SWAP CONTRACTS Derivatives market OUTLINE + Definition of swaps ° NY M + Currency swaps What is swap ? *A swap is an over-the-counter agreement between two companies to ‘exchange cashflows inthe future, ‘The agreement defines the dates when the cash lows are to be paid and the way in which they are tobe caleulated,Interest rate swap @ Nature of intrest rate swap © owoes of interest rate swap © Vatwation of nverest rate swap @ledging by interest rate swap Interest rate swap Floating rate a Payer Swap (Bayer a Receiver Swap eter Interest rate swap ‘The most common type of swap is & “plain vanilla in estate swap, One company agrees to pay to another company cash flows equal 10 interest at predetermined fixed rate on @ notional principal for a pre= determined number of years, In return, i receives interest ata floating rate on the same notional principal forthe same period of time from the ‘other company Interest rate swap, Payment exchange “Only exchange of net cashflow *No exchange of principalMlustration *3.year swap initiated on March 5, 2017, be tween Mierosoft and Intel. We suppose Microsoft agrees to pay Intel an interest rate of 5% per annum on principal of $100 million, and in return Intel agrees to pay Microsoft the ‘6-month LIBOR rate on the same principal. Microsoft is the fixed-rate payer; Intel i the floating-rate payer . We assume the agreement specifies ‘that payment sare to be exchanged every 6 months and thatthe 5% interest rate is quoted with semiannual compounding. Cash Flows to Microsoft Millions of Dollars LIBOR FLOATING FIXED Net Mlustration Microsoft Ml: Cash Flows to Intel Millions of Dollars LIBOR FLOATING FIXED Net Date Rate___Cash Flow Cash Flow Cash Flow. Date Rate___Cash Flow Cash Flow Cash Flow. MarS,2017 42% MarS,2017 42% Sept.$,2017 4.8% Sept.$,2017 4.8% Mar5,2018 5.3% Mar5,2018 5.3% Sept.$,2018 5.5% Sept.$,2018 5.5% Mars,2019 5.6% Mars,2019 5.6% Sept-$,2019 5.9% Sept-$,2019 5.9% MarS,2020 6.4% MarS,2020 6.4%‘The Comparative Advantage Argument “Suppose hat wo orp, A Corp an 1 Corp, bth wish row $100 milion for 5 years and bave Ben oer th rats sown ia Tale A Crp his AAA cat ‘ing: BBBCorp hss 2 BBB credit rating We assume that B Corp want to Boro afte re of inet, wheres A wants 1 row at a Noting rat of interest linked 6am BOR, ‘Aad B can borrow by 2 ways ‘1: brow from the bank fr S ens with Heating ft, intrest payments made very 6 months "2: And Bean fe 5 yebond with fined rte, coupon payment is made every 6 montis Interest rate swap Step 1: and B choose o boro the way they have comparative scvanage 3% The Comparative Advantage Argument ‘Table 1: Borrowing rates that provide a basis for the comparative advantage argument Floating Fixed Objectives A Euribor 5.0% Floating B Euribor +0,50 65% Fixed Interest rate swap Step 2: and B entera swap agreement to ensure that A recelves fixed mate of 5.50% and pay B EurborInterest rate swap Cash Flow A Ficed | Foang Bond | a Swap [8.596 |-Buibor Net $0.59 |= Enibor + Net interest rate = Euribor ~ 0.5% < Buribor “® Objectives: Floating rate Net gain= 0.5% Interest rate swap 1% What isthe total gain from this interest rate swap arrangement ? Interest rate swap re a eae a EL = + Net interest rate= 6 % < 6.5% ® Objective: fixed rate Interest rate swap The ttl gain from his typeof intrest at swap arrangement: 05-15|= 1% The total gain A oe Sal “The distribution ofthis gain depends on each party's negotInterest rate swap ‘Acash ow Fist Floating Bond Swap Net CF Betsh ow Fixed [ Flstng ak Soap Net CF (Cash Flow — Financial intermediaries a B Nace Question: Net Cash flow of each party? Net interest rate ofeach party? ‘The net gain of each panty? The total gain? Setting up a swap when no financial intermediary is involved ‘A and B are offered fixed rate