Swaps
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Swaps. Swaps involve exchange of one set of financial obligations with another e.g. fixed rate of interests with floating rate of interest, one currency obligation to another, a floating price of a commodity to fixed price etc. History of Swaps. First currency swap was engineered in

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Swaps

Swaps

Swaps involve exchange of one set

of financial obligations with another e.g. fixed rate of interests with floating rate of interest, one currency obligation to another, a floating price of a commodity to fixed price etc.


History of swaps

History of Swaps

First currency swap was engineered in

London in 1979, but the next deal structured by

Salomon Brothers in 1981 in London involving

organizations of the stature of World bank and

IBM, not only ended the 2-year obscurity but

also gave credibility to the instrument, so

necessary for its extremely fast growth.


History of swaps1

History of Swaps

First Interest rate swap was engineered

in London in 1981and was introduced in

the US in 1982 by Student Loan

Marketing Association (Sallie Mae).

Commodity swaps were first engineered

in 1986 by Chase Manhattan Bank.


Purpose of a swap

Purpose of a Swap

  • Reduce cost of capital

  • Manage risk

  • Exploit economies of scale

  • Arbitrage across capital markets

  • Enter new markets

  • Create synthetic instruments


Basic types of swap

Basic Types of Swap

  • Interest Rate Swaps

  • Currency Swaps

  • Commodity Swaps

    Interest rate swaps and currency swaps

    are together known as Rate Swaps.


Rate conventions

Rate Conventions

  • Swaps are most often tied to LIBOR.

  • It is quoted “actual over 360”, as though the year is of 360 days. This raises the effective rate for a period and has compounding effect.

  • Bond equivalent yields are quoted on actual over 365 days.

  • For comparison, adjustments can be made by multiplication of a rate differential by 365/360 or by 360/365.


Cash market transactions

Cash Market Transactions

Swaps are used in conjunction with

following basic cash market transactions:

  • Obtain actuals from cash market

  • Make/receive payments to/from cash market

  • Supply actuals to cash market


Initial exchange of notionals optional

Initial Exchange of Notionals(Optional)

.

Notionals

Swap

Dealer

Notionals

Counterparty B

Counterparty A

Notionals

Notional


Periodic usage or purchase payments required

Periodic Usage or Purchase Payments(Required)

.

Fixed Price

Swap

Dealer

Fixed Price

Counterparty B

Counterparty A

Floating

Price

Floating Price


Re exchange of notionals optional

Re-exchange of Notionals(Optional)

.

Notionals

Swap

Dealer

Notionals

Counterparty B

Counterparty A

Notionals

Notionals


Interest rate swap

Interest Rate Swap

  • A, desirous of 10-yr fixed rate debt (available at 11.25% sa) has access to cheap floating rate financing (LIBOR + 50bp).

  • B, desirous of a 10-yr floating rate financing (available at LIBOR) has access to cheaper fixed rate financing (10.25% sa).

  • A dealer available can be a floating rate payer or receiver at LIBOR and a fixed rate payer at 10.40% sa and receiver at 10.50% sa.


Interest rate swap1

Interest Rate Swap

CASH MARKET TRANSACTIONS

.

Debt market

(Floating Rate)

Debt Market

(Fixed Rate)

Principal

Principal

Counterparty A

Swap

Dealer

Counterparty B

SWAP


Interest rate swap2

Interest Rate Swap

CASH MARKET TRANSACTIONS

.

Debt market

(Floating Rate)

Debt Market

(Fixed Rate)

6-M LIBOR +50bps

10.25% (sa)

10.40% (sa)

Counterparty A

10.50% (sa)

Swap

Dealer

Counterparty B

6-M LIBOR

6-M LIBOR

SWAP


Interest rate swap3

Interest Rate Swap

CASH MARKET TRANSACTIONS

.

Debt market

(Floating Rate)

Debt Market

(Fixed Rate)

Principal

Principal

Counterparty A

Swap

Dealer

Counterparty B

SWAP


Currency swap

Currency Swap

  • A, needing floating rate dollars, can borrow euros at 9.0% fixed and dollars at 1-yr LIBOR floating.

  • B, needing fixed rate euros, can borrow euros at 10.1% fixed and dollars at 1-yr LIBOR floating.

  • Swap dealer can pay 9.45% fixed on euros against dollar LIBOR and dollar LIBOR against 9.55% fixed on euros.


Currency swap1

Currency Swap

CASH MARKET TRANSACTIONS

.

Debt market

(Euro)

Debt Market

($)

9%

LIBOR

9.55%

Counterparty A

9.45%

Swap

Dealer

Counterparty B

LIBOR

LIBOR

SWAP


Commodity swap

Commodity Swap

  • A crude oil producer wants to fix a price to be received for 5 years on production of 8000 barrels p.m. He agrees to pay average of preceding month price to swap dealer against a receipt of $68.20/barrel.

  • An oil refiner wants to fix the price he pays for oil for 5 years on his average need of 12000 barrels. He agrees to pay $68.40 against market price of $69.50/barrel for an average price of preceding month.


Commodity swap1

Commodity Swap

CASH MARKET TRANSACTIONS

.

Spot

Oil

Market

Actuals

Actuals

Spot Price

Spot Price

$68.40/barrel

Counterparty A

$68.20/barrel

Swap

Dealer

Counterparty B

Spot Price

(average)

Spot Price

(average)

Oil Producer

Refiner

SWAP


Why a swap dealer

Why a Swap Dealer?

If A and B attempted a swap with each

other directly, it would have failed due

to different requirements. Swap dealer

can be a fixed-rate payer on 4000

barrels and till such time he can hedge

in futures.


Swaption

Swaption

When a firm doesn’t want a swap now but can lock-in the terms of swap now by buying an option on swap called Swaption.


Case study

Case Study

B. F. Goodrich - Rabobank


Issues in the case

Issues in the case

  • Why was the need for swap felt?

  • How could the rate of borrowing be reduced for Goodrich?

  • Describe the structure of the Swap diagrammatically.

  • Comment on the role of financial innovations with reference to the case.


Interest rate swap4

Interest Rate Swap

CASH MARKET TRANSACTIONS

.

US Bond

(Floating Rate)

Eurobond

(Fixed Rate)

3-M LIBOR +50bps

11%(10.7%)

11%

B.F. Goodrich

11%

Morgan

Bank

Rabobank

LIBOR-x

LIBOR-x

SWAP


Calculations

Calculations

Cost for B.F.Goodrich:

LIBOR + 50bp +11 – LIBOR + x = 11.5 +x (i.e. 11.6 to 11.875) as against 12 to 12.5% (a saving of 40 to 60 bps approx.)

Cost for Rabobank:

8.75 – x as against 10.70%

Morgan Bank gets: one time fees ($125000 + annual fees)


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