MFIN6003 Derivative Securities

Lecture Note Five

HKU Business School

University of Hong Kong

Dr. Huiyan Qiu

5-1
 Outline
Introduction to swaps using an example of a
commodity swap.
• Computing swap price
• Swap settlement and swap counterparty
• Market value of a swap
Interest Rate Swaps
Currency Swaps
Swap bank
Appendix:
• (1) Swaptions (2) Total Return Swaps
Reading: McDonald Chapter 8 5-2
 Introduction to Swaps
A swap is an agreement / contract calling for an
exchange of payments over time
• A single-payment swap is the same thing as a
cash-settled forward contract
• The swap payments are determined by the
difference in swap price and market price over
time
• A swap provides a means to hedge a stream of
risky payments (lower transaction cost)

5-3
An Example of a Commodity Swap
An industrial producer, IP Inc., needs to buy
100,000 barrels of oil 1 year from today and 2
years from today (concern? P↑)
How to hedge against the risk in oil cost?
Relevant information:
• The forward prices for deliver in 1 year and 2
years are $20 and $21/barrel.
• The risk-free 1- and 2-year zero-coupon bond
effeceive yields are 6% and 6.5%, respectively.
5-4
 A Commodity Swap (cont’d)
Strategy 1: Long forward contracts for 100,000
barrels in each of the next 2 years
• IP pays $20 in year one and $21 in year two for oil
Strategy 2: Prepaid swap
• A single payment today for multiple deliveries of
oil in the future.
$20 $21
𝑃𝑉 = + 2
= $37.383
1.06 1.065
• IP pays an oil supplier $37.383 per barrel now in
exchange for a commitment to delivering one
barrel in each of the next two years. Credit risk?
5-5
 A Commodity Swap (cont’d)
Strategy 3: Swap
• Defer payments until the oil is delivered, while still
fixing the total price
• A swap usually calls for equal payment in each year
𝑥 𝑥
+ 2 = $37.383 ⇒ 𝑥 = $20.483
1.06 1.065
• The 2-year swap price is $20.483
Any series of payments that have a PV of $37.383
is acceptable (ignoring the credit risk)
5-6
 Timeline – Payments

0 1 2

Unhedged S1 S2
Strategy 1 20 21
Strategy 2 37.873
Strategy 3 20.483 20.483

All series of payments have a PV of $37.383.

5-7
Swaps, Forwards, and Financing
Swaps are nothing more than forward contracts
coupled with borrowing and lending money
• Compare the swap price and the forward prices, we
are overpaying by $0.483 in the first year, and we
are underpaying by $0.517 in the second year
• We are lending the counterparty money for 1 year.
The interest rate on this loan is
0.517/0.483 – 1 = 7%.
• Given 1- and 2-year zero-coupon bond yields of 6%
and 6.5%, 7% is the 1-year implied forward yield
from year 1 to year 2. (Fair pricing!)
5-8
Swaps, Forwards, and Financing

0 1 2

Forwards 20 21
Swap 20.483 20.483

Consider lending of 0.483 from year 1 to year 2

at 7% interest rate.

Forwards + the lending = Swap

9
 No-Arbitrage Principle
The present value of future payments for the
same series of future commodity delivery should
be the same. Otherwise, arbitrage!

For example: if the present value of payment

using two forward contracts for the oil delivery in
year 1 and in year 2 is lower than that of
payment using two-year swap.
• One can long the two forward contracts and short
the swap to gain the arbitrage profit.

5-10
 Computing the Swap Price
Suppose there are n swap settlements, occurring
on dates ti, i = 1,… , n. What is the swap price R?
PV (swap price) = PV (forward price)
𝑛 𝑛
𝑅 𝐹0,𝑡𝑖
෍ 𝑡 =෍
[1 + 𝑟(0, 𝑡𝑖 )] 𝑖 [1 + 𝑟(0, 𝑡𝑖 )]𝑡𝑖
𝑖=1 𝑖=1
𝑛 𝑛

෍ 𝑅𝑃(0, 𝑡𝑖 ) = ෍ 𝐹0,𝑡𝑖 𝑃(0, 𝑡𝑖 )

