Swaps
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Terminology
• A swap is an agreement to exchange cash flows at specified
future times according to certain specified rules
• Counterparties are the two parties to a swap agreement
a) Fixed-rate payer makes fixed payments based on the notional
amount
b) Floating-rate payer makes variable payments on the notional amount
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Terminology
• The notional is the principal amount underlying the swap
agreement
• The term of the swap agreement is called the tenor
• A standard, or “plain vanilla”, swap involves one party paying
a fixed rate and the other paying a floating rate
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Terminating a Swap
Swaps can be terminated by:
a) Mutual agreement / payment with counterparty
b) Enter offsetting swap
c) Exercise a swaption
d) Sell position with permission of counterparty
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Characteristics of Swaps
• Customized instruments
• Not traded in any organized secondary market
• Largely unregulated
• Default risk is a concern
• Most participants are large institutions
• Private agreements
• Difficult to alter or terminate
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Swaps & Forwards
• A swap can be regarded as a convenient way of packaging
forward contracts
– A swap is similar to a series of 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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Common Types of Swaps
INTEREST RATE SWAP
• If A loans money to B for a fixed rate of interest and B loans
the same amount to A for floating rate of interest
CURRENCY SWAP
• If the loans are in two different currencies
EQUITY SWAP
• If one of the returns streams is based on a stock portfolio or
index return
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“Plain Vanilla”: the most basic form of swaps
INTEREST RATE SWAP
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Interest Rate Swap
• Used to convert fixed-rate debt to floating-rate debt
• One party agrees to make periodic fixed-rate payments to the
other, while the counterparty makes floating-rate payments
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Interest Rate Swap
• Each period, the payments are netted against each other with
the net amount paid by one to the other
• No money is exchanged at initiation and the fixed rate is
determined based on an initial swap value of zero
– Notional amount is not exchanged at the beginning or end of the swap
(both loans are in same currency and amount)
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Interest Rate Swap
• The LIBOR rate is determined at the beginning of the period
and paid at the end of the period
• Floating rate is usually tied to LIBOR
– Floating rate payments are typically made in arrears, payment is made
at end of period based on beginning-of-period LIBOR
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Example #1: Interest Rate Swap
An agreement by URC 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. Possible cash flow:
Fixed Cash
Date LIBOR Floating Cash Flow Flow Net Cash Flow
Mar 5, 2012 4.20%
Sep 5, 2012 4.80% +2.10 −2.50 −0.40
Mar 5, 2013 5.30% +2.40 −2.50 −0.10
Sep 5, 2013 5.50% +2.65 −2.50 + 0.15
Mar 5, 2014 5.60% +2.75 −2.50 +0.25
Sep 5, 2014 5.90% +2.80 −2.50 +0.30
Mar 5, 2015 +2.95 −2.50 +0.45
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Example #2: Interest Rate Swap
A portfolio manager owns a $10 million portfolio of floating-rate
notes whose coupons are LIBOR + 2%.
He expects interest rates will be falling, so he would rather have
a fixed-rate bond portfolio.
This can be accomplished with the following swap:
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CURRENCY SWAP
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Currency Swap
• Used to convert debt denominated in one currency into
another or to exploit a comparative advantage in borrowing
rates in another country
• At initiation, notional amounts of each currency are
exchanged at the current exchange rate
– Value of exchange = zero
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Currency Swap
• Subsequently, periodic payments are made (fixed-for floating
or fixed-for-fixed) based on the reference rate
• At expiration, the notional amounts are returned in the same
amount as the initial exchange
– Take note…exchange rates have changed
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Currency Swap
• 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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Example #1: Currency Swap
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Currency Swap
JOLLIBEE FOODS CORPORATION
PSE: JFC
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