m A swap is an agreement between 2 firms to

exchange cashflows in the future

m The agreement defines the dates when the

cashflows are to be paid and the way they are to
be calculated

m A swap is based on the Theory of comparative

advantage
 Bank X wants to pay fixed rates and receive floating rates while
Bank Y wants to pay floating and receive fixed rates

m A notional swap is agreed upon by all the parties

m Start Dates and Maturity Dates are fixed (Term of the swap can
range from 1 week to 1 year)

m The fixed rate (to be paid by Bank X to Bank Y) is agreed upon

by Banks X and Y

m Floating rate calculations are made to replicate accrual on the

notional principal as if the notional is actually lent in the
overnight market for the term of the swap
 áypothetical 3 year swap initiated on March 5 2007
between Microsoft and Intel

MS agrees to pay Intel interest @ 5% pa on a Prin of $

100MM; in return Intel agrees to pay MS 6 month
LIBOR on the same principal

MS is the fixed rate payer

INTEL is the floating rate payer
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m Enters into 2 offsetting txns with MS and Intel

m If one of the firms defaults, the FI still has to honour itǯs

agreement with the other firm

m Market Makers
m Many large Fis act as market makers for swaps

m This means they are prepared to enter into a swap without

having an offsetting swap with another counterparty (known as
warehousing swaps)

m They must carefully quantify and hedge the risks they are
taking
m Some firms have a comparative advantage when
borrowing in fixed rate markets; others in floating rate
mkts
- Fixed Floating

m AAA Corp: 4.0% 6 mo LIBOR -0.1%

m BBB Corp: 5.2% 6 mo LIBOR +0.6%

m A swap rate is the average of:
a) Fixed rate that the Swap MM is prepared to pay in
exchange for receiving LIBOR
b) Fixed Rate that he is prepared to receive in return for
paying LIBOR
m Companies X and Y have been offered the following rates per
annum on a $ 20 mill 5 year loan
- Fixed Floating
m Co. X : 5.0% LIBOR +0.1%

m Co Y 6.4% LIBOR +0.6%

m _o X requires a floating rate loan.

m _o Y requires a fixed rate loan

m Design a swap that will net the bank intermediary 0.1 % pa

and will be equally attractive to both companies
m A ± comparative advantage in fixed
m B ± comparative advantage in floating

m 1.4% differential in fixed

m 0.5% differential in floating

m Total gain to all parties : 0.9% pa

m Margin to intermediary bank : 0.1% pa

m A borrows at LIBOR ± 0.3%

m B borrows at fixed 5.4% pa
m Kxchanging principal and interest payments in one
currency for principal and interest payments in
another

m Requires the principal to be specified in each of

the 2 currencies

m The principal amounts in each ccy are usually

exchanged at the beginning and at the end of the
life of each swap
' 5 year ccy swap between IBM and BP entered into on 1-
feb-07.

' IBM pays fixed rate of interest @ 5% in GBP and receives

fixed rate of interest @ 6% in $ from BP

' Int payments are made once a year; principal amts are $ 18
mm and GBP 10 mm.

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 · int rts in both ccys are fixed

' Such swaps can be used to transform borrowings in one

ccy to another
' Contracts such as swaps that are private
arrangements between 2 firms entail credit risk

' Potential losses from default on a swap are much less

than potential losses from defaults on a loan with the
same principal
' 6    : principal reduces in a certain way

'   
 : principal increases in a predetermined way

' ij


: parties do not begin to exchange interest
payments until some future date

' j
j  

 : combination of fixed for floating IR swap
and fixed for fixed ccy swap ;Also known as a Cross Currency swap

' K   
: agreement to change total return (dividends + capital gains)
realized on an equity index for either Fixed / floating rate of interest
'
'   
: (Options on Swaps) These provide one party the   to enter
into a swap where a predetermined fixed rate is exchanged for floating
' Fastest growing area in derivatives mkt is Credit
Derivatives

' In 2000 the total notional principal for o/s derivative

contracts was $ 800 bn; in June 2007 it had grown to $ 42
trillion

' Banks and Fis can manage their portfolio of credit risks,
keeping some and entering into credit derivatives to
protect themselves against others

' Banks have been the biggest buyers and insurance coǯs
have been the biggest sellers
' Credit derivatives can be categorized as   or    :

' Single Name : Credit Default Swap

' Multiname : CDO

' CDS provides insurance against risk of default by a particular firm. This firm is
known as the REFERENCE ENTITY and a default by the firm is known as the
CREDIT EVENT

