Chapter 12: Swaps

I once had to explain to my father that the bank didn’t really

make its money taking deposits and lending out money to
poor folk so they could buy houses. I explained that the
bank actually traded for a living.
Stan Jonas
Derivatives Strategy, April, 1998, p. 19

D. M. Chance An Introduction to Derivatives an Ch. 12: 1

d Risk Management, 6th ed.
Important Concepts in Chapter 12

 The concept of a swap

 Different types of swaps, based on underlying currency,
interest rate, or equity
 Pricing and valuation of swaps
 Strategies using swaps

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 Definition of a swap
 Four types of swaps
 Currency
 Interest rate
 Equity
 Commodity (not covered in this book)
 Characteristics of swaps
 No cash up front
 Notional principal
 Settlement date, settlement period
 Credit risk
 Dealer market
 See Figure 12.1, p. 426 for growth in world-wide notional principal

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Interest Rate Swaps
 The Structure of a Typical Interest Rate Swap
 Example: On December 15 XYZ enters into $50

million NP swap with ABSwaps. Payments will be

on 15th of March, June, September, December for
one year, based on LIBOR. XYZ will pay 7.5%
fixed and ABSwaps will pay LIBOR. Interest based
on exact day count and 360 days (30 per month). In
general the cash flow to the fixed payer will be
⎛ Days ⎞
(Notional principal)(LIBOR - Fixed rate)⎜ ⎟
⎝ 360 or 365 ⎠

D. M. Chance An Introduction to Derivatives an Ch. 12: 4

d Risk Management, 6th ed.
Interest Rate Swaps (continued)
 The Structure of a Typical Interest Rate Swap
(continued)
 The payments in this swap are
⎛ Days ⎞
($50,000,000)(LIBOR - .075)⎜ ⎟
⎝ 360 ⎠
 Payments are netted.
 See Figure 12.2, p. 428 for payment pattern
 See Table 12.1, p. 429 for sample of payments after-
the-fact.

D. M. Chance An Introduction to Derivatives an Ch. 12: 5

d Risk Management, 6th ed.
Interest Rate Swaps (continued)
 The Pricing and Valuation of Interest Rate Swaps
 How is the fixed rate determined?

 A digression on floating-rate securities. The price

of a LIBOR zero coupon bond for maturity of ti days

is 1
B 0 (t i ) =
1 + L 0 (t i )(t i /360)

• Starting at the maturity date and working back,

we see that the price is par on each coupon date.
See Figure 12.3, p. 430.

D. M. Chance An Introduction to Derivatives an Ch. 12: 6

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Interest Rate Swaps (continued)
 The Pricing and Valuation of Interest Rate Swaps
(continued)
 By adding the notional principals at the end, we can

separate the cash flow streams of an interest rate

swap into those of a fixed-rate bond and a floating-
rate bond.
 See Figure 12.4, p. 431.

 The value of a fixed-rate bond (q = days/360):

n
VFXRB = ∑RqB (t ) + B (t
0 i 0 n)
i =1

D. M. Chance An Introduction to Derivatives an Ch. 12: 7

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Interest Rate Swaps (continued)
 The Pricing and Valuation of Interest Rate Swaps
(continued)
 The value of a floating-rate bond

VFLRB = 1 (at time 0 or a payment date)

 At time t, between 0 and 1,
1 + L 0 (t1 )q
VFLRB = (between payment dates 0 and 1)
1 + L t (t1 )(t1 −t)/360
 The value of the swap (pay fixed, receive floating)
is, therefore,
VS = VFLRB −VFXRB

D. M. Chance An Introduction to Derivatives an Ch. 12: 8

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Interest Rate Swaps (continued)
 The Pricing and Valuation of Interest Rate Swaps (continued)
 To price the swap at the start, set this value to zero and solve for R

⎛ ⎞
⎜ ⎟
⎛ 1 ⎞⎜1 −B 0 (t n ) ⎟
R = ⎜⎜ ⎟⎟⎜ n ⎟
⎝ q ⎠⎜ ⎟
 See Table 12.2, p. 433 ⎝
⎜ ∑ B (t )
0 i ⎟
⎠
fori =1an example.
 Note how dealers quote as a spread over Treasury rate.