𝑖=1 𝑖=1
𝒏
σ𝑛𝑖=1 𝐹0,𝑡𝑖 𝑃(0, 𝑡𝑖 ) 𝑷(𝟎, 𝒕𝒊 )
𝑹= =෍ 𝒏 𝑭
σ𝑛𝑖=1 𝑃(0, 𝑡𝑖 ) σ𝒋=𝟏 𝑷(𝟎, 𝒕𝒋 ) 𝟎,𝒕𝒊
𝒊=𝟏 5-11
 In-Class Exercise
The XYZ Inc. will need 100,000 barrel of oil in
year 3. The company wants to hedge the future
price risk. Based on the following information on
the zero-coupon bond prices and oil swap prices,
what will be the company’s hedged cash flow in
year 3?

year 1 2 3 4
oil swap price 43.5 45 44 44.5
zero-coupon bond price 0.9852 0.9701 0.9546 0.9388

5-12
 In-Class Exercise
Solution:

5-13
 Outline
Introduction to swaps using an example of a
commodity swap.
• Computing swap price
• Swap settlement and swap counterparty
• Market value of a swap
Interest Rate Swaps
Currency Swaps
Swap bank
Appendix:
• (1) Swaptions (2) Total Return Swaps
Reading: McDonald Chapter 8 5-14
Physical vs. Financial Settlement
The results for the buyer are the same whether the
swap is settled physically or financially. In both
cases, the net cost of the buyer is fixed at the swap
price of $20.483, whatever the market price of oil.
Physical settlement

5-15
 Financial Settlement
The oil buyer, IP, pays the swap counterparty the
difference between $20.483 and the spot price, and the oil
buyer then buys oil at the spot price

100,000 barrels are the notional amount of the swap,

used to determine the magnitude of the payments when
the swap is settled financially 5-16
 The Swap Counterparty
The swap counterparty is a dealer, who is, in
effect, a broker between buyer and seller

The fixed price paid by the buyer, usually,

exceeds the fixed price received by the seller.
This price difference is a bid-ask spread, and is
the dealer’s fee

Back-to-back transaction or “matched book”

transaction: the situation where the dealer
matches the buyer and seller.
5-17
 Matched Book Transaction
The dealer bears the credit risk of both parties,
but is not exposed to price risk

5-18
Unmatched Book Transaction
In the case that the swap transaction is not
matched, the dealer serves as counterparty to
the oil buyer and is facing future oil price risk:
obligation to receive fixed price and pay
floating price.

$20.483
Swap
Oil Buyer Counterparty
Oil spot price

5-19
 Unmatched Book Transaction
To hedge the swap transaction with the buyer, the
dealer can enter into long forward or futures
contracts.
Cash flows:

The net cash flow for the hedged dealer is a loan

Thus, the dealer also has interest rate exposure (which
can be hedged by using short-term rate futures or FRAs)
5-20
 The Market Value of a Swap
The market value of a swap is zero at inception
• Once the swap is struck, its market value will
generally no longer be zero (change in forward price,
in interest rate…)
• Even if there is no change in interest rates or the
forward prices, the swap changes value after
payment.
The market value of the swap is the difference in
the PV of payments between the original and new
swap prices
5-21
 The Market Value of a Swap
Example: change in forward price
• Assume immediately after the initiation of the swap,
the forward curve for oil rises by $2 in both years
• Assume interest rates are unchanged
• The new swap price will be $22.483, $2 higher than
the old one (check and understand why exactly $2)
• PV of the differences = 2/1.06 + 2/(1.0652) = $3.65
• $3.65 is the market value of the old swap

5-22
 In-Class Exercise
The oil forward prices for 1 year and 2 years are
$20, and $22. The continuously compounding
1-year and 2-year interest rate is 3% and 4%.
• What is the 2-year swap price?
• You are the dealer who is receiving the fixed oil
price and paying the floating price. Suppose that
immediately after you enter the swap, 1-year
forward price increases by $1 and 2-year forward
price increases by $2 and the interest rates are
changed from 3% to 3.5% and from 4% to 4.5%.
What happens to the value of your swap position?