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' Buyer makes regular payments to the Seller until the life of the CDS or until a
Credit Default occurs

' Total FV of the bonds that can be sold is known as the CDSÈ   
' Credit derivatives can be categorized as Single Name or Multiname :

' Single Name : Credit Default Swap

' Multiname : CDO

' CDS provides insurance against risk of default by a particular firm. This firm is
known as the REFERENCE ENTITY and a default by the firm is known as the
CREDIT EVENT

'  i: Right to sell bonds issued by the firm at Face Value when a
Credit Event occurs

' i: Agrees to buy bonds at FV when the Credit Event occurs

' Buyer makes regular payments to the Seller until the life of the CDS or until a
Credit Default occurs

' Total FV of the bonds that can be sold is known as the CDSǯ Notional Principal
m 4otional Principal : $ 100 mm

m Buyer agrees to pay 90 basis points annually for protection

against default by the reference entity

m If the reference entity does not default i.e. there is no credit

event, the buyer receives no payoff and pays $ 0.9mm. This is
known as the _

 .

m _ontracts with maturities are most popular but other maturities

(1/2/3/7/10 years) are not uncommon.

m Definition of Default : In Kurope, ³restructuring´ is included as a

_RKDIT K K4T; in contracts in 4A, it is not
m _DS can be used to hedge a posn in a corp bond
m _oupon : 7% pa
m _DS spread : 2% pa
m Kffect of the _DS is to convert the _orp bond to a risk-
free bond almost immediately

m If the bond issuer does not default «.

m If the bond issuer does default,
o The investor earns 5% up to the time of default

m _DS spreads on individual reference entities can be

calculated from default probability estimates
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m There are a number of reference entities
m When the 1st one defaults there is a payoff and the
basket _DS terminates

m The value of a 1st to default ______ as the

correlation between the reference entities
increases

m Prob of default is high when correlation is ZKRO

m 
 
 
m In the event of a default the buyer of protection sells bonds
issued by the reference entity for their F .
m Bonds with a total F = notional principal can be sold

m _ 
 
m A calculation agent estimates the value of the cheapest-to-
deliver bonds issued by the reference entity a specified no
of days after the default event.

m The cash payoff is based on the face value of these bonds

over the estimated value
m Security created from a portfolio of loans, bonds, credit
card receivables, mortgages, auto loans, etc
m Auto Loans :
o PRIMK / 4O4-PRIMK and SUBPRIMK

m SP aka trust/ conduit :

m SP issues secs backed by the c/fs of these loans and
sells these securities to investors

m Investor¶s return depends solely on the c/fs of these loans

m Bank earns a fee for originating and servicing the loans

o $ 100 mm portfolio of debt secs :
o 5 year tenor

o 
: finances 5% of total prin and is promised a return of
30% (unrated)

o —
: finances 20% of total prin and is promised a return
of 10% (BBB)

o

: finances 75% of total prin and is promised a return of
6% (AAA)

o Tranches receive their return in order of seniority

o
o Mezzanine tranches are difficult to sell
o _ombine mezzanine tranches of say 20 different ABS into a
new ABS.

o _onvince rating agencies to assign a AAA rating to the most

senior tranche of the new ABS.

o If these multiple mezzanine tranches have a high + ve

correlation, there could be problem

o
o Liar loans
o 4I4
A
o Adjustable rate mortgages

o
o Assets being securitized are bonds issued by
corps or countries

o Creator of the CDO acquires a portfolio of bonds .

These are then passed onto an SPV which passes the
income generated by the bond to a series of
tranches

o Objective of the originator of the CDO is to sell the

tranches to investors for more than they paid for the
bonds

o This is a Cash CDO

o   iÈ

o A long position in a corporate bond has essentially the same credit risk as a
SáORT position in the corresponding CDS (where protection has been
sold)

o Forms a portfolio consisting of short positions in CDSs. The credit risks are
then passed on to tranches

o Tranche 1 is responsible for the 1st $5 mm of losses (earns 15% on

remaining Tranche 1 principal

o Tranche 2 is responsible for the next $20 mm of losses (earns 1% on

remaining Tranche 2 principal )

o Tranche 3 is responsible for all losses in excess of $25 mm (earns 0.1% on

remaining Tranche 3 principal

o (Notional principal in a tranche is reduced by the losses that are paid for by
the tranche holders)