3.2.2 Swaps

2. Swaps

2.1 Introduction to Swaps

Swaps are over-the-counter (OTC) derivatives contracts where the parties agree to exchange certain cash flows in the future.

• 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

Three primary forms of swaps:

• Interest rate swap: the two parties exchange a series of cash flow based on different interest rate. Plain vanilla IRS is to exchange fixed and floating rate.
• Currency swap: the swap is based on two different currencies.
• Equity swap: One of the return streams is based on a stock portfolio or index return.

Terminology

• Notional principal is the amount used to calculate periodic payments.
• Tenor is the amount of time left before expiration.
• Settlement dates is payment due dates.
• Financial intermediaries are ones who bring the two appropriate parties together to transact. International Swaps and Derivatives Association (ISDA) sets confirmations, which is detailed legal agreements of swap transaction.

Credit risk exposure in a swap position

• Because swap is an OTC derivative, one with positive payoff would face credit risks. One with negative payoff may trigger default.
• When no collateral is posted, or when transactions are only partly collateralized, the credit exposure must be monitored carefully.

2.2 Comparative advantage

2.2.1 Absolute and Comparative Advantages

Company X wants a fixed borrowing while company Y wants a floating borrowing. The two companies have borrowing rate as following:

Company	Fixed borrowing	Floating borrowing
X	$7.5\%$	LIBOR $+200$ bps
Y	$4.5\%$	LIBOR
Incremental	$3\%$	$2\%$

Y has absolute advantages in both fixed and floating markets.

X has a comparative advantage in floating market, while Y has a comparative advantage in fixed market.

Y chooses the side firstly, he chooses his comparative advantage of fixed-rate borrowing, and the other side, floating-rate borrowing, would be left for X.

• If there is no swap, company X must pay $7.5\%$ interest rate, while company Y must pay Libor. Their total cost is $\text{Libor}+7.5\%$
• If financing through swap, the total cost will be $\text{Libor}+6.5\%$, which is $1\%$ lower.
• If they share the saving equally, the arrangement would be following
  

2.2.2 Use swaps to transform an asset or a liability

A company with a floating-rate loan can use a swap to convert it to a fixed rate liability.

A company with a fixed-rate loan can use a swap tp convert it to a floating-rate liability.

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2.3 Swap Cash Flow Calculating

2.3.1 Interest Rate Swap

Swap rate is the fixed portion of a swap as determined by its particular market and the parties involved.

Floating rates are based on some short-term reference interest rate, such as three-month or six-month dollar Libor (London Interbank Offered Rate).

LIBOR is an unsecured borrowing rate between banks is quoted for several different currencies and for borrowing periods ranging one day to one year.

Plain vanilla interest rate swap: fixed interest rate payments are exchanged for floating-rate payments.

• Interest payments are netted : on settlements dates, both interest payments are calculated and only the difference is paid by the party owing the greater amount.
• Notional principal is not exchanged at the beginning and end of the swap.

The net income for the fixed-rated payer in the $t^{th}$ period is

$$({\text{Libor}}_{t-1}-\text{Swap Fixed Rate})\ast \text{principal}\ast \frac{\text{days per period}}{360}$$

Floating rate payments are typically made in arrears, payment is made at the end of period based on beginning-of-period LIBOR.

2.3.2 Currency Swap

It means that one party pay currency A to the other party, and receiver currency B from the other.

• It has another name as back-to-back loan or parallel loan.
• Fixed-for-fixed, fixed-for-floating, floating-for-fixed, floating-for-floating currency swaps exist in reality.

Notional amount is exchanged at the beginning and the end of the swap. Different currencies must be exchanged.

Interest payments are not netted. Interests are in different currencies, so they must be exchanged.

On settlement dates, both interest payments are calculated and paid in separate currency. One would pay interest in currency A, and receive interest in currency B.

2.3 Swap Valuation

Pricing swaps requires the determination of the swap rate.

• Swap rate is the rate paid by the pay-fixed side.
• Principle: $P{V}_{\text{fixed-payments}}=P{V}_{\text{floating-payments}}$

Swap value is the difference in the value of the fixed payments and floating payments.

