FRM Training07-A.ppt

FRM Training07-B.ppt

FRM Training07-C.ppt

FRM Training07-D.ppt

FRM Training07-E.ppt

FRM Training07-F1.ppt

FRM Training07-F2.ppt

FRM Training07-F3.ppt

FRM Training07-F4.ppt

Outline of This Lecture
What is a swap
Interest rate swaps
Mechanics of interest rate swaps
Pricing interest rate swaps
Currency swaps
Mechanics of currency swaps
Pricing currency swaps
1. What is a swap? Example
Company A buys electricity from wholesalers and provides power service to consumers in California

The electricity price selling to consumers is fixed, while the purchasing price from wholesalers is variable

For A, the cash inflows are quite stable, but the outflows are uncertain

In case such as the high oil price, the electricity price in wholesale market become very high, and the company may bankrupt.

To manage the risk, the company may want to exchange their floating (variable) outflows with a fixed outflow or to exchange their fixed inflows with a floating inflows.

The company can do it by using a swap.
What is a swap?
A swap is an OTC agreement between two parties (called counterparties) to exchange a series of cash flows over a period of time.

Four major types of swaps:
Interest rate swaps (IRS)
Currency swaps
Equity swaps
Commodity swaps
Some terminologies about swaps
Notional principal: the amount of money used to determine the payments or the sizes of swap contracts. It may or may not be exchanged

Initially, the value of a swap is zero. Thus, no payment is needed at the beginning

Settlement date: the date on which a payment occurs.

Settlement period: the period between two consecutive settlement dates

Tenor: time to maturity
Features of the swaps market
Privacy: only the counterparties know your position

Virtually no government regulation in U.S.
Industrial self-regulation. Major regulator:
ISDA: The International Swap and Derivatives Association

Three concerns or limitations
Difficult to find counterparties
Now swap dealers make markets, and this problem has been solved

Difficult to close before maturity: liquidity risk

Counterparty default risk:
This is an important concern in dealing with swaps.
Swap rates depend on credit ratings
Only deal with large firms
2. Interest rate swaps (IRS)
IRS are swaps to exchange interest payments in the same currency

The most popular IRS is fixed-for-floating swap, also called plain vanilla interest rate swap

1) Mechanics of IRSs
In a plain vanilla interest rate swap, there are two counterparties: A and B.
A: agrees to pay B a sequence of interest rate payments based to a fixed rate and a “principal”, called the notional principal.
A is called the fixed payer

B: agrees to pay A a sequence of interest rate payments based to the market rates, or floating-rates and the notional principal.
B is called the floating payer

No fund is exchanged initially.
The fixed-rate is predetermined, called the swap rate.
The floating rate in many IRS is LIBOR rate.
Example: A Plain Vanilla IRS
Company A entered an agreement with Bank B initiated on Sept.1, 2000

Company A:
Pays Bank B a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million.
Receives 6-month LIBOR every 6 months for 3 years on a notional principal of $100 million.

The notional principal is not exchanged.

There is no fund exchange at t=0.

The actual payments are the net payments.

Tenor: (the time to maturity): three years
Plain Vanilla IRS
Example: A Plain Vanilla IRS
Cash flow to company A:

Date LIBOR Inflow Outflow Net Cash Flow
receive-floating pay-fixed

09/01/2000 4.2%
03/01/2001 4.8% 2.10 -2.50 -0.40
09/01/2001 5.3% 2.40 -2.50 -0.10
03/01/2002 5.5% 2.65 -2.50 +0.15
09/01/2002 5.6% 2.75 -2.50 +0.25
03/01/2003 5.9% 2.80 -2.50 +0.30
09/01/2003 6.4% 2.95 -2.50 +0.45

On Sept. 1(time t=0): the first LIBOR rate was known, and so the first cash flow was known. The subsequent cash flows are unknown, because the LIBOR rates are uncertain.
Gain or loss: Depend on the difference between the floating rates and the fixed-rate.
Zero-sum game.
The fixed-rate in a plain vanilla IRS is set so that the initial value of the agreement is zero

Swap pricing is referred to determine the fair value of a fixed rate, called a swap rate.

In this example, the floating payment is determined in advance and paid in arrears. Most swaps are of this type.

The payment paid on Mar. 01, 2003, $2.80 million, is determined on Sept. 01, 2002, based on the spot 6-month LIBOR rate quoted on Sept. 1, 2002, 5.6%.

Some swaps are paid in advance, called in-advance swaps
Some motivations of using an IRS
Converting a liability:
From fixed rate to floating rate
From floating rate to fixed rate

Converting an investment or asset
From fixed rate to floating rate
From floating rate to fixed rate

Taking comparative advantages
Example 1: Converting a liability
Company A has a floating rate liability to pay a LIBOR+0.8% interest rate on a loan, and wishes to convert it into a fixed rate loan.

A can enter into a plain vanilla IRS with a bank to pay a fixed rate of 5.5% in exchange of receiving LIBOR rate.

Thus, in net, A pays a fixed rate of 6%.

Converting a liability
Example 2: Converting an asset
Mr. Li has an investment which pays a fixed rate of 5.2%. Li wishes to receive a market rate.

Li can enter into a plain vanilla IRS with a bank to pay a fixed rate of 5.5% in exchange of receiving LIBOR rate.

Thus, in net, A receives LIBOR-0.3%.

Converting a liability
Example 3. Comparative advantages
Company A wants to borrow $10 million for 5 years at a
floating rate

Company B wants to borrow $10 million at fixed rate for 5

The interest rates offered by banks:
Comparative advantages
The difference between the two fixed rates is:
11.20-10.00 =1.20%

The difference between the two floating rate is
(LIBOR+1.00%)-(LIBOR+0.30%) =0.70%

Though B has always to pay higher rate than A, B could pay a relatively lower rate at floating than at fixed, comparing to the rates A pays.

That is, though A has absolute advantages in two markets, B has comparative advantage in floating.

The comparative advantage is 1.20-0.70=0.50%

A should borrow at fixed and B should borrow at floating, then, they exchange the loans to meet their needs.
Comparative advantages
To take the comparative advantage:

A borrows at the fixed rate, paying: 10%

B borrows at the floating rate, paying:

LIBOR + 1%

A and B enter a swap in which A pays LIBOR to B, and B pays fixed 9.95% to A.



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