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Chapter 7

Swaps

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014 1
Nature of Swaps
A swap is an agreement to exchange
cash flows at specified future times
according to certain specified rules

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John C. Hull 2014 2
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 (Day count conventions are not
considered)

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John C. Hull 2014 3
One Possible Outcome for Cash
Flows to Microsoft (Table 7.1, page 155)
Date LIBOR Floating Cash Fixed Cash Net Cash
Flow Flow Flow
Mar 5, 4.20%
2014
Sep 5, 2014 4.80% +2.10 2.50 0.40
Mar 5, 5.30% +2.40 2.50 0.10
2015
Sep 5, 2015 5.50% +2.65 2.50 + 0.15
Mar 5, 5.60% +2.75 2.50 +0.25
2016
Sep 5, 2016 5.90% +2.80 2.50 +0.30
Mar 5, Options, Futures, and+2.95 2.50
Other Derivatives, 9th Edition, +0.45
2017 Copyright John C. Hull 2014 4
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

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

5%

5.2%
Intel MS
LIBOR+0.1%
LIBOR

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Financial Institution is Involved
(Figure 7.4, page 157)

4.985% 5.015%

5.2%
Intel F.I. MS
LIBOR+0.1
LIBOR LIBOR %

Financial Institution has two offsetting


swaps

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John C. Hull 2014 7
Intel and Microsoft (MS) Transform an
Asset (Figure 7.3, page 156)
5%
4.7%
Intel MS
LIBOR-0.2%

LIBOR

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John C. Hull 2014 8
Financial Institution is Involved
(See Figure 7.5, page 157)

4.985% 5.015%
4.7%
Intel F.I. MS
LIBOR-0.2%
LIBOR LIBOR

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John C. Hull 2014 9
Quotes By a Swap Market Maker
(Table 7.3, page 158)

Maturity Bid (%) Offer (%) Swap Rate (%)


2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850

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John C. Hull 2014 10
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

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John C. Hull 2014 11
Confirmations
Confirmations specify the terms of a
transaction
The International Swaps and Derivatives has
developed Master Agreements that can be
used to cover all agreements between two
counterparties
Many interest rate swaps are now cleared
through a CCP such as LCH Clearnet or the
CME Group
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John C. Hull 2014 12
The Comparative Advantage Argument
(Table 7.4, page 160)

AAACorp wants to borrow floating


BBBCorp wants to borrow fixed

Fixed Floating
AAACorp 4.0% 6 month LIBOR 0.1%
BBBCorp 5.2% 6 month LIBOR + 0.6%

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John C. Hull 2014 13
The Swap (Figure 7.6, page 161)

4.35%
4%
AAACorp BBBCorp
LIBOR+0.6%

LIBOR

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John C. Hull 2014 14
The Swap when a Financial
Institution is Involved (Figure 7.7, page 162)
4.33% 4.37%
4%
AAACorp F.I BBBCorp
. LIBOR+0.6%
LIBOR LIBOR

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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 LIBOR0.1% and LIBOR+0.6% rates
available in the floating rate market are six-
month rates
BBBCorps fixed rate depends on the spread
above LIBOR it borrows at in the future

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The Nature of Swap Rates
Six-month LIBOR is a short-term AA borrowing
rate
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

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John C. Hull 2014 17
The Discount Rate
Pre-crisis derivatives cash flows were
discounted at LIBOR
As Chapter 9 explains, this has changed
Here we illustrate the valuation methodology
by assuming that LIBOR is the discount rate

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John C. Hull 2014 18
Using Swap Rates to Bootstrap the
LIBOR/Swap Zero Curve
Consider a new swap where the fixed rate is the
swap rate
When principals are added to both sides on the final
payment date the swap is the exchange of a fixed
rate bond for a floating rate bond
The floating-rate rate bond is worth par assuming
LIBOR discounting is used. The swap is worth zero.
The fixed-rate bond must therefore also be worth par
This shows that swap rates define par yield bonds
that can be used to bootstrap the LIBOR (or
LIBOR/swap) zero curve
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John C. Hull 2014 19
Example of Bootstrapping the
LIBOR/Swap Curve (Example 7.1, page 164)
6-month, 12-month, and 18-month
LIBOR/swap rates are 4%, 4.5%, and 4.8%
with continuous compounding.
Two-year swap rate is 5% (semiannual)

2.5e 0.040.5 2.5e 0.0451.0 2.5e 0.0481.5


2 R
102.5e 100

The 2-year LIBOR/swap rate, R, is 4.953%


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John C. Hull 2014 20
Valuation of an Interest Rate Swap
Initially interest rate swaps are worth close
to zero
At later times they can be valued as the
difference between the value of a fixed-rate
bond and the value of a floating-rate bond
Alternatively, they can be valued as a
portfolio of forward rate agreements (FRAs)

