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Nick Taylor
nick.taylor@bristol.ac.uk
University of Bristol
Table of contents
1 Learning Outcomes
2 General Information
4 Currency Swaps
5 Miscellanea
6 Summary
7 Reading
General Information
Types
A swap is an agreement to exchange cash flows at specified future times
according to certain specified rules. Usually the cash flows involve the future
value of an interest rate, an exchange rate, or other market variables. There
are two main types:
1 In a (“plain vanilla”) interest rate swap, one party agrees to pay the
other party interest at a fixed rate, in return for interest at a floating
rate.
2 In a currency swap, two parties exchange principal and interest
payments in one currency, for principal and interest payments in
another.
Example (cont.)
Suppose that Microsoft has arranged to borrow $100 million at LIBOR plus 10
basis points. This means that Microsoft has the following three sets of cash
flows:
Example (cont.)
Suppose that Intel has a 3-year $100 million loan outstanding on which it pays
5.2%. In this instance, Intel incurs the following three sets of cash flows:
Example (cont.)
The above cash flows can be represented diagrammatically as follows:
5.2% 5%
Intel - Microsoft -
LIBOR LIBOR + 0.1%
Example (cont.)
Two nonfinancial companies usually arrange a swap via a financial institution.
The institution usually earns around 3 basis points. In this instance, the
following diagram depicts the cash flows:
Example (cont.)
Suppose that Microsoft owns $100 million in bonds that provide 4.7% per
annum over the next 3 years. This means that Microsoft has the following three
sets of cash flows:
Thus, it has transformed an asset earning 4.7% into an asset earning LIBOR
minus 30 basis points.
Example (cont.)
Suppose that Intel has an investment of $100 million that delivers LIBOR minus
20 basis points. This means that Intel has the following three sets of cash flows:
Thus, it has transformed an asset earning LIBOR minus 20 basis points into an
asset earning 4.8%.
Example (cont.)
The above cash flows can be represented diagrammatically as follows:
5% 4.7%
- Intel - Microsoft
LIBOR − 0.2% LIBOR
Example (cont.)
In the presence of a financial institution earning around 3 basis points we have
Example
Consider the situation where AAACorp wants to borrow floating, and BBBCorp
wants to borrow fixed. In both cases, each company wants to borrow $10
million for 5 years. Moreover, they face the following borrowing rates:
Company Fixed Floating
AAACorp 4.0% 6-month LIBOR − 0.1%
BBBCorp 5.2% 6-month LIBOR + 0.6%
In this instance, while BBBCorp faces more expensive costs of borrowing in
both markets, it pays 1.2% more in the fixed-rate markets but only 0.7% more
in floating-rate markets.
Therefore, BBBCorp has a comparative advantage in the floating-rate markets,
whereas AAACorp appears to have a comparative advantage in the fixed-rate
markets.
Example (cont.)
Given their comparative advantages, AAACorp borrows using the fixed-rate
market, and BBBCorp borrows using the floating-rate market.
Moreover, given their initial preferences, AAACorp and BBBCorp agree to a
swap, such that AAACorp pays BBBCorp interest at 6-month LIBOR on $10
million, in return BBBCorp pays AAACorp interest at a fixed rate of 4.35% per
annum on $10 million.
The cash flows can be represented diagrammatically as follows:
4.0% 4.35%
AAACorp - BBBCorp -
LIBOR LIBOR + 0.6%
The net effect of these cash flows in that AAACorp pays LIBOR minus 0.35%
per annum (0.25% less than the direct floating-rate), while BBBCorp pays
4.95% per annum (0.25% less than the direct fixed-rate).
Example (cont.)
In the presence of a financial institution, the cash flows could be represented
diagrammatically as follows:
Valuation
Floating-rate payer perspective
A swap is equivalent to a long position in a fixed-rate bond and a short
position in a floating-rate bond, hence swap value is given by
Valuation (cont.)
Fixed-rate bond value (Bfix )
This is given by the sum of the discounted cash flows (coupons and/or
par), that is,
n
X
Bfix = ci e −ri ti ,
i=1
where ci is the cash flow at time ti , ri is the zero rate applicable at the
time of the ith cash flow, and ti is the time to the cash flow receipt (in
years).
Valuation (cont.)