• The value is zero at initiation, but usually non-zero after initiation.
• Swap rate must be set properly so swap value at initiation is zero.

2.3.1 Interest Rate Swap Valuation

Value a swap could be regarded as the difference of values between two bonds. For interest rate swap, it is regarded as the difference of value between a fixed-rate bond and floating-rate bond.

Value of payer swap(支付固定利率) = value of “replicating” floating rate bond - value of “replicating” fixed rate bond.
Value of receiver swap(支付浮动利率) = value of “replicating” fixed rate bond - value of “replicating” floating rate bond.

Bonds have principal payments, but swaps do not. Bond’s principal payments should be included in the valuation procedure.

Fixed rate payer is equivalent to a long position in a floating rate bond and a short position in a fixed rate bond.
Floating rate payer is equivalent to a long position in a fixed rate bond and a short position in a floating rate bond.

Fixed-rate bond could use cash flow discount valuation method.
$$P=\sum _{t=1}^n\frac{c}{(1+Z_t{)}^t}+\frac{FV}{(1+Z_n{)}^n}$$

• $Z_n$:spot rate for period $n$.

Floating-rate bond need detailed analysis on valuation.

On each settlement date, the value of a floating rate note (FRN) will always reset to par (interest rates “adjust” to market rates).

On other dates, three steps are involved:

• First, finding the next settlement date.
• Second, on next settlement date, total value equals par plus coupon payment at that point.
• Third, discount that value to current time point.

2.3.2 Example of Interest Rate Swap Valuation

Consider a $ $2$ million notional swap that floating rate bases on 6-month Hong Kong Interbank Offered Rate (HIBOR). Cooper pays a fixed rate of $7\%$ semiannually. A swap payment has just made. The swap has a remaining life of 18 months, with pay dates at 6, 12, 18 months. Continuously compounded spot HIBOR rates for 6-month, 12- month, 18-month and 24-month are $6.5\%$, $6.8\%$, $7.5\%$ and $7.7\%$ respectively. The value of the swap to Cooper is closest to:

$PMT(\text{fixed})=\frac{7\%}{2}\times 2000000=70000$

The present value of the fixed bond is:

$70000e^{-6.5\%\times 0.5}+70000e^{-6.8\%\times 1}+(70000+2000000{)}^{-7.5\%\times 1.5}=1982907$

The present value of the floating bond at the payment date is the notional principal $2000000$

The value of the swap to Cooper = value of “replicating floating rate bond”-value of “replicating” fixed rate bond, which is:

$2000000-1982907=17903$

2.3.3 Currency Swap Valuation

For currency swap, it is regarded as the difference of value between bond in one currency and a bond in another.

One party longs a bond denominated in currency X, and shorts a bond denominated in currency Y.

Total cash flow, including interests and principals, should be translated by the exchange rate at each time point, and the difference of values in the same currency is the value of this currency swap.

2.3.4 Example of Currency Swap Valuation

A firm has entered a 3-year fixed-for-fixed currency swap two years ago with a position receiving USD semiannually and paying EUR annually. A swap payment has just been made. The USD leg has a notional value of USD $10,000,000$ and an annual coupon of $1.5\%$. The EUR leg has a value of EUR $8,080,808$ and an annual coupon of $0.5\%$. Given the following discount and forward rates, what is the present value in USD of the swap on December 15, 2021?

Pay Date	USD/EUR Forward Rate	USD Discount Curve
June 15, 2021	$1.240$	$0.9975$
December 15, 2021	$1.245$	0.9950

The present value of USD leg:
$10,000,000\times \frac{1.5\%}{2}\times 0.9975+(10,000,000+10,000,000\times \frac{1.5\%}{2})\times 0.9950=10,099,437$

The present value of EUR leg:
$8,080,808(1+5\%)\times 1.245\times 0.9950=10,060,354$

The value of the swap for the USD receiver: $10,099,437-10,060,354=39,083$