paid in arrears. That interest rate will be
account (i.e., margin), which is then marked to determined on the same date as the delivery
market on a daily basis. date of the March futures contract. The first row
Trading results for the Eurodollar contract in the table shows the June interest payment for
for Monday, October 31, 1994, are displayed in four possible levels of LIBOR in March. The
Table 4.1. The total open i~terest,which is the example is simplified by assuming a 90-day time
number of outstanding contracts, is enormous. period so the interest payments are just one-
Those data are reported with a day lag, so on the quarter of the rate times $10 million. If LIBOR is
previous Friday, total open interest for all 39 8 percent in March, the interest payment in June
delivery dates out to September of 2004 ex- would be $200,000. Concerned with the possibil-
ceeded 2.5 million contracts. Although the trad- ity of rising LIBOR, the firm elects to hedge that
ing volume on the Treasury bond futures con- risk by selling ten March Eurodollar futures
tract at the Chicago Board of Trade rivals the contracts. This short position will gain as futures
Eurodollar contract at the CME, its open inter- rates rise and futures prices fall.
est is much less, averaging about one-half mil- Notice that the futures prices quoted in
lion contracts. In fact, the ratio of trading volume Table 4.1 (i.e., the opening price for the day, the
to open interest signals a key difference between high, the low, and the closing price that is used
Table 4.1 Eurodollar Futures Trading Results for October 31, 1994
Yield
Month Open High Low Settle Change Settle Change Open Interest
December
March 1995
June
September
December
March 1996
June
September
December
March 1997
June
September
December
March 1998
June
September
December
March 1999
June
September
December
March 2000
June
September
December
March 2001
June
September
December
March 2002
June
September
December
March 2003
June
September
December
March 2004
June
September
Note: Estimated volume, 240,341; volume Friday, 656,910; open interest, 2,584,249, +39,653.
Source: Wall Street Journal, November 1, 1994.
Table 4.2 Hedging a Bank Loan with EurodoIar Futures

Hypothetical Levels for LIBOR in March
Interest on a $10 million bank loan at LIBOR, set in

March, paid in June (shown as a negative flow)
Cumulative payoff on ten short Eurodollar futures
contracts sold at 93.51 ($25/bps per contract) -$ 37,250 -$ 12,250 $; 12,750 $ 37,750
All-in cost of funds $162,250 $162,250 $162,250 $162,250
for daily settlement) are merely 100 minus the The firm's all-in cost of funds will probably
yield. This price index has no meaningful inter- not turn out to be exactly 6.49 percent for two
pretation in terms of money; its purpose is reasons. First, the cumulative gain or loss on the
simply to preserve the dictum in financial mar- futures in the table neglects the time value of
kets that the long position gains when prices money. Suppose that the daily settlement pay-
rise and the short gains when prices fall. Even ments or receipts can be funded or invested at,
though the contract is cash settled, it is as if the say, 6.25 percent. If LIBOR ended up at 8
buyer commits to purchase (and the seller com- percent, the 151 cumulative basis points cred-
mits to deliver) a three-month, $1 million Euro- ited would correspond to total gains in excess of
dollar time deposit having a coupon rate equal to $37,750, especially because those gains can re-
the futures rate. The buyer, therefore, gains if main invested until June when the bank loan
rates fall, because the contract represents an payment is made. At the end of the period, the
agreement to lend at an above-market rate. The all-in cost of funds would be less than 6.49
seller gains if rates rise, because then the con- percent. If LIBOR ended up at 5 percent, fund-
tract provides for borrowing at what is a below- ing the 149 cumulative basis points lost would
market cost of funds. correspond to total losses in excess of $37,250.
Daily settlement adjustments in the Eurodol- The result is an all-in cost of funds that exceeds
lar futures market are figured as $25 per basis 6.49 percent. Notice that the firm is overhedged
point per contract, where $25 is the basis point whether rates rise or fall. Both gains and losses
value of one contract (calculated as ($1,000,000 are too high to attain a cost of funds of 6.49
x (90/360) x 0.01 percent). The exact number percent. This overhedging problem can be rem-
of contracts needed to hedge a particular risk edied by an adjustment known as tailing the
exposure is determined by dividing the basis hedge, which is described in the next chapter.
point value for the entire position by $25. Re-
turning to the example in Table 4.2, we can now The Relationship Between Futures,
calculate the cumulative gain or loss over the FRA, and Swap Prices. With this back-
hedging interval. These results are shown in the ground, the connection between FRAs and Eu-
second row of the table. If LIBOR is 8 percent, rodollar futures is immediate. The FRA offer
the futures price index would be 92.00. Because rate will be a markup over, and the FRA bid rate
the firm went short at 93.51 (e.g., 100 - 6.49), a markdown from, the futures rate correspond-
the cumulative gain is 151 basis points. So, 151 ing to the contracts used to hedge the position.
basis points times $25 per basis point times ten This relationship is easy to see for FRAs that
contracts generates a cumulative gain of coincide with the IMM delivery dates. For ex-
$37,750. For each assumed level of LIBOR in ample, suppose the March 1995futures rate is still
March, the net interest cost, combining the 6.49 percent on December 13,1994,which is three
proceeds on the futures contracts with the loan months prior to the delivery date. If a 4basis-point
payment, is $162,250. That amount corresponds spread is needed to cover the market maker's
to an annualized interest rate of 6.49 percent costs, 3 x 6 FRAs would likely be priced at 6.51
($162,250 divided by $10 million times the four percent offered and 6.47 percent bid. If the market
90-day periods in the 360-day year). maker sold the FRA at its offered rate, it would
hedge its position by going short March futures. hedge for the FRA across the Eurodollar futures
The exact number of contracts would depend on contracts. Notice this hedge is riskier than one
the basis point value of the FRA and would be based on the IMM date because it implicitly
"tailed" to avoid overhedging. If the market maker assumes parallel shifts in the forward curve. The
bought the F'RA at its bid rate, it would hedge its market maker would like to price the FRA at a
position by going long March futures. These hedg- wider spread to compensate for the risk, but in
ing decisions might at first seem to be reversed, practice, the FRA market is quite competitive
given that ordinarily one thinks of selling futures and the sizes of the bid-offer spreads tend not to
to hedge a long cash position and vice versa. Any change as IMM dates near.
confusion is semantic, however; payoffs in futures Another practical problem is to price FRAs
are expressed by prices, but they are expressed in based on six-month LIBOR off the Eurodollar
rates for FRAs (and swaps), and those metrics are futures strip. With no futures contract on six-
inversely related. month LIBOR, a 6 x 12 FRA would be derived
Pricing FRAs on non-IMM dates requires from rates on the 6 x 9 and 9 x 12 agreements.
some further calculation. Suppose we need to Those two would be obtained as above, typically
price a 3 x 6 FRA on October 31st. The payoff interpolating along the futures rates for three-
on that FRA would depend on three-month month LIBOR. Suppose that the midpoints for
LIBOR on the valuation date, January 31, 1995. the 6 x 9 and 9 x 12 FRAs are 6.86 percent and
The problem is that the available futures allow 7.20 percent, respectively. Also, those quarterly
for delivery either in December, at 5.95 percent, periods span 90 and 91 days, respectively, for a
or in March, at 6.49 percent. In such a case, total of 181 days. The six-month rate for the 6 x
market makers will take a weighted average of 12 FRA would then be the solution for F&,,,
those two futures rates using the extent of in the following equation:
overlap with the FRA time frame as the weights.
This situation is illustrated in Figure 4.2. The
averaged futures rates will be 6.24 percent; that is,
So, the 3 x 6 offered FRA rate might be 6.26 Here FW,,, equals 7.09 percent, so the of-
percent while the bid rate is 6.22 percent. These fered rate on the 6 x 12 agreement might be
weights also indicate the distribution of the 7.11 percent with a bid rate of 7.07 percent.
Figure 4.2 Pricing a 3 x 6 FRA on a Non-IMM Date

December Futures March Futures FRA Settlement Date
FRA Trade Date Delivery Date FRA Value Date Delivery Date (In Arrears)
October 31,1984 December 19,1994 January 31,1955 March 13,1995 April 30, 1995
4
3 x 6 FRA
*
f-- >
December Eurodollar Futures
-
4 >
March Eurodollar Futures
41 Days
Overlap:
f-----------)
48 Days
As the discussion in both this and the pre- from accrued interest, are presumed to be on a
ceding section illustrates, FRAs can be viewed coupon payment date. The implied zero curve is
as an intermediate stage between rates on ex- the series of zero-coupon Treasury rates consis-
change-traded futures and fixed rates on interest tent with the observed yield curve on coupon-
rate swaps. Even in pricing swaps directly off the bearing securities in the sense of permitting no
futures curve for LIBOR, the process is the arbitrage opportunities. Mathematically, the im-
same; that is, the futures rates can be strung plied zero curve is the solutions for z,, %, and z,
together to derive a sequence of zero-coupon (the subscript here indicates years, above it was
discount factors, which are used to solve for the months) in the following equations:
present value average of the relevant segment of
the Eurodollar futures curve. This, in turn, per-
mits calculation of a midpoint swap fixed rate off
the observed futures curve as easily as we can
derive it from the observed forward curve in the
FRA market. In short, swap prices are linked to
forward rates, and whether this curve is found in and
exchange-traded or over-the-counter markets
does not affect the calculation of the proper
theoretical level.
Pricing Interest Rate Swaps Off

the Implied Forward Curve Although the par curve is 8 percent, 10 percent,
Suppose that we need to price an interest rate and 12 percent, the implied zero curve (some-
swap in a market having no directly observed times called the term structure of interest rates
futures or forward curve but ample trading in or the spot yield curve) lies above the par curve at
the underlying cash market for coupon-bearing 8 percent, 10.1020 percent, and 12.3437 percent.
securities of various maturities. The methods The solution method is another example of
described above for pricing a swap contract can bootstrapping. The first point on the implied
still be used after deriving an implied forward zero curve, z,, is obtained from the first equa-
curve. Essentially, such a curve represents tion. That term is plugged into the second
where explicit forward (or futures) rates would equation to get 2,; 2, and z, are plugged into the
have to be if such markets did exist. In this third equation to get 2,; and so forth out the
process, we first must calculate an implied zero yield curve.
curve based on an assumption that bond market With these values, we can now calculate the
arbitrage activities are not profitable. The im- implied forward curve, which is the sequence of
plied zero curve is then used to generate the short-term rates indicating the marginal return
forward curve that also will be consistent with for extending the maturity for an additional
the absence of arbitrage. period. Note that calculating the implied zero
A straightforward numerical example illus- curve is a necessary step in the procedure. No
trates these techniques. (In practice, these general formula exists for calculating implied
methods must address more complex institu- forwards directly from yields on coupon-bearing
tional detail but still follow the same pattern and bonds.1 The implied forward rate between Year
are easily adapted to computer-based solutions.)
Suppose that the task is to price a three-year
swap with annual settlements in arrears based
on the one-year Treasury rate. One-, two-, and General formulas to calculate implied forward rates
depend on how the spot rates are quoted. If they are on a
three-year cash market Treasuries yield 8 per- bond basis, meaning the rates are all annualized assuming
cent, 10 percent, and 12 percent, respectively. the same number of periods in the year (e.g., U.S. Trea-
Each trades at par value so the coupon rates suries are commonly quoted on a semiannual bond basis so
equal the yields and, to avoid complications that the quoted yield will be the yield per six-month period
1 and Year 2 (denoted IFRlx& will be the Figure 4.3 Implied Zero Curve and
solution to the expression Implied Forward Curve
So, IFR,,, equals 12.245 percent. Similarly, the

Implied Forward Curve
implied forward rate between Year 2 and Year 3 12.3437%
(denoted IFR,,,) can be established by solving 8.0000% 10.1020%
Implied Zero Curve

or IFR,,, equals 16.965 percent. The implied
forward curve will consist of the current one-
year rate, 8 percent (for the 0 x 1 period); the
one-year rate, one year forward of 12.245 per- Years
cent (for the 1 x 2 period); and the one-year

rate, two years forward of 16.965 percent (for the the swap dealer's bid-offer spread. Solving for
2 x 3 period). Both the implied zero and forward SFR, the swap fixed rate, in the following formu-
curves are plotted in Figure 4.3. Notice that the lation:
time reference on the horizontal axis differs for
the curves: The implied zeros are yields to
maturity with each point represenling a different
time to maturity; the implied forwards are all
one-year yields.
Assuming that these implied forwards indi-
cate the rates at which explicit forward contracts
SFR
yields a value of 12 percent. Notice that, as

I
would be trading if they existed, this curve can before, the notional principal, NP, is the same
now be used to price the three-year interest rate for each date and will therefore cancel out from
swap. We have the forward curve and the zero- each side of the equation. Thus, the three-year
coupon discount rates; we need only calculate swap in this example would have its bid-offer
the present value average to set the mid-point of spread based on a midpoint of 12 percent. A
different way of visualizing this averaging pro-
cess is shown in Figure 4.4. The swap fixed rate
times two periods in the year), the following formula can be should be selected so that the present value of
used: the settlement payments that the pay-fixed and
receive-fixed counterparties will make to one
another will be equal, if future LIBOR was
where Z,, is the spot yield for A years to maturity, Z,,
locked in by hedging transactions. Swap pricing
the spot yield for B years, and IFZAxBthe implied forward does not require that the counterparties actually
rate between years A and B. Each yield is annualized for hedge the floating side of the agreement, only
"n" periods a year. If the rates are quoted on a money that they could and would do so if it captured an
market basis (e.g., LIBOR), the formula above is not arbitrage opportunity. These discounted settle-
applicable because rates with different maturities are an- ment payments are represented by the shaded
nualized for a different number of periods in the year. No n
corresponds to all rates. In this case, the following formula squares in the figure.
can be used: Recognize that the same midpoint swap fixed
rate would be obtained whether the forward
curve comes from observed futures rates or is
implied by the underlying spot yield curve. The
size of the bid-offer spreads would differ, how-
ever. A futures rate can be secured more pre-
where & , is the money market rate for A days to cisely and easily than locking in an implied
maturity, &
, the rate for B days, and IFRAxBthe implied forward rate, which requires offsetting short and
forward rate between days A and B. long positions in the cash market. Of course,
ngure 4.4 Pricinga Plain Vanilla

Interest Rate Swap
20 L- Implied Forward
- 313 X SFR 4- 20 X SFR 10 X SFR
I'V h>t ]'a?-Fiwd (1.08)' (1.10102)~ (1.123437)''
+
Srtt t m i e n l ~
which generates a value for SF'R equal to 10.60
Ih -
I,\' ut I<vc~-i
r.c--T:iur~l
percent The iixed rate on the amortizing swap
St~ti1rmm:- is lower than the plain vanilla structure (i.e., 12
percent) because more weight is placed on the
early part of the forward curve. Given that the
forward curve is upward sloping, the weighted
average is reduced compared with the plain
vanilla swap, which places equal weight on each
cash flow, The same process applies to other
types of varying notional principal swaps such as
accreting swaps, on which the notional amounts
increase over time, and roller-coaster swaps,
I) I -7 I J which have notional amounts that rise and fall
Years over the swap's lifetime so as to follow the
estimated outstanding amount of principal on a
these additional transactions represent a more revolving-credit agreement.
expensive endeavor, and that higher cost would A forward swap, which was introduced in
be built into the bid-offer spread. Chapter 3, is also easily priced once we have the
forward curve and the set of discount rates.
Pricing Nonplain Vanilla Interest Suppose that we need to price a 1 x 3 forward
Rate Swaps swap, meaning a two-year swap that is deferred
So far, we have only priced interest rate for one year. The fixed rate and all other terms
swaps having a constant notional principal over to the agreement (e.g., the settlement dates, the
the lifetime of the agreement and an immediate reference rate, the governing law) are set in
start date. Varying the notional principal and advance, but the transaction does not begin at
postponing the start date create innovative, non- once. The fixed rate on the forward swap will
plain vanilla structures. In any case, these can be merely be the present value average of the
priced using the same present-valueaverage relevant segment of the forward curve, as por-
methodology just used for plain vanilla swaps. trayed in Figure 4.5. The bid-offer spread will
To extend the earlier example, suppose the spot surround the midpoint SFR value of 14.42 per-
yield curve for zerocoupon transactions and the cent, calculated as the solution to
forward curve are the same as displayed in
Figure 4.3. The yields on one, two-, and three-
year zerocoupon securities are 8 percent,
10.1020 percent, and 12.3437 percent, and the SFR SFR
forward rates are 8 percent, 12.245 percent, and -
(1.10102)' (1.123437)3'
16.965 percent.
+
Assume now that we need to price a three- As noted earlier, when the forward curve is
year amortizing swap for which the notional upward sloping, deferred-start swaps will have
principal will be $30 million for the first year, $20 higher fixed rates than plain vanilla structures,
million for the second year, and $10 million for which would commence immediately. Recog-
the third. To solve for the swap fixed rate in this nize that the same methodology can be used to
case, we need only adjust the relative weights price combinations of varying notional principals
for each settlement date in the basic pricing and forward start dates. As we have stressed,
formula. the forward curve is the key to pricing interest
Figure 4.5 Pricing a Forward Inierest Rate Swap
rate swaps, even on such a complex structure as The LIBOR forward curve can be estimated
a roller-coaster swap with a delayed starting from the Treasury forward curve, which itself
date. can be derived using any of the techniques
described above. The difference between a for-
ward rate on LIBOR and a Treasury bill is
Pricing Interest Rate Swaps Off known as the TED spread. (Formally, the TED
the Treasury Curve spread is the difference between the price index
Many financial markets have no interest rate on the Treasury bill futures contract and the
futures contract from which to observe the price index on the Eurodollar contract deliver-
forward curve directly. Moreover, many mar- able on the same date.) Once the Treasury
kets have no underlying yield curve from which forward curve has been established, the LIBOR
to calculate the implied forward rates. This forward curve is obtained by estimating and
deficiency has been as much a problem in the adding the average TED spread for the future
U.S. dollar market in the past as it is in emerging time periods. To be precise, the present values
markets in the present. Only in the past few of the cash flows based on the T-bill forward
years has the Eurodollar futures contract ex- rates plus the TED spread would equal the
tended out beyond three years of delivery dates. present value of the cash flows based on the
Furthermore, no ready series of IDOR-equiva- LIBOR forward curve. This process is illustrated
lent, long-term, coupon-bearing cash market se- in Figure 4.6.
curities is available for computing the implied Figure 4.7 summarizes the pricing of interest
zero and forward curves, even in U.S. dollars. rate swaps off the forward curve for the floating
The Treasury market is the best source of data reference rate, assumed here to be LIBOR Two
for yield curve analysis because of its size, pricing "zones" are shown: one in which the
depth, and liquidity. forward curve is directly observed in the futures
Chafiter 4. Prician Interest Rate and C u m c y Swaps
Figure 4.6 Estimating the LIBOR Forward Curve Off of the Treasury Curve
LIBOR Forward Curve
TED Spread
Implied Forward T-Bill Curve
Implied Zero Treasury Curve
Observed Coupon-Bearing
Treasury Yield Curve
Tie
market and one in which it must be estimated ticing Currency Swaps

from yields on government debt. The direct The salient difference between an interest
observation method produces more exact swap rate swap and a currency swap, besides the
prices and narrower bid-offer spreads than obvious fact that the latter involves an exchange
does Treasury-based estimation of the LIBOR across currencies, is that principal as well as
forward curve. In the U.S. dollar market, the coupon interest is exchanged in a typical cur-
segmentation line has moved to the right over rency swap. Ironically, this principal exchange
the years, meaning that more swaps with longer will make it easier to price a plain vanilla cur-
tenors are being priced off of the Eurodollar rency swap than a currency a~lnuityswap, for
futures strip. A market for long-dated swaps will which no such exchange takes place at maturity.
still exist, however, for which the forward curve The intuition behind this observation is that the
must be estimated, typically by forecasting fu- plain vanilla currency swap with its re-exchange
ture levels of the TED spread. Those forecasts of principal at maturity looks very much like a
largely determine the swap spread over the package of bonds, as suggested in Chapter 2 by
Treasury yield curve. Whatever its source, the capital market interpretation of the swap.
though, the forward curve determines the rnid- The annuity, or coupon-only, swap has no com-
point of the bid-offer spread. Other factors such parable capital market analog, making its pric-
as the precision of the forward curve and default ing more difficult.
risk determine the width of the spread.
Plain Vanilla Currency Swap Pricing.
Figure 4.7 Directly Observed Versus Assume that two firms, Companies ABC and
Estimated Forward Curves XYZ, are equal in credit rating and access to
international capital markets. Suppose further
that these firms can both issue three-year, float-
ing-rate notes at one-year deutschemark LIBOR
flat or at one-year dollar LIBOR flat for principal
amounts of DEM 150 million or USD 100 mil-
lion. The spot market FX rate is assumed to be
DEM 1.50/USI). Currently, one-year deutsche-
mark LIBOR and dollar LIBOR are assumed to
be 9 percent and 4 percent, respectively. ABC
and XYZ can also issue par-value, annual-pay-
rnent, fixed-rate debt at the following yields (and
coupon rates), stated on a 365day basis:
Ma ta rity Yield in DEM Yield in USD and in USD:

