Swaps

Prof Mahesh Kumar

Amity Business School
profmaheshkumar@rediffmail.com
Introduction- Definition and Uses
 A swap is an arrangement between two
companies to exchange cash flows at one or
more future dates.
 Swaps are used:
1. To reduce the cost of capital
2. Manage risk (interest rate, exchange rate,
commodity price movement)
3. Exploit economies of scale
4. Enter new markets
5. Create synthetic instruments
Introduction-Swap Variants
 ‘Vanilla Swaps’ can be used in three different
settings:
1. An interest rate swap to convert a fixed rate
obligation to a floating rate obligation
2. A currency swap to convert an obligation in
one currency to an obligation in another
currency
3. A commodity swap to convert a floating price
to fixed price
Introduction
 A forward contract can be viewed as simple
example of swap.
 A forward contract leads to the exchange of
cash flows on just one future date, swaps
typically lead to cash flow exchanges taking
place on several future dates.
 Interest rate and currency swaps are often
discussed together and are collectively called
rate swaps.
Introduction-LIBOR
 The floating side has most often been tied to the
London Inter bank Offer Rate abbreviated as LIBOR.
 LIBOR is the rate of interest offered by the banks
on deposits of other banks in Eurocurrency
markets.
 One month LIBOR is the rate offered on one month
deposit, three month LIBOR is the rate offered on three
month deposit and so on.
 LIBOR rates are determined by trading between banks
and change frequently so that the supply of funds in
inter bank market equals the demand for funds in that
market.
Introduction-LIBOR
 A five year loan with a rate of interest specified as
6 month LIBOR plus 0.5% p.a. In this life of loan
is divided into ten periods each six months in
length. For each period the rate of interest is set
at 0.5% p.a. above the six month LIBOR rate at
the beginning of the period. Interest is paid at the
end of the period.
 LIBOR rates are quoted on annual basis and by
convention is stated as though year has 360 days,
but the interest is actually paid everyday. This
results in increase in effective rate of interest.
Introduction-LIBOR Example
 If 6-month LIBOR is quoted at 8% we would
expect that six month periodic rate is 4% But in
fact one could earn 182/360*8%=4.0444% for
first half and 183/360*8=4.0667 for second
half.
 The second complication is that compound
raises the effective annual rate of interest.
ER=[(1.040444*1.040667)-1=8.276%
Thus we see that effective annual rate
corresponding to 6M LIBOR quote of 8% is
about 8.276%
Introduction-LIBOR Example
 Fixed rate side of a rate swap, called the swap coupon,
is most often quoted as Bond Equivalent Yield (BEY).
Bond Equivalent Yields are calculated on the basis of a
365 day year. This differing treatment implies that
LIBOR rate differential and swap coupon differentials
are not comparable.
 To make rates comparable, either the six month LIBOR
rate must be multiplied by 365/360 or the fixed rate
must be multiplied by 360/365. This adjustment is
only correct, however, if the payment frequencies on
the two sides (legs) of the swap are the same i.e.
either they are both quarterly or semi-annual or
annual.
Structure of Swap
 All swaps have basically the same structure.
 Two parties, called counterparties, agree to one
or more exchanges of specified quantities of
underlying assets.
 These underlying assets are known as notional.
 A swap may involve one exchange of notional,
two exchange of notional, a series of exchange
of notional or no exchange of notional.
 The notional exchanged in the swap may be
same or different.
Structure of Swap
 Between the exchange of notional counter party make
payments to each other for using the underlying
assets. The first counterparty makes periodic payment
at a fixed price for using second counter party’s
assets. The fixed price is the swap coupon. At the
same time, the second counter party makes periodic
payment at a floating rate for using the first
counterparty’s assets.
 Usually we have an intermediary that serves as a
counterparty to both end user and is called swap
dealer or market maker or swap bank. The swap
dealer profits from bid-ask spread it imposes on the
swap coupon.
Interest Rate Swap
 A standardized fixed-to-floating interest rate swap,
known in the market jargon as plain vanilla coupon
swap (also referred to as ‘exchange of borrowings’) is
an agreement between two parties in which each
contracts to make payment to the other on a particular
dates in the future till a specified termination date.
 The party which makes fixed payments and which are
fixed at outset are known as fixed rate payer.
 The party which makes payments the size of which
depends upon the future evolution of a specified
interest rate index e.g. LIBOR is known as floating rate
