6-1
Finance 457
Swaps
6
Chapter Six
6-2
Finance 457
Chapter Outline
6.1 Mechanics of interest rate swaps
6.2 The comparative-advantage argument
6.3 Swap quotes and LIBOR zero rates
6.4 Valuation of interest rate swaps
6.5 Currency swaps
6.6 Valuation of currency swaps
6.7 Credit risk
6.8 Summary & Conclusions
6-3
Finance 457
Swaps Contracts: Definitions
In a swap, two counterparties agree to a
contractual arrangement wherein they agree to
exchange cash flows at periodic intervals.
There are two types of interest rate swaps:
Single currency interest rate swap
Plain vanilla fixed-for-floating swaps are often just
called interest rate swaps.
Cross-Currency interest rate swap
This is often called a currency swap; fixed for fixed
rate debt service in two (or more) currencies.
6-4
Finance 457
The Swap Bank
A swap bank is a generic term to describe a financial
institution that facilitates swaps between
counterparties.
The swap bank can serve as either a broker or a
dealer.
As a broker, the swap bank matches counterparties but
does not assume any of the risks of the swap.
As a dealer, the swap bank stands ready to accept either
side of a currency swap, and then later lay off their risk, or
match it with a counterparty.
6-5
Finance 457
An Example of an Interest Rate Swap
Consider this example of a plain vanilla interest
rate swap.
Bank A is a AAA-rated international bank located in
the U.K. and wishes to raise $10,000,000 to finance
floating-rate Eurodollar loans.
Bank A is considering issuing 5-year fixed-rate Eurodollar
bonds at 10 percent.
It would make more sense to for the bank to issue
floating-rate notes at LIBOR to finance floating-rate
Eurodollar loans.
6-6
Finance 457
An Example of an Interest Rate Swap
Firm B is a BBB-rated U.S. company. It needs
$10,000,000 to finance an investment with a fiveyear economic life.
Firm B is considering issuing 5-year fixed-rate
Eurodollar bonds at 11.75 percent.
Alternatively, firm B can raise the money by issuing 5year floating-rate notes at LIBOR + percent.
Firm B would prefer to borrow at a fixed rate.
6-7
Finance 457
An Example of an Interest Rate Swap
The borrowing opportunities of the two firms are:
COMPANY
Fixed rate
Floating rate
BANK A
11.75%
10%
LIBOR + .5%
LIBOR
6-8
Finance 457
An Example of an Interest Rate Swap
The swap bank makes
this offer to Bank A: You
pay LIBOR 1/8 % per
year on $10 million for 5
years and we will pay
you 10 3/8% on $10
million for 5 years
Swap
10 3/8%
Bank
LIBOR 1/8%
Bank
A
COMPANY
Fixed rate
Floating rate
BANK A
11.75%
10%
LIBOR + .5%
LIBOR
6-9
Finance 457
An Example of an Interest Rate Swap
% of $10,000,000 =
$50,000. Thats quite
a cost savings per year
for 5 years.
10 3/8%
Heres whats in it for Bank A:
They can borrow externally at
10% fixed and have a net
borrowing position of
Swap
Bank
-10 3/8 + 10 + (LIBOR 1/8) =
LIBOR 1/8%
Bank
10%
LIBOR % which is %
better than they can borrow
floating without a swap.
A
COMPANY
Fixed rate
Floating rate
BANK A
11.75%
10%
LIBOR + .5%
LIBOR
6-10
Finance 457
An Example of an Interest Rate Swap
The swap bank
makes this offer to
company B: You
pay us 10% per
year on $10 million
for 5 years and we
will pay you
LIBOR % per
year on $10 million
for 5 years.
Fixed rate
Floating rate
Swap
Bank
10 %
LIBOR %
Company
B
COMPANY
BANK A
11.75%
10%
LIBOR + .5%
LIBOR
6-11
Finance 457
An Example of an Interest Rate Swap
Heres whats in it for B:
Swap
% of $10,000,000 =
$50,000 thats quite a cost
savings per year for 5
years.
Bank
10 %
They can borrow externally at
LIBOR + % and have a net
LIBOR %
Company
borrowing position of
10 + (LIBOR + ) - (LIBOR - ) = 11.25%
which is % better than they can borrow floating.
COMPANY
Fixed rate
Floating rate
BANK A
11.75%
10%
LIBOR + .5%
LIBOR
LIBOR
+ %
6-12
Finance 457
An Example of an Interest Rate Swap
The swap bank makes money too.
% of $10 million
= $25,000 per year
for 5 years.