One year 9% 4%
T~7oyears 8 5
Three years 6
So, the deutschemark yield curve on coupon-
bearing securities is downward sloping and the
dollar curve is upward sloping.
(1.04)' +
SFR
(1.050252) + sFR 1
(1.060829)"
From these equations, the three-year swap fixed
The implied zero-yield curves, calculated
by the process described earlier, are as follows: rate in deutschemarks would be 7 percent (ver-
sus DEM LIBOR flat), and the dollar swap fixed
Maturity Yield in DEM Yield in USD rate would be 6 percent in exchange for dollar
One year 9.0000% 4.0000% LIBOR flat. These results are not at all surpris-
Two years 7.9604 5.0252 ing given the assumption that Companies ABC
Three years 6.9069 6.0829 and XYZ could issue three-year debt at LIBOR
flat in either currency or at 7 percent fixed in
The implied forward curves in each currency deutschemarks or 6 percent fixed in dollars.
can then be calculated using these implied zero- These swap calculations merely demonstrate
coupon rates: that we can enter the pricing cycle at various
points: the coupon curve, the zero curve, or the
In DEM: forward curve. From any starting point, we can
derive the others using the assumption that
(1.09) X (1 + IFRIx2)
these markets are free from arbitrage.
= (1.079604)~,or IFRlX2= 6.9307% Chapter 1 listed four plain vanilla currency
swap structures: floating/floating, floating/
(1.079604)2X (1 + IFR2x3) fixed, fixed/floating, and fixed/fixed. For these
DEM/USD currency swaps, the no-arbitrage
= (1.069069)', or IFR2:,3= 4.8306%' swap prices for three-year transactions between
counterparties ABC and XYZ would have to be
and in USD: DEM LIBOR/USD LIBOR, DEM LIBOR/6 per-
cent USD, 7 percent DEM/USD LIBOR, and 7
percent DEM/6 percent USD. The standard for
quotation is most likely to be the third of these,
the nondollar fixed rate versus dollar LIBOR.
The others all can be obtained from plain vanilla
interest rate swap quotes in each currency.
Notice again that we are focusing on the mid-
Because we have the forward curve and the point of the bid-offer spread; other consider-
zero-coupon discount rates, the theoretical ations such as default risk enter when determin-
interest rate swap fixed rates are easy to ing the spread around this value.
calculate. For three-year plain vanilla swaps, Currency Annuity Swap Pricing. The
the fixed rates are derived from the following plain vanilla currency swap just considered as-
equations: sumes an exchange of principal at origination
and re-exchange at maturity. Will the swap
In DEM: prices change if the re-exchange is dropped?
The answer is yes, as long as the yield curves in
the two currencies differ in level or shape. The
reason is that the principal exchanges at origi-
nation and maturity are typically based on the
(1.09) +
SFR
+ 1
(1.07904)~ (1.069069)~ '
same FX rate: the original spot rate. When the
yield curves differ, however, this rate will very
likely be an off-market forward rate at the time be exchanged for DEM 150 million on the Date
of maturity. To see this, first calculate the EX 3 settlement in addition to the final coupon
forward rates that would be consistent with exchange. That implicit off-market forward FX
interest rate parity. rate of DEM 1.5/USD matches the current spot
One-year FX Forward: market but not the interest rate parity result of
DEM 1.5352/USD for a forward FX transaction.
DEM 1.5/USD x jm)1.09 = DEM 1.5721/USD
Clearly, the plain vanilla structure benefits XYZ
as the payer of deutschemarks and the receiver
of dollars on the re-exchange of principal. Com-
Two-year FX Forward: pany ABC, the counterparty who is paying dol-
lars, should be getting the parity rate of DEM
DEM 1.5/USD x
= DEM
i'"79604,21.5850/USD
153.52 million for the payment of USD 100
million, but it gets only DEM 150 million. ABC
benefits on the first two coupon exchanges in an
Three-year FX Forward: amount just sufficient to offset the loss on the
final settlement. That is the nature of swap
pricing-the present values of the positions
should be equivalent.
Now, suppose that the cross-currencydeutsche-
= DEM 1.5352/USD. mark-for-dollar LIBOR swap is structured on an
In this example, the dollar is at a forward annuity basis without the principal trade at
premium to the deutschemark because the dol- maturity. Company ABC will now have to com-
lar interest rates are lower than in deutsche- pensate XYZ for the absence of the favorable
marks. Date 3 transaction. To determine the amount of
Suppose Companies ABC and XYZ enter a the payment, assume that the receipt of DEM
cross-currency basis swap, trading deutsche- 150 million by ABC at maturity on the plain
mark LIBOR for dollar LIBOR for three years. vanilla cross-currency basis swap can be sold
This transaction is shown in Figure 4.8, which forward at the three-year rate of DEM 1.5352/
casts ABC as the payer of dollar LIBOR and XYZ USD. That transaction translates to a Date 3
as the payer of deutschemark LIBOR. In the receipt of USD 97.707139 million @EM 150
plain vanilla structure, USD 100 million would million + DEM 1.5352/USD). The net dollar
outflow for the re-exchange of principal on
Figure 4.8 A Plain Vanilla Cross- Date 3, therefore, is a payment of USD
Currency FloatinglFloating 2.292861 million from ABC to XYZ. The
Swap present value of that amount is USD 1.920621
million, using the implied three-year dollar
zero-coupon rate of 6.0829 percent as the
1 + DEM LIBOR discount factor.
Figure 4.9 summarizes the resultant cash
flows on the cross-currency annuity swap. ABC
I I LP; DEM LLROR 1 ]
Figure 4.9 A Cross-Currency Annuity
Swap
nE\l 13' Million

ttinics LTSD 100 Million)
Ci
U
J1: I
ARC'+I'd y~nt-trl\ LSD LIIZOR
Y1.7'1 Itl*+r~pf~ L5L) I,IROK
L'5lJ 100 \lillion)
(t~ti?tec
would have to pay XYZ 1.920621 percent of the arbitrage-free pricing and the bid- offer spread
USD notional principal up front. Instead, if around that midpoint that contains the other
spread out over the three years and paid as a relevant pricing variables (e.g., default risk, li-
margin over dollar LIBOR on the swap, the quidity risk, hedging costs, operations costs,
amortized amount would be 71 basis points. and profit). The assumption that prices will
This amount can be obtained as the margin that move to eliminate arbitrage opportunities is
when discounted by the dollar zero-coupon in- central to modern financial analysis. This as-
terest rates, equals the up-front payment; that is, sumption, however, does not mean that arbi-
Margin Margin trage opportunities will never exist. Quite to the
1.920621 = --
1.04
+ (1.050252) contrary, those opportunities will sometimes
exist but will be exploited until the risk-return
Margin trade-off is back to normal. We used arbitrage-
+ (1.060829) '
or Margin = 0.70982%. free pricing in several key analytic techniques,
including the implied zero curve, implied for-
In conclusion, the plain vanilla basis swap ward rates, implied FX forward rates, and in
would be an exchange of deutschemark LIBOR establishing the link between the FRA and Eu-
for dollar LIBOR, which follows directly from rodollar futures markets. The power of no-arbi-
the capital market interpretation of the swap. trage pricing results is that little need be as-
Barring default, the cash flows on a combination sumed about the behavior and information of
of buying one FRN and issuing the other will be market participants.
the same as the currency basis swap. This result The second theme that was stressed is the
is particularly evident in the exchange of princi- importance of the forward curve in swap pricing.
pals that the capital market transactions, as well Plain vanilla swaps, as well as some basic mod-
as the plain vanilla currency swap, would entail. ifications such as those having varying notional
The annuity swap, however, would require a principal or a deferred start date, can be priced
margin over dollar LIBOR in exchange for deut- by calculating the present value average of the
schemark LIBOR. The same result would hold relevant segment of the forward curve. The
for the other varieties of currency swaps. For problem ultimately is to establish the forward
instance, the plain vanilla three-year, fixed/fixed curve in the first place, a task made easier when
swap would be priced at 7 percent DEM versus an actively traded futures contract exists in the
6 percent USD. The fixed/fiixed annuity swap swap's reference rate, such as the Eurodollar
would be an exchange of 7 percent DEM against futures contract in the U.S. dollar market. When
6.71 percent USD. a directly observed forward curve is not avail-
able, the curve must be estimated, which is
Summary of interest Rate and where logistical difticulties often arise, even with a
Currency Swap Pricing well-established forward curve in government se-
This chapter emphasized two central themes. curities. Finally, currency swaps present a differ-
First, swap pricing can be separated into two ent sort of problem, mainly because of the ex-
parts: the theoretical value that is based on change (or nonexchange) of principal at maturity.
Exercises
Exercise 4.1: It is mid-June of 1994, and as the short-term swap trader for a
"boutique" derivatives house, you are routinely asked to quote a two-way market for
plain vanilla deals with maturities ranging out as far as five years. The most recent
request has come from the treasurer of a middle-market consumer services company
that is trying to convert the last year of an outstanding debt issue from a floating rate
to a fmed rate. This debt issue has a face value of $30 million and requires four more
LIBOR-based quarterly payments, the next of which is scheduled in September of 1994
based on today's three-month rate.
You base the pricing for short-term swaps such as this one on the exchange-traded
Eurodollar futures contract at the CME. To be specific, you set your bid and offer fixed
rates off the midpoint of the "average" of the futures rates. Because competition is
strong in this maturity range, you will only be able to add (subtract) 2 basis points
when quoting your offer (bid) rate on the swap. In the Eurodollar futures markets, the
current settlement prices are 95.02 for delivery in September 1994, 94.78 for delivery
in December 1994, and 94.43 for delivery in March 1995. At this time, the level of
three-month LIBOR is 4.70 percent.
(a) Based on this information, what swap f ~ e rate
d would you quote the treasurer for
this deal? You may assume that each quarter has exactly 91.25 days, that LIBOR is on
a 365-day basis, and that all quoted rates can be converted to a quarterly rate simply
by dividing by four. For example, if LIBOR is 4.70 percent, the periodic coupon
payment on the outstanding debt would be exactly $352,500. Also, the swap fixed rates
are quoted on a quarterly bond basis (the quarterly rate times four). With these
simplifying assumptions, no day-count conversions need be made.
(b) What positions in Eurodollar futures contracts would you enter to hedge your
market risk if the company elects to enter the swap with you? Indicate the specific futures
position (i.e., long or short), the delivery dates, and the specific number of contracts.
Solution: In general, you will set the swap fixed rate according to the present value
average of the futures strip-the rate such that when you discount the cash flows that
can be locked in for the future levels of LIBOR, you get the same present value as the
discounted cash flows for the swap rate. That fixed rate will turn out to be 5.11 percent,
giving a bid rate of 5.09 percent and an offer of 5.13 percent. The company will want
to pay the fixed rate on the swap to hedge its cost of funds, thereby paying your offer
rate of 5.13 percent. Upon "selling" the one-year swap, you become exposed to higher
market rates. Your hedge must be to sell Eurodollar futures contracts so that you gain
when futures rates rise and prices fall. The exact number of contracts will be based on
"tailing" the hedge. The basic hedge ratio is 30 contracts in each delivery month, the
September, the December, and the March. The tailed-hedge ratio will be the present
value of 30 in 6, 9, and 12 months.
(a) The spot rate for LIBOR is 4.70 percent. The futures rates are 4.98 percent in
September, 5.22 percent in December, and 5.57 percent in March. Recall that the
futures rate is merely 100 minus the price index. Those points are the first four on the
Eurodollar futures strip. Now find the break-even SFR that solves the following equation:
$30 million X
4
X [1SFR + -
SFR
+
SFR
-
+I
SFR
+ x 3 1 + x 6 l + x , 1+x12
million x ' x [ +- + x , + + x , "' I l + x l , '

4.70% 4.98% 5.22%
= $30 - --- ----
4 1 +x, 1 1
where the zero-coupon discount factors derived by "repackaging" the futures data are
The solution, which becomes the midpoint of the bid-ask spread, is SFR = (19.83121
percent/3.87870) = 5.11285 percent. Adding 2 basis points onto this value and then
rounding gives an offer rate of 5.13 percent. Similarly, your bid-side quote to clients
wishing to receive the swap fixed rate would be 5.11 percent less 2 basis points, or 5.09
percent.
(b) You will need to hedge your own market risk on the swap by selling the September,
December, and March futures contracts. Notice that the first settlement of the swap is
set at today's LIBOR and need not (in fact, cannot) be hedged. For each delivery date,
you will need 30 contracts prior to tailing the hedges. The basis point value of the
exposure on the $30 million swap is $750. To see this, calculate the floating-rate
payment if LIBOR is 5 percent. It would be $375,000, the notional principal of $30
million times the day-count factor of 1/4 times 5 percent. Then, recalculate the
payment if LIBOR is 5.01 percent-a 1-basis-point change. It would be $375,750, a
difference of $750. The basis point value of each futures contract is $25. The 30
contract requirement is the ratio of the difference in payment to the basis point value
of the contract, or $750 divided by $25.
Thirty contracts for each delivery date, however, would lead to overhedging as gains
and losses on the futures are realized daily. Theoretically, the optimal number of
September contracts to enter at once would be 30 divided by 1 + z,, or 29.3 contracts.
Notice that the six-month discount rate is used even though the futures are for delivery
in three months. The idea is that the gains or losses on the futures hedge would be
invested or funded until the in-arrears settlement in December. Similarly, the other
tailed-hedge ratios would be 28.9 December contracts and 28.5 March contracts.
Exercise 4.2: Suppose that the spot and implied forward rates shown in Table E-4.1
prevail in the market for zero-coupon time deposits. The rates are quoted on a
semiannual bond basis, so a 5.0-year time deposit in the amount of $1million at a stated
rate of 8.68 percent would pay $1 million x [ l + (0.0868/2)]'~ = $1,529,355 at
maturity. Likewise, a 4.5-year time deposit at a rate of 8.27 percent would pay $1 million
x (1 + (0.0827/2)19 = $1,440,027 at maturity. The implied forwards represent
break-even reinvestment rates and are calculated from the zero-coupon rates. For
example, the forward rate implied by the 4.5-year and 5.0-year spot market zero-coupon
rates is 12.41 percent, which is the solution to the following expression:
Calculate the midpoint fixed rate on a five-year, $25 million, plain vanilla interest rate
swap.
Solution:The swap fixed rate will be the present value average of the implied forward
curve. Note that the current six-month rate of 6.14 percent will be the first point on the
forward curve. The remaining points will be the implied forward rates (i.e., the 0.5 x
1.0, the 1.0 x 1.5, and so forth). The swap fixed rate will be the solution for SFR in the
following expression:
Table E-4.1 Hypothetical Spot and Implied Forward

Rates in Market for Zero-Coupon Time
Deposits
Maturity Zero-Coupon Forward
(years) Rates Rates
SFR SFR SFR

= $25 million x
(1 + 0.0614/2)' + (1 + 0.0642/2)2 + (1+ 0.0660/2)3
SFR SFR SFR SFR
+ (1 + 0.0684/2) + (1 + 0.0702/2) + (1 + 0.072612) + (1 + 0.07542 ')
SFR
+ (1 + 0.0795/2)8 +
SFR
(1 + 0.0827/2)' + (1+ 0.0868/2)1°
" 1 '
SFR is 8.4504 percent, and the five-year bid and offer fixed rates will be based on this
midpoint value.
Exercise 4.3: Based on the same spot market and implied forward curves as in
Exercise 4.2, calculate the fixed rates on the following nonplain vanilla swaps:
(a) A three-year accreting swap that starts with a notional principal of $25 million and
then adds $5 million every six months until it reaches $50 million for the last settlement
period.
(b) A $25 million, 2 x 5 forward swap; that is, a three-year swap that has its start time
deferred for two years.
Solution: These swaps will be priced off the forward curve. On the accreting swap, the
notional principal cannot be factored out of the present value expressions. On the
forward swap, the averaging process takes place on the 2 x 5 segment of the curve.
Otherwise, the pricing methodology is the same as on plain vanilla swaps.
x 7.74% 50 x 8.46% 25 x SFR 30 x SFR

+ (145+ 0.070212)" 1
(1 + 0.072612)6] = 2 [(l + 0.061412) + (1 + 0.064212)2
+ (1 35 x SFR
+ 0.0660/2)3 +
40 x SFR 45 x SFR
(1 + 0.0684/2)4 (1 + 0.070212)
+
+-(1 +500.072612)
sFR I '
Solving for SFR produces 7.3849 percent.
SFR SFR SFR

= $25 million x
+ 0.070212) + (1 + 0.072612) + (1 + 0.075412)
SFR
+ (1 + 0.079512)8 +
SFR
(1 + 0.082712)9
On the 2 x 5 forward swap, SFR equals 9.7872 percent.
+ (1 + 0.0868/2)10
--------
sFR 1
•
Exercise 4.4: Your new job is on the currency derivatives trading desk of a New York
bank subsidiary in Toronto. You have primary responsibility for pricing, trading, and
hedging the bank's book of Canadian dollar (CAD)/U.S. dollar currency swaps. One
day you are asked by a steady customer to price a three-year, annual settlement,
fixed/fixed CAD/USD annuity swap. You immediately check the yield curves in each
currency and find, to your surprise and delight, that each curve is exactly flat-in CAD
at 10 percent, in USD at 8 percent, both rates on an annual payment basis. This
situation is indeed quite rare, but because of it, the implied zero and implied forward
curves will also be flat in CAD and USD at 10 percent and 8 percent, respectively. In
the spot FX market, the exchange rate is CAD 1.3333/USD.
What is your theoretical pricing (before setting the bid-offer spread) for the annuity
swap? Assume that the customer wants the fixed rate in CAD to be 10 percent on a
notional principal of CAD 53,332,000, or USD 40,000,000 at the current spot rate.
Solution: Start with the plain vanilla, 10 percent in CAD versus 8 percent in USD
currency swap. The annual coupon exchanges will be CAD 5,333,200 for USD
3,200,000. These amounts are just the annual interest rates times the principal
amounts. Note that they imply a very favorable FX rate of CAD 1.6666/USD to the U.S.
payer. The principal exchange at maturity in Year 3 will be at the current spot rate of
CAD 1.3333/USD, or CAD 53,332,000 for USD 40,000,000.
The innovation with a currency annuity swap is the absence of the principal
exchange. In that case, the U.S. dollar payer will have to pay a higher fixed rate
because CAD 1.6666/USD is higher than available in the current spot market. In fact,
the futed/fixed annuity swap should end up at the average FX rate of the one-, two-, and
three-year points on the EX forward curve. To identify where in theory that curve
should be, calculate the EX forwards that would be consistent with interest rate parity
and flat yield curves at 10 percent in Canadian dollars and 8 percent in U.S. dollars.
One-year FX Forward:
1.10
CAD 1.3333/USD x /i08)= CAD 1.357991/USD
Two-year FX Forward:
1.10
CAD 1.3333/USD x [m) = CAD 1.383139/USD
Three-year FX Forward:
CAD 1.3333/USD x jmj1.10 = CAD 1.408752/USD.
Assume now that you can sell the Year 3 principal flow of CAD 53,332,000 at the
implied FX forward rate of CAD 1.408752/USD. That amount corresponds to USD
37,857,622. The U.S. dollar payer on the plain vanilla currency swap, therefore, loses
USD 2,142,378 on the principal exchange. That loss can be amortized at 8 percent a
year over the three years at USD 659,924, an annual loss of 1.649811 percent of the
notional principal of USD 40,000,000. The annuity swap fixed rates will be 10 percent
in Canadian dollars and 9.649811 percent in U.S. dollars. Now convert that to annual
cash flows: CAD 5,333,200 in exchange for USD 3,859,924, the latter found as the
product of 9.649811 percent and USD 40,000,000.
The accuracy of this pricing can be established by finding the present value of each
side in the annuity swap. The present value of a three-year annuity of CAD 5,333,200
a year discounted at 10 percent is CAD 13,262,879.The present value of the three-year
annuity of USD 3,859,924 at 8 percent is USD 9,947,399. At the spot exchange rate of
CAD 1.3333/USD, that amount corresponds to CAD 13,262,867,which differs from the
present value of the Canadian dollar leg of the swap only because of rounding errors.
Notice also that the implicit FX rate is CAD 1.3817/USD, found as CAD 5,333,200
divided by USD 3,859,924, which is the average of the implied FX forward rates. A
currency annuity swap is comparable to a plain vanilla interest rate swap. The fixed rate
on the latter is an average of the forward interest rates. The implicit fured EX rate on
the former is an average of the FX forward curve. The plain vanilla currency swap took
its standard form to include the exchange of principal at origination and maturity at a
time when most transactions were based on newly issued bonds. As more swaps are
motivated by financial restructuring and risk management, the number of annuity
swaps is likely to increase because they represent cleanly a package of FX forwards.
Chapter 5. The Risks in Swap Contracting
In financial analysis, risk is usually defined in lated. Also, swap risk can depend on the moti-
the context of the return volatility and the sto- vation for the swap. A firm that is truly hedging
chastic processes that drive price variables. This is not concerned with market risk, only default
chapter addresses risk in its more colloquial risk. If the MTM value of the swap moves
sense: Swap risk is all the things that can go against the firm, the firm will gain elsewhere on
wrong after a counterparty enters an interest the balance sheet or income statement; that is
rate or currency swap. For example, if a com- the essential nature of a hedge.
pany is using a receive-fixed/pay-floating swap This chapter outlines the myriad risks that
transaction to speculate that LIBOR will decline, anyone contracting in the swap market is likely
two types of risk will predominate. One is that to face. Consistent with the attention swap credit
the speculator will be incorrect and LIBOR will risk attracts from participants and regulators,
move to a much higher level than expected. This the discussion begins with an analysis of this
type of risk is market risk: the risk that the dimension, including the current methods for
mark-to-market value of the swap moves against measuring it, as well as how it is handled in
the firm and the transaction becomes a signifi- practice. We next adopt the perspective of a
cant liability. If the speculation is right, however, corporation using swaps to hedge an interest
and rates do indeed fall as expected, the swap rate or currency exposure and examine the
becomes a significant asset. The threat now is additional sources of uncertainty, including the
one of credit risk, the risk that the counterparty significant enterflrise, accounting, and tax risks
will fail to perform its side of the contract and that must be analyzed when structuring a swap
the firm will suffer a loss when replacing the transaction. Even after these elements are ac-
swap under disadvantageous conditions. counted for, however, there is usually some
These two aspects of swap risk are not basis risk that cannot be hedged away. We
additive; total swap risk is not the sum of market conclude with a discussion of the special risks
risk and credit risk. If the firm using a swap to swap dealers face, including those associated
speculate on lower short-term rates gets worried with hedging their swap books and the vagaries
about market risk because it is losing money, it of the legal system.
is not likely to be concerned with the credit risk
of the counterparty. If the swap is a liability to
one party, it must be an asset to the other. Swap Credit Risk
Therefore, market risk and credit risk, as mirror Default risk on swap transactions has two
images of the same process, are inversely re- dimensions. Potential credit risk, which involves
83
an assessment of future interest and FX rates dealer truly had to replace the defaulted swap, it
and the likelihood that the counterparty will would have to transact at the prevailing market
default in those environments, is inherently bi- rate. Assume that the average of the other
lateral. That is, depending on future market dealers' quoted bid rates is 6.13 percent quoted
conditions, either participant to an agreement on a 30/360 day-count basis to match the origi-
could be hurt by the default of the counterparty. nal transaction. The default loss to the dealer
This possibility is of practical concern for banks will be the present value of an eight-period
that make markets in swaps, because they can- annuity of $115,000 a period, calculated as
not require the same set of restrictive covenants
as they might on a loan document. Negotiations
over swap documentation are more on a "level
playing field" than a typical debt agreement is.
In the extreme, a strong corporation might By having to receive a lower fixed rate on the
refuse to enter a swap with a lower rated com- new swap than on the original contract, the
mercial bank that lends it money. dealer will be losing the equivalent of $115,000
Actual credit risk is the loss, in present value each quarter, no matter what LIBOR happens to
terms, that a participant would suffer if its coun- be. In fact, notice that the difference in these two
terparty defaulted now. In this regard, an event swap fixed rates is what matters, not current
of default is not limited to the nonpayment of an LIBOR. Current LIBOR, as the anchor to the
owed amount. For example, a common inclusion forward curve, is merely part of the 6.13 percent
in a swap document is a cross-default clause, replacement swap fixed rate.
which brings the contract to early termination if Calculating the present value of that annuity
a third party files bankruptcy proceedings requires the selection of a discount factor. In
against the distressed firm. Actual credit risk, presenting the default loss to the bankruptcy
which is simply the MTM value of the swap, is court, the dealer would like as large a dollar
based on the current fixed rate for a replace- amount as can be justified and so would argue
ment swap having the same remaining tenor, for low discount rates, perhaps the dealer's own
settlement dates, and reference rate. At origina- cost of borrowed funds or perhaps using differ-
tion, actual credit risk is zero on an at-market ent zero-coupon rates for each settlement date.
swap because no initial payment is made. After Using the new swap fixed rate of 6.13 percent,
origination, however, the MTM amount will the present value of the loss is found to be
become positive or negative as market-fixed $859,664, or
rates change over time. Therefore, actual credit
risk is always unilateral in that a swap is a
"zero-sum" game. One side's loss is the other
side's gain, so the swap can have positive MTM
value to only one counterparty at a time.
Notice that this loss is a small fraction, just 1.72
Measuring Actual Credit Risk. S u p percent, of the $50 million transaction amount,
pose that one year ago a corporation agreed to which highlights the point that the notional
pay the fixed offer rate of 7.05 percent (against principal is a very misleading summary statistic
three-month LIBOR) to a swap dealer on a for default risk.
three-year, quarterly settlement contract with a Clearly, the dealer (i.e., the receive-fixed
notional principal of $50 million. Now, with party) will suffer a loss if the corporation de-
exactly two years remaining on the agreement, faults when the replacement swap rate is below
the firm defaults on its remaining obligations. 7.05 percent. Suppose, however, the default oc-
To measure its loss, the dealer will use the curs when the two-year swap fixed rate is above
average quoted market rates from a number of 7.05 percent, say at 8.13 percent. The MTM
other dealers. These quoted rates represent the value of the swap to the dealer at that time would
fixed rates the other dealers would be willing to be a negative $987,556. The present value of the
pay to receive LIBOR. The idea is that if the loss per period is
Putting all transactions under one agreement