payer.
Interest Rate Swap
 Interest rate swaps are used to reduce the cost
of financing.
 In these cases, one party has access to
comparatively cheap fixed rate funding but
desires floating rate of interest while another
party has access to comparatively cheap
floating rate funding but desires fixed rate of
funding.
Interest Rate Swap-Example
 Consider a three year swap initiated on March 15,2005,
between Infosys and Wipro. We assume Infosys agrees
to pay to Wipro an interest rate of 5% p.a. on a notional
principal of 100 crores and in return Wipro agrees to pay
Infosys six month LIBOR rate on the same notional
principal. We assume that agreement specifies that
payments are exchanged every six months, and the 5%
rate is quoted with semi annual compounding.
The swap can be diagrammatically depicted as:
5%
Wipro Infosys
LIBOR
Interest Rate Swap-Example
Cash flows to Infosys in a Rs100 cr three year interest rate swap
when a fixed rate is paid and LIBOR is received
Date 6 mth LIBOR Floating cash Fixed cash Net cash flow
rate (%) flow rcvd flow paid
Mar 15,’05 4.20
Sep 15,’05 4.80 +2.10 -2.50 -0.40
Mar 15,’06 5.30 +2.40 -2.50 -0.10
Sep 15,’06 5.50 +2.65 -2.50 +0.15
Mar 15,’07 5.60 +2.75 -2.50 +0.25
Sep 15,’07 5.90 +2.80 -2.50 +0.30
Mar 15,’08 6.40 +2.95 -2.50 +0.45
Interest Rate Swap-Example
 From above table we can enunciate the cash flows
in the third column of the table are the cash flows
from a long position in a floating rate bond. The
cash flows in the fourth column of the table are
the cash flows from the short position in a fixed
rate bond. The exchange can be regarded as the
exchange of fixed rate bond for a floating rate
bond. Infosys whose position is described in the
table is long a floating rate bond and short a fixed
rate bond. Wipro is similarly long a fixed rate
bond and short a floating rate bond.
Using the Swap to Transform a Liability
 The swap could be used to transform a floating rate loan
into a fixed rate loan. Suppose that Infosys arranged to
borrow Rs.100 cr at LIBOR plus 10 basis points and
Wipro has a three year Rs.100 cr loan outstanding on
which it pay 5.2%. The swap between two companies
can be shown as
5.2% 5%
Wipro Infosys
LIBOR LIBOR+0.1%
Using the Swap to Transform a Liability
 After Infosys has entered into the swap it has three
cash flows:
1. It pays LIBOR plus 0.10 to its outside lenders.
2. It receives LIBOR under the terms of the swap.
3. It pays 5% under the term of the swap.
 These three sets of cash flows net out to an interest
rate payment of 5.1%. Thus for Infosys the swap could
have the effect of transforming borrowings at a floating
rate of LIBOR plus 10 basis point into a borrowings at a
fixed rate of 5.1%
Using the Swap to Transform a Liability
 For WIPRO the swap has following three set of cash
flows:
1. It pays 5.2% to its outside lenders
2. It pays LIBOR under the terms of the swap.
3. It receives 5% under the terms of the swap.
 These three cash flows net out to an interest payment
of LIBOR plus 0.2% . Thus for WIPRO the swap has the
effect of transforming borrowings at a fixed rate of
5.2% into a borrowings at a floating rate of LIBOR plus
20 basis points.
Using the Swap to Transform an Asset
 Swaps can be used to transform the nature of an asset.
Suppose that Infosys owns Rs.100cr in bonds which
provide an interest of 4.7% over next three year and
Wipro has an investment of similar amount that yields
LIBOR minus 25 basis points. The swap between two
companies can be shown as
LIBOR-0.25% 5%
Wipro Infosys
LIBOR 4.7%
Using the Swap to Transform an Asset
 After Infosys has entered into the swap it has three
cash flows:
1. It receives 4.7% on the bonds.
2. It receives LIBOR under the terms of the swap.
3. It pays 5% under the terms of the swap.
 These three sets of cash flows net out to an interest
rate inflow of LIBOR minus 30 basis points. Thus
Infosys has transformed an asset earning 4.7% into an
asset earning LIBOR minus 30 basis points.
Using the Swap to Transform an Asset
 After Wipro has entered into the swap it has three set
of cash flows:
1. It receives LIBOR minus 25 basis points on investment.
2. It pays LIBOR under the terms of the swap.
3. It receives 5% under the terms of the swap.
 These three cash flows net out to an interest rate inflow
of 4.75%. Thus Wipro has transformed an asset earning
LIBOR minus 25 basis points into an asset earning
4.75%
Role of a Swap Dealer
 Usually two non-financial companies such as
Infosys and Wipro do not get in touch directly
to arrange a swap. They each deal with a
financial intermediary such as bank or other
financial institutions.
 ‘Plain vanilla’ fixed for floating swaps are
usually structures so that financial institution
earns 3-4 basis points on the pair of offsetting
transactions.
Role of a Swap Dealer