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Valuation in Terms of Bonds
The fixed rate bond is valued in the usual way
The floating rate bond is valued by noting that
it is worth par immediately after the next
payment date

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Valution of Floating-Rate Bond
Value = PV
of L+k* at t*

Value = Value = L
L+k*

0 t*

Valuation First Pmt Second


Date Date Pmt Date Maturity
Floating Date
Pmt =k*

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John C. Hull 2014 23
Example
Receive six-month LIBOR, pay 3% (s.a.
compounding) on a principal of $100 million
Remaining life 1.25 years
LIBOR zero rates for 3-months, 9-months and
15-months are 2.8%, 3.2%, and 3.4% (cont
comp)
6-month LIBOR on last payment date was
2.9% (s.a. compounding)
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John C. Hull 2014 24
Valuation Using Bonds (page 166)
Time Bfix cash Bfl cash Disc PV PV
flow flow factor Bfix Bfl
0.25 1.5 101.450 0.9930 1.4895 100.742
3
0.75 1.5 0.9763 1.4644
1.25 101.5 0.9584 97.2766
Total 100.230 100.742
6 3

Swap value = 100.7423 100.2306 = 0.5117

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John C. Hull 2014 25
Valuation in Terms of FRAs
Each exchange of payments in an interest
rate swap is an FRA
The FRAs can be valued on the
assumption that todays forward rates are
realized

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John C. Hull 2014 26
Valuation of Example Using FRAs
(page 167)

Time Fixed Floating Net Cash Disc PV


cash cash Flow factor Bfl
flow flow
0.25 1.5000 +1.4500 0.0050 0.9930 0.0497
0.75 1.5000 +1.7145 +0.2145 0.9763 +0.2094
1.25 1.5000 +1.8672 +0.3672 0.9584 +0.3519
Total +0.5117

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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

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John C. Hull 2014 28
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

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The Cash Flows (Table 7.7, page 170)

Date Dollar Cash Sterling cash


Flows flow
(millions) (millions)
Feb 1, 2014 15.00 +10.0
Feb 1, 2015 +0.90 0.50
Feb 1, 2016 +0.90 0.50
Feb 1, 2017 +0.90 0.50
Feb 1, 2018 +0.90 0.50
Feb 1, 2019 +15.90 10.50

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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

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Comparative Advantage May Be
Real Because of Taxes
General Electric wants to borrow AUD
Quantas wants to borrow USD
Costs after adjusting for the differential
impact of taxes:
USD AUD

General Electric 5.0% 7.6%

Quantas 7.0% 8.0%

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John C. Hull 2014 32
Valuation of Currency Swaps
Like interest rate swaps, currency swaps can
be valued either as the difference between 2
bonds or as a portfolio of forward contracts

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John C. Hull 2014 33
Example
All Japanese LIBOR/swap rates are 4%
All USD LIBOR/swap rates are 9%
5% is received in yen; 8% is paid in dollars.
Payments are made annually
Principals are $10 million and 1,200 million
yen
Swap will last for 3 more years
Current exchange rate is 110 yen per dollar
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John C. Hull 2014 34
Valuation in Terms of Bonds (Table 7.9,
page 173)

Time Cash Flows PV ($) Cash flows PV (yen)


($) (yen)
1 0.8 0.731 60 57.65
1
2 0.8 0.668 60 55.39
2
3 0.8 0.610 60 53.22
7
3 10.0 7.633 1,200 1,064.30
Value of Swap = 1230.55/1108 9.6439 = 1.5430
Total 9.643 1,230.55
9
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Valuation in Terms of Forwards
(Table 7.10, page 174)

Time $ cash Yen cash Forward Yen cash Net Presen


flow flow Exch flow in $ Cash t value
rate Flow
1 -0.8 60 0.009557 0.5734 -0.2266 -0.2071
2 -0.8 60 0.010047 0.6028 -0.1972 -0.1647
3 -0.8 60 0.010562 0.6337 -0.1663 -0.1269
3 -10.0 1200 0.010562 12.6746 +2.6746 2.0417

Total 1.5430

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John C. Hull 2014 36
Swaps & Forwards
A swap can be regarded as a convenient
way of packaging forward contracts
Although the swap contract is usually
worth close to zero at the outset, each of
the underlying forward contracts are not
worth zero

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John C. Hull 2014 37
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?

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John C. Hull 2014 38
Other Types of Swaps
Floating-for-floating interest rate swaps
amortizing swaps
step up swaps
forward swaps
constant maturity swaps
compounding swaps
LIBOR-in-arrears swaps
accrual swaps
diff swaps
cross currency interest rate swaps
equity swaps
extendable swaps
puttable swaps
swaptions
commodity swaps
volatility swaps
etc etc

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John C. Hull 2014 39