is intended to eliminate "cherry-picking," which
is the deliberate selection of transactions to
so that default on (i.e., those with negative values) and
not to default on (i.e., those with positive val-
ues). Close-out netting means that the mark-to-
market value of all positions held by the default-
ing party are calculated using market
The swap in this environment is an asset to the quotations. Those are added up, including all
corporation and a liability to the dealer, meaning positive and negative amounts, with any accrued
that the dealer's actual credit exposure to the interest or settlement payments due added in as
firm is effectively zero. What happens if the well. Under full two-way settlement, this net
corporation goes into default, whether or not it amount, if positive to the defaulting party, is paid
has missed a payment to the dealer? Will the by the nondefaulter; if negative, it is paid by the
dealer have to pay the corporation the MTM defaulter. If the defaulting firm is insolvent, the
value? The answers to these questions depend owed party becomes a general unsecured claim-
on the termination clause specified in the swap ant, unless the swap agreement was initially
documentation. The two standard alternatives in collateralized. The reason for recommending
the ISDA document are (1) limited two-way full two-way settlement is to make the value of
settlements, which would not allow the default- the ultimate net position under the single master
ing party to receive a net settlement payment agreement more certain and to avoid costly
upon termination if the value of the swap is litigation. Limited two-way settlement tends to
determined to be in its favor, or (2) ficll two-way discourage (and postpone) default, creating un-
settlements, which require the nondefaulting certainty about the ultimate resolution of the
party to make a termination payment if the value problem. Note that eliminating limited two-way
of the swap favors the defaulting party. settlements might also have the effects of ex-
Until recently, limited two-way settlement cluding lower rated firms from accessing the
has been the norm for the swap market. Under swap market and of promoting the use of collat-
this system, the dealer would not have to pay the eral.
corporation anything if the event of default
occurred when the swap frrred rate had risen to MeasuringPotentialCredit Risk. Swap
8.13 percent. With full two-way settlement, the market makers must calculate their potential
dealer would pay the corporation $987,556, the credit risk to be sure they are holding sufficient
MTM value of the swap. In current practice, the loss reserves. Unlike actual credit risk, which
industry recommends full two-way settlement in can be accurately measured given current mar-
the context of a single master agreement for all ket conditions, potential default risk is simply an
derivative transactions. In July 1993, the Group estimate of the MTM exposure that might occur
of Thirty, a financial services industry commit- in the future if the counterparty defaults at some
tee chaired by Paul Volcker, published a set of later date. Therefore, potential, or fractional,
recommendations for dealers and end users of exposure depends on both the financial distress
derivatives, including Recommendation 13: of the counterparty and an adverse movement in
interest rates since origination. The potential
Dealers and end-users are encouraged to credit risk calculation is often done using Monte
use one master agreement as widely as Carlo simulation, an empirical technique of run-
possible with each counterparty to docu- ning thousands of randomly selected rate sce-
ment existing and future derivatives trans- narios, calculating the MTM value associated
actions, including foreign exchange for- with each one, and then compiling the out-
wards and options. Master agreements comes. For any given settlement date in the
should provide for payments netting and future, potential exposure can then be measured
close-out netting, using a full two-way as either the average or the "worst case" (e.g.,
payments approach. the 95th percentile) of the random MTM out-
comes. The potential credit risk for the entire ment in market rates. In general, the amount of
swap is simply the largest of the settlement-date- maximum exposure depends on the credit qual-
specific exposures. ity of the counterparty, the tenor of the swap,
Figure 5.1 illustrates potential credit risk on and the parameters chosen for the stochastic
five-year and ten-year swaps for typical assump process for future rates.
tions about interest rate movements. Notice that As an example of the simulation process,
the point of maximum loss occurs on a settle- consider the potential credit risk borne by the
ment date in the middle of the swap's life. This futed-rate payer on a new 8 percent, five-year
pattern results from two offsetting factors: the swap with semiannual settlement and a notional
number of remaining settlements, which obvi- principal of $25 million at a time when the yield
ously goes down as time passes, and the possi- curve is upward sloping. Table 5.1 reports the
bility that the current swap fixed rate might go mean and 95th percentile of the distribution of
up or down as time passes, thus diverging from potential MTM exposures based on 2,000 ran-
the original level. At origination, potential credit domly generated interest rate paths for each of
risk is zero, assuming an at-market swap, Just the ten future settlement dates.1 Two facts from
before maturity, potential credit risk is limited to this table support the previous analysis. First,
the largest likely change in LIBOR times the even under the worst-case scenario, the poten-
notional principal. At intermediate dates, the tial estimated default loss on the swap is a small
potential loss is higher because multiple remain- fraction of the $25 million notional principal.
ing settlements would be affected by a move- Second, this fractional exposure reaches its
maximum of 2.20 percent on the fourth settle-
ment date (i.e., two years into the life of the
Figure 5.1 The Potential Credit Risk agreement).
Profile of an Interest Rate
Swap
Specifically, this simulation assumed that changes in
the original swap fixed rate would follow a mean-reverting
stochastic process of the form dr = a(b - r)dt + o[r]'I2dz,
with the parameters a = 0.2, b = 8.50 percent (i.e., the
long-term trend rate), o = 0.01, t = the number of
settlement periods into the future, and dx generated as a
standard normal random variable. For each of the 2,000
projected rates corresponding to a particular settlement
date, the MTM value of the swap was calculated and set
5 Years 10 Years equal to zero if negative (i.e., if the swap was a liability to
Tenor the pay-fixed position).
Table 5.1 Estimating Potential Credit Risk: Monte Carlo Simulation Results
Average 95th Percentile
Percent Percent
Settlement Date Exposure of NPa Exposure of NP"
0.5 years
1.o
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
"NP = Notional principal.
A key reason for the diminution of potential or with credit enhancements. Other things be-
credit risk on an interest rate swap as maturity ing equal, the dealer would pay a lower, or receive
nears is the absence of any exchange of princi- a higher, fixed rate on an unsecured swap the
pal. In contrast, the presence of such an ex- greater the credit risk of the counterparty. Alter-
change on plain vanilla cross-currency swap natively, instead of adjusting the bid-offer spread,
contracts dramatically alters the time profile of the dealer could require that the counterparty
credit risk in that it peaks at the maturity date either have a certain credit rating or provide
and at a much greater percentage of the princi- equivalent assurance through a letter of credit or
pal amount. Another, more technical factor con- by posting collateral. Some swap contracts limit
cerns the assumed stochastic process that the mount of MTM value, and hence credit risk,
drives the volatility. Many processes for interest that can build up over time. When that threshold is
rates, such as the one governing the preceding reached, a termination clause is triggered and the
example, assume mean reversion, implying a swap is closed out at the MTM value.
tendency for rates to move toward some long- The credit adjustment to the bid-offer
term average. Thus, if market forces keep inter- spread will depend on several factors, including
est rates from moving too much, the potential the credit quality of the dealer, the credit quality
exposure on the swap is muted. In a currency of the counterparty, and the shape of the yield
swap, however, mean reversion in nominal FX curve. When the dealer is the stronger party, the
rates is not an obvious assumption. Conse- bid- offer spread will widen. Because potential
quently, extensive changes in FX rates over the credit risk is bilateral, the bid-offer spread
lifetime of the currency swap can lead to a large would have to narrow for a weaker dealer to
amount of credit risk on the maturity date when transact with a stronger counterparty. In prac-
the principal re-exchange is to be made. tice, the supranationals and the strongest corpo-
This discussion underscores yet another risk rations tend to limit their swap activity to include
to swap management: model risk. Theoretical only the strongest dealers. To gain access to
models are used in a number of ways in deriva-
that market, a number of investment banks have
tives operations, from pricing the swaps to fig-
set up special-purpose swap subsidiaries that are
uring out how to hedge them to calculating
sufficiently capitalized and possess sufficient
default loss. The risk is that the model is wrong,
"firewalls" to warrant a AAA rating.
that the assumptions implicit in the model turn
out not to hold. For example, theoretical valua- To see why the shape of the yield curve
tion models often assume continuous trading matters in the credit-adjustment process, con-
without any large or discrete jumps in prices sider again a pay-fixed swap in an upwardly
from day to day. These models can break down sloped yield curve environment. The swap fixed
in times of illiquidity and market disruption. As rate will be an average of the forward curve.
another example, recognize that mean reversion During the first half of the swap's life, this side
in interest rates is really a political assumption. of the deal would have negative MTM values
That is, it presumes that the government and because the fixed-payer is paying a higher rate
central bank have the ability and, more impor- than on the comparable FRAs or futures (hence
tantly, the will to do what is necessary to keep a "negative carry"). The second half would then
inflation under control (e.g., by allowing a reces- have positive values, which implies credit risk.
sion to drive unemployment rates up). Although So, under these conditions, potential credit risk
economic conditions alone might suggest mean on a pay-fixed swap is "back-loaded," or concen-
reversion in real rates, mean reversion in nom- trated in the last half of the tenor. The opposite
inal rates has a political context. The risk to the result holds for receive-fixed swaps; concern
swap dealer, therefore, is that the reserves held over credit risk is focused in the first half. Given
for default loss turn out to be inadequate. that the ability to assess financial distress in the
counterparty is more difficult the more distant
Adjusting Swap Pricingfor Credit Risk. the horizon, potential credit risk would be
Broadly speaking, swap dealers manage credit greater when paying the fixed rate than when
risk either by pricing it into the bid- offer spread receiving it when the forward curve slopes up.
87
The opposite conclusion can be drawn, of dealer is willing to pay a higher rate because the
course, when the curve is downward sloping. credit risk problem is not back-loaded as it is
The risk adjustment around the theoretical when the curve is rising.
value extracted from the forward curve need not
be symmetric. In a steep yield curve setting, the End-User Swan Risk
market maker would want a larger adjustment In addition to market and credit risks, which
on the bid side than the offer side. Suppose the all swap participants confront to varying de-
present value average of the forward curve is grees, end users face additional risks that must
7.55 percent. The bid-offer spread in a rising be analyzed when evaluating the quality of any
yield curve market might be 7.51 percent bid particular swaprelated transaction. The most
and 7.57 percent offered. In an inverted yield important of these are measurement risk, basis
curve market generating the same theoretical risk, and accounting risk.
midpoint, however, the pricing might be 7.53
percent bid and 7.59 percent offered. Notice that Measurement Risk. Consider a nonfi-
we have once again made this argument without nancial corporation that has the stylized balance
regard to expectations about future rates. We sheet portrayed in Figure 5.3. Its assets consist
have based it on the arbitrage-free method of of cash, inventory, and plant and equipment,
pricing and the idea that credit risk is an increas- which are funded by short-term and floating-rate
ing function of the time to maturity. Thus, the debt; long-term, fixed-rate debt; and equity.
result should hold whether or not LIBOR is Given our risk-management focus, the liabilities
expected to rise in line with prices on a corre- have been grouped by duration, rather than
sponding strip of Eurodollar futures contracts. maturity. In that regard, recall that long-term,
Figure 5.2 illustrates the credit risk adjust- floating-rate notes have low implied-durationsta-
ment from the perspective of an A-rated swap tistics and, therefore, have more in common
dealer paying the fixed rate to BBB-rated, A- with short-term debt than with long-term, fixed-
rated, and AA-rated counterparties in rising, flat, rate bonds. (See the appendix for further discus-
and inverted yield curve environments. With a sion of duration.)
flat yield curve, a swap with the equally credit- Is this corporation exposed to rising or fall-
worthy counterparty would not be adjusted. ing interest rates? Looking only at the liabilities,
When the counterparty is better than A-rated, an easy conclusion would be that rising interest
the dealer would pay a higher fured rate (about rates will lead to a higher cost of funds. If the
5 basis points in the diagram). When the curve corporate treasury is operated as a cost center,
is upward sloping, the dealer, as payer of the management would certainly conclude that the
fixed rate, views its credit risk as greater than exposure is to higher rates. That perspective can
that of its counterparty, so it reduces its bid be limiting, however. From an enterprise point of
fixed rate. If the yield curve is inverted, the
Figure 5.3 A Stylized Balance Sheet
Figure 5.2 Credit Adjustments to the for a Nonfinancial
Bid4fFer Spread Corporation
Assets Liabilities and Equity
I
I
Y
Short-Term and
Floating-Rate Debt
Inventory
a"
d
A
Flat Curve
52
C
-5
Steep Curve Long-Term
Plant Fixed-Rate Debt
U ' and
AA A BBB Equipment
Credit Quality of Fixed Receiver
Equity
Source: Sorensen and Bollier (1994)
view, the interest sensitivity of the revenues sured, the correct hedging program is quite
must be considered along with the expenses. difficult to put together. Some risks are them-
Suppose that the corporation's net revenues are selves correlated to other risks; for instance,
positively correlated to interest rates because commodity prices, FX rates, and interest rates
each is driven by inflation. Then, higher com- are all connected by inflation. This correlation
modity prices that raise operating revenues suggests that overall financial risk should be
might fully compensate the firm for higher interest measured by the covariances, as well as the
rates that raise the cost of short-term and floating- variances, of prices and rates. Although viewing
rate debt. In that case, the corporation already is risk from a full balance sheet perspective, in-
internally hedged against interest rate risk. cluding its strategic dimension, might be ele-
A common problem in corporate risk man- gant in theory, accounting and tax consider-
zgement is measuring the extent of the expo- ations often force a manager to treat risk on a
sure itself. Suppose the corporate treasurer, transaction-by-transaction basis. Thus, what is
given the myopic perspective of debt manage- hedging and what is speculation often turns out
ment alone, were to enter a pay-fixed swap to to be a gray area, yet that designation can matter
hedge the firm's apparent exposure to higher a great deal in how industry analysts, regulators,
rates. By ignoring the revenue side of its oper- and even the corporation's shareholders view
ations, the firm could end up overhedged, effec- the outcome of the swap.
tively speculating on higher rates. Although Basis Risk. Returning to the balance
evaluating risk on an enterprise basis might be sheet in Figure 5.3, suppose the corporation's
the proper thing to do, it is quite di£ficult to
operating revenues are not correlated at all with
implement in practice. The interest sensitivity of market interest rates so that the firm is unam-
revenues to interest rates might not be stable
biguously exposed to an upward shift in the
over time. Rather, it might depend on the pric-
yield curve. Assume further that its short-term
ing strategies of competitors and the reason why debt is largely commercial paper (CP). The CP
interest rates have changed. Revenues might is issued regularly with maturities of 30 to 90
rise if rates increase because of inflation but fall days depending on market conditions and the
with higher real (i.e., inflation-adjusted) rates. corporate treasurer's view on future rates. Con-
The measurement problem also arises with cerned with higher rates brought on by tighten-
foreign exchange and commodity prices, espe- ing monetary policy, the treasurer has already
cially when considering what is known as stra- lengthened maturities as much as the CP mar-
tegic risk management. Suppose this corpora- ket will allow. To lengthen the average maturity
tion's operations are entirely based in U.S. of debt even more, the treasurer decides to pay
dollars and its major competitor is a foreign firm the f ~ e rate
d on a three-year interest rate swap.
entirely based in Canadian dollars. From a stra- The nature of the problem and the swap solution
tegic point of view, the corporation can be can be laid out in a matrix, as below, to highlight
exposed to the CAD/USD exchange rate even the fact that the payoffs on the hedge product
though it never has a transaction in Canadian must be negatively correlated with the underly-
dollars. The reason is that a favorable swing in ing exposure.
the FX rate to the competitor can worsen the
corporation's market share and profits. The Exposure Hedge
same could hold for commodity price exposure Event (Issue CP) (Pay-Fixed Swap)
if, say, the competitor's technology makes it Rates Rise Lose Gain
very dependent on hydroelectric energy prices Rates Fall Gain Lose
and the corporation's technology does not.
Again, the corporation's share price could be come Assume that a swap dealer offers the corpo-
lated to a variable in which it does not itself transact ration the two alternatives for the swap shown in
These examples illustrate one thing that can Figure 5.4. In the LIBOR-based hedge, the cor-
go wrong with the use of any derivative contract: poration would pay 7.05 percent fixed for three
It could be the right solution to the wrong years and receive LIBOR flat. (This plain vanilla
problem. Unless risk has been correctly mea- transaction is the same as that used in the actual
credit risk example above.) Alternatively, the The treasurer's choice between the two alter-
corporation could pay 6.75 percent fixed and natives will likely turn on the perceived trade-off
receive a cash flow tied to a CP index based on between the better liquidity of the LIBOR swap
a set of Al/Pl-rated issuers. The treasurer versus the lesser basis risk of the CP index
expects the spread between LIBOR and the CP swap. In this context, basis risk arises from the
index to average 30 basis points during the next extent to which the firm's own CP rate does not
three years; if not, a clear preference would exist track perfectly the floating reference rate on the
between the swap structures. Notice that in swap. Because LIBOR picks up bank risk and
neither case would the cost of funds be constant the CP index picks up nonbank corporate risk,
over the three years. In the first deal, the all-in the plain vanilla swap presumably would have
rate each period will vary with the difference the greater degree of basis risk. If, however, the
between LIBOR and the corporation's CP rate. treasurer foresees the possibility of unwinding
In the second, the all-in rate depends on the the swap prior to maturity, perhaps because his
difference between the industrywide CP index or her view on market conditions might change,
and the firm-specific CP rate. the LIBOR swap might be preferred because the
market in this structure is the deeper of the two.
Figure 5.4 Pay-Fixed Swap Assuming that the treasurer chooses the LIBOR-
Alternatives based transaction, another element that could
go wrong with the swap is that the corporation's
A LIB OR-Based Hedge own CP rate might increase much more than
LIBOR. This eventuality would raise the cost of
funds more than expected and render the swap
I Corporation
I Swap Dealer I a less effective hedge.
Accounting Risk. Table 5.2 presents a
numerical example of how the preceding hedge
Issue I is supposed to work for the corporation. The
example assumes that the CP rate, LIBOR, and
the swap fixed rate are all converted to the same
conventions and that the LIBOR-CP spread is
I Investors I 30 basis points. Regardless of the actual level of
market rates, the all-in cost of funds is shown to
be 6.75 percent, the sum of the interest expense
Cost of Funds: 7.05%- (LIBOR - CP Rate) on the CP and the net settlement on the swap.
This formulation ignores the accounting treat-
ment of the payments, however.
The implicit assumption in the numerical
A CP-Based Hedge example is the application of hedge accounting. If
hedge accounting applies, the two transac-
6.75%
-
Table 5.2 A Numerical Example of the
Corporation Swap Dealer
Hedge
Net Payment All-in Cost

CP Rate LIBOR on Swapa of ~ u n d s ~
I
Issue
Cp
"Net payment of swap = 7.05 percent - LIBOR.