5.2% 4.985% 5.015%

Swap Infosys
Wipro
Dealer

LIBOR LIBOR LIBOR+0.1%

Role of a Swap Dealer

4.985% 5.015% 4.7%

Swap Infosys
Wipro
Dealer

LIBOR LIBOR LIBOR

-0.25%
Role of a Swap Dealer
 Swaps as financial instruments have gained popularity
with transformation of swap brokers into swap dealers.
 The swap dealer stands ready to enter a swap as a
counterparty and with equal willingness to play the role
of fixed rate payer or fixed rate receiver.
 Unlike direct swap between two end users, the swap
dealer does not need to match all the terms of the first
swap with Counterparty A to the second swap with
Counterparty B.
 The swap dealer does not need to have an immediately
available counterparty B into order to enter a swap with
counterparty A.
Role of a Swap Dealer
 Swap dealers warehouse swaps and run a swap book.
They seek to match their swap book in order to remove
the risk associated with unmatched swaps. Thus swap
dealer strives to have balanced book and any
unbalances which exist are hedged by the swap dealer.
4.985%
Wipro Swap Dealer
6m LIBOR

4.985% 5-yr T-note (long position)

Wipro Swap Dealer G Sec Market
6 m LIBOR 6 m T-bill (short position)
The Comparative Advantage Argument
 The popularity of swaps concerns comparative
advantages. Some companies have
comparative advantage when borrowing in
fixed rates whereas others have a comparative
advantage in floating rate markets.
 To obtain a new loan, it makes sense for a
company to go to the market it has a
comparative advantage.
The Comparative Advantage Argument

 AAACorp wants to borrow floating

 BBBCorp wants to borrow fixed

Fixed Floating

AAACorp 4.00% 6-month LIBOR + 0.30%

BBBCorp 5.20% 6-month LIBOR + 1.00%
The Comparative Advantage Argument
 A key feature of the rates offered by AAACorp
and BBBCorp is that difference between the
two fixed rates is greater than the difference
between the two floating rates.
 BBBCorp pay 1.2% more than AAACorp in fixed
rate and 0.7% more than AAACorp in floating
rate markets.
 Thus BBBCorp appears to have a comparative
advantage in floating rate markets whereas
AAACorp has comparative advantage in fixed
rates markets. It is this anomaly that can lead
to a swap being negotiated.
The Swap

3.95%

4%
AAA BBB
LIBOR+1%

LIBOR
The Comparative Advantage Argument
 The swap arrangement appears to improve the
position of AAACorp and BBBCorp by 0.25%
each. The total gain from deal is 0.5%.
 The total apparent gain from this type of
interest rate arrangement is always a-b, where
a is the difference between the interest rates
facing the two companies in fixed rate market,
b is the difference between the interest rates
facing the two companies in floating rate
markets. In this case a=1.2% and b=0.70%
The Swap when a Financial Institution is
Involved

