d-l6-swaps

MBF1243 Derivatives

L6: Swaps

Nature of Swaps

• A swap is an agreement to exchange of payments at specified future times according to certain specified rules

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

2

An Example of a “Plain Vanilla” Interest Rate Swap

• 3-year swap agreement between Microsoft and Intel on 5 March 2014

• Microsoft to pay Intel a fixed interest rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million

• In return Intel agrees to pay Microsoft 6-month LIBOR on the same of principal of $100 million

• Microsoft is the fixed-rate payer, and Intel is the floating-rate payer.

• Next slide illustrates cash flows that could occur (Day count conventions are not considered)

>>>The floating rate in most interest swap agreements is the LIBOR. It is the rate at which a bank is prepared to deposit money with other banks in the Eurocurrency market.

3

One Possible Outcome for Cash Flows to Microsoft

Date LIBOR Floating Cash Flow Fixed Cash Flow

Net Cash Flow

Mar 5, 2014 4.20%

Sep 5, 2014 4.80% +2.10 −2.50 −0.40

Mar 5, 2015 5.30% +2.40 −2.50 −0.10

Sep 5, 2015 5.50% +2.65 −2.50 + 0.15

Mar 5, 2016 5.60% +2.75 −2.50 +0.25

Sep 5, 2016 5.90% +2.80 −2.50 +0.30

Mar 5, 2017 +2.95 −2.50 +0.45

• The first exchange of payments would take place on 5 Sept 2014, 6 months after the initiation of the agreement.

• Microsoft would pay Intel $2.5 million. This is the interest on the $100 million principal for 6 months at 5%.

• Intel would pay Microsoft interest on the $100 million principal at the 6-month LlBOR rate prevailing 6 months prior to 5 Sept 2014-that is, on 5 March 2014. Suppose that the 6-month LlBOR rate on 5 March 2014, is 4.2%. >>>Intel pays Microsoft 0.5 x 0.042 x $100 = $2.1 million.

4

One Possible Outcome for Cash Flows to Microsoft

• The second exchange of payments would take place on March 5, 2015, a year after the initiation of the agreement.

• Microsoft would pay $2.5 million to Intel. Intel would pay interest on the $100 million principal to Microsoft at the 6-month LlBOR rate prevailing 6 months prior to March 5, 2015-that is, on September 5, 2014. Suppose that the 6-month LlBOR rate on September 5, 2014, is 4.8%. Intel pays 0.5 x 0.048 x $100 = $2.4 million to Microsoft.

• In total, there are six exchanges of payment on the swap.

• The fixed payments are always $2.5 million. The floating-rate payments on a payment date are calculated using the 6-month LlBOR rate prevailing 6 months before the payment date.

• An interest rate swap is generally structured so that one side remits the difference between the two payments to the other side. In our example, Microsoft would pay Intel $0.4 million (= $2.5 million - $2.1 million) on September 5, 2007, and $0.1 million (= $2.5 million - $2.4 million) on March 5, 2008

5

Typical Uses of an Interest Rate Swap

• Converting a liability from • fixed rate to floating rate • floating rate to fixed rate

• Converting an investment from

• fixed rate to floating rate • floating rate to fixed rate

• >>>Refer to handouts

6

Typical Uses of an Interest Rate Swap • Converting a liability from

• fixed rate to floating rate • floating rate to fixed rate

7

• For Microsoft, the swap could be used to transform a floating-rate loan into a fixed-rate loan.

• Suppose that Microsoft has arranged to borrow $100 million at LlBOR plus • 10 basis points. (One basis point is one-hundredth of I %, so the rate is LlBOR • plus 0.1 %.) After Microsoft has entered into the swap, it has the following three sets of cash flows: 1. It pays LlBOR plus 0.1 % to its outside lenders. 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 payment of 5.1 %. Thus, for Microsoft, the swap could have the effect of transforming borrowings at a floating rate of LlBOR plus 10 basis points into borrowings at a fixed rate of 5.1 %.

Intel and Microsoft (MS) Transform a Liability (Figure 7.2, page 155)

8

Intel MS LIBOR

5%

LIBOR+0.1%

5.2%

Typical Uses of an Interest Rate Swap • Converting an investment from

• fixed rate to floating rate • floating rate to fixed rate

9

Swaps can also be used to transform the nature of an asset. Consider Microsoft in our example. The swap could have the effect of transforming an asset earning a fixed rate of interest into an asset earning a floating rate of interest. Suppose that Microsoft owns $100 million in bonds that will provide interest at 4.7% per annum over the next 3 years. After Microsoft has entered into the swap, it has the following three sets of cash flows: l. It receives 4.7% on the bonds. 2. It receives LlBOR 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, one possible use of the swap for Microsoft is to transform an asset earning 4.7% into an asset earning LIBOR minus 30 basis points.

Intel and Microsoft (MS) Transform a Asset

10

Intel MS LIBOR

5% 5.2% LIBOR + 0.1%

Day Count

• A day count convention is specified for for fixed and floating payment

• For example, LIBOR is likely to be actual/360 in the US because LIBOR is a money market rate

• In the Microsoft and Intel example, the floating payment is based on LIBOR rate of 4.2% is shown as $2.10 million.