Cost of Funds: 6.75% - (CP Index - CP Rate) bAll-in cost of funds = CP rate + net payment of swap.
Chapter 5. The Risks in Swafi Contracting
tions-the interest payments on the CP and the attached to an FRN that pays coupons tied to a
net settlements on the swap-are effectively CP Index. It could be a problem, though, if this
combined. The reported interest expense for the transaction were a forward swap structured
period would be 6.75 percent times the principal. around a view of current low rates but higher
The benefit of this arrangement is that the swap future rates. Second, what is the degree of
would not be marked to market on the current correlation? Clearly, this question is an empiri-
year's financial statement because the underly- cal one that can depend on the time frame of the
ing CP liability is carried at book value. There- data series and whether it is ex post or ex ante
fore, gains or losses represented by the MTM correlation that matters. Suppose a firm hedges
value are deferred until any subsequent transac- FX risk exposure to one currency with another
tion is actually made. to which it is pegged for political reasons (e.g.,
If hedge accounting does not apply, the the British pound and the deutschemark prior to
MTM value of the swap would have to be September 1992). Should hedge accounting still
recognized even though such gains or losses are apply if for some reason the currencies become
unrealized in the current period. That recogni- delinked, as when Britain exited the Exchange
tion could lead to more volatility in the firm's Rate Mechanism?
financial statements than the economics of the Accounting risk arises from uncertainty over
transaction warrant. So, when the swap is used the treatment that the swap will get from its
for hedging, the appropriate accounting treat- outside auditors or from the regulators. A his-
ment is hedge accounting. If the swap is specu- torical problem has been that some instruments
lative, the appropriate treatment would be to have guidelines (mostly dealing with FX risk)
mark the position to its market value. Conse- and others do not. Some rules, such as the fact
quently, the distinction between hedging and that the deferral of gains and losses is intended
speculation matters, even if they are often d a - for legitimate hedges and not speculative posi-
cult to distinguish. The current criteria for tions, have been clear, but the rules for hedge
hedge accounting generally include: accounting are tremendously ambiguous, with
different standards and treatments for FX and
Designation of the swap as a hedge to a interest rate risk, as well as for hedging with
particular transaction at the time of initi- futures, swaps, and options. Further complicat-
ation. This practice prevents a firm from ing these matters is a growing movement within
sorting through its positions at the end of the accounting profession to eliminate hedge
a year to manipulate reported income by accounting treatment altogether. Such a change
identifying some swaps as hedges and in practice would force firms to mark all posi-
others as not hedges. tions to market regardless of their intended use.
Commitment to a future transaction that
must represent a bona fide risk. This Tax Risk. A risk-management strategy
commitment is to prevent the deferral of must work on both a pretax and after-tax basis.
swap losses on what are no more than In practice, this condition requires a timing
vague intentions to transact in the future. match, a character match, and a sourcing match
Correlation between the exposed position for the cash flows (or MTM values) on the
and the hedge product. Typically the cor- underlying exposure and the hedge product. In
relation must be on the order of 80 per- this setting, timing is a matter of whether the
cent. cash flows correspond to the current tax period
or are deferred to a future period, character is
Now reconsider the LIBOR-based, pay-fixed whether the income or expense (or change in
swap to hedge the corporation's exposure to MTM value) is treated as an ordinary or capital
higher future CP rates. Will it qualify for hedge gain or loss, and sourcing refers to whether the
accounting? Most likely it will, but with a couple income or expense is treated as domestic or
of potential problems. First, is the firm a regular foreign.
issues of CP or new to the market? This distinc- In recent years, there has been a great deal
tion would not be a problem if the swap were of uncertainty about possible character mis-
matches that could seriously undermine the gone away as a source of risk on a swap trans-
efficiency of many risk-management strategies. action.
This uncertainty arose from the Internal Reve-
nue Service's application of the Supreme Court's Dealer Swap Risk
ruling in the 1988 Arkansas Best case (Arkansas Although the market maker can be viewed as
Best Corporation v. Commissioner of Internal just another corporate participant in the swap
Revenue) and in several well-publicized audits market and therefore subject to all of the expo-
and tax court cases, notably against the Federal sures listed above, some additional risks come
National Mortgage Association. The Supreme with managing a swap book.
Court ruled that Section 1221 of the IRS Code
clearly states that all property used in the course Managing Swap Market Risk With Fu-
of doing business is to be regarded as capital, tures. In an earlier example, the dealer
with five specific exceptions (including accounts agreed to receive the fixed rate of 7.05 percent
receivable and inventory) that give rise to ordi- on a three-year swap from a corporate counter-
nary income and expense. party. Immediately upon selling this swap, the
Based on that ruling, the IRS argued that the dealer would be exposed to increases in swap
net cash flows on most positions in derivatives fixed rates, which determine the MTM value of
should be treated as capital gains and losses. its newly acquired position. The dealer could, of
Even if the firm was hedging what is an ordinary course, do nothing and simply speculate that
expense, the swap or futures contract would be swap rates will fall, but the more likely event is
a capital asset because it did not fall among the that the open position will be covered. In prac-
five exceptions. Under this interpretation, a clas- tice, large swap market makers use a portfolio
sic liability hedge-using a pay-fixed interest approach to book management, meaning that
rate swap to transform floating-rate debt-would individual swaps are not separately hedged.
have a character mismatch in that the settle- Rather, each new contract merely contributes to
ment payments on the swap would be capital the portfolio's overall duration and convexity
and the interest expense on the floating-rate characteristics. Depending on the degree of
debt ordinary. Returning to the numerical exam- aggregation (i.e., if products such as FRAs,
ple in Table 5.2, the problem is that the CP rate swaps, caps, and floors are all combined), the
is ordinary interest expense but the net payment residual risk of the swap book then will be
on the swap is a capital loss when LIBOR is less hedged as its own entity. To draw attention to
than 7.05 percent and a capital gain when LIBOR additional sources of risk, though, we assume
is above 7.05 percent. Only ordinary losses are that the dealer hedges this particular three-year,
deductible against ordinary income. Capital receive-fixed swap using Eurodollar futures con-
losses are deductible only to the extent that tracts.
capital gains exist and the timing of carry- As noted, the dealer's market risk is that the
forwards and carry-backs is limited. swap fixed rates will rise, rendering 7.05 percent
This tax risk was immense in the early 1990s. a below-market, fixed-rate receipt for payment of
The risk hanging over many corporations that LIBOR. Notice that we avoid saying that the risk
had actively used derivatives in risk manage- involved in this transaction is that current
ment was that the IRS would retroactively char- LIBOR goes up. The market risk is exposure to
acterize reported losses during an audit of an movement in the entire forward curve, not just
open tax year. Fortunately for corporate end to its end point. To hedge this exposure, the
users of derivative products, the tax court ruled dealer sells Eurodollar futures contracts, be-
unanimously (16-0) against the IRS in the Fan- cause higher futures rates will equate to lower
nie Mae case. In October 1993, the Service futures prices. (Recall from the discussion of
announced it was revising its litigating position these instruments in Chapter 4 that the futures
with respect to Arkansas Best and in 1994 issued price index is 100 minus the futures rate and
new rules clarifying the character treatment of that the seller gains $25 a contract per basis
derivatives. Many tax issues remain unresolved, point increase.) Figure 5.5 illustrates the deal-
however, so tax treatment has not completely er's hedge position.
Chapter 5. Tlze Risks in Swap Contracting
Figure 5.5 Dealer's Hedge Using ens, the strip hedge would still work because of
Eurodollar Futures gains on the distant delivery dates but the stack
hedge would fail because it is located entirely at
' LIBOR
" " the near end of the curve, which did not move
much. Not shown is an inversion in the forward
curve whereby the near-term rates rise drarnat-
Eurodollar
Futures ically; in this case, the stack hedge would over-
Contracts
perform and more than cover the loss on the
swap. Essentially, the decision to use a stack
The dealer has to make a number of deci- hedge becomes a bet on the likelihood of a
sions beyond deciding to go short, such as nonparallel shift in the forward curve. Some-
which contract month and how many. A major times, this exposure is unavoidable because, for
decision is whether to use a strip hedge or a stack example, in most non-USD currencies, futures
hedge. With the former, the dealer would sell the contracts do not offer delivery dates much be-
requisite number of contracts for all the delivery yond one year.
dates corresponding to the settlement dates of Assuming the dealer chooses the strip
the swap. With the latter, the dealer "stacks up" hedge, the issue of determining the number of
all the contracts on the nearest few delivery contracts for each delivery date remains. S u p
dates. This decision would be based on the pose the swap is for quarterly settlement and a
trade-off of greater liquidity (as measured by notional principal of $50 million. Selling 50 fu-
open interest) in the nearer-to-delivery contracts tures contracts for each delivery date, each for
against greater basis risk. The basis risk of a $1 million, would lead to overhedging, because
stack hedge derives from the chance of a non- the gains and losses on the hedge would be
parallel shift of the yield curve. realized each day while the gains and losses on
The effectiveness of the strip versus stack the swap would remain unrealized until the
hedge is illustrated in Figure 5.6. The original settlement date. This overhedging can be rem-
swap fixed rate is the present value average of edied by tailing the hedge ratio. In effect, tailing
the original forward curve (plus the dealer's the ratio is accomplished by selling the present
offer spread). Additionally, the figure shows two value of the "untailed" number of contracts. If
new forward curves, one representing a parallel the three-year interest rate is 7.25 percent, the
shift and the other a steepened curve. Notice dealer would sell only 40 or 41 contracts for
that the new swap fixed rate-and the amount of delivery in three years (50/1.07253 = 40.5). The
loss in MTM value-is the same for either shift. idea is that gains on the hedge as rates rise can
If the parallel shift prevails, both hedges would be invested while losses as rates fall need to be
work equally well because all futures rates rise funded. The amount to be invested or borrowed
by the same amount. If the forward curve steep should be the present value of the amount
eventually needed. Tailing the hedge corrects
Figure 5.6 Hedging the Swap with a for the time value of money.
Futures Strip or Futures Another source of risk in swap book manage-
Stack ment using futures contracts concerns the ac-
tual investment or funding rate compared with
the assumed rate that is used to calculate the
New Swap tailed hedge. Notice that the seller of the futures
Fixed Rate contracts is in a propitious position. The as-
Swap
Original swap /&;;a;we sumed rate is 7.25 percent, but if market rates
Fixed Rate Forward Curve rise, the short position benefits from daily set-
tlement, given that the chances are good that
the receipts can be invested at a rate above 7.25
percent. Moreover, if market rates fall, the short
1 2 3 might be able to fund the losses at a rate below
Years 7.25 percent. Thus, if rates move in either direc-
tion, the short hedge stands to benefit. Because come down because of competition, because the
futures are a zero-sum game, a systematic bias dealer in a competitive market might be forced
in favor of the short position must imply a to share with the counterparty some of the
systematic bias against the long position. In- favorable circumstance of hedging the position
deed, the buyer of the Eurodollar futures con- by selling Eurodollar futures. In practice, this
tract gains if prices rise (and rates fall) and loses convexity-of-the-tail effect appears to be small,
if prices fall (and rates rise). The buyer, there- with the midpoint of the FRAs maturing beyond
fore, gets to invest gains into the low-rate envi- three years tending to be anywhere from 5 to 15
ronment but must fund losses when rates have basis points below the corresponding futures
gone up. This phenomenon is called the convez- rate. Nevertheless, neglecting to deal with tail-
ity of the tail. ing and the convexity issue would lead to swap
The convexity-of-thetail problem becomes mispricing, which itself would be a source of
an issue in pricing swaps, as well as in hedging business risk.
them. Recall that a swap can be viewed as a Managing Swap Market Risk in the
series of FRAs; in fact, one source of the fonvard Cash Market. Suppose the swap dealer
curve in pricing swaps is the observed fixed chooses to hedge the market risk following the
rates on FRAs. In Chapter 4, we saw that FRAs sale of the three-year swap by using the cash
are priced around the futures rates that are used market in Treasury notes, a situation that might
to hedge the positions. On some longdated arise if no Eurodollar futures market exists in
FRAs, however, the systematic bias toward the which to lay off the risk of an upward move in
short hedge and against the long hedge be- market rates. The alternative hedge would be to
comes a factor in pricing. This bias is illustrated sell three-year Treasury notes to a government
in Figure 5.7. The bid-offer spread is shown to securities dealer. The proceeds from this short
widen at more distant delivery dates for several sale would likely be invested in the overnight
reasons, including the greater difficulty in as- rep0 (i.e., sale-repurchase agreement) market.
sessing credit risk, the operational costs of This hedge position is illustrated in Figure 5.8.
managing the hedges for longer time periods, The idea of this hedge is that changes in the
and the inherent risks of managing long-term MTM value of the swap will track market move-
positions (e.g., adverse regulatory, legal, or ac- ments at the three-year point of the Treasury
counting rulings). The midpoint of the bid-offer yield curve. The short sale will produce a gain if
spread also diverges from the futures rate for rates rise, because the dealer would be able to
more distant FRAs. The bid rate would come buy the T-note in the cash market at a lower
down because the required hedge would be the price to close out the position. That gain offsets
adversely affected long positions. Recognizing the loss on the value of the swap, as shown in
that fact, the dealer is willing to pay only a lower Figure 5.9. The original swap fixed rate is an
fixed rate than otherwise. The offer rate would average of the forward curve and is quoted as a
spread over the three-year Treasury. Thus,
Figure 5.7 Implication of the Convexity when the agreement is hedged in the cash
of the Tail on the Pricing of market, the swap spread becomes a source of
Long-Dated FRAs OR of basis risk. To the extent that any change in the
Eurodollar Futures swap fixed rate fully corresponds to a change in
the Treasury rate, the swap spread must remain
Figure 5.8 Dealer's Hedge Using Cash
Market Treasury Notes
Three-Year
Treasury
Time to Delivery Notes
-- - - -
constant. The hedge fails if the source of the Used by analysts as a barometer of market
higher swap rate is an increase entirely in the conditions, the TED spread is difficult to fore-
swap spread without a commensurate ,move in cast because it is essentially picking up the
the Treasury note. Similarly, the hedge overper- credit risk differential between a money-center
forms if the swap spread falls from its original bank and the Treasury. The TED spread widens
level. during "flights to quality," because investors
flock to Treasuries, driving their prices up and
Figure 5.9 Hedging the Swap in the yields down. l'he dealer could attempt to hedge
Cash Market the exposure to the swap spread itself by taking
positions in the TED spread to the extent that
New Forward LIBOR and T-bill futures contracts are available.
/
' If the reason for hedging in Treasuries in the
first place is the absence of those contracts,
however, the swap spread wiIl remain a source
Ori inalSwap
Ifixed Rate of risk to the dealer in managing its book.
New 3-Yew
T-Note Yield
Original
Legal Risk. After the events of 1994, swap
Ori 'nal %Year SW~D risk will be impossible to discuss without ad-
Yield
dressing its legal dimension. Recent litigation
involving swap transactions, most notably the
Procter & Gamble v. Bankers Trust case, makes
the existence of legal risk undeniable. The crit-
Years ical issues that all market makers must consider
are the suitability of the transactions for their
The swap spread can be broken down into clients and disclosure of each deal's various
two components: the average TED spread, risks. These can be challenging matters, even
which is the difference between LIBOR and the on what appear to be straightforward, plain
T-bill rate for each future settlement date; and vanilla agreements. If a corporation has diffi-
the coupon bias, which is the difference between culty in measuring its own interest rate and FX
the yield on a coupon-bearingTreasury note and risk and, therefore, in knowing whether a par-
a zero-coupon Treasury having an equivalent ticular swap moves it to a more speculative or
maturity.2 Forecasting the swap spread then hedged position, how can the swap dealer hope
dissolves into forecasting those variables. The to assess suitability? How can all the risks be
coupon bias can be directly measured from the disclosed, particularly the tax and accounting
Treasury yield curve and the implied zero curve. risks, when authoritative rulings are not avail-
It is larger when the Treasury yield curve is able?
higher or steeper and the time to maturity is Concern about the legal status of derivatives
longer. Increases in these factors, other things was heightened by the 1991 British High Court
being equal, should correlate with increases in ultra uires ruling regarding a number of swap
observed swap spreads in the market. and options contracts transacted between banks
and local authorities (notably the London bor-
ough of Hammersmith and Fulham). The local
The swap spread is the difference between the swap
fixed rate and the yield on the comparable-maturity coupon
governments, although originally intending to
Treasury note. The swap fixed rate is the average of the hedge, ended up with large speculative posi-
LIBOR path, and the zero-coupon Treasury yield is the tions. The court essentially ruled that they were
average of the T-bill path. The coupon bias is the difference not authorized to enter such contracts, thereby
between the yield on the coupon-bearing note and the voiding their losses of about £500 million, even
zero-coupon note for the same maturities. After some though the Bank of England had approved the
substitution and rearrangement of terms, one gets that the
swap spread can be expressed as the difference between original hedging strategies.
the average LIBOR path and theT-bill path, which is simply Another aspect of swap legal risk comes from
the average TED spread plus the coupon bias. a lesser known case, a 1992 Indiana State Court
ruling in Brane v. Roth. This case involved the Market risk, however, is quite unlikely to go
management of a grain co-operative. Co-op away. Fortunately, as different financial risks
shareholders successfully sued the manager dominate at different times, swap contracts can
and directors for not using derivatives to hedge be designed to hedge the movements of any
losses following from an unexpected decline in variable price, a point emphasized in the next
grain prices. The court ruled that management chapter. Conversely, credit risk is the mirror
was negligent in not adequately using grain image to market risk. In this respect, the history
futures to hedge the risk exposure. The co- of swaps, and in particular the practice of setting
operative's accountant had advised the directors a single f ~ e drate to all settlement periods,
to authorize management to use futures con- impacts risk. For example, although the plain
tracts. The directors did so, but management vanilla design was needed in early arbitrage
covered only a very small fraction of the transactions, it does generate more risk than
exposure. The court also ruled that the direc-
would a series of fixed rates that follow the
tors had an obligation to understand hedging
forward curve. The risk of default can be effec-
techniques.
tively managed, though, by pricing the risk into
the swap fixed rate, by holding capital reserves
Summary of Swap Risk
for potential credit risk, by netting provisions
The risk in swap transactions is partly un-
under master agreements, by holding collateral,
avoidable and partly a reflection of their history,
as short a time period as that might be. Account- or by limiting the buildup of value before early
ing and tax risks are largely attributable to the termination is triggered.
newness of the swap market. The accounting Swap market makers face other business
profession moves slowly in formulating new risks. As intermediaries in these markets, they
doctrine. This deliberation is, perhaps, a matter must hedge their open positions in some man-
of bureaucracy, but it also reflects the rapid pace ner. Whether they use futures markets or cash
of financial innovation in recent years. Only if an markets in Treasuries, some degree of basis risk
innovation persists, as interest rate and currency will always remain. Legal risk is the latest con-
swaps have, will it reach the agenda of the cern to the derivatives industry. As litigation is
Emerging Issues Task Force of the Financial resolved, however, both in and out of court, the
Accounting Standards Board. As the financial swap market will emerge with a better under-
and tax accounting for derivatives is clarified, standing of the legal rights and responsibilities
some of their risk will diminish. of end users and market makers.
Exercises
Exercise 5.1: A midsized regional commercial bank funds its acquisition of commer-
cial and real estate loans mostly in the retail deposit and brokered CD (certificates of
deposit) markets. Brokered CDs are large, negotiable time deposits typically pur-
chased in the national market by institutional investors via specialized CD brokers.
The bank's president is concerned with rising market rates and the higher cost of
borrowed funds, particularly on its brokered CDs, which very quickly reflect changes
in money market conditions. The banker decides to enter a $50 million, three-year,
7.75 percent pay-fixed interest rate swap with a New York money-center bank as the
counterparty. The reference rate is chosen to be three-month LIBOR, even though the
regional bank has very few deposits tied to LIBOR. The reason for choosing this swap
structure is its liquidity-should management's view on the market change, the hedge
using a plain vanilla instrument can be more readily unwound than a swap tied to bank
CD rates. If you were a risk-management consultant asked to make a presentation to
the bank's board of directors, what specific risks to the transaction would you discuss?
Solution: You would always discuss default risk because swaps are credit instruments
with a potential unrealized buildup of value and, therefore, credit risk. To be specific,
the credit risk is that the money-center bank will default at a time when the fixed rate
on a replacement swap is higher than 7.75 percent. If market swap rates are above that
level, the existing transaction is an asset to the regional bank because it would be
paying a below-market fixed rate for receipt of LIBOR. If the counterparty were to
default, the regional bank would have to replace the swap at the higher market rate.
The basis risk on the swap arises from hedging an exposure to CD rates with a plain
vanilla swap tied to LIBOR. The synthetic fxed rate created by attaching the swap to
CDs is 7.75 percent plus the CD rate minus LIBOR. For example, if LIBOR is 6 percent
and the CD rate is 5.90 percent, the all-in cost of funds would be 7.65 percent. As the
difference between the rates varies, the all-in cost will vary. The risk to the bank is that
its CD rate rises relative to LIBOR. Note that the CD rate is specific to this regional
bank, whereas LIBOR in the swap is an average of prime money-center banks. (The
swap document will specify exactly how LIBOR is to be determined).
Your presentation should cover accounting risk. Unless the bank marks its liabilities
to market, which it probably does not, it will want hedge accounting treatment on the
swap, if permissible. In that case, its reported interest expense on the CDs over the
three years will be fixed, at least to the extent that the spread between LIBOR and the
CD rate does not vary. If hedge accounting does not apply, the bank will have to book
the mark-to-market value of the swap. Of the three criteria for hedge accounting,
designation should not be a problem if the bank has its bookkeeping operations in
order. The correlation between the CD rates and LIBOR is an empirical matter that can
be easily tested. Given that most money market rates track closely together, the
correlation is likely to be sufticiently strong. Commitment could be problematical,
however. If the bank has an ongoing relationship with the CD brokers and regularly
uses that market as a source of funds, hedge accounting would seem to be justified. If
the bank is new to the brokered CD market, then an auditor or regulator could
conceivably argue that a swap that has a tenor beyond the current accounting period
is speculative because the bank has no commitment to the underlying position. The
risk is that an adverse ruling could force the bank to mark the swap to market when
it has a significant negative value, thereby reducing its capital adequacy ratios.
Tax risk should be mentioned as well, even though the threat of an "Arkansas Best7'
ruling by the IRS that would recharacterize losses on hedge positions has abated. The
egciency of the swap should be examined on both a before-tax and after-tax basis.
Interest Rate and Currency Swaps: A Tatorial
Exercise 5.2: Suppose that on April 15, 1987, a French corporation entered into an
annual-settlement, three-year currency swap to receive 12.72 percent in U.S. dollars
and to pay 14.88 percent in French francs. Suppose that the spot market exchange rate
was FRF 8.4435/USD at the time, or USD 0.118433/FRF. The principal on the swap
was USD 100 million, which equals FRF 844.35 million. The scheduled cash flows on
the swap from the perspective of the French corporation were the following:
Date Receive pay