Swap
10 3/8%
Bank
10 %
LIBOR 1/8%
Bank
LIBOR %
LIBOR 1/8 [LIBOR ]= 1/8
Company
10 - 10 3/8 = 1/8
COMPANY
Fixed rate
Floating rate
BANK A
11.75%
10%
LIBOR + .5%
LIBOR
6-13
Finance 457
An Example of an Interest Rate Swap
The swap bank makes %
Swap
10 3/8%
Bank
10 %
LIBOR 1/8%
LIBOR %
Bank
Company
A
A saves %
Fixed rate
Floating rate
COMPANY
B saves %
BANK A
11.75%
10%
LIBOR + .5%
LIBOR
6-14
Finance 457
An Example of a Currency Swap
Suppose a U.S. MNC wants to finance a 10,000,000
expansion of a British plant.
They could borrow dollars in the U.S. where they are well
known and exchange for dollars for pounds.
This will give them exchange rate risk: financing a
sterling project with dollars.
They could borrow pounds in the international bond market,
but pay a premium since they are not as well known abroad.
6-15
Finance 457
An Example of a Currency Swap
If they can find a British MNC with a mirror-image
financing need they may both benefit from a swap.
If the spot exchange rate is S0($/) = $1.60/, the U.S. firm
needs to find a British firm wanting to finance dollar
borrowing in the amount of $16,000,000.
6-16
Finance 457
An Example of a Currency Swap
Consider two firms A and B: firm A is a U.S.based
multinational and firm B is a U.K.based multinational.
Both firms wish to finance a project in each others country of
the same size. Their borrowing opportunities are given in the
table below.
Company A
8.0%
11.6%
Company B
10.0% 12.0%
6-17
Finance 457
An Example of a Currency Swap
Swap
Bank
$8%
$9.4%
11%
$8%
12%
Firm
Firm
B
$
Company A
8.0%
11.6%
Company B
10.0% 12.0%
12%
6-18
Finance 457
An Example of a Currency Swap
As net position is to borrow at 11%
Swap
Bank
$8%
$9.4%
11%
$8%
12%
Firm
Firm
A saves .6%
$
Company A
8.0%
11.6%
Company B
10.0% 12.0%
12%
6-19
Finance 457
An Example of a Currency Swap
Bs net position is to borrow at $9.4%
Swap
Bank
$8%
$9.4%
11%
$8%
12%
Firm
Firm
B
$
Company A
8.0%
11.6%
Company B
10.0% 12.0%
12%
B saves $.6%
6-20
Finance 457
An Example of a Currency Swap
The swap bank makes money too:
Swap
1.4% of $16 million
financed with 1% of
10 million per year
for 5 years.
$9.4%
Bank
$8%
11%
$8%
Firm
A
12%
Firm 12%
At S0($/) = $1.60/, that
is a gain of $124,000 per
B
year for 5 years. The swap bank
$
Company A
Company B
faces exchange rate
8.0% 11.6% risk, but maybe
10.0% 12.0% they can lay it off
(in another swap).
6-21
Finance 457
Variations of Basic Swaps
Currency Swaps
fixed for fixed
fixed for floating
floating for floating
amortizing
Interest Rate Swaps
zero-for floating
floating for floating
Exotica
For a swap to be possible, two humans must like the idea.
Beyond that, creativity is the only limit.
6-22
Finance 457
Risks of Interest Rate and Currency Swaps
Interest Rate Risk
Interest rates might move against the swap bank after it
has only gotten half of a swap on the books, or if it has an
unhedged position.
Basis Risk
If the floating rates of the two counterparties are not
pegged to the same index.
Exchange Rate Risk
In the example of a currency swap given earlier, the swap
bank would be worse off if the pound appreciated.
6-23
Finance 457
Risks of Interest Rate and Currency Swaps
Credit Risk
This is the major risk faced by a swap dealerthe risk
that a counter party will default on its end of the swap.
Mismatch Risk
Its hard to find a counterparty that wants to borrow the
right amount of money for the right amount of time.
Sovereign Risk
The risk that a country will impose exchange rate
restrictions that will interfere with performance on the
swap.
6-24
Finance 457
Pricing a Swap
A swap is a derivative security so it can be priced in
terms of the underlying assets:
How to:
Plain vanilla fixed for floating swap gets valued just like
a bond.
Currency swap gets valued just like a nest of currency
futures.
6-25
Finance 457
Summary & Conclusions
Swaps can be used to hedge; a swap can be viewed
as a portfolio of futures with different maturities.