• Because there are 184 days between 5 March 2014 and 5 September 2007, it should be computed as

100 x 0.042 x 184 = $2.147 m 365

11

Confirmations

• A confirmations is the legal agreement underlying a swap and is signed by representatives of the 2 parties

• The International Swaps and Derivatives Association has developed Master Agreements that can be used to cover all agreements between two counterparties

12

The Comparative Advantage Argument

• An explanation commonly put forward to explain the popularity of swaps concerns comparative advantages.

• Some companies, it is argued, have a comparative advantage when borrowing in fixed-rate markets, whereas other companies have a comparative advantage in floating-rate markets.

Example- 2 companies, AAACorp and BBBCorp, both wish to borrow $10 million for 5

years and have been offered the rates shown in the table. • AAACorp wants to borrow floating – company is rated AAA • BBBCorp wants to borrow fixed - company is rated BBB Because it has a worse credit rating than AAACorp, BBBCorp pays a higher rate of interest than AAACorp in both fixed and floating market.

13

Fixed Floating

AAACorp 4.0% 6 month LIBOR − 0.1%

BBBCorp 5.2% 6 month LIBOR + 0.6%

The Comparative Advantage Argument (Table 7.4, page 160)

• The difference between the two fixed rates is greater than the difference between the two floating rates.

• BBBCorp pays 1.2% more than AAACorp in fixed-rate markets and only 0.7% more an AAACorp in floating-rate markets.

• BBBCorp appears to have a comparative vantage in floating-rate markets, whereas AAACorp appears to have a comparative advantage in fixed-rate markets.

• It is this apparent anomaly that can lead to a swap being negotiated. AAACorp borrows fixed-rate funds at 4% per annum. BBBCorp borrows floating-rate funds at LIBOR plus 0.6% per

annum. They then enter into a swap agreement to ensure that AAACorp

ends up with floating-rate funds and BBBCorp ends up with fixed-rate funds.

14

Criticism of the Comparative Advantage Argument

• The 4.0% and 5.2% rates available to AAACorp and BBBCorp in fixed rate markets are 5-year rates

• The LIBOR−0.1% and LIBOR+0.6% rates available in the floating rate market are six-month rates

• BBBCorp’s fixed rate depends on the spread above LIBOR it borrows at in the future

15

The Nature of Swap Rates

• Six-month LIBOR is a short-term AA borrowing rate for period between 1 and 12 months from other banks

• The 5-year swap rate has a risk corresponding to the situation where 10 six-month loans are made to AA borrowers at LIBOR

• This is because the lender can enter into a swap where income from the LIBOR loans is exchanged for the 5-year swap rate

16

An Example of a Currency Swap

• An agreement to pay 5% on a sterling principal of £10,000,000 & receive 6% on a US$ principal of $15,000,000 every year for 5 years

• In an interest rate swap the principal is not exchanged

• In a currency swap the principal is usually exchanged at the beginning and the end of the swap’s life

17

Typical Uses of a Currency Swap

• Convert a liability in one currency to a liability in another currency

• Convert an investment in one currency to an investment in another currency

18

Comparative Advantage May Be Real Because of Taxes

• General Electric wants to borrow AUD • Qantas wants to borrow USD • The spread between the rates paid by GE and Qantas in the 2

markets are not the same • Qantas pays 2% more than GE in the USD market and only

0.4% more than GE in the AUD market • Hence, GE has comparative advantage in the USD market while

Qantas has comparative advantage in the AUD market

• Borrowing rates providing basis for currency swap

19

USD AUD

General Electric 5.0% 7.6%

Quantas 7.0% 8.0%

Credit Risk: Single Uncollateralized Transaction with Counterparty

A swap is worth zero to a company initially At a future time its value is liable to be either positive or negative The company has credit risk exposure only when ithe value is positive Some swaps are more likely to lead to credit risk exposure than others What is the situation if early forward rates have a positive value? What is the situation when the early forward rates have a negative value?

20

8-21

Swaptions

• A swaption is an option to enter into a swap with specified terms. This contract will have a premium

• A swaption is analogous to an ordinary option, with the PV of the swap obligations (the price of the prepaid swap) as the underlying asset

• Swaptions can be American or European

8-22

Swaptions (cont’d)

• A payer swaption gives its holder the right, but not the obligation, to pay the fixed price and receive the floating price • The holder of a receiver swaption would exercise

when the fixed swap price is above the strike

• A receiver swaption gives its holder the right to pay the floating price and receive the fixed strike price. • The holder of a receiver swaption would exercise

when the fixed swap price is below the strike

8-23

Total Return Swaps

• A total return swap is a swap, in which one party pays the realized total return (dividends plus capital gains) on a reference asset, and the other party pays a floating return such as LIBOR

• The two parties exchange only the difference between these rates

• The party paying the return on the reference asset is the total return payer

8-24

Total Return Swaps (cont’d)

• Some uses of total return swaps are • avoiding withholding taxes on foreign stocks • management of credit risk

• A default swap is a swap, in which the seller makes a payment to the buyer if the reference asset experiences a “credit event” (e.g., a failure to make a scheduled payment on a bond)

• A default swap allows the buyer to eliminate bankruptcy risk, while retaining interest rate risk

• The buyer pays a premium, usually amortized over a series of payments