April 15, 1988 USD 12,720,000 FRF 125,639,280
April 15, 1989 12,720,000 125,639,280
April 15, 1990 112,720,000 969,989,280
On April 15, 1988, just after the initial coupon exchange, the counterparty to the
swap filed for bankruptcy. On that date, plain vanilla, two-year, fixed/fixed currency
swaps were quoted by a number of dealers at 10.20 percent in dollars versus 12.78
percent in francs. The spot market exchange rate was FRF 9.4829/USD, or USD
0.105453/FRF.
(a) Calculate the mark-to-market value of the currency swap. Did the French
corporation experience a loss because of the default? Assume the swap document
called for limited two-way settlement.
(b) If the French corporation chose to replace the swap on April 15,1988, and wanted
to continue receiving 12.72 percent in dollars for USD 100 million in principal, what
franc interest rate would it have been willing to pay? What would have been the specific
cash flows on this replacement swap?
Solution:
(a) The MTM value of the swap was the present value of the dollar inflows converted
to francs at the spot rate, less the present value of the franc outflows. The reduction in
the dollar interest rate from 12.72 percent to 10.20 percent raised the value of the swap
(and the default loss), and the reduction in the franc rate from 14.88 percent to 12.78
percent lowered the value. Adding the appreciation in the dollar relative to the franc
from FRF 8.4435/USD to FRF 9.4829/USD suggests that the net effect should have
been a positive MTM value. This result is confirmed by the following calculations:
USD 12,720,000 USD 112,720,000
PVUSD
= -+ = USD 104,361,843
1.1020 (1.1020)
FRF 125,639,280 FRF 969,989,280
PVm =
1.1278
+ (1.1278)~ = FRF 874,012,546
-
USD 104,361,843
Value = FRF 874,012,546 = FRF 115,640,124.
USD 0.105453/m -
The default by the counterparty caused the French corporation to lose FRF
115,640,124, the market value of the swap that had become an asset.
(b) The at-market, plain vanilla currency swaps that were available in the market on
April 15,1988, were priced such that the French corporation could receive a fixed rate
of 10.20 percent in dollars and pay a fixed rate of 12.78 percent in francs. If the
corporation wanted an off-market swap to receive 12.72 percent (an additional 252
basis points in dollars), it would need to pay a higher rate in francs. First calculate the
value, in francs, of 252 basis points in dollars:
252 bps 252 bps x x

1.1020 + (1.1020)~= 1.1278 (1.1278)~
+
or x = 260.7375 bps.
The off-market swap fmed rates would be 12.72 percent in dollars versus 15.387375
percent in francs (15.387375 percent = 12.78 percent + 2.607375 percent). The
principal on the swap would be USD 100 million = FRF 948,290,000.
The scheduled cash flows on the two-year swap from the perspective of the French
corporation would be:
Date Receive pay

April 15, 1989 USD 12,720,000 FRF 145,916,938
April 15, 1990 112,720,000 1,094,206,938
The MTM value of the currency swap can also be measured as the present value of
the lost (or gained) cash flows from entering into a replacement swap at current rates.
Because the remaining scheduled and replacement cash receipts are the same, the
value of the swap is the difference between the payments. Those differences are FRF
20,277,658 on April 15,1989, and FRF 124,217,658 on April 15,1990. Discounting those
amounts by 12.78 percent provides the value of the swap.
FRF 20,277,658 FRF 124,217,658
MTM Value = i- = FRF 115,640,383.
1.1278 (1.1278)
Note that the value of the swap obtained by the replacement swap method is virtually
identical to the more direct mark-to-market method (differing only because of rounding).
Exercise 5.3: A leasing company is in serious financial distress and is teetering on the
brink of bankruptcy. Although no event of default has yet taken place, senior
management is seriously considering relief under Chapter 11. At issue is the timing of
the filing; the company could keep going as is for several more months, perhaps for a
year or so. Management decides to hinge its timing decision on the single largest
transaction on its books, an interest rate swap on which it pays a fmed rate of 7.50
percent and receives six-month LIBOR semiannually for a notional principal of $82.5
million. The swap, which was entered two years before, has exactly three years
remaining. Settlement payments are based on an actua1/360 day count for LIBOR and
30/360 for the fixed rate, and they are paid in arrears. The swap document specifies
limited two-way settlement in event of default.
Indicate the strategy you would recommend for the company in each of the
following yield curve environments:
Current Six- Three-Year

Month LIBOR Swap Fixed Rate
7.00% 7.OO%
7.00 8.00
8.00 7.00
8.00 8.00
Assume that there are 181 days in the next six-month time period. These yield curve
environments are pictured in Figure E-5.1.
Solution: The key point is that current LIBOR will determine the direction and
amount of the next scheduled settlement payment, whereas the swap fixed rate
determines the MTM value of the swap.
Figure E-5.1 Hypothetical Yield Curve

Environments
0.5 1.0 1.5 2.0 2.5 3.0

Current Years Swap
LIBOR Fixed Rate
Scenario A: The MTM value of the swap will be negative $1,099,014, calculated as a
six-period annuity of $206,250 per period using 7 percent as the discount rate.
The company is scheduled to make the next settlement payment to the counterparty
in the amount of $190,208:
The swap is a liability to the corporation, and the next settlement payment is an
outflow. The company appears to have no reason not to enter bankruptcy proceedings
at this time, but it could defer default until the payment date in six months because
market rates could possibly rise dramatically to reverse the sign on the value of the
swap.
Scenario B: The company is still scheduled to make the next settlement payment in the
amount of $190,208, but the MTM value of the swap now will be positive $1,081,191,
calculated using 8 percent as the discount factor. That is,
The company should attempt to sell the swap to capture its market value as much as
possible. Any event of default would definitely be postponed because of the limited
two-way settlement clause.
Scenario C: The MTM value of the swap again will be negative $1,099,014, but the
company is scheduled to receive $244,583 on the next settlement date.
Here the case for defemng default is strong because the firm can collect the payment
in six months and then default. The role of cross-default clauses is to protect the
counterparty from this sort of "default-timing" option.
Scenario D:The MTM value of the swap will be positive $1,081,191, and the company
is scheduled to receive $244,583 on the next settlement date. The swap should be sold
if possible, and any event of default postponed.
Exercise 5.4: A Savings and Loan Association (S&L) has just been taken over by the
Office of 'I'hrift Supervision, an event of default that triggers early termination of the
S&L's two swap contracts with a commercial bank. The swaps are under a master
agreement that calls for close-out netting with full two-way settlement. The terms of the
two swaps are as follows:
Swap # I . The S&L pays 6.32 percent and receives three-month LIBOR (quar-
terly settlement in arrears) on a two-year, $37 million, plain vanilla interest rate
swap.
Swap #2. The S&L receives 5.89 percent and pays three-month LIBOR (quar-
terly settlement in arrears) on a three-year, $25 million, plain vanilla interest rate
swap.
Who owes whom how much to close out these positions? To simplify the calculations,
assume that the current date is a settlement date. A survey of market makers reveals
the following average bid and offer fixed rates for two-year and three-year swaps
against three-month LIBOR; these are the rates the surveyed dealers would be willing
to pay to or receive from the bank soliciting the quotations:
Settlement Date Bid

Two years 7.02%
Three years 7.41
Solution: The two- and three-year swaps are compared in Figure E-5.2. For the
two-year swap, the close-out value will be based on the surveyed market makers' bid
rate of 7.02 percent. The idea is that if the bank were to replace the swap, it would enter
a new transaction "selling" LIBOR and getting the dealer's bid rate. This swap is an
asset to the S&L because it is paying a below-market fixed rate for receipt of LIBOR.
The bank would owe the S&L $479,373 on this position:
Figure E-5.2 The Savings and Loan

Swaps
Two-Year Swap:
LIBOR
6.32%
Three-YearSwap:
LIBOR
*
Bank
The close-out value for the three-year swap will be based on the market makers'
offered rate of 7.45 percent. If the bank were to replace this swap, it would have to
"buy" LIBOR and pay the dealer's offered rate. This swap is a liability to the S&L
because it is receiving a below-market fixed rate for payment of LIBOR. The S&L
would owe the bank $1,039,857 to close out this position.
Combining the two positions, the bank's claim to the Office of Thrift Supervision would
be for $560,484.
Chapter 6. Swap Design Variations and
Extensions
The preceding chapters demonstrated that inter- choose to have the swap payments tied to a
est rate and currency swaps are an extremely commercial paper index (plus or minus a
flexible form of financial contracting. In this spread). In this manner, the manager would be
chapter, we describe several ways in which able to maintain the short duration of any out-
these agreements have been adapted to make standing debt payments linked to LIBOR but
them even more appealing to their ultimate end convert the effective rate basis to a preferable
users. In presenting these innovations, we have exposure. In general, any short-term rate can be
made a somewhat arbitrary distinction between built into this contract design, including the
those that are merely variations on the basic prime rate or the Treasury bill yield. In fact, a
swap theme, such as the forward swap and TED spread swap, in which the counterparties
varying notional principal swap contracts, and exchange cash flows based on LIBOR and a
those that extend the concept to applications in spread-adjusted T-bill rate, could be used to
new markets such as equity and commodity risk speculate on an increase or decrease in the
management. market-driven risk premium built into LIBOR.
Variations on the Basic Swap Constant-Maturity Swaps. An interest-

ing form of the basis swap is the constant-
Some of the more popular contract adjust-
maturity swap (CMS). Also known as yield
ments that have been introduced by financial
intermediaries in recent years include basis curve swaps, these agreements call for the ex-
change of cash flows tied to the short end of the
swaps, constant-maturity swaps, "dB" swaps,
yield curve (e.g., three- or six-month LIBOR) for
arrears swaps, MTM swaps, indexed amortizing
those based on movements farther out the
rate swaps, and corridor swaps.
curve. The contract draws its name from the fact
44FloatinglFIoating''(or Basis) Swaps. that the maturity of the security underlying this
The simplest departure from the plain vanilla latter movement-typically a Treasury note or a
format is to link each of the swap cash flows to plain vanilla swap-remains fixed throughout
different reference rates that are allowed to vary the tenor of the agreement. A typical application
over time. For example, in lieu of making fixed- for the CMS structure is illustrated in Figure 6.1.
rate payments in exchange for LIBOR-based In this case, a bond manager who is invested in
receipts, a corporate cash manager might a LIBOR-linked FRN has used the swap to
103
Figure 6.1 A Constant-Maturity Basis on the changes in the shape of a yield curve in
Swap another country (relative to its own) without
Six-Month having to hold foreign securities directly. To see
how this swap might work, suppose that a
( Swat, Dealer British money manager is holding GBP 10 rnil-
less 125 bps

I lion worth of two-year securities paying quar-
terly coupons equal to sterling LIBOR. The
Receive
manager's view is that British money rates will
LIBOR-based decrease significantly over the next few years at
Income
the same time short-term German rates rise.
Further, assume that the present levels of ster-
I Issuer
I
ling- and deutschemark-denominated LIBOR
are 6.25 percent and 5.15 percent, respectively,
and both rates are adjusted to reflect an actual/
365 day count.
convert the basis for his receipts into the five- Figure 6.2 captures the essence of how a diff
year constant-maturity Treasury bond (CMT) swap could be designed to assist this manager.
yield less 1.25 percent. That is, every settlement The swap agreement would allow for the trans-
date for the life of the swap, the manager will formation of the sterling coupons into receipts
receive a swap flow linked to the five-year T- based on deutschemark LIBOR plus a spread of
bond yield prevailing at that time. (The data
1.85 percent. Both of the swap cash flows would
series for the CMT is maintained by the Federal
be denominated in sterling and the same GBP
Reserve Board.)
The innovative aspect of the constant-matu- 10 million notional principal would apply to each.
rity swap is that it allows the counterparties to The 185-basis-point spread would have been
participate in changes in the shape of the curve determined by several factors, including the
over the life of the contract. In this example, the levels and shapes of the pound and deutsche-
bond manager will benefit from a steepening mark yield curves, the assumed correlation be-
yield curve-at least in the six-month to five- tween yields in each currency, and the exchange
year segment-because his net settlement re- rate between them.
ceipt (payrnent) will be successively larger An immediate implication of this structure is
(smaller). In contrast, an unanticipated flatten- that during the first quarterly settlement period
ing or inversion of the yield curve benefits the on the swap (assumed to be 91 days), the British
CMT payer. manager will receive a net settlement payment
Notice that the CMS payments can also be from the swap dealer equal to:
adapted to a more traditional fixed/floating for-
mat by replacing LIBOR with a fured rate ex-
changed against CMT flat. Of course, this fixed Figure 6.2 A Rate-DifferentialSwap
rate would now be an average of the forward
five-year CMT rates, rather than the forward Three-Month DEM LIBOR
plus 185 bps (times GBP 10
six-month LIBOR, and will be appropriately - million)
4
higher in an upward-slopingyield curve environ- British Swap Dealer
ment. Money Manager
*
R a t e - D g i(or ~ 'DiB) Swaps. An- A Three-Month GBP LIBOR
(times GBP 10 million)
other way basis swaps have been structured Receive
involves the exchange of cash flows based on GBP LIBOR
Income
short-term rates from two different countries but
denominated in the same base currency. The
primary advantage of this sort of arrangement is
that it allows an investment fund to take views rl British Issuer
Chapter 6. Swap Design Variations and Extensions
arrears swap pricing, consider the cash flows

associated with two-year, semiannual-settlement
versions of each agreement using the rate cal-
x (GBP 10,000,000) = GBP 18,699, culations summarized in Tables 6.1 and 6.2.
which adds to the coupon interest of the GBP Table 6.1 presents the current LIBOR yield
155,822 (calculated as GBP 10,000,000 x curve (based on a hypothetical set of long-dated,
(91/365) x 0.0625) received on the sterling zero-coupon Euro-time deposits adjusted to a
floater. Of course, because the spread adjust- semiannual bond basis) and the sequence of
ment was set, in part, by the market's anticipa- six-month implied forward rates, calculated as in
tion that sterling rates will increase far more Chapter 4. Table 6.2 indicates the floating rate
rapidly than deutschemark LIBOR, the money applicable to each settlement date, given these
manager is likely to be making the net settle- implied forward rates. Notice that with an u p
ment payments to the dealer later in the lifetime ward-sloping yield curve, the implied forward
of the agreement. LIBOR rates also increase with successively
distant investment dates. The importance of this
Arrears Swaps. An arrears swap is pattern is that the anticipated floating-rate pay-
equivalent to a plain vanilla agreement in which ments for the arrears swap will be larger on each
the floating rate is both set and paid at the end settlement date than those for the traditional
of a settlement period. In addition to modifying agreement. The result is a larger swap f ~ e rate
d
a traditional fixed/floating structure, the arrears on the arrears swap-4.74 percent versus 4.39
concept can also be extended to become a basis percent-which can be established by setting
swap by, say, exchanging LIBOR set in advance the "fixed rate" present value formula,
for LIBOR set in arrears. In either case, the main
benefit of the arrears format is that it allows end SFR SFR
users to lock in the dynamics of a yield curve (1 + 0.0400/2)' + (1 + 0.0410/2)~
that is more upwardly sloped than previously
SFR SF'R
(e.g., the U.S. curve in the early 1990s). For + (1 + 0.0420~)~(1 + 0 . 0 4 4 0 ~ ) ~ ~
instance, a floating-rate issuer seeking a pay- +
fixed swap and believing rates will rise more equal, in turn, to each of the following "arrears
rapidly than the rates priced into the existing floating" and "traditional floating" discount
curve will prefer an agreement that sets the equations:
LIBOR receipt at the end of the settlement
period. Conversely, a LIBOR-based investor can
arrange to receive the fixed rate on an arrears
swap if he or she thinks future rates will either
decline or rise by less than the rates implied by
the forward curve and hence priced into the
fixed rate on the swap.
To see the difference between traditional and and
Table 6.1 LIBOR Yield Curve and Table 6.2 Floating-Rate Determination
Associated Implied Forward for Two-Year Traditional and
Rates Arrears Swaps
Maturity Current Forward Date Forward Settlement Traditional Arrears
(months) LIBOR (months) Rates Period Swap Swap
(months) LIBOR LIBOR Difterence
as the discount factor for all future cash

flows.
Immediately upon unwinding the old
swap, the participants enter into a new
swap at the current fixed rate and with the
same notional principal as the original but
and then solving for the separate SFR values. one fewer settlement periods to maturity.
That is, pricing the arrears swap entails averag- Repeat the previous two steps on each
ing a two-year segment of the forward curve settlement date until the maturity date of
shifted out by one period. the original swap.
"Mark-to-Market" (MTM) Swaps. The
mark-to-market swap was developed specifically As an example of how this procedure might
to reduce the amount of actual credit risk either work in practice, suppose that a corporate bor-
of the two counterparties to the transaction must rower arranges a two-year, nonamortizing loan
carry during the life of the contract. To see how from a commercial bank in the amount of $100
this can be accomplished, consider the time line million. The interest rate on the loan is set at
illustrated in Figure 6.3, which assumes that a six-month LIBOR plus 1 percent, with semian-
(T + N)-period swap was negotiated at date - T nual payments in arrears. The corporate trea-
relative to the current date, 0. In short, the MTM surer, fearing higher market rates could cut into
swap is designed to eliminate the actual expo- operating margins, seeks to transform the debt
sure on the swap accumulated from the origina- into a synthetic fixed-rate liability using a pay-
tion date (or, alternatively, the last "marking" fixed interest rate swap. The best terms offered
date) to the present. the corporation are a pay-fixed rate of 6 percent
for a mark-to-market swap. The top panel of
Table 6.3 illustrates a hypothetical path for the
Figure 6.3 Time Line for Mark-to- future LIBOR and swap fixed rates that govern
Market Swap Example the settlement cash flows on the loan/swap
Periodic Settlement Dates package. To simplify the calculations, assume
that LIBOR and the swap rates are on a semian-
nual bond basis for payment in arrears on a
30/360 day count. This means that cash flows
Swap Current Swap will be the annualized rate times 0.5 times the
Ori ination Date Maturity
bate Date principal. These settlement date flows are
shown in the lower panel of the table.
The all-in, realized cost of funds (COF) for
The basic premise of this agreement can be the loan/swap combination is found by solving
seen in the following example. Imagine that a
swap dealer and a corporate counterparty had
structured the following agreement at date - T:
Enter into a plain vanilla interest rate

swap for T + N periods with the corpora-
tion paying and the dealer receiving the for COF, which equals 7.00 percent. Notice that
prevailing swap fixed rate. this outcome is exactly the same as would have
On the first settlement date, the counter- resulted from combining the loan at LIBOR plus
parties make their respective fixed- and 1percent with a plain vanilla pay-fixed swap at 6
floating-rate payments on the existing percent. The difference is that in the latter
swap and then liquidate the remaining scheme, the actual credit exposure would build
portion of the existing swap using the up throughout the life of the agreement,
new swap fixed rate for an agreement that whereas the MTM format calls for cash pay-
continues through the original maturity ments that eliminate this exposure on each
Table 6.3 Mark-to-Market Swap Mechanics