5-23
 In-Class Exercise (cont’d)
• What hedging instrument would have protected
you against price risk in this position?
Solution:

5-24
 Outline
Introduction to swaps using an example of a
commodity swap.
• Computing swap price
• Swap settlement and swap counterparty
• Market value of a swap
Interest Rate Swaps
Currency Swaps
Swap bank
Appendix:
• (1) Swaptions (2) Total Return Swaps
Reading: McDonald Chapter 8 5-25
 Interest Rate Swaps
An interest rate swap is a forward contract in
which one stream of future interest payments is
exchanged for another based on a specified
principal amount.
Interest rate swaps usually involve the exchange
of a fixed interest rate (swap rate) for a floating
rate, or vice versa.
A swap can also involve the exchange of one type
of floating rate for another, which is called a
basis swap.
5-26
 Interest Rate Swap: An Example
XYZ Corp. has $200M of floating-rate debt, i.e., it
pays interest at 𝑟0(0,1) for year 1, 𝑟1(1,2) for year
2, and 𝑟2(2,3) for year 3. XYZ would prefer to
have fixed-rate debt with 3 years to maturity
• Retire the floating-rate debt and issue fixed rate
debt (Transaction cost? Feasible? )
• Enter a strip of forward rate agreements (FRA rates
varies)
• Enter a swap, in which they receive a floating rate
and pay the fixed rate
5-27
 An Example (cont’d)
Suppose the risk-free 1-, 2-, and 3-year zero-
coupon bond yields are 6%, 6.5%, and 7%,
respectively. All rates are annual and effective.
The forward rates for year 2 and year 3 can be
calculated to be 7.0024% and 8.0071%.

1.0652
𝑟0 1,2 = − 1 = 7.0024%
1.06

1.073
𝑟0 2,3 = 2 − 1 = 8.0071%
1.065
5-28
 Computing the Swap Rate
How to determine the swap rate?
Suppose the notional principle is 𝑄 and there are
n floating interest payments, occurring on dates
ti, i = 1,… , n.
• The implied forward interest rate from date ti-1 to
date ti, known at date 0, is r0(ti-1, ti). By using
forward rate agreement, interest payment at ti can
be fixed at 𝑄 × 𝑟0 𝑡𝑖−1 , 𝑡𝑖 .
Now consider the swap with n swap settlements.
Swap rate is R.
5-29
Computing the Swap Rate (cont’d)
By using swap, the interest payment at all dates
will be fixed at 𝑄 × 𝑅.
Suppose the price of a zero-coupon bond maturing
1
on date ti is P(0, ti). (Note: 𝑃 0, 𝑡𝑖 = )
1+𝑟(0,𝑡𝑖 ) 𝑡𝑖

Using FRAs to hedge or using swap to hedge →

same present value:
𝑛 𝑛

෍ 𝑃(0, 𝑡𝑖 )𝑟0(𝑡𝑖−1, 𝑡𝑖 ) = ෍ 𝑃(0, 𝑡𝑖 )𝑅

𝑖=1 𝑖=1
5-30
Computing the Swap Rate (cont’d)
Rewrite
σ𝑛𝑖=1 𝑃(0, 𝑡𝑖 )𝑟0 (𝑡𝑖−1 , 𝑡𝑖 )
𝑹=
σ𝑛𝑖=1 𝑃(0, 𝑡𝑖 )
𝑛
𝑃(0, 𝑡𝑖 )
=෍ 𝑛 𝑟0 (𝑡𝑖−1 , 𝑡𝑖 )
σ𝑗=1 𝑃(0, 𝑡𝑗 )
𝑖=1

Thus, the fixed swap rate is a weighted

average of the implied forward rates, where
zero-coupon bond prices are used to determine
the weights
5-31
Computing the Swap Rate (cont’d)
Note P(0, ti −1 )
1 + r0 (ti −1 , ti ) =
P(0, ti )
An alternative way to express the swap rate is


n
P(0, ti ) r0 (ti −1 , ti )
R= i =1

i =1 P(0, ti )
n

 P (0, ti −1 ) 
 P(0, ti )  − 1
n
i =1
 P (0, ti )  1 − P (0,tn )
= = n
i =1 P(0, ti ) i =1 P(0,ti )
n

5-32
 An Example (cont’d)
Back to the example, using the given interest
rate information, we have