 To value a swap during its life, simply find the difference between

the present values of the two streams of payments. See

Table 12.3, p. 434. Market value reflects the economic value, is
necessary for accounting, and gives an indication of the credit
risk.

D. M. Chance An Introduction to Derivatives an Ch. 12: 9

d Risk Management, 6th ed.
Interest Rate Swaps (continued)
 The Pricing and Valuation of Interest Rate Swaps
(continued)
 A basis swap is equivalent to the difference between

two plain vanilla swaps based on different rates:

• A swap to pay T-bill, receive fixed, plus
• A swap to pay fixed, receive LIBOR, equals
• A swap to pay T-bill, receive LIBOR, plus pay
the difference between the LIBOR and T-bill
fixed rates
• See Tables 12.4 and 12.5, p. 436 for examples of
pricing and valuation of a basis swap.

D. M. Chance An Introduction to Derivatives an Ch. 12: 10

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Interest Rate Swaps (continued)
 Interest Rate Swap Strategies
 See Figure 12.5, p. 437 for example of converting

floating-rate loan into fixed-rate loan

 Other types of swaps

• Index amortizing swaps

• Diff swaps
• Constant maturity swaps

D. M. Chance An Introduction to Derivatives an Ch. 12: 11

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Currency Swaps
 Example: Reston Technology enters into currency
swap with GSI. Reston will pay euros at 4.35% based
on NP of €10 million semiannually for two years. GSI
will pay dollars at 6.1% based on NP of $9.804 million
semiannually for two years. Notional principals will be
exchanged.
 See Figure 12.6, p. 440.

 Note the relationship between interest rate and currency

swaps in Figure 12.7, p. 441.

D. M. Chance An Introduction to Derivatives an Ch. 12: 12

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Currency Swaps (continued)
 Pricing and Valuation of Currency Swaps
 Let dollar notional principal be NP$. Then euro notional principal

is NP€ = 1/S0 for every dollar notional principal. Here euro

notional principal will be €10 million. With S0 = $0.9804, NP$ =
$9,804,000.
 For fixed payments, we use the fixed rate on plain vanilla swaps

in that currency, R$ or R€.

 No pricing is required for the floating side of a currency swap.

 See Table 12.6, p. 443.

 During the life of the swap, we value it by finding the difference

in the present values of the two streams of payments, adjusting for

the notional principals, and converting to a common currency.
Assume new exchange rate is $0.9790 three months later.
 See Table 12.7, p. 444 for calculations of values of streams of

payments per unit notional principal.

D. M. Chance An Introduction to Derivatives an Ch. 12: 13

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Currency Swaps (continued)
 Pricing and Valuation of Currency Swaps (continued)
 Dollars fixed for NP of $9.804 million =

$9,804,000(1.01132335) = $9,915,014
 Dollars floating for NP of $9.804 million =

$9,804,000(1.013115) = $9,932,579
 Euros fixed for NP of €10 million =

€10,000,000(1.00883078) = €10,088,308
 Euros floating for NP of €10 million =

€10,000,000(1.0091157) = €10,091,157

D. M. Chance An Introduction to Derivatives an Ch. 12: 14

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Currency Swaps (continued)
 Pricing and Valuation of Currency Swaps (continued)
 Value of swap to pay € fixed, receive $ fixed

• $9,915,014 - €10,088,308($0.9790/€) = $38,560

 Value of swap to pay € fixed, receive $ floating

• $9,932,579 - €10,088,308($0.9790/€) = $56,125

 Value of swap to pay € floating, receive $ fixed

• $9,915,014 - €10,091,157($0.9790/€) = $35,771

 Value of swap to pay € floating, receive $ floating

• $9,932,579 - €10,091,157($0.9790/€) = $53,336

D. M. Chance An Introduction to Derivatives an Ch. 12: 15

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Currency Swaps (continued)
 Currency Swap Strategies
 A typical case is a firm borrowing in one currency

and wanting to borrow in another. See

Figure 12.8, p. 448 for Reston-GSI example.
Reston could get a better rate due to its familiarity
to GSI and also due to credit risk.
 Also a currency swap be used to convert a stream of

foreign cash flows. This type of swap would

probably have no exchange of notional principals.