Assumed LIBOR and Future Swap Fixed-Rate Paths
Date 0 LIBOR = 4.00% 2.0-year swap fixed rate = 6.00%
Date 1 LIBOR = 4.25% 1.5-year swap fxed rate = 5.75%
Date 2 LIBOR = 4.75% 1.0-year swap fxed rate = 6.25%
Date 3 LIBOR = 5.00% 0.5-year swap fuced rate = 5.00%
Settlement-Date Cash Flows

Date 1 Swap settlemeni: (6% - 4%)(0.5)($ 100,000,000) = $1,000,000
Mark-to-market settlement:
Loan payment: (4.00% + 1.00%)(0.5)($100,000,000) = $2,500,000

Total payment: $3,854,428
Date 2 Swap settlement: (5.75% - 4.25%)(0.5)($100,000,000) = $750,000
Loan payment: (4.25% + 1.00%)(0.5)($100,000,000) = $2,625,000

Date 3 Swap settlement: (6.25% - 4.75%)(0.5)($ 100,000,000) = $750,000
[(0.0625 - 0.05)(0.5)(100,000,000) + (1.025) = $609,756
Loan payment: (4.75% + 1.00%)(0.5)($100,000,000) = $2,875,000
Date 4 Swap settlement: (5% - 5%)(0.5)($100,000,000) = $0
Mark-to-market settlement: $0
Loan payment: (5.00% + 1.00%)(0.5)($100,000,000) = $3,000,000
settlement date. Importantly, although the prac- Indexed Amortizing Rate (IAR) Swaps.
tice of mark-to-market valuation and settlement An IAR swap is a traditional frxed/floating inter-
changes the timing of the cash flows, the interest rate swap that has been altered to mimic the
nal rate of return is the same (barring default) as performance of a mortgage portfolio. An impor-
it would have been with a regular swap. A tant feature of such portfolios is the negative
corollary to this result is that the ultimate cost of convexity that results from the homeowner's
funds does not depend on any "errors" in the prepayment option. In effect, these contracts
fixed rates used to mark the swap to market; this represent a "pseudo" mortgage bank that funds
independence will hold as long as the same mortgage assets with LIBOR-based liabilities.
fixed rate is used to calculate the required MTM The end user of the swap will receive cash flows
payment and to set the new fixed rate on the similar to a pool of fixed-rate mortgages and pay
replacement swap. This condition is important cash flows linked to LIBOR.
because an active market in swaps might not This parallel can be appreciated by first con-
exist on the reset date as a result of a general sidering the dynamics of a commercial bank that
decline in swap transactions or inactivity in that obtains its funds in the short-term deposit mar-
particular tenor. ket and invests in whole mortgages or mort-
gage-backed pass-throughs paying a fixed rate. The other $10 million would be subject to "rein-
If both deposit and mortgage rates rise, the bank vestment risk" in the sense that the receive-
experiences a lower net interest margin, assum- fixed counterparty would have to find an alter-
ing a parallel shift in the yield curve. Conversely, native revenue stream under less profitable
if deposit and mortgage rates both fall, the bank market conditions.
bears the burden of increased refinancings and In general, the receiver of the fixed rate on
prepayments, meaning that its high-coupon as- an IAR swap obtains a considerably higher swap
sets simply disappear. Thus, the bank thrives spread than on a plain vanilla swap. This addi-
best in a world with a static, upwardly sloped yield tional amount can be viewed as the premium on
curve; it suifers most if rates dramatically rise or fall. a path-dependent option written by the fixed-rate
This bank can be described as being inher- receiver. In options parlance, the fixed-rate re-
ently "short volatility" in that it benefits if inter- ceiver is "selling volatility," as indicated by the
est rate volatility declines. Of course, the key negative convexity of the IAR swap. In fact, an
factor in this analysis is that fixed-rate mort- advantage of the IAR swap relative to actually
gages are prepayable at the option of the holding the mortgage securities is that the no-
homeowner, not the investor. Consequently, in tional principal reduction in the former is tied
contrast to typical (noncallable) fixed-income exclusively to rate movements while prepay-
instruments, upside gains in mortgage products ments in the latter can occur for myriad other
are limited as rates fall. A receive-fixed IAR swap reasons (e.g., home sales because of job trans-
is designed to replicate these value changes in a fers or retirement, or property insurance settle-
mortgage portfolio funded with deposits. The ments after a natural disaster) that may be
fixed rate received-the underlying Treasury difficult to forecast. Accordingly, end users have
yield plus the swap spread-represents the long tended to be banks and other institutions that
position in mortgages; the floating rate paid (LI- want the performance of a mortgage portfolio
BOR) represents the short position in deposits. without having to hold the underlying instru-
The negative convexity on the mortgages is ments. Furthermore, some banks have used
mimicked by varying the notional principal on IARs as a substitute for more traditional banking
the swap as conditions in the market change. activities when loan demand has been weak.
Unlike a varying-principal swap that follows a
predetermined schedule to reduce the notional Corridor Swaps. Traditional interest rate
amount, an IAR swap ties the reduction in swaps allow the end user to speculate on the
principal each period to the change in some direction of interest rate movements. Constant-
market reference rate (not necessarily the one maturity swaps allow the end user to speculate
that determines the settlement cash flows). This on changes in the shape of the yield curve.
reference rate is often a constant-maturity Trea- Corridor swaps are another example of what has
sury bond yield. For example, a simple structure come to be known as "structured" swaps. They
might be that after a "lockout" period of two allow the end user to speculate on the volatility
years, the notional principal declines by: of rate changes. For example, suppose that a
fund manager currently holding floating-rate
0 percent if the (ten-year) CMT is un- debt securities in his or her portfolio can enter
changed or rises during the period, into either of the following three-year, semian-
20 percent if the CMT declines by up to nual settlement swaps:
200 basis points, or
Traditional: Pay six-month LIBOR, and
100 percent if the CMT declines by more
receive 5.75 percent.
than 200 basis points.
Corridor: Year 1 Payment: Six-month
For example, if the CMT yield were to fall from LIBOR for days when 4 per-
its original level of 8 percent to i7percent after cent 5 LIBOR 5 5 percent, 0
the lockout period had passed, an IAR swap that all other days;
started with a notional principal of $50 million Year 2 Payment: Six-month
would see that amount reduced to $40 million. LIBOR for days when 5 per-
cent 5 LIBOR 5 6 percent, 0 having a predetermined fixed rate at some later

all other days; date. As with all options, these agreements are
Year 3 Payment: Six-month of two types: receiver and payer swaptions.
LIBOR for days when 6 per- A receiver swaption gives the buyer the
cent r LIBOR 5 7 percent, 0 right, but not the obligation, to enter a swap on
all other days; and prearranged terms (fixed rate, tenor, notional
Receive 4.50 percent. principal, floating rate index, settlement periods,
documentation, etc.) as the fixed-rate receiver.
Although the traditional swap would allow The writer of the option, in return for an up-front
the manager to lock in a fixed income of 5.75 premium, must enter the swap as the f~ed-rate
percent, the corridor arrangement offers the payer upon demand of the buyer. Naturally, the
possibility of an enhanced return if LIBOR falls buyer will only exercise the receiver swaption if
outside of the prescribed range during a sub- the market swap rate is less than the strike rate
stantial portion of the settlement period. For at the maturity of the option; that is, if he or she
example, if LIBOR is 3.80 percent for the first can receive an above-market fixed rate while
half of a settlement period during Year 1 and paying LIBOR.
4.20 percent for the second, the combined yield A payer swaption gives the buyer the right,
of a corridor swap and an FRN paying LIBOR but not the obligation, to enter a swap on
flat would be 6.40 percent, computed as 4 per- prearranged terms as the fixed-rate payer. The
cent received on the floater [(0.50 x 3.80 per- writer of the option is obligated to receive the
cent) + (0.50 x 4.20 percent)] plus 4.50 percent fixed rate at the buyer's request. The holder of
received on the swap less 2.10 percent paid on the the payer swaption will only exercise if the
swap [ (0.50 x 0 percent) + (0.50 x 4.20 percent) 1. market pay-fixed swap rate prevailing at the
If LIBOR was 4.20 percent during the whole option exercise date is higher than the strike
period, however, this same combination would rate, thereby entitling him or her to pay a
yield just the 4.50 percent on the fully swapped below-market fixed rate while receiving LIBOR.
coupon, considerably less than the 5.75 percent Swaptions are most useful to those firms
that could have been realized with the plain vanilla who, at the present time, are not sure whether
alternative. Consequently, a manager committing they will be exposed to interest rate movements
to the corridor agreement is attempting to en- in the future. An example would be a bond
hance return by taking the view that short-term portfolio manager who may be forced to liqui-
rate movements will be extreme enough to carry date part of his or her holdings in a year's time.
LIBOR outside the designated band. In such a situation, the bond manager might like
to have the option of furing the future interest
Extensions of the Swap Concept rate at the levels priced into today's forward
Although the preceding forms of contracting curve.
are all legitimate innovations, each of them can Another example of how swaptions are used
be viewed as a straightforward modification of involves the management of callable debt. Spe-
the original swap design. Further, they all were cifically, assume the following scenario, which is
described by applications in fixed-income secu- illustrated on the time line in Figure 6.4. Three
rity management. In this section, we discuss years ago, Company XYZ issued 15-year, fured-
three ways in which swap agreements have rate callable debt with a coupon rate of 12
been adapted to help investors and issuers man- percent. Interest rates for XYZ's credit grade
age risk in other markets as well.
Options on Swaps ("Swaptions3. One Figure 6.4 Time Line for Callable Debt
of the most important developments in the swap Management Example
market of the late 1980s was the growth of the
swap entry option, or swaption. A swaption gives Year: -3
the holder of the option the right, but not the Original Today Bond Bond
obligation, to enter into an interest rate swap Bond Issue Call Date Maturity
however, it can also be used to effectively re- equity swaps can be structured include TOPIX
structure the coupon rate on the underlying (japan), FTSE 100 (Great Britain), DAX (Ger-
bond by setting the strike rate on the swaption many), CAC 40 (France), TSE 35 (Canada),
at a level other than 12 percent. EOE (Netherlands), and Hang Seng (Hong
One important caution about using this strat- Kong) .
egy is that swap rates and bond rates do not Equity swaps can be structured so that the
necessarily move in exactly the same fashion. cash flows are denominated in the same cur-
This possibility will create basis (or correlation) rency or in two different currencies. Typically,
risk in that a swap market instrument is being the equity-index-based cash flow is denominated
used as a substitute, or proxy, for a capital in the currency of the index's country of origi-
market instrument. For instance, in this exam- nation, but the swap can be designed so that this
ple, the worst-case result for the company would payment is hedged into a different currency.
have been if the fixed rate on a ten-year swap These agreements speclfy a notional principal
was below 12 percent in two years but its debt that is not exchanged at origination but serves
refunding rate in the capital market was above the purpose of converting percentage returns
12 percent. This situation, which could occur if into cash flows. This notional principal can be
XYZ's credit quality deteriorates over the next either variable or fixed during the life of the
two years, would mean that the company would agreement, but the same notional principal ap-
be forced either to enter into a swap it does not plies to both sides of the transaction.
want or to liquidate the position at a disadvan- The equity swap market has developed for
tage and not be able to refinance its borrowing several reasons. First, these agreements allow
profitably. investors to take advantage of overall price
movements in a specific country's stock market
Equity-Index-Linked Swaps. Similar in without having to purchase the equity securities
form to plain vanilla interest rate swaps, equity- directly. This feature has the advantage of re-
index-linked swaps are equivalent to portfolios ducing both the transaction costs and tracking
of forward contracts calling for the exchange of error associated with actually assembling a port-
cash flows based on two different investment folio that mimics the index, as well as allowing
rates: a variable debt rate (e.g., three-month the investor to avoid dividend withholding taxes
LIBOR) and the return to a n equity index (e.g., normally associated with cross-border investing.
Standard & Poor's 500). The index-linked pay- Second, creating a direct equity investment in a
ment is based either on the total return (i.e., foreign country may be difficult for some com-
dividends and capital gain or loss) or on the panies for which that strategy is prohibited by
percentage index change for the settlement law or operating policy. Third, an investment
period plus a fixed spread adjustment, which is fund wanting to accumulate foreign index re-
expressed in basis points and can be negative. turns denominated in their domestic currencies
The floating-rate payments are typically based may not be able, in some cases because of legal
on LIBOR flat. Like interest rate and currency prohibitions, to obtain sufficient exchange-
swaps, equity swaps are traded in the over-the- traded futures or option contracts to hedge a
counter markets and have maturities out to ten direct equity investment. The equity swap can
years. be structured so that separate hedging transac-
Swaps linked to equity indexes are a major tions are unnecessary.
part of a larger, rapidly developing market in The most common application for an equity
equity derivative products. In addition to swaps, swap involves a counterparty that receives an
other prominent equity derivatives include op- index-based payment in exchange for making a
tions and warrants on individual shares or mar- floating-rate payment. As an example of how this
ket indexes and index-linked bonds. The two transaction might arise, consider a pension fund
most commonly used-and frequently quoted- that currently has a substantial portion of its
indexes in the equity swap market are the asset portfolio invested in floating-rate notes
Standard & Poor's 500 (United States) and paying quarterly coupons based on LIBOR. If
Nikkei 225 gapan). Other indexes for which the manager of this fund would like to change
111
the existing asset allocation by converting some and Index*, and Index,, represent the index
of these debt-based cash flows into equity-based levels occumng on the current and immediate
receipts, he or she has two ways to do so. One past settlement dates, assuming all dividends
way is to sell the existing floating-,ratenotes and are reinvested. Notice that to minimize calcula-
purchase a portfolio of equities directly in the tions, the settlement payment is computed using
market. Alternatively, the manager could enter (LIBOR - Spread) rather than adding a sepa-
into an equity swap with an initial notional rate inflow for the equity spread itself. Indicative
principal equal to the amount of the existing quotes for this spread as of late 1992 are listed in
debt holdings to be converted. From the stand- Table 6.4 for several difEerent countries. It
point of reducing transaction costs, the second should be noted, however, that the equity swap
alternative is clearly preferable. The mechanics quotation methods are not standardized across
of this arrangement are illustrated in Figure 6.7. all dealers and so the quoted values may not be
directly comparable.
Figure 6.7 Altering an Asset Allocation
Position with an Equity Table 6.4 Indicative Spreads on One-
Swap Year Equity Swaps
Equity Return
(basis points)
+
~y&3
Pension Fund
Country (Index)
Germany (Dm
France (CAC 40)
Index Plus
Switzerland (SMI)
United Kingdom ( F E E )
LIBOR
United States (S&P 500)
Japan (Nikkei 225)
Netherlands (EOE)
Ori inal FRN
Australia (All Ordinaries)
Bssuer Hong Kong (Hang Seng)
Source: Swiss Bank Corporation.
The net return to the fund in this example is

Another way to see the effect of this swap-
simply the return on the equity index plus the
based cash flow transformation is shown in
spread adjustment. If the floating-rate notes held
Figure 6.8. This illustration makes clear that
as an asset yield more than LIBOR, this incre-
equity swaps differ from interest rate and cur-
mental amount would serve to increase the
rency swaps in one important way. Specifically,
overall net return. Assuming that both cash
because the equity index is not guaranteed to
flows are denominated in the same currency, the
appreciate in value from one settlement period
net settlement payment on the swap from the
to the next, the party receiving the equity index
company's standpoint can be calculated as the
could have to make a double payment. First, it
difference between the variable-rate outflow and
will have to pay the usual cash flow based on
the equity-linked inflow, where
LIBOR. Second, whenever Indeq, is less than
Payment = (LIBOR - Spread) Index,,,, it will also make an equity-index-based
payment to ("receive" a negative payment from)
x Notional principal x ("i,","s) its counterparty. Thus, rather than netting one
cash flow against the other, the company will
and pay both when the value of the equity index
declines. Examples of this situation are repre-
Receipt =
i Index,, - Indexold
Indexold I sented by the third and fifth swapped cash flows
in the diagram.
This company now faces two sources of
x Notional principal credit risk. First, as the holder of the floating-
Chapter 6. Swap Desigrt Variations and Externions
- - - -
Figure 6.8 An Equity-Index-Linked ner in which both LIBOR and the equity index
Swap Transaction are marked to market each period. In this sense,
the equity swap is similar to a floating/floating
Purchase nn FRN
interest rate swap (i.e., a basis swap).
Commodity Swaps. As the preceding