1 − 𝑃(0,3)
𝑅=
𝑃 0,1 + 𝑃 0,2 + 𝑃(0,3)
1 − 0.816298
= = 𝟔. 𝟗𝟓𝟒𝟖𝟓%
0.943396 + 0.881659 + 0.816298
5-33
 An Example (cont’d)

On net, XYZ pays 6.9548%

XYZ net payment = – LIBOR + LIBOR – 6.9548% = –6.9548%

Floating Payment Swap Payment

5-34
Variation of Interest Rate Swaps
A deferred swap is a swap that begins at some date
in the future, but its swap rate is agreed upon today
An amortizing swap is a swap where the notional
value is declining over time (e.g., floating rate
mortgage)
An accreting swap is a swap where the notional
value is growing over time
General formula for the swap rate:

σ𝑛𝑖=𝑘 𝑄𝑡 𝑃(0, 𝑡𝑖 )𝑟0 (𝑡𝑖−1 , 𝑡𝑖 )

𝑅=
σ𝑛𝑖=𝑘 𝑄𝑡 𝑃(0, 𝑡𝑖 )
5-35
 Outline
Introduction to swaps using an example of a
commodity swap.
• Computing swap price
• Swap settlement and swap counterparty
• Market value of a swap
Interest Rate Swaps
Currency Swaps
Swap bank
Appendix:
• (1) Swaptions (2) Total Return Swaps
Reading: McDonald Chapter 8 5-36
 Currency Swaps
A currency swap entails an exchange of
payments in different currencies

For two things to be swappable, they must

have the same present value.
• The swap is fair to both parties.
• Market value of swap at initiation is zero.

5-37
Currency Swap: An Example
Suppose a dollar-based company is facing the
following euro payments in the future: – €10m in
year 1, – €15m in year 2, and – €20m in year 3.
The company would like to swap the future euro
payments into fixed dollar payments in the next
three years.
Would should be the yearly fixed payment in
dollar? Assume the current exchange rate is 1.17
$/€ and dollar-denominated interest rate is 1%
and euro-denominated interest rate is 1.2%, both
annual and effective. 5-38
Example (cont’d)

€ payment 10 15 20
$ payment R R R

R is chosen so that the stream of euro payments and

dollar payments can be swapped. They must have the
same present value.
10 15 20
𝑃𝑉€ = 1.012 + 1.0122 + 1.0123 = 43.8247 €
𝑅 𝑅 𝑅
𝑃𝑉$ = 1.01 + 1.012 + 1.013 = 2.9410𝑅 $
𝑃𝑉€ = 𝑃𝑉$ → 43.8247€ × 1.17$/€ = 2.9410𝑅 $

43.8247×1.17
→R= 2.9410
= 𝟏𝟕. 𝟒𝟑𝟒𝟓 million dollars
5-39
 Currency Swaps
Currency swap can also be used to swap
payments of bonds dominated in two currencies.
The currency swap used is equivalent to
borrowing in one currency and lending in
another.
Example: A dollar-based firm has a 3-year 3.5%
euro-dominated par bond with a €100 par.
Current exchange rate is $0.90/€. How to hedge
the exchange rate risk?

5-40
Currency Swap Example (cont’d)
The firm can enter a currency swap with the
market-maker –– making payments on a dollar-
based bond and receiving payments for its euro-
based bond

$, $, $ (how much?)
Firm Market-maker
€3.5, €3.5, €103.5

Rule: the present value of the payments (from

and to the market-maker) should be the same!
5-41
Currency Swap Example (cont’d)
The euro-based par bond has value €100, which is
equivalent to $90, given the current exchange rate
of $0.90/€.
Therefore, the dollar-based par bond should have
value $90.
Suppose the effective annual dollar-denominated
interest rate is 6%
The payments on dollar-based bond are:
$5.40, $5.40, and $95.40.