on a notional principal of $20m for S years relatively 12% and 13.5%; floating rate of Euribor +0.1% and Euribor 10.6%. A wants to borrow floating rate loan, B wants to borrow fixed rate loan Setting up a swap without financial intermediary and the gain from swap is equally shared among two partiesswap when a financial intermediary is involved ‘A and B are offered fixed rate on notional principal of $20m for 5 years relatively 12% and 13.4% floating rate of Euribor 40.1% and Buribor 40.6%. ‘A wants to borrow floating rate, B wants to borrow fixed rate. Setting up a swap when a financial intermediary receives 0.1%‘annum from swap and that will appear equally attractive to both companies, “Example Consider the balance sheet ofthe bank ? What risk does the bank exposure to and when? Asset Loan: Euribor + 1% (6 month floating interest rate) Silty Deposit: 8% (6 years) Application of interest rate swap, ‘Transform a liability ‘To hedge interest rate risk, bank needs to reduce the duration of liability “Banks should sell 5 years swap, in which Receive fixed rate of 8%annum, Pay floating rate of (Eurbor ~1%) ‘The payment is made every 6 months‘Transform an asset ‘Transform an asset ‘To hedge interest rate risk, bank needs to reduce the duration of asset Example ‘Banks should buy 5 years ~ swap, in which Consider the balance sheet ofthe bank ? What risk does the bank > Pay fixed rate of 8%lannum > Receive floating rate of (Eurbor ~ 1%) exposure to and when? — rom “The payment is made every 6 months Loan: 10% Deposit: Euribor- 1% 5 years (6 month floating interest rate) Currency swaps Currency swap ‘Exchanging principal and interest payments at a fixed rate in one (Upp store of currency swaps ‘currency for principal and interest payments ata fied rate in another currency. ‘The principal amounts are usually exchanged atthe beginning and atthe © calf of te rap “The principal amounts are chosen to be approximately equivalent using the exchange rate atthe swap's initiation, Sp oti fewren mpCurrency swap year curency swap agroement between IBM and British Petroleum entered into on February 1, 2017, We suppose that IB M pays a fixed rate of interest ofS in stering and receives fixed rate of interest of 6% in dollars from British Petroleum, Inerest rate payment sare made ‘once a year and the principal amounts are $15 million and £10 million = ” = Currency swap Step 1: GM and QA each borrow in the market where they have a ‘comparative advantage. Tati, SGM booms USD 5% OA bores AUD 139% ‘Step 2: Then they use a cureney swap with a financial institution (premium 0.2%) SGM and QA’ gain rom SWAP: (1.6% 0262 = 07% GM transforms oan into a AUD los tans its loan into an USD loan ‘Comparative Advantage Arguments for Currency Swaps Suppose that General Motors wants to bortow 20 mion AUD in $ years and ‘Quant Airway wants to horrow 12 milion USD forthe same pid. -lnterst rate posed to 2 companies areas follows usb) AUD Objectives ‘General Motors 50% 20mAUD Qantas Airways 7.0% 12musp ‘The eurtent exchange rate (1 AUD in terms of USD) is 0,600. Currency swap Financial institution bears foreign exchange risk bh 800 [+] pene 80Applications of currency swaps ‘+Accurteney swap might be used to transform a loan from this currency tw other without changing the principal ‘Currency swap can be used to hedge exchange rate risk when there is a ccureney mismatch in the balance sheet Applications of currency swaps “Example ‘Consider the balance sheet of an American bank: Asset Liab Loan: GBP Deposit: 100m USD (Ged interest rat 44 years) (xed increst ate) year, Applications of curreney swaps Example Consider the balance sheet of an American bank: Asset Liability Loan: USD. Deposit $0 m GBP (Fixe interest rate) ‘ (xed intrest rate 10%iyear, 44 year)