equity example just demonstrated, swap con-
tracting can be applied to hedging exposures to
economic variables other than interest and ex-
change rates. In particular, there is a fast-grow-
ing market for over-the-counter derivative agree-
ments tailored to mitigate uncertain commodity
price movements. Although the producers and
end users of any commodity could benefit from
the existence of well-developed swap markets,
the most active markets to date have been
related to energy (crude oil, heating oil, unleaded
gas, and natural gas), precious metals (gold and
silver), and base metals (aluminum, copper,
nickel, zinc, lead, and tin). As in the rate swap
markets, the growth of commodity swaps has
been primarily attributable to the constraints
imposed on hedgers and speculators by the
rigid standardization of exchange-traded futures
contracts.
A commodity swap effectively fixes the price
of a commodity over a certain period of time (the
swap tenor) in the same way that an interest rate
swap fixes the value of LIBOR. On each settle-
ment date, the two counterparties exchange
cash flows based on (1) a fixed commodity price
that does not change over the life of the agree-
ment and (2) a variable commodity price that
does. The analog to the floating-rate index in a
commodity swap is the price of a commodity
index, (e.g., the West Texas Intermediate Oil
index or the COMEX gold index), which is reset
periodically over the life of the swap. The agree
ment also sets a notional amount of the com-
modity on which the periodic cash exchanges
rate asset, it is exposed to the firm that issued are based, but no physical delivery ever takes
the bond. Second, it is now also exposed to the place.
swap counterparty. This second exposure will To illustrate how a commodity swap works
manifest itself on any settlement date when the and who might benefit from its use, suppose
index-linked return is greater than LIBOR. From Company OIL is a Dallas-based independent
the viewpoint of the "pay-equity-index" side of producer of oil whose production is limited to
the deal (the swap counterparty in this exam- 500,000 barrels a month. Because of high pro-
ple), this exposure can be magnified by the fact duction costs, OIL needs to guarantee that it
that equity returns can be negative. The credit receives an average price of $19.50 a barrel,
exposure on the swap is limited to a single particularly as the firm attempts to recover its
settlement date, however, because of the man- initial investment. Company KEM is a Houston-
based firm that uses a monthly average of measurement of actual and potential default
500,000 barrels of West Texas Intermediate exposure is comparable to that for rate swaps.
(WTI) in the production of its petrochemicals. Using commodity swaps to maintain the eco-
Because of the competitive nature of its busi- nomic viability of a high-cost project such as oil
ness and the highly elastic demand for its prod- drilling or gold mining is not merely a matter of
ucts, KEM's operations will lose financial viabil- convenience. Because reopening oil fields or
ity if oil prices rise above $20.50 a barrel during mines that have been shut down can cost an
the next three years. inordinate amount of money, typically it pays to
Clearly, in this case, OIL and KEM are keep them running at a loss for a limited period
concerned about falling and rising oil prices, of time. Thus, it is often prudent for producers
respectively. Thus, they are good candidates for (e.g., Company OIL4)to enter into receive-fmed
a three-year oil swap with monthly settlement commodity swaps to remove price volatility at
and "notional principal" of 500,000 barrels. those times when the operation is particularly
Working through a swap dealer, they arrange vulnerable.
the transactions illustrated in Figure 6.9. The Commodity swaps can also be used to re-
monthly WTI index value is determined as the verse forward positions previously transacted if
average of the daily settlement prices for the the counterparty to those agreements changes
WTI futures contract traded on the New York its view of the future prices. For example, air-
Mercantile Exchange. By their agreements with lines often use forward contracts to lock in the
the swap dealer, OIL is effectively fixing the price of jet fuel two or three years out. If a
price of its oil sales at $20.00 a barrel and KEM carrier believes prices will decrease to a level
is fixing the price of its purchase at $20.10. The below the contracted price, a swap could neu-
actual settlement transactions will be as follows: tralize the long forward position, allowing the
user to effectively pa)Tthe market price.
If average WTI settlement price is $20.75:
OIL pays to Dealer: ($20.75 - $20.00) x Summary of Swap Variations and
(500,000) = $375,000, and
KEM receives from Dealer: ($20.75 -
Extensions
$20.10) X (500,000) = $325,000. The rapid a.nd phenomenal growth of the
If average WTI settlement price is $19.40: swap industry could not have occurred if only
OIL receives from Dealer: ($20.00 - one basic product were available or if it could be
$19.40) x (500,000) = $300,000, and used in only one way. In this chapter, we have
KEM pays to Dealer: ($20.10 - $19.40) x described several ways in which the plain vanilla
(500,000) = $350,000. form of swap contracting has been expanded to
meet the needs of an increasingly sophisticated
and demanding audience. These adaptations
Notice that, barring default of one of the coun- range from straightforward variations on the
terparties, the swap dealer in this matched trans- traditional theme to extensions of the concept into
action has no exposure to WTI prices and simply entirely new markets. Any such list will always be
collects the spread of $50,000 each month. The incomplete and, given the present rate of progress,
is likely soon to be obsolete. Nevertheless, we
hope to have conveyed a sense that swap agree-
Figure 6.9 Illustration of an Oil- ments are one of the most flexible financial instru-
1 Company
,
Oriented Commodity Swap
$20.00
(per barrel)
Average WTI
Futures Price
swap Dealer
--$20.10
(per barrel)
Average WTI
+
Futures Price
Company
KEM
ments ever created. The importance of swaps in
modem financial markets cannot be overstated,
and consequently, a thorough understanding of
why they exist and how they work is imperative
for anyone functioning in those niarkets. It is our
hope that the preceding discussionshave provided
(per barrel) (per barrel) guidance in this regard.
Exercises
Exercise 6.1: The diff swap illustrated in Figure 6.2 required the swap dealer to pay
DEM LIBOR plus 1.85 percent in exchange for sterling LIBOR, with both rates
translated into cash flows using the same GBP 10 million notional principal. The tenor
of this agreement, which specified quarterly settlements, was two years.
(a) Assuming that the swap dealer has left this position unhedged, what is the implicit view
he is taking with respect to rate changes in the United Kingdom and Germany?
(b) Given that the present pound and deutschemark LIBOR differential (i.e., 110 bps
= 6.25 percent - 5.15 percent) is less than the 185-basis-pointswap spread differential,
one immediate problem the dealer faces is that he will be required to make the first net
settlement payment. Suppose that bid-ask fixed rates on two-year, sterling-denomi-
nated, plain vanilla swaps (against three-month sterling LIBOR) are currently being
quoted in the interbank market at 8.00 percent and 8.05 percent, respectively. What
combination of transactions would be needed to transform the diff swap into a contract
by which the dealer receives a cash flow of the form (constant percent - deutsche-
mark LIBOR) and pays sterling LIROR? After engineering this modification, comment
on whether the dealer's resulting exposure is consistent with the implied view from
Part (a) above.
Solution:
(a) The dealer is implicitly assuming that the differential between British and German
short-term rates will widen more rapidly, and by a greater amount, than the current
market view. Such a result could occur if German rates actually fall as British rates rise,
or if sterling LIBOR rises at an accelerated pace relative to deutschemark LIBOR.
(b) The desired transformation could be made by combining a pay-deutschemark
LIBOR/receive-sterling LIBOR diff swap position with two receive-8.00 percent
fixed/pay-sterling LIBOR swaps (or one for twice the GBP 10 million principal). Figure
E-6.1 shows this transaction graphically (assuming the swap fixed rate is also quoted
on an actua1/365 day count). Notice that the dealer's initial net cash flow on the
Figure E-6.1 Converting the Diff Swap

Synthetically
O n e diff swap
DEM LIBOR + 185 bps
P
Money Manager Swap Dealer
plus two receive-fixed plain vanilla swaps

2 x GBP LIBOR
I
Another Dealer
2 x 8.00% (in GBP)
equals
GBP LIBOR
Swap Dealer
2 x 8.00% - (DEM LIBOR + 185 bps)

= 14.15% - DEM LIBOR
combined transaction is now positive [2.75 percent = (14.15 percent - 5.15 percent)
- 6.25 percent]. Although the dealer still benefits from a German or British rate
decline, an increase in either rate-regardless of the size of the differential between
them-will erode this advantage. Thus, the new position creates a markedly different
exposure for the dealer than did the original diff swap.
Exercise 6.2: A recently negotiated, indexed, amortizing rate swap contract has the
following terms:
Maturity Three years
Notional principal USD 50 million
Fixed rate 6.50% (actua1/365 day count)
Floating rate index Six-month LIBOR (actua1/360 day count)
Lockout period One year
Payment and Semiannually
amortization frequency
Amortization If LIBOR < 3.50 percent, 100 percent amortization
schedule If LIBOR > 7.50 percent, 0 percent amortization
If 3.50 percent 5 LIBOR 5 7.50 percent, amortize
0.25 percent of notional per basis point
"Clean up" call When principal has amortized to 15 percent of origi-
nal principal, swap terminates
Suppose that the LIBOR values corresponding to each future settlement/amortization
date are as follows: 0-6 months, 6.00 percent; 6-12 months, 6.75 percent; 12-18
months, 6.25 percent; 18-24 months, 5.50 percent; 24-30 months, 5.00 percent; and
30-36 months, 4.50 percent. Calculate the outstanding notional principal on each
settlement date.
Solution: The amortization schedule implied by the designated LIBOR path is
presented in Table E-6.1. For instance, the reduction to $34.38 million on the first
amortization date is calculated as $50 million times [ l - (750 bps - 625 bps) x (0.25
per bp)]. The principal balance of $17.19 million in the next period is then calculated
as $34.38 times [ l - (750 bps - 550 bps) x (0.0025)]. The swap terminates in the
following period when the clean-up call limit of (0.15 x $50,000,000) = $7.5 million is
reached.
Table E-6.1 Amortization Schedule for IAR Swap

Outstanding
Period LIBOR Reduction Notional Principal
(months) (%) (%I ($million)
Lockout 50.00
Lockout 50.00
31.25 34.38
50.00 17.19
62.50 6.45
Swap terminated
Exercise 6.3: Suppose that two years ago, in August 1992, a corporation issued
seven-year bonds with a frxed coupon rate of 10 percent payable semiannually on
February 15 and August 15 of each year. The debt was structured to be callable (at par)
after a four-year deferment period and was issued at par value of $100 million. Now, in
August 1994, the bonds are trading in the market at a price of 106, reflecting the
general decline in market interest rates and the corporation's recent upgrade in its
credit quality. The corporate treasurer believes that the current interest rate cycle has
bottomed. If the bonds were callable today, the firm would realize a considerable
savings in annual interest expense. Unfortunately, however, the bonds are still in the
call-protectionperiod. The treasurer's fear is that market rates might rise considerably
prior to the call date in August 1996.
Assess the pros and cons of the following strategies that could be adopted in August
1994 to manage the corporation's interest rate risk problem. For each strategy, plot the
gains and losses associated with the underlying exposure and affiliated hedge against
the three-year Treasury yield (T) that prevails in August 1996. In this effort, define the
corporation's August 1996 refunding rate as T + BS, where BS is the company-specific
bond credit spread. The value of the swap position (as of August 1996) will depend on
prevailing three-year swap fixed rates, or T + SS, where SS stands for the swap spread.
Strategy I: Enter an off-market forward swap as the fixed-rate payer by agreeing to
pay 9.50 percent (rather than the at-market rate of 8.50 percent) for a three-year swap,
two years forward. Because this fixed rate is above the at-market level, the corporation
will receive from its counterparty an up-front payment of $2.25 million. Assume that the
corporation's refunding spread remains at its current 100-basis-point level and the
three-year swap spread over Treasuries remains at 50 basis points. Then, the annual
reduction in interest expense after refunding is [lo percent - (T + 0.50 percent)] if the
firm is able to refund, zero if it is not. The gain (or loss) on unwinding the swap is the
fixed rate at that time: [(T + 0.50 percent) - 9.50 percent]. Those two effects net to
zero, given the assumed spreads. Thus, the corporation has effectively "sold" the
embedded call option for $2.25 million.
Strategy II: Buy a payer swaption expiring in two years with a strike rate of 9.50
percent. This transaction would give the corporation the right to enter a $100 million,
three-year swap as the fixed-payer, and the counterparty that wrote the option would
be obligated to receive the fixed rate. The corporation would exercise the option if the
fixed rate on three-year swaps in 1996 is above 9.50 percent and then unwind the swap
position at a profit. That gain would offset the loss of not being able to call the bonds
and refinance at lower interest expense. (For example, if interest rates in August 1996
are 12 percent, the bond would not be called but the swaption would be worth the
present value of a three-year annuity of $2.5 million.) This payer swaption would cost
the firm only $1.1 million because the swaption is out of the money; a swaption with a
strike rate below 8.50 percent would be in the money.
Strategy III: Sell a receiver swaption expiring in two years at a strike rate of 9.50
percent. This arrangement gives the buyer, presumably a swap dealer, the right to
enter a three-year swap in 1996 as the fixed receiver while the corporation pays the
fixed rate. The dealer would exercise the option only if the future swap fixed rate is less
than 9.50 percent. Presuming that both three-year swap and bond rates are less than
9.50 percent in August 1996, both the corporation and the bank will exercise their
options, with the benefit of one offsetting the cost of the other. The premium the
corporation receives for selling this in-the-money swaption is $2.5 million. Thus, as in
Strategy I, the company has effectively monetized its embedded call option position.
Solution: The August 1996 decisions and payoff diagrams associated with each
strategy are as follows:
Strategy I. Enter an of-market forward swap.

Initial cash flow: Receive $2.25 million
August 1996 decisions:
Gain on refunding (per settlement period):
[lo percent - (T + BS)] if T + BS < 10 percent,
0 if T + BS 1: 10 percent.
Gain (or loss) on unwinding the swap (per settlement period):
- [9.50 percent - (T + SS)] if T + SS < 9.50 percent,
[(T + SS) - 9.50 percent] if T + SS r 9.50 percent.
Assuming that BS = 1.00 percent and SS = 0.50 percent, these gains and losses in 1996
can be depicted as in the top panel of Figure E-6.2. The net effect is shown in the lower
panel.
Figure E-6.2 Callable Debt Management

with a Forward Swap
Gains If Bs
Gain on
Refunding
G:rar
Unwinding
goes up
If SS goes down
Losses
Net Gain
If SS oes down
Losses 1 or BEgoes up
Notice that because the company stands to gain in August 1996 if rates rise, it has
not fully monetized the embedded call option. The problem with this solution is that it
uses a symmetric-payoff instrument (a forward swap) to hedge an asymmetric-payoff
(option) problem.
Strategy II. Buy payer swaption.
Initial cash flow: Pay $1.10 million
Gain on refunding (per settlement period):
[ l o percent - (T + BS) ] if T + BS < 10 percent,
0 if T + BS 2 10 percent.
Gain on unwinding the swap (per settlement period):

[ (T + SS) - 9.50 percent] if T + SS > 9.50 percent,
0 if T + SS I9.50 percent.
With BS = 1.00 percent and SS = 0.50 percent, these gains and losses are as shown
in the top panel of Figure E-6.3. The net gain is shown in the lower panel.
Figure E-6.3 Callable Debt Management
,
with a Payer Swaption
Gain on Gain on
Refunding Exercising
Gains
I \
Payer Swaption
1 lf Bs
goes up 4, If 93 g o o down
Losses
Gains Net Gain
If SS oes down
or BE goes up
9% T
Losses
In this case, the company will benefit from Treasury rates being either higher or
lower than 9 percent in August 1996. Of course, the treasurer had to spend an
additional $1.10 million to lock in this "straddle," so although the benefit to the
embedded refunding option has been preserved, it was done at a significant price.
Strategy III. Sell receiver swaption.
Initial cash flow: Receive $2.50 million
Gain on refunding (per settlement period) :
[lo percent - (T + BS) ] if T + BS < 10 percent,
0 if T + BS >. 10 percent.
Loss on unwinding the swap (per settlement period):
0 if T + SS 2 9.50 percent,
[9.50 percent - (T + SS) ] if T + SS < 9.50 percent.
With BS = 1.00 percent and SS = 0.50 percent, these gains and losses and the net
effect are as shown in Figure E-6.4.
By selling the receiver swaption, the company has been able to simulate the sale of the
embedded call feature of the bond, thus fully monetizing that option. The only remaining
uncertainty is the basis risk associated with unanticipated changes in swap and bond spreads.
Fgure Em6.4 Calabk Debt Management

with a Receiver Swaption
Gain on
Gains
I Refunding
If Bs\
goes up
If SS goes down
Losses I Loss on Selling

Receiver Swaption
Gains Net Gain
If SS oes down
Losses 1 or BEgoes u p
Exercise 6.4: On December 2, the manager of a tactical asset allocation fund that is
currently invested entirely in floating-rate debt securities decides to shift a portion of
her portfolio to equities. To effect this change, she has chosen to enter into the
"receive equity index" side of a one-year equity swap based on movements in the S&P
500 index plus a spread of 10 basis points. The swap is to have quarterly settlement
payments, and the floating-rate side of the agreement is pegged to three-month LIBOR
denominated in U.S. dollars. At the origination of the swap, the value of the S&P 500
index was 463.11 and three-month LIBOR was 3.50 percent. The notional principal of
the swap is fixed for the life of the agreement at $50 million, which matches the amount
of debt holdings in the fund that she would like to convert to equity.
(a) Calculate the net cash receipt or payment-from the fund manager's perspec-
tive- on each future settlement date, assuming the values for the S&P 500 index (with
all dividends reinvested) and LIBOR are as follows:
Number of S&P LIBOR
Settlement Date Days Level Level
December 2
(initial year)
March 2
(following year)
June 2
September 2
December 2
(b) Explain why the fund manager might want the notional principal on this swap to
vary over time and what the most logical pattern for this variation would be.
Solution:
(a) With these estimates, the settlement payments can be calculated as follows:
March 2:
Floating-rate payment =
(0.0350 - 0.0010) x ($50,000,000) X (90/360) = $425,000
Equity-index receipt =
[(477.51 - 463.11)/463.11] X ($50,000,000) = $1,554,706.
So the net receipt the fund expects would be ($1,554,706 - $425,000) = $1,129,706.
June 2:
(0.0325 - 0.0010) X ($50,000,000) X (92/360) = $402,500
[ (464.74 - 477.51)/477.51] X ($50,000,000) = -$1,337,145.
So the net payment the fund owes would be ($1,337,145 + $402,500) = $1,739,645.
September 2:
(0.0375 - 0.0010) X ($50,000,000) X (92/360) = $466,389
I(480.86 - 464.74)/464.74] X ($50,000,000) = $1,734,303.
So the net receipt the fund expects would be ($1,734,303 - $466,389) = $1,267,914.
December 2:
(0.0400 - 0.0010) X ($50,000,000) X (91/360) = $492,917
[ (482.59 - 480.86) /480.86] X ($50,000,000) = $179,886.
So the net payment the fund owes would be ($492,917 - $179,886) = $313,031.
(b) It is also quite common for equity swaps to be based on a notional principal amount
that varies directly with the level of the underlying index. If, for instance, the swap
participants had agreed to let the initial notional principal of $50 million vary over time,
it would have been adjusted up on March 2 to $51.555 million. This adjustment is
calculated as ($50 million (1 + [(477.51 - 463.11)/463.11] 1). That is, each settlement
date, the notional principal is adjusted up (down) by the percentage of capital
appreciation (depreciation) in the starting level of the index. This adjustment process,
which is equivalent to adding the gross equity settlement payment to the initial
notional principal, simulates the return that investors with direct stock positions would
obtain inasmuch as their actual equity exposure would rise or fall with market
conditions. In contrast, a fmed notional principal in an equity swap is equivalent to an
asset allocation strategy by which the equity exposure is kept constant.
Appendix: Calculation of the Macaulay Duration
Statistic
Duration is a summary statistic about the price risk of a financial asset or liability. It
combines both the coupon and maturity effects of a change in yield on the market
value of the security. Technically, duration is a measure of the price elasticity of the
security with respect to its yield, measuring the percentage change in price for a given
percentage change in its periodic yield. That is,
Duration - -
APrice/Price
A (1 + Yield) / (1 + Yield) '
Consider a 12 percent, annual payment, five-year bond that is priced at 107.581574
(percent of par value) to yield 10 percent. If the yield were to fall by 1basis point to 9.99
percent, the price would rise to 107.621428. The duration of the bond can be
approximated as
Duration - -
(107.621428 - 107.581574)/107.581574
- 0.0001/1.1000
= 4.075.
Although duration in this context has no dimension (it is merely a percentage change
divided by another percentage change), it usually is interpreted in units of time. This
five-year bond would have a duration of about 4.075 years. Notice that this measure is
an approximation of the true relationship between a bond's price and its yield to
maturity. For a fixed-income security without embedded options, that connection is
convex; duration provides a linear approximation of what really is a nonlinear
relationship. Moreover, duration is a somewhat biased approximation in that it
overestimates price decreases when yields rise and it underestimates price increases
when yields fall. This relationship is illustrated in Figure A-1.
Many applications of duration come from rearranging the elasticity expression
-APrice - - Duration X A(l + Yield)

Price (1 + Yield) '
The percentage price change is a measure of the riskiness of a financial asset. For a
given change in yield, duration provides an estimate of the percentage price move-
Figure A-1 Price-Yield Relationship for Fixed-Income Bonds without Embedded

Options
Underestimate of Price Increase

When the Yield Falls
8
.d
8 Overestimate of
Price Decrease
When the Yield Rises
Convex Price-Yield
Curve
Yield
ment. Clearly, the larger the duration, the greater the price change. Another
rearrangement focuses on the absolute change in the yield, not the percentage change;
that is,
APrice Duration
- x AYield.
(1 + Yield)
N
N
Price
Duration divided by 1 plus the yield per period is known as modzf;tedduration.
Yet another rearrangement draws attention to the absolute change in the asset's
price.
-
Duration
(1 + Yield)
x Price x AYield.
I
The term in brackets, the modified duration times the market value of the security, is
known as dollar duration.
Another special case is when the change in price is measured for a change in yield
limited to 1basis point. If AYield is equal to 0.0001, then APrice is known as the basis
point value (BPV) of the bond:
BPVx -
Duration
(1 + Yield)
x Price
I X 0.0001.
Duration was first developed and named by Frederick Macaulay in 1938. His
duration statistic, which continues to bear his name, is calculated as a weighted
average time to maturity, where the weights are the shares of total value represented
by each cash flow. This can be written as:
+ Yield) Coupon/(l + Yield)2
Coupon/(l
]] + (2 [ Price II
+ . . . + {WLW x [(Coupon + Par)/
Price
(1 + Yield) #pDS
Notice that the numerators of the terms in brackets are the present values of the cash
flows. The numerator in the final term combines the last coupon and the redemption
of the par value. Each cash flow is discounted by the periodic yield to maturity. The
denominator in each term is the market price of the security. Therefore, the terms in
brackets are the shares of total present value for each cash flow. Finally, note that the
Appendix: Calculation of the Macazclay Duration Statistic
present value share of each cash flow is multiplied by the date the payment is received,
from the first to the final payment. The total number of periods is indicated by #PDS.
Consider again the five-year, 12 percent bond yielding 10 percent. Suppose its par
value is $1,000. The price and duration statistic can be calculated as shown in Table
A-1. Notice that the Macaulay duration statistic, shown to be 4.074, is virtually the same
as found above by estimating the price elasticity to yield changes. This five-year
coupon bond can now be thought of as a portfolio of five zero-coupon bonds, one for
each payment date. The duration of the coupon bond at 4.0740 years is the weighted
average maturity of the portfolio, where the weights are the respective shares of
market value (e.g., the one-year zero is 10.14 percent of the value of the portfolio, the
five-year zero is 64.64 percent). Duration also can be interpreted as the zero-coupon
equivalent maturity: A five-year coupon bond having a duration of 4.0740 years is
"equivalent" in terms of price risk to a zero-coupon bond having a maturity of 4.0740
years.
Table A-1 Calculation of the Macaulay Duration Statistic