3.93% 3.97%
4%
AAA F.I. BBB
LIBOR+1%
LIBOR LIBOR
The Comparative Advantage Argument
 Why are spreads between the rates offered to AAACorp
and BBBCorp be different in fixed and floating market?
We expect these differences to be arbitraged away.
 The reason for spread differentials is due to the nature
of contracts available to companies in fixed and floating
markets.
 The 4% and 5.2% rates available to AAACorp and
BBBCorp in fixed rate markets are five year rates (the
rates at which companies can issue five year fixed rate
bonds). The LIBOR+0.3% and LIBOR+1% rates
available to AAACorp and BBBCorp in floating rate
markets are six month rates.
The Comparative Advantage Argument
 In floating rate market , the lender usually has the
opportunity to receive floating rates every six months (in
extreme cases can even refuse rollover of the loan),
while the fixed rate financing do not have the option to
change the terms of the loan.
 The spreads between the rates offered to AAACorp are
the reflection of the extent to which BBBCorp is more
likely to default than AAACorp. During the next six
months there is a little chance that either AAACorp or
BBBCorp will default. As we look further ahead, default
stastics show that the probability of default by a
company with low credit rating (such as BBBCorp)
increases faster then the probability of default by
company with relatively higher credit rating (such as
AAACorp). This is why spread in five year loan is greater
than the spread of the six month rate.
Quotes By a Swap Market Maker
Maturity Bid (%) Offer (%) Swap Rate (%)
2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850
Quotes By a Swap Market Maker
 Financial institutions are merchant makers and
they give quotes for a number of different
maturities and number of different currencies.
 The bid is the fixed price in a contract where
market maker will pay the fixed and receive
floating; the offer is the fixed rate in a swap
where the market maker will receive fixed and
pay floating.
 The average bid and offer fixed rates is known
as the swap rate.
 Valuation of an Interest Rate Swap

5.2% 5.0% LIBOR+0.1%

Wipro Infosys
LIBOR
 Infosys has lent Rs.100cr to Wipro at 6 mth LIBOR rate
 Wipro has lent Rs100cr to Infosys at 5% p.a.
 To put it other way Infosys has purchased floating rate bond
from Wipro and has sold Rs.100cr fixed rate bond to Wipro.
Value of Swap to a company receiving floating and paying
fixed rate( in our case Infosys is ):
Vswap= Bfl-Bfix
Valuation of Interest Rate Swaps
 Bfix= Ke-riti+Le-rntn

ti= Time until ith payments are exchanged.

N= Notional principal in swap arrangement
ri=LIBOR zero rate corresponding to maturity ti
K=Fixed payment made on each bond.
 Immediately after a payment date this is identical to a
newly issued floating rate bond & B fl=L immediately after
the payment date.
 Immediately before the next payment date B fl=L+K* where
k* is the floating rate payment that will be made on next
payment date.
 The value of swap today is its value just before the next
payment date discounted at rate r1 and time t1
Bfl=(L+K*)e-r1t1
Valuation of Interest Rate Swaps
 Example: Suppose that under the terms of a
swap, a financial institution has agreed to pay
six month LIBOR and receive 8% pa (with semi
annual compounding) on a notional value of
Rs.100cr. The swap rate has life of 1.25years.
The LIBOR rates for 3 mth, 9 mth and 15 mth
maturities are 10%, 10.5% & 11% continuous
compounding. The 6 mth LIBOR rate at the last
payment date was 10.2%. Calculate the value
of the swap?
Valuation of Interest Rate Swaps
 K=Rs.4cr , k*=Rs.5.1cr
Bfix= Ke-riti+Le-rntn
=4e-0.1*3/12+4e-0.105*9/12+104e-0.11*15/12
=Rs.98.24cr
Bfl =5.1e-0.1*3/12+100e-0.1*3/12
=Rs. 102.51cr

Value of Swap=98.24-102.51 =Rs.-4.27cr

Example
 Receive 8% per annum and pay floating semiannually
on a principal of $100 million.
 1.25 years to go and next floating payment is $5.1
million
Time Fixed Floating Disc PV fixed PV floating
Bond Bond Factor Bond Bond
0.25 4 105.1 0.9753 3.901 102.5045
0.75 4 0.9243 3.697
1.25 104 0.8715 90.64
98.238 102.505