Floating-rate bond value (Bfl )
Immediately after the next interest payment, the floating-rate bond
value equal its notional principal, it follows that
∗ ∗
Bfl = (L + k ∗ )e −r t ,
where L is the notional principal, r ∗ is the zero rate applicable at time
t ∗ , and k ∗ is the floating payment (determined at last payment date)
occurring at time t ∗ .
Valuation (cont.)
Example
Suppose a financial institution has agreed to pay six-month LIBOR, and receive
8% (s.a. compounding) on a principal of $100 million. The swap has a
remaining life of 1.25 years, and respective LIBOR rates for 3-months, 9-months
and 15-months are 10%, 10.5%, and 11% (continuous compounding). The
6-month LIBOR on the last payment date was 10.2% (s.a. compounding). The
calculations are summarised as follows:
Time C.F.(fix) C.F.(fl) Discount Factor PV(fix) PV(fl)
0.25 4.0 105.100 0.9753 3.901 102.505
0.75 4.0 0.9243 3.697
1.25 104.0 0.8715 90.640
Total 98.238 102.505
Therefore,
Vswap = 98.238 − 102.505 = −4.267,
or −$4.267 million.
Example
Suppose that on February 1, 2014, IBM agrees to pay 5% (fixed) on a sterling
principal of £10000000 and receives 6% (fixed) on a US$ principal of
$15000000 every year for 5 years from British Airways.
Example (cont.)
Suppose that IBM can issue $15 million of US-dollar-denominated bonds at 6%.
The above swap has the effect of transforming this transaction into one where
IBM has borrowed £10 million at 5%.
Example (cont.)
Suppose that IBM can invest £10 million in the UK to yield 5% per annum for
the next 5 years, but is worried that the US dollar will strengthen. The above
swap has the effect of transforming this UK investment into a $15 million
investment in the US yielding 6%.
Example (cont.)
In the absence of a financial institution, the cash flows can be represented
diagrammatically as follows:
USD 6.0%
USD 5.0%
GE - Qantas -
AUD 7.8% AUD 8.0%
The net effect of these cash flows in that General Electric pays AUD 6.8% per
annum (0.8% less than the direct AUD rate), while Qantas Airways pays USD
6.2% per annum (0.8% less than the direct USD rate).
Note: The total gain of 1.6% necessarily equals the difference between the
interest rate differential faced in the USD markets and the interest rate
differential faced in the AUD markets (i.e., 2.0% − 0.4% = 1.6%).
Valuation
Home currency receiver perspective
The swap value is given by
Vswap = BD − S0 BF ,
where BD is the value of the bond defined by the domestic cash flows
on the swap, BF is the value of the bond defined by the foreign cash
flows on the swap, and S0 is the spot exchange rate (number of dollars
per unit of foreign currency).
Foreign currency receiver perspective
The swap value is given by
Vswap = S0 BF − BD ,
Valuation (cont.)
Example
Some time ago a financial institution has entered into a currency swap in which
it receives 5% per annum in yen and pays 8% per annum in dollars once a year.
The principles in the two currencies are $10 million and 1200 million yen. The
swap will last another 3 years, and the current exchange rate is 110 yen = $1.
Furthermore, all Japanese LIBOR/swap rates are 4% and all USD LIBOR/swap
rates are 9% (both with continuous compounding).
The calculations are summarised as follows:
Time C.F.(dollar) PV(dollar) C.F.(yen) PV(yen)
1 0.8 0.7311 60 57.65
2 0.8 0.6682 60 55.39
3 0.8 0.6107 60 53.22
3 10.0 7.6338 1200 1064.30
Total 9.6439 1230.55
Therefore,
1230.55
Vswap = − 9.6439 = 1.5430 (or $1.543 million).
110
Credit Risk
If a financial institution has entered into offsetting contracts with two
companies then it has to honour the contract if either party defaults. Some
other points to remember:
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 its value is positive.
Miscellanea
Summary
Basics
Interest rate v. currency swaps.
Interest Rate Swaps
Cash flows, functions, and comparative advantage.
Currency Swaps
Cash flows, functions, and comparative advantage.
Miscellanea
Credit risk and other types of swaps.
Essential Reading
Chapter 7, Hull (2015).
Further Reading
Litzenberger, R., 1992, Swaps: plain and fanciful, Journal of Finance 47,
831–850.