Year Cash Flow PV at 10% (PV/Price) [Year(PV/Price) ]
120 109.09 0.1014 0.1014
120 99.17 0.0922 0.1844
120 90.16 0.0838 0.2514
120 81.96 0.0762 0.3047
1,120 695.43 0.6464 3.2321
Price = 1,075.82 Duration = 4.0740
A general formula for calculating the Macaulay duration statistic can be derived
from taking the sums of the finite geometric series and rearranging terms. This
formula can be written as
1 + Yield 1 + Yield+ {#PDS x [(Coupon/Par) - Yield]}
Duration = -
Yield {(Coupon/Par) x [(I + Yield)#PDS
- I]} + Yield'
In the numerical example above, yield = 0.10, #PDS = 5, and the coupon rate, given
as (coupon/par), = 0.12. The Macaulay duration can be solved as
1+0.10 1+0.10+[5x(O.12-0.10)]
Duration = - = 4.0740.
0.10 {0.12 x [(I + 0.10)~- 11) + 0.10
The Macaulay duration formula is applicable only to fixed-income securities. For
instance, one cannot directly calculate the duration of an FRN because the future cash
flows are not known with certainty. Using the idea that duration is a measure of price
elasticity, however, analysts often use the concept of implied duration. The implied
duration of an FRN that resets its coupon every six months (e.g., at LIBOR + 0.25
percent) is taken to be the time remaining in the coupon reset period.
Immediately before the next coupon rate is set, the implied duration is zero. The
market price of the FRN will be par value no matter what the level of LIBOR. Note that
this result assumes no constraining maximum or minimum coupon rate and no change
in the credit risk of the issuer or in the marketability of the issue itself. Immediately
after the rate is set, the implied duration is six months because, like any zero-coupon
security, the next cash flow is certain. The implied duration will then decline in a linear
fashion as the next reset date nears. This pattern is shown in Figure A-2.
Figure A-2 Implied Duration for a Floating-Rate Note

n
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Swaps, Currency Swaps, and Credit Risk." Issues in Bank the Bid Ask Spread of Default-Risky Interest Rate Swaps."
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Smith, Clifford W., Jr., Charles W. Smithson, and Lee M.
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Glossary of Swap Terminology
Arbitrage: The opportunity to exploit price correlated. Basis risk in swap transactions can
differentials on tv~ootherwise identical sets of exist because of reference rate, notional prin-
cash flows. In arbitrage-free financial mar- cipal, or settlement date mismatches. Basis
kets, any two transactions with the same risks risk is also known as tracking error or corye-
and expected cash flows should have the lation risk.
same price. Basis Swap: An interest rate swap in which
Arrears Swap: A swap agreement in which both sides are linked to reference rates that
the floating rate is both set and paid at the end reset on each settlement date.
of the settlement period. In contrast, the usual Bid-Offer Spread: The fixed rate at which a
arrangement is to set the rate in advance and dealer will take either the pay- or the receive-
pay it in arrears. fixed side of a swap transaction. The offer rate
Asset Swap: A standard swap contract that is is also called the ask rate.
used to convert the interest rate or currency Broker: A financial institution that facilitates a
exposure of any security held as an asset. swap transaction between two counterparties
Assignment: The transfer of an existing swap but does not itself become a counterparty to
contract from one counterparty to another. the agreement. The broker's compensation
Because of credit quality differentials becomes in the form of a swap arrangement fee.
tween the existing and potential participants, Cap Agreement: A contract that on each set-
assignment requires either consent of the tlement date pays its holder the greater of the
remaining counterparty or legal action. difference between the reference rate and the
Basis Point (bp): An amount equal to 0.01 strike rate or zero. A cap is equivalent to a
percentage point. For example, a change in series of call options on the reference rate or
rates from 5.00 percent to 5.25 percent would put options on the underlying security.
be an increase of 25 basis points. Collar Agreement: The combination of a
Basis-Point Value: The change in the market long (short) cap agreement and a short (long)
value of an investment holding caused by a floor agreement for which the cap and floor
1-basis-point change in interest rates. This strike rates are usually selected to be out of
change is often approximated by multiplying the money. An interest rate swap can be
a position's dollar duration statistic by 0.0001. viewed as a zero-cost collar in which the cap
Basis Risk: The residual risk resulting from and floor strike rates are identical. Also called
hedging an underlying economic exposure a range forward in foreign exchange (FX)
with a hedge vehicle that is less-than-perfectly deals.
Commodity Swap: A swap transaction in Counterparty: A participant in a swap trans-

which one of the cash flows is tied to a fixed action. It is often useful to distinguish be-
price for a commodity and the other is based tween counterparties that are corporate end
on a fluctuating commodity index level. The users and the market makers whose function
most common commodity swaps involve base is to facilitate trade.
metals, precious metals, and energy. Cross-Default: A swap contract provision
Constant-Maturity Swap: A form of basis specifying that default by a counterparty on
swap in which one side is referenced to a any other financial transaction triggers de-
short-term rate such as LIBOR and the other fault on the swap. This condition is intended
is based on the long-term constant-maturity to eliminate a distressed firm's ability to stra-
Treasury bond yield. By resetting the two tegically time a swap's default.
sides of the agreement to different points on Currency Swap: A swap transaction in which
the yield curve, this contract is often used to the cash flows are denominated in different
exploit changes in the shape of the term currencies. This type of contract often dic-
structure of interest rates. Also known as a tates a physical exchange of principal on the
yield curve swap. origination and maturity dates. It can be de-
Constant-Maturity Treasury (CMT): An in- signed so that both rates are fixed, both are
terest rate index that is based on a hypothet- floating, or one is floating and the other fwed.
ical Treasury security with a fixed maturity. A deal structure that does not require the
Most often used as the floating-rate side of a re-exchange of principal at maturity is called a
constant-maturity basis swap or the reference currency annuity swap.
rate in an indexed amortizing rate swap. Day Count: The convention used for prorating
Convexity: A statistic summarizing how the an interest rate movement expressed on an
duration of a fixed-income security changes annual basis to the percentage of the year
when yields change. Convexity can be viewed represented by the settlement period. The
as the approximate difference between the three most common day-count conventions
actual price response to a given interest rate are actua1/360, actua1/365, and 30/360.
change and the response predicted by the Dealer: A financial institution that facilitates
duration-based formula. A security with posi- swap transactions by acting as a direct coun-
tive convexity will benefit more (suffer less) terparty. A dealer's compensation comes as
than predicted from rate declines (increases). trading profit from paying a low fixed rate
Negative convexity instruments such as mort- (i.e., the bid rate) and receiving a high fwed
gage-linked securities having prepayment op- rate (i.e., the offer rate).
tions will show the opposite effect. Default Exposure: The loss that would be
Correlation: A statistical measure summariz- incurred by an individual or corporation on a
ing the joint volatility of two variables such as swap transaction if its counterparty defaults.
the prices or yields on different financial Measurement of default exposure is usually
instruments. A positive correlation coefficient divided into the actual loss that would be
indicates that two security returns tend to realized if the counterparty defaults today
move in the same direction. Negative correla- (i.e., mark-to-market exposure) and the worst-
tion, which is the basis for hedging, exists case potential exposure (i.e., fractional expo-
when the two return series tend to move in sure) if the counterparty defaults at some
opposite directions. point in the future.
Corridor Swap: An interest rate swap in Dollar Duration: A statistic approximating the
which the payment obligation accrues only on dollar change in the price of a fixed-income
those days during the settlement period when security for a given percentage change in 1
the reference rate is within a predetermined plus the periodic yield. Dollar duration is
range, or corridor. This arrangement is struc- calculated by rearranging the basic Macaulay
tured to help a counterparty exploit a view on duration equation linking percentage price
the volatility of interest rates. and percentage yield movements.
Duration: A statistic summarizing the approx- fured and a floating rate, respectively. FRAs
imate relationship between the price of a can be viewed as one-date interest rate swaps.
fixed-income security and interest rates. Ma- Forward Swap: Also known as a deferredstad
caulay duration links the percentage change swap, this agreement is one for which the
in a bond's price with the inverse of the terms are negotiated now but not scheduled
percentage change in 1 plus the periodic to begin until a later date.
yield; modified duration is the Macaulay sta- Fractional Exposure: The potential default
tistic divided by 1 plus the periodic yield. exposure on an uncollateralized derivative
Equity Swap: A swap transaction in which one transaction. This exposure is often calculated
cash flow is tied to the return to an equity by measuring the mark-to-market exposure of
portfolio position, often an index such as the a swap, cap, or floor at every future settlement
Standard & Poor's 500, while the other is date using each of several projected interest
based on a floating-debt yield such as LIBOR. rate paths and then selecting the worst-case
Financial Engineering: An idiomatic expres- scenario.
sion most often associated with the action of Gap Analysis: The process of establishing
packaging or repackaging a set of cash flows interest rate and currency exposure mis-
in order to satisfy the disparate needs of matches among the assets and liabilities on a
different end users or to create a risk-return balance sheet. Duration gap is one form of
trade-off that is otherwise unavailable. A sim- this analysis using the present value sensitiv-
ple example would be combining a floating- ities of the various accounts.
rate note with an interest rate swap to convert Hedge: A financial transaction designed to re-
a variable stream of debt payments into a duce, either fully or partially, the market risk
fixed-rate obligation. associated with a particular security or bal-
ance sheet account. This reduction in risk is
Floating-Rate Note (FRN): Also known as
accomplished by adopting a hedge position,
floaters, these instruments are short- to inter-
often by using a derivative such as a swap that
mediate-term bonds with coupon payments
is negatively correlated with the underlying
linked to a variable reference rate, most often exposure.
LIBOR. Common coupon reset formulas in- Hedge Ratio: The amount of the hedge posi-
clude traditional floaters, for which the cash tion required to offset the market risk in an
flow varies directly with LIBOR movements; underlying position. Depending on the nature
reverse FRNs, which specify a coupon equal to of the instruments Involved, hedge ratios can
a constant percentage less LIBOR; and bear be expressed in either numbers of contracts
floaters, with coupons equal to a multiple of or the total dollar value needed.
LIBOR less a constant percentage. Implied Forward Rate: The reinvestment
Floor Agreement: A contract that on each rate built into the yields of financial instru-
settlement date pays its holder the greater of ments that differ only in time to maturity. For
the difference between the strike rate and the example, one- and two-year zero-coupon
reference rate or zero. A floor is equivalent to yields of 5 percent and 6 percent, respectively,
a series of put options on the reference rate or imply a one-year yield, one year forward of 7
call options on the underlying security. percent; that is, 6 percent a year for two years
Forward Curve: The sequence of future yields is equivalent to 5 percent for the first rolled
corresponding to the floating reference rates on into 7 percent for the second.
a swap. Forward curves can be observed di- Implied Volatility: A volatility measure de-
rectly from the rates built into fomard rate rived by setting the market price of a deriva-
agreements and Eurodollar futures prices, in- tive security (such as a swaption) equal to its
ferred from cash market prices, or estimated by fair value, as indicated by a theoretical valua-
interpolation from the Treasury yield curve. tion model. Implied volatility statistics are
Forward Rate Agreement (FRA): A trans- often used as surrogate measures in deter-
action in which two counterparties agree to a mining whether a derivative security is mis-
single exchange of cash flows based on a priced.
In the Money: A derivative security that is Mark-to-Market (MTM) Exposure: The ac-
profitable for the holder to exercise at current tual loss incurred on an existing swap (or a
market conditions is said to be in the money. long position in a cap or floor) if the counter-
For example, an in-the-money cap agreement party defaults today, measured as the cost of
is one for which the level of the reference rate negotiating a replacement for the defaulted
is greater than the strike rate. transaction. For instance, if a company paying
Indexed Amortizing Rate Swap: A swap in fixed on an 8 percent, three-year swap had its
which the notional principal varies according counterparty default at a time when new
to changes in a market reference rate, often swaps require 9 percent payments, the MTM
the constant-maturity Treasury index or exposure would be the present value of a
LIBOR. Used to mimic the negative convexity three-year annuity equal to the 1 percent rate
in mortgage securities, the notional principal differential times the notional principal.
is typically scheduled to decline as market Mark-to-Market Swap: An interest rate
rates fall. swap in which the mark-to-market (i.e., ac-
Interest Rate Swap: A generic agreement tual) default exposure is exchanged in cash
calling for the periodic exchange of cash on each settlement date, along with the usual
flows, one based on an interest rate that net settlement payment. The fixed rate on the
remains fixed for the tenor of the contract and swap is then reset to reflect prevailing market
the other linked to a variable-rate index. Cash conditions.
payments are determined by a notional prin- Market Maker: In a swap context, any dealer
cipal and are usually made on a net settlement or intermediary who provides regular bid and
basis. offer quotes and stands ready to book either a
Intermediation: The act of repackaging the pay-fixed or receive-fixed transaction.
cash flows between the ultimate long and Market Risk: The exposure that results from
short positions in a financial transaction. In holding an unhedged swap as market condi-
the swap market, intermediation usually in- tions change. For instance, the fixed-rate re-
volves hedging one contract with any of sev- ceiver will see the value of its existing swap
eral different instruments, including other position decline as new fixed rates on compa-
swaps, forward rate agreements, futures, and rable replacement swaps increase.
option contracts. This process is sometimes Master Swap Agreement: Created and
called running a dynamic book. maintained by ISDA, the set of documents
International Swap and Derivatives Asso- outlining the standard terms and conditions
ciation (ISDA): A trade group whose major governing all swap transactions between two
contribution has been the creation of the counterparties.
Master Swap Agreement, which has become Net Settlement: A condition of a swap agree-
the standard for documentation in the indus- ment that simplifies the settlement process by
try. having the counterparty that owes the larger
London Interbank Offered Rate (LIBOR): amount pay the net of the larger and smaller
The primary short-term rate used in Euromar- gross obligations.
ket security and swap transactions. LIBOR Netting Agreement: A provision in a swap
can be expressed in several currencies, in- contract that allows for the offset of settle-
cluding U.S. dollars, British sterling, German ment payments and receipts on all contracts
marks, Swiss francs, and Japanese yen. between the same two counterparties. Al-
Long Position: The holder, or buyer, of an though not fully established in all legal ven-
investment position. Being long in a plain ues, this provision is intended to limit default
vanilla swap refers to the counterparty in the exposure to a counterparty.
pay-fixed position. Notional Principal: The principal value of a
Matched Book: A situation in which a market swap transaction, which is not exchanged but
maker has arranged exactly offsetting swap is used as a scale factor to translate interest
transactions so that he or she has no net rate differentials into cash settlement pay-
market risk. ments.
Off-Market Swap: An interest rate swap in bond market and swap spread in swap trans-
which the fmed rate is purposefully set away actions.
from the market-clearing level. This requires Settlement Date: The point in time on which
a payment from the receiver of the above- swap cash flows are documented and ex-
market (or payer of the below-market) rate to changed. Quarterly or semiannual settlement
the other counterparty. dates are typical for swap agreements.
Out of the Money: A derivative security that Short Position: The seller of an investment
is out of the money cannot be exercised by its position. Being short in a plain vanilla swap
holder at a profit under current market con- refers to the counterparty in the receive-fixed
ditions. For instance, an out-of-the-money position.
floor agreement is one for which the level of Strike Rate: The rate at which a cap, floor, or
the reference yield is greater than the strike swap option can be exercised. It is analogous
rate. to the fixed rate in a swap agreement.
Parallel Loans: An arrangement that pre- Structured Finance: An approach to creating
cedes a swap transaction whereby two coun- financial transactions that attempts to tailor an
terparties create simultaneous loans with one instrument to the specific needs of the even-
another. These loans are typically made in tual end user. These deals often require an
different currencies and often have different intermediary to combine stock and bond po-
fixed/floating rate exposures. sitions with derivative securities to construct
Plain Vanilla: A term used to describe the a set of cash flows that either have the desired
most basic form of a single-currency, con- properties or create an arbitrage opportunity.
stant-notional-principal interest rate swap in Swap Option: Also called swaptions, these
contracts give the holder the right, but not
which futed-rate cash flows are exchanged for
the obligation, to enter into an interest rate or
floating-rate payments.
currency swap at prearranged terms. A re-
Quality-Spread Differential: The difference
ceiver swaption gives the holder the right to
between the borrowing advantage that a su- enter the swap as the fixed-rate receiver; a
perior-credit company has over a weak-credit payer swaption permits entry as the fixed-rate
firm in different maturity classes. The stan- pa.yer. Swaptions can also be designed to
dard credit arbitrage explanation for interest allow a counterparty to exit from an existing
rate swaps relies on the existence of a non- swap.
zero quality-spread differential between the Swap Spread: The difference between the
fixed- and floating-rate markets. fixed rate on a swap and the Treasury yield of
Rate-Differential Swap: Also known as a dif equivalent maturity. Most often used as a
swap, this contract is a form of basis swap in convenience in quoting U.S. dollar-denomi-
which the two cash flows are referenced to nated interest rate swaps.
short-term rates established in different coun- TED Spread: The Treasury bill futures price
tries but denominated in the same base cur- less the Eurodollar futures price for contracts
rency. In general, derivative structures in of comparable maturities and a common de-
which a rate settles in a currency different livery date.
from the original denomination are called TED Spread Swap: A basis swap structured
quantos. so that the respective cash flows are refer-
Reference Rate: The interest rate index de- enced to LIBOR and the Treasury bill yield.
fining the floating-rate side of a swap, cap, This contract is designed to take advantage of
floor, or swap option agreement. LIBOR is the changes in the credit spread at the short-term
pre-eminent reference rate in swap-related end of the yield curve.
transactions. Tenor: The maturity of a swap transaction.
Risk Premium: The difference between the Varying Notional Principal Swap: A swap
yield set for a risky transaction and the risk- transaction in which the notional principal
free rate of corresponding maturity. The risk changes with each settlement, usually accord-
premium is known as a credit spread in the ing to a prearranged schedule. Amortizi~g
135
Interest Rate and Currency Swaps: A Tz&torial
swaps have decreasing notional principal lev- Yield Curve: A graphical depiction of the cur-
els, and accreting swaps have increasing lev- rent yields to maturity versus time for a set of
els. An agreement that first accretes and then financial instruments that are alike in all
amortizes is called a roller coaster swap. respects (e.g., liquidity, taxation, default risk)
Volatility: A statistical representation of the except for maturity. Also known as the term
changes in price or yield of a given security or structure of interest rates when referring to
balance sheet account over time. Often used yields on zero-coupon, default-free securities.
to gauge the level of market risk inherent in Zero-Coupon Swap: A swap in which the
an underlying position before structuring a fixed-rate receiver gets a single settlement
hedge portfolio, volatility is indicated by such payment at maturity and the fixed-rate payer
quantitative measures as standard deviation receives periodic settlements based on move-
or beta. ments in a floating-rate index.

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Keith C.

Interest Rate and Currency Swaps:

The Research Foundation of

The Research Foundation of

Acknowledgments ...................................... viii

Chapter 1. Overview of the Swap Market . . . . . . . . . . . . . . . . . . . I

This project began in 1986 when, as full-time consultants to Manufacturers Hanover

Keith C. Brown, CFA

Katrina F. Sherrerd, CFA

First Difference of 10-Year (Constant-Maturity) U.S. Treasury Yield Series

Data Source: Federal Reserve System.

I Growth of the Interest Rate

Figure 1.3 A Matched Pair of Five-Year Swap Transactions

Origination date: September 30, 1994

Initial Exchange of Principal

Receive Fixed DollarlPay Dollar LIBOX

Net Transaction: Pay Fixed SterlinglReceive Fixed Dollar

U.S. Dollar 8.04%

Table 1.7 Swap Activity by Currency as of Year-End 1993

Note: The currency swap total is unadjusted for double-counting of contracts.

U.S. Dollar Notional Principal

Figure E-1.1 A Matched Set of Seven-

Floating-rate payment = (0.0550) x (g) x ($40,000,000) = $1,106,111

Fixed-rate receipt = (0.0714) x

Table E- 1.1 Settlement Cash Flows, Fixed-Rate Receiver

Japanese Yen British Pound

receive 9.83 percent British sterling, pay U.S. dollar LIBOR.

Yen payment = (0.0492) x /El X (JPY 3,186,750,000)= JPY 78,608,828

Pound receipt = (0.0983) x (El x ((GBP 13,736,264) = GBP 686,390.

Table D l.2 Cash Flow Exchanges, Counterparty

Figure E-1.2 Company X's Synthetic

Fixed-rate debt coupon payment = (8.00%) x (360/365) = 7.89%

Figure E-1.3 Company Y's Synthetic

Figure E-1.4 Market Maker's Swap Exposures

Figure 2.1 Interpreting a Plain Vanilla R d e F i x e d Internst Rate Swap as a Pair

F i r e 2.2 Gapital Market Interpretation of a Currency Swap

These two examples raise an interesting The interpretation of a swap as a combination

A Swap as a Pair sf Option

Margin over LIBOR

Figure 2.9 Interpretingan Off-Market

At-Market, Pay-Fixed Off-Market, Pay-Fixed

loan; the series of incremental fixed payments in

(b) The bank is scheduled to pay $6,491.72 to DEF on March 15th.

Table E-2.1 Movements in the Swap Yield Curve

(0.0810 - 0.0720) X $25 million

(0.0770 - 0.0720) X $25 million

(0.0720 - 0.0675) x $25 million

Figure E-2.1 Converting a Dollar Bond with a Currency Swap

lssue a 10% Fixed-Coupon, USD 40 Million,Five-Year Bond

balance sheet exposure is to incur an offsetting amount of dollar-denominated

Table E-2.2 FX Forward Implied by Interest Rate Parity

Year Transaction Type Rate WPY/USD)

One-year FX forward = UPY 125/USD) x 1'' +

Three-year FX forward = UPY 125/USD) x [((I + 0'05))3] = JPY 108.718/USI)

Four-year FX forward = UPY 125/USD) x [((I + o'051)4] = JPY 103.776/USD

Five-year FX forward =: UPY 125/USD) x = JPY 99.059/USD.

Interest Rate Caps Interest Rate Floors

Net worth $; 100

The fact that FNC Company's duration gap is