D. M. Chance An Introduction to Derivatives an Ch. 12: 16

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Equity Swaps
 Characteristics
 One party pays the return on an equity, the other

pays fixed, floating, or the return on another equity

 Rate of return is paid, so payment can be negative

 Payment is not determined until end of period

D. M. Chance An Introduction to Derivatives an Ch. 12: 17

d Risk Management, 6th ed.
Equity Swaps (continued)
 The Structure of a Typical Equity Swap
 Cash flow to party paying stock and receiving fixed
⎛ ⎛ Days ⎞ ⎞
⎜(Fixed rate)⎜ ⎟ ⎟
(Notional principal)⎜ ⎝ 360 or 365 ⎠ ⎟
⎜−Return on stock over settlement period ⎟
⎝ ⎠
 Example: IVM enters into a swap with FNS to pay
S&P 500 Total Return and receive a fixed rate of
3.45%. The index starts at 2710.55. Payments
every 90 days for one year. Net payment will be
⎛ ⎛ 90 ⎞ ⎞
($25,000,000)⎜
⎜.0345⎜ ⎟ −Return on stock index over settlement period ⎟
⎟
⎝ ⎝ 360 ⎠ ⎠

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Equity Swaps (continued)
 The Structure of a Typical Equity Swap (continued)
 The fixed payment will be

• $25,000,000(.0345)(90/360) = $215,625
 See Table 12.8, p. 451 for example of payments.

The first equity payment is

⎛ 2764.90 ⎞
$25,000,000⎜ −1⎟ = $501,282
⎝ 2710.55 ⎠
 So the first net payment is IVM pays $285,657.

D. M. Chance An Introduction to Derivatives an Ch. 12: 19

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Equity Swaps (continued)
 The Structure of a Typical Equity Swap (continued)
 If IVM had received floating, the payoff formula

would be
⎛ ⎛ Days ⎞ ⎞
⎜(LIBOR)⎜ ⎟ ⎟
(Notional principal)⎜ ⎝ 360 ⎠ ⎟
⎜−Return on stock over settlement period ⎟
⎝ ⎠
 If the swap were structured so that IVM pays the
return on one stock index and receives the return on
another, the payoff formula would be
(Notional principal)(Return on one stock index - Return on other stock index )

D. M. Chance An Introduction to Derivatives an Ch. 12: 20

d Risk Management, 6th ed.
Equity Swaps (continued)
 Pricing and Valuation of Equity Swaps
 For a swap to pay fixed and receive equity, we replicate as follows:

• Invest $1 in stock
• Issue $1 face value loan with interest at rate R. Pay interest on
each swap settlement date and repay principal at swap
termination date. Interest based on q = days/360.
• Example: Assume payments on days 180 and 360.
– On day 180, stock worth S180/S0. Sell stock and withdraw
S180/S0 - 1
– Owe interest of Rq
– Overall cash flow is S180/S0 – 1 – Rq, which is equivalent
to the first swap payment. $1 is left over. Reinvest in the
stock.

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Equity Swaps (continued)
 Pricing and Valuation of Equity Swaps (continued)
 On day 360, stock is worth S /S .
360 180
 Liquidate stock. Pay back loan of $1 and interest of

Rq.
 Overall cash flow is S /S
360 180 – 1 – Rq, which is
equivalent to the second swap payment.
 The value of the position is the value of the swap.

