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Chapter 8

Swaps
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London Interbank Offered Rate
The London Interbank Offered Rate
(LIBOR) is the average interest rate
estimated by leading banks in London that
they would be charged if borrowing from
other banks.
LIBOR is widely used as a reference rate in
financial world.
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Floating- Rate securities
Floating-rate securities are bonds for which the coupon
interest payment over the life of the security vary based on a
specified interest rate.
For example, if market interest rates are moving up, the
coupons on floating-rate securities will rise as well.
In essence, these bonds have coupons that are reset
periodically.
The most common procedure for setting the coupon rates on
floating- rate securities is one which starts with a reference
rate (such as LIBOR ), then adds or subtracts a stated margin
to or from the reference rate.
New coupon rate = reference rate quoted margin.
Example: LIBOR + 3%
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Introduction to Swaps
A swap is a contract calling for an exchange
of payments, on one or more dates,
determined by the difference in two prices
A swap provides a means to hedge a stream
of risky payments
A single-payment swap is the same thing as
a cash-settled forward contract
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Introduction to Swaps
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Interest rate swap
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Interest rate swap
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Interest rate swap
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A Simple Interest Rate Swap
XYZ Corp. has $200M of floating-rate debt
at LIBOR, i.e., every year it pays that years
current LIBOR
XYZ would prefer to have fixed-rate debt
with 3 years to maturity
XYZ could enter a swap, in which they
receive a floating rate and pay the fixed
rate, which is 6.9548%
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A Simple Interest Rate Swap
(contd)
On net, XYZ pays 6.9548%
XYZ net payment = LIBOR + LIBOR 6.9548% =
6.9548%
Floating payment Swap payment
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Interest Rate Swaps
Companies use interest rate swaps to
modify their interest rate exposure
The interest payments are based on the
notional principle of the swap
The life of the swap is the swap term
or swap tenor
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Summaries about interest rate
swap
Because the notional principal swapped is the same for both
counterparties and is in the same currency units, there is no
need to actually exchange the cash, Notional principal is
generally not swapped in single currency swaps.
The determination of the variable rate is at the beginning of
the settlement period, and the cash interest payment is made
at the end of the settlement period. Because the interest
payments are in the same currency, there is no need for both
counterparties to actually transfer the cash.
The difference between the fixed-rate payment and the
variable-rate payment is calculated and paid to the
appropriate counterparty => Net interest is paid by the one
who owes it.
At the conclusion of the swap, there is no transfer of fund.
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Summaries about interest rate
swap
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Questions for interest rate swap
A fixed- rate payer in an interest rate swap
is equivalent to what ?
A floating- rate payer in an interest rate
swap is equivalent to what ?
A swap looks like a series of forward
contracts. Fixed- rate payer is equivalent to
long interest rate forward or short interest
rate forward ?
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Example for Practice
Bank A enters into a $1,000,000 quarterly-pay plain vanilla
interest rate swap as the fixed- rate payer at a fixed rate of
6% based on a 360-day year. The floating-rate payer agrees
to pay 90-day LIBOR plus a 1% margin; 90- day LIBOR is
currently 4%.
90-day LIBOR rates are:
4.5% 90 days from now.
5.0% 180 days from now.
5.5% 270 days from now.
6.0% 360 days from now.
Calculate the amount bank A pays or receives 90, 270 and
360 days from now.
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Currency Swaps
A currency swap entails an exchange of
payments in different currencies
A currency swap is equivalent to borrowing
in one currency and lending
in another
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Currency Swaps
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Currency Swaps
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Currency swaps
Fixed for fixed.
Floating for fixed.
Fixed for floating.
Floating for floating.
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Currency swaps
Example: Party 1 pays party 2 $10 million
at contract initiation in return for 9.8
million. On each of the settlement dates,
Party 1, having received euros, makes
payments at a 6% annualized rate in euros
on the 9.8 million to Party 2. Party 2
makes payments as an annualized rate of
5% on the $10 million to party 1. These
settlement payments are both made. They
are not netted as they are in a single
currency interest rate swap.
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Currency Swaps
Example:
A 5-year currency swap between IBM and British
Petroleum. IBM pays a fixed interest rate of 5% on
a principal of 10,000,000 & receives 6% on a US$
principal of $18,000,000 every year for 5 years.
The contract initiate at 1 Feb 2011, the term of
Cash flow is 5 years from 2011 to 2016, the
payments are made at every 1 February each year.
Calculate the cash flows for IBM from 2011 to
2016.
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Currency Swaps
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Practice Questions
BB can borrow in the United State for 9%, while AA
has to pay 10% to borrow in the United State. AA
can borrow in Australian for 7%, while BB has to
pay 8% to borrow in Australia. BB will doing
business in Australia and needs USD. The exchange
rate is 2AUD/USD. AA needs USD 1.0 million and
BB needs AUD 2.0 million. They decide to borrow
the funds locally and swap the borrowed funds,
charging each other the rate the other party would
have paid had they borrowed in the foreign market.
The swap period is for 5 years. Calculate the cash
flow for this swap.
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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

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Equity Swaps
The Structure of a Typical Equity
Swap
Cash flow to party paying stock
and receiving fixed

(Notional amount)
(Fixed rate)
Days
360 or 365
|
\

|
.
|
Return on stock over settlement period
|
\



|
.
|
|
|
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Equity Swaps
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

|
|
.
|

\
|

|
.
|

\
|
period settlement over index stock on Return
360
90
.0345 00) ($25,000,0
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Equity Swaps
u Continue with the example, if in 90 days, the
index is 2764.9.
u The Structure of a Typical Equity Swap
(continued)
F The fixed payment will be
$25,000,000(.0345)(90/360) = $215,625
F The first equity payment is


F So the first net payment is IVM pays $285,657.

282 , 501 $ 1
2710.55
2764.90
0 $25,000,00 =
|
.
|

\
|

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Equity Swaps
Calculate the cash flow from receiving fixed
perspective in 180 days, 270 days and 360
days if the corresponding indexes in these
days are 2653.65, 2805.2 and 2705.95
respectively.

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



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 amount)
(LIBOR)
Days
360
|
\

|
.
|
Return on stock over settlement period
|
\



|
.
|
|
|
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Review
Equity swap example:
Ms. Smith enters into a 2-year $10 million
quarterly swap as the fixed payer and will
receive the index return on the S&P 500. The
fixed rate is 8%, and the index is currently at
986. At the end of the next three quarters, the
index level is: 1030, 968, and 989.
Calculate the net payment for each of the next
three quarters and identify the direction of the
payment
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Review currency swap example







Calculate the cash flow for each party in
year 0,1,2,3.
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Review Interest rate swap
example
1). An investor expects that the LIBOR will increase in the next 2 years.
He recently has a deposit account that yield 5% semiannually. He
want to enter into a swap contract to bet on the upward trend of
interest rate. Which side will he be willing to take in the swap,
floating-rate payer or fixed-rate payer? Why ?
2). Ms. Janey enters into a $2,000,000 semiannually-pay plain vanilla
interest rate swap as the fixed-rate payer at a fixed rate of 5%
based on a 360 day-year. The floating rate payer agrees to pay 180-
day LIBOR plus a 1% margin; 180-day LIBOR is currently 4%.
180-day LIBOR rates are:
5.0% 180 days from now
5.5% 360 days from now
6.0% 540 days from now
6.5% 720 days from now
Calculate the amount Ms.Janey pays or receives 180, 360, 540, 720
days from now.

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