Swaps

Chapter 7

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008

Nature of Swaps
A swap is an agreement to exchange cash flows at specified future times according to certain specified rules

Options, Futures, and Other Derivatives 7th Edition, Copyright John C. Hull 2008

Example
A soybean farmer agrees to receive $10 per bushel and pay cash market price for 100,000 bushels for the next 10 years Soybean processor agrees to pay fixed and receive market Example: market price in 2012 is $12, then farmer gives the processor $200,000

Example

Homebuyer agrees to pay fixed and receive variable Bank does the opposite Agree on 10% on $200,000 for 20 years Actual rate is 12% in 2012 Homebuyer gets 2% times $200,000 from the bank Note that the homebuyer will probably have to pay a higher rate on their variable mortgage and that the bank will be earning a higher rate on loans

An Example of a Plain Vanilla Interest Rate Swap

An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million Next slide illustrates cash flows that could occur

Options, Futures, and Other Derivatives 7th Edition, Copyright John C. Hull 2008

Cash Flows to Microsoft

(See Table 7.1, page 149)
---------Millions of Dollars--------LIBOR FLOATING Date Rate FIXED Net Cash Flow Cash Flow Cash Flow +2.10 2.50 0.40

Mar.5, 2004
Sept. 5, 2004

4.2%
4.8%

Mar.5, 2005
Sept. 5, 2005 Mar.5, 2006

5.3%
5.5% 5.6%

+2.40
+2.65 +2.75

2.50
2.50 2.50

0.10
+0.15 +0.25

Sept. 5, 2006
Mar.5, 2007

5.9%
6.4%

+2.80
+2.95

2.50
2.50

+0.30
+0.45

Options, Futures, and Other Derivatives 7th Edition, Copyright John C. Hull 2008

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

Options, Futures, and Other Derivatives 7th Edition, Copyright John C. Hull 2008

Quotes By a Swap Market Maker (Table 7.3, page 153)

Maturity
2 years 3 years 4 years

Bid (%)
6.03 6.21 6.35

Offer (%)
6.06 6.24 6.39

Swap Rate (%)

6.045 6.225 6.370

5 years
7 years 10 years

6.47
6.65 6.83

6.51
6.68 6.87

6.490
6.665 6.850

Options, Futures, and Other Derivatives 7th Edition, Copyright John C. Hull 2008

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 $18,000,000 every year for 5 years

Options, Futures, and Other Derivatives 7th Edition, Copyright John C. Hull 2008

Exchange of Principal
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 swaps life

Options, Futures, and Other Derivatives 7th Edition, Copyright John C. Hull 2008

10

The Cash Flows (Table 7.7, page 164)

Dollars Pounds $ ------millions-----18.00 +10.00 +1.08 0.50 +1.08 0.50 +1.08 0.50 +1.08 0.50 +19.08 10.50

Year 2004 2005 2006 2007 2008 2009

Options, Futures, and Other Derivatives 7th Edition, Copyright John C. Hull 2008

11

Typical Uses of a Currency Swap

Conversion from a liability in one currency to a liability in another currency Conversion from an investment in one currency to an investment in another currency

Options, Futures, and Other Derivatives 7th Edition, Copyright John C. Hull 2008

12

Comparative Advantage Arguments for Currency Swaps (Table 7.8, page 165)
General Electric wants to borrow AUD Qantas wants to borrow USD
USD
General Motors Qantas 5.0% 7.0%

AUD
7.6% 8.0%

Options, Futures, and Other Derivatives 7th Edition, Copyright John C. Hull 2008

13