In general for n payments, the value at the start is

n
1 −B0 (t n ) −Rq ∑B0 (t i )
i =1

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Equity Swaps (continued)
 Pricing and Valuation of Equity Swaps (continued)
 Setting the value to zero and solving for R gives

⎛ ⎞
⎜ ⎟
⎛ 1 ⎞⎜1 −B0 (t n ) ⎟
R =⎜
⎜q ⎟⎟⎜ n
⎝ ⎠ ⎟
B
⎜∑ 0 i ⎟ (t )
⎝ i =1 ⎠
 which is the same as the fixed rate on an interest
rate swap. See Table 12.9, p. 453 for pricing the
IVM swap.

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Equity Swaps (continued)
 Pricing and Valuation of Equity Swaps (continued)
 To value the swap at time t during its life, consider the party

paying fixed and receiving equity.

 To replicate the first payment, at time t

• Purchase 1/S0 shares at a cost of (1/S0)St. Borrow $1 at

rate R maturing at next payment date.
• At the next payment date (assume day 90), shares are
worth (1/S0)S90. Sell the stock, generating (1/S0)S90 – 1
(equivalent to the equity payment on the swap), plus $1
left over, which is reinvested in the stock. Pay the loan
interest, Rq (which is equivalent to the fixed payment on
the swap).
• Do this for each payment on the swap.

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Equity Swaps (continued)
 Pricing and Valuation of Equity Swaps (continued)
 The cost to do this strategy at time t is

⎛ St ⎞ n
⎜
⎜S ⎟ ⎟ −B t (t n ) −Rq ∑B t (t i )
⎝ 0⎠ i =1
 This is the value of the swap. See Table 12.10, p. 454 for an

example of the IVM swap.

 To value the equity swap receiving floating and paying equity,

note the equivalence to

• A swap to pay equity and receive fixed, plus
• A swap to pay fixed and receive floating.
 So we can use what we already know.

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Equity Swaps (continued)
 Pricing and Valuation of Equity Swaps (continued)
 Using the new discount factors, the value of the fixed payments (plus

hypothetical notional principal) is

• .0345(90/360)(0.9971 + 0.9877 + 0.9778 + 0.9677) + 1(0.9677) =
1.00159884
 The value of the floating payments (plus hypothetical notional principal) is

• (1 + .03(90/360))(0.9971) = 1.00457825
 The plain vanilla swap value is, thus,

• 1.00457825 – 1.00159884 = -0.00297941

 For a $25 million notional principal,

• $25,000,000(-0.00297941) = -$74,485
 So the value of the equity swap is (using -$227,964, the value of the equity

swap to pay fixed)

• -$227,964 - $74,485 = -$302,449

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Equity Swaps (continued)
 Pricing and Valuation of Equity Swaps (continued)
 For swaps to pay one equity and receive another,

replicate by selling short one stock and buy the

other. Each period withdraw the cash return,
reinvesting $1. Cover short position by buying it
back, and then sell short $1. So each period start
with $1 long one stock and $1 short the other.
 For the IVM swap, suppose we pay the S&P and

receive NASDAQ, which starts at 2710.55 and goes

to 2739.60. The value of the swap is
⎛1915.71 ⎞ ⎛ 2739.60 ⎞
⎜ ⎟ −⎜ ⎟ = 0.03312974
⎝1835.24 ⎠ ⎝ 2710.55 ⎠

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Equity Swaps (continued)
 Pricing and Valuation of Equity Swaps (continued)
 For $25 million notional principal, the value is

• $25,000,000(0.03312974) = $828,244

D. M. Chance An Introduction to Derivatives an Ch. 12: 28

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Equity Swaps (continued)
 Equity Swap Strategies
 Used to synthetically buy or sell stock

 See Figure 12.9, p. 456 for example.

 Some risks

• default
• tracking error
• cash flow shortages

D. M. Chance An Introduction to Derivatives an Ch. 12: 29

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Some Final Words About Swaps
 Similarities to forwards and futures
 Offsetting swaps
 Go back to dealer

 Offset with another counterparty

 Forward contract or option on the swap

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Summary

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