 Swap value = 98.238 − 102.505= − 4.267

Currency Swap
 In simplest form currency swap involves
exchanging principal and interest payment in
one currency for principal and interest
payments in another currency.
 A currency swap agreement requires the
principal to be specified in each of the two
currencies and they are exchanged at the
beginning and at the end of the life of the
swap. The principal amounts are chosen to be
approximately equivalent using the exchange
rate at the swap’s initiation.
Currency Swap- Example
 Consider a hypothetical five year currency swap between
IBM (a US based Co) and British Petroleum (a UK based
Co) into on Feb 1, 2002. Suppose IBM pays a fixed rate
of interest of 11% in sterling and receives a fixed rate of
interest of 8% in dollars from British Petroleum. Interest
payments are made once a year and principal amounts
are $15 million and GBP 10 million. The swap for this
deal can be depicted as :
11%
IBM British Petroleum
8%
Currency Swap- Example
 This type of swap is known as fixed currency swap
because interest rates in both the currencies are fixed.
 Initially the principal amounts flow in opposite direction
to the arrows.
 Thus at the outset IBM receives GBP 10 million and pays
$15 million.
 Each year during the life of the swap contract , IBM
receives $ 1.20 million (8% of $15million) and pays GBP
1.10 million ( 11% of GBP 10 million)
 At the end of the life of the swap, it pays a principal of
GBP 10 million and receives a principal of $15 million.
The Cash Flows
Dollars Pounds
$ £
Year ------millions------
2001 –15.00 +10.00
2002 +1.20 -1.10
2003 +1.20 –1.10
2004 +1.20 –1.10
2005 +16.20 –11.10
Currency Swap
 A currency swap can transform borrowings in
one currency to borrowings in another
currency.
 The swap can also be used to transform the
nature of asset. Suppose that IBM can invest
GBP10 million in UK to yield 11% pa for the
next five years, but feels that US dollar will
strengthen against sterling and prefers US
denominated investment. The swap has the
effect of transforming the UK investment into a
$15 million investment in the US yielding 8%.
Comparative Advantage
 Currency swap can be motivated by comparative
advantage.
 Suppose the five year fixed rate borrowing cost to
General Motors and Jet Airways in USD and INR is given
below:
USD INR
General Motors 5.0% 12.6%
Jet Airways 7.0% 13%
1. INR rates are higher than US interest rates.
2. General motors is more creditworthy than Jet Airways
because it is offered a more favorable rate of interest in
both the currencies.
3. Since spreads are different in different currencies, swaps
can be negotiated.
Comparative Advantage
 Here a=2, b=0.4. This may be on account of
comparative tax advantage of two companies.
General Motors position might be such that
USD borrowing lead to lower taxes on its
worldwide income than INR borrowings and
may be vice versa for Jet Airways.
 We now suppose that General Motors wants to
borrow in INR and Jet Airways in USD.
 Total gain to all parties on account of this swap
deal is 2-0.4=1.6% pa
 The deal can be depicted as;
Comparative Advantage
USD 5.0% USD 6.3%
GM Swap Dealer Jet Airways
USD 5.0% INR 11.9% INR 13% INR 13%

USD 5.0% USD 5.2%

GM Swap Dealer Quantas Air
USD 5.0% INR 11.9% INR 11.9% INR 13%
Jet Airways some foreign risk

USD 6.1% USD 6.3%

GM Swap Dealer Quantas Air
USD 5.0% INR 13% INR 13% INR 13%
GM bears some foreign risk
Commodity Swap
 In commodity swap, the first counterparty
makes periodic payment to the second at a per
unit fixed price for a given quantity of some
commodity.
 The second counterparty pay the first a per
unit floating price for a given quantity of some
commodity.
$20
Oil Producer Refinery
Spot Price
Credit Risk in Swaps
 Since swaps are tailor made private arrangement between two
parties, therefore they entail credit risk.
 If neither party defaults, the financial institution remains fully
hedged.
 A financial institution has credit exposure from a swap only
when the value of swap to the financial institution is positive
and there will be no effect on the financial institution’s position
if the value of swap is negative.
 Potential losses from default on a swap are much less than the
potential losses from default on loan with the same principal.
This is because the value of the swap is usually only a small
fraction of the value of the loan.
 Potential losses from defaults on a currency swap are greater
than on an interest rate swap. The reason being principal
amount in two different currencies are exchanged at the end of
the life of a currency swap, a currency swap has greater value
than an interest rate swap.