5-42
 Currency Swaps
A currency swap is equivalent to borrowing in one
currency and lending in another

$90 now

$5.4, $5.4, $95.4

Firm Market-maker
€3.5, €3.5, €103.5

€100 now

5-43
 In-Class Exercise
(Continue on the example). Suppose one year
later, dollar-denominated interest rate is 5% and
euro-denominated interest rate is 3%, both
annual and effective. The exchange rate one year
later is 1.02$/€. What is the market value of the
firm’s swap position?
Suppose instead of using currency swap, the firm
uses currency forward contracts to hedge the
exchange rate risk, what are the fixed future
payments in dollar for all three years?
5-44
 In-Class Exercise
Solution:

5-45
 Outline
Introduction to swaps using an example of a
commodity swap.
• Computing swap price
• Swap settlement and swap counterparty
• Market value of a swap
Interest Rate Swaps
Currency Swaps
Swap bank
Appendix:
• (1) Swaptions (2) Total Return Swaps
Reading: McDonald Chapter 8 5-46
 Swap Bank
Swap bank is a financial institution that acts as
an intermediary for interest and currency swaps.
• Function: to find counterparties for those who
want to participate in swap agreements.
• The swap bank typically earns a slight premium
for facilitating the swap.
In general, companies do not directly approach
other companies in an attempt to create swap
agreements. In most cases, companies don't even
know the identities of their swap counterparties.
5-47
 Swap Bank: Example
Both company A and company B need to take
$5m loan. Company A prefers to pay variable
rate of interest while company B prefers to pay
fixed rate of interest.
Company A is big, well-known, and well-
established. It is offered with 5% fixed rate or
SOFR by bank X.
Company B is less well-known and smaller. It is
offered with 8% fixed rate or SOFR+1% by bank
Y.
How can a swap bank help here?
5-48
Swap Bank: Example (cont’d)
The swap bank offers a swap to company A as
follows:
SOFR
Co. A Swap Bank
5.5%

By taking the loan from bank X at 5% and

signing the swap above with the swap bank,
effectively, company A is paying at a variable
rate of SOFR-0.5%. Great!
5-49
Swap Bank: Example (cont’d)
The swap bank offers a swap to company B as
follows:
6%
Co. B Swap Bank
SOFR

By taking the loan from bank Y at SOFR+1%

and signing the swap above with the swap bank,
efectively, company B is paying at a fixed rate of
7%. Great!
5-50
Swap Bank: Example (cont’d)
Both company A and company B are better off.
The swap bank earns 0.5%

SOFR SOFR
Co. A Swap Bank Co. B
5.5% 6%

Concerns: default risk (credit risk) …

5-51
End of the Notes!

5-52
 Appendix:

More on Swaps

5-53
 Swaptions
A swaption is an option to enter in the future
into a swap with pre-specified terms
• Swaption can be used to speculate on the swap
price/rate in the future
A swaption is analogous to an ordinary option.
• Swaption has a premium.
• Swaptions can be American or European.

5-54
 Payer / Receiver Swaption
A payer swaption gives its holder the right, but
not the obligation, to pay the pre-specified price
(strike price) and receive the market swap price
• The holder of a payer swaption would exercise
when the market swap price is above the strike
A receiver swaption gives its holder the right,
but not the obligation to pay the market swap
price and receive the pre-specified strike price
• The holder of a receiver swaption would exercise
when the market swap price is below the strike
5-55
 Example: Payer Swaption
Suppose we enter into a 3-month European payer
oil swaption: the strike price = $21 and the
underlying swap commences in 1 year and has 2
settlements
After 3 months, the fixed price on the underlying
swap is $21.50: Exercise the option, obligating us
to pay $21/barrel for 2 years and allowing us to
receive $21.5/barrel for 2 years.
• In year 1 and year 2, we will receive $21.50 and pay
$21, for a certain net cash flow each year of $0.50
5-56
 Total Return Swaps
A total return swap is a swap, in which one
party pays the realized total return (dividends
plus capital gains) on a reference asset, and the
other party pays a floating return such as LIBOR
The two parties exchange only the difference
between these rates
The party paying the return on the reference
asset is the total return payer

5-57
 Example: Total Return Swap
ABC Asset Management want to sell $1 billion of
investment in S&P index
An alternative is to swap the total stock return
into a floating short-term rate
Table Illustration of cash flows on a total return swap
with annual settlement for 3 years.

5-58
 Total Return Swaps (cont’d)
Why to use a total return swap?
• The total return payer gives up the possible risk
premium on the stock index
• The payoff for the swap is equivalent to direct
selling of the stock and buying a floating-rate
note
• However, the total return swap can allow foreign
investors to own stocks without physically holding
them, so as to avoid withholding foreign taxes
• Flexible management of credit risk
5-59