SWAPS Structure, Function and Mechanics of the Worldâ€˜s Largest Component of OTC Derivative Markets Swaps â€“ Nature and History How it works â€“ Mechanism of Plain Vanilla Interest Rate Swaps Swap Markets and Swap  Quotations A Typical Swap Application Valuation of IR â€“ Swaps Currency Swaps
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Structure, Function and Mechanics of the World‘s Largest Component of OTC Derivative Markets
How it works – Mechanism of Plain Vanilla Interest Rate Swaps
Swap Markets and Swap  Quotations
A Typical Swap Application
Valuation of IR – Swaps
Currency Swaps
Extensions: Forward Swaps, Swaptions, Credit Default Swaps & others
ContentsNature and History
A pays B a fixed rate on a fixed contract volume
B pays A a variable rate on a fixed contract volume
PayerSwap(Long)
Receiver Swap(Short)
Nature of SwapsA
B
Comparing Portugal with England, Portugal is clearly more efficiently producing than England. Seemingly there is no incentive for cooperation between Portugal and England:
Comparing the absolute production costs (time needed for production per unit) the picture remains the same. Portugal is superior and has no incentives to cooperate with England:
Comparing the opportunity costs of production, the picture now changes: Portugal is still superior comparing the production of textiles but is relatively inferior, if we look at the vine production. One unit of Vine in Portugal costs 0.1 units of textils production while the „price“ of vine in England is now only at 0.02 units of textiles per unit of vine.
Assume that both countries decide to spend 10h on textiles production and 2h on the production of vine. Without cooperation the total output would then reach up to 110 textiles and 200 vine. But as Portugal has a comparative advantage in textiles production and England an advantage in producing vine, both countries could gain from cooperation, if each focuses only on it‘s specific strengths.
Both countries could gain from cooperation, if each focuses only on it‘s specific strengths. If Portugal allocates 12h on textile production and England 12h on vine production the total outcome will significantly rise: Although it seems, as if Portugal is the overall superior nation, a cooperation with England, which is seemingly overall inferior, makes sense. Both may gain from cooperation !!!
A
Basic Concept Plain Vanilla Interest Rate Swap
Fixed Rate
Variable Rate
The party paying the fixed rate is called to be in a PayerSwapposition, while the party receiving fixed rates takes the ReceiverSwapposition.
Valuation: When the contract is signed, the N.P.V. of both cash flows, the variable and the fixed equal zero.
PlainVanilla Interest Rate SwapExample
Two corporations, A (Rating AAA) and B (Rating A) are exposed to very different market conditions:
Euribor: European Interbank Offered Rate, an average interbank rate, calculated and published every day at 11.00 a.m. in Brussels from bidprices of 43 European Banks.
On a first glance, there is no reason for A to cooperate with B.
A closer look at the different conditions shows, that there is a comparative advantage of B financing at variable rates. Whenever the condition
holds, a SWAP contract is reasonable for both parties. In our case, the difference is 1,0% (1.5%  0.5% = 1.0%) indicating the possible combined advantage for both parties when setting up a SWAP. How this advantage will be distributed, is subject of negotiation between the parties.
Floating rate loan
B issues afloating rate loan at EUR + 0.5%.
EURIBOR+ 0.50 %
A issues astraight bond at 5%.
5% fixe rate
B
A
PlainVanilla Interest Rate Swap
1. Step:
A and B chose financing contracts at their relatively best positions, i.e. A choses a fixed rate while B enters a floating rate loan.
B issues afloating rate loan at EUR + 0.5%.
Straight Bond
EURIBOR+ 0.50 %
A issues astraight bond at 5%.
5% fixed rate
B
EURIBOR
A
SWAP
SWAP
Fixed rate 5.5 %
PlainVanilla Interest Rate Swap
2. Step:A and B sign a swapcontract, with A receiving a fixed rate of 5.5 % from B and paying EURIBOR to B.
BOND
Floating Loan
EUR – 0.5%
6 %
EURIBOR+ 0.50 %
5% Fixed Rate
Euribor
B
A
SWAP
SWAP
Fixed rate 5.5 %
PlainVanilla Interest Rate Swap
Balance of Payment A:
Balance of Payment B:
Bond
EUR+ 0.50 %
5% fixed
5.75 % fixed
EUR
B
A
5.25 %fixed
EURIBOR
PlainVanilla Interest Rate Swap
More realistic: A und B contract a Swap – agreement by a financial intermediator (JPSwap).
JPSWAP
5.75 % Fest
EUR
A
5.25 %FIXED
EURIBOR
JPSWAP
PlainVanilla Interest Rate Swap
Balance JPSwap:
Balance B:
Balance A:
Straight Bond
Floating Rate Note
EUR+ 0.50 %
B
SWAP – Markets andSWAP Quotations
Banks publish their swapconditions. The fixed rates offered referring payer or receiverswaps are determined by the current term structure of interest rates:
WestLB (as of Dec 26th 2005 vs. Oct, 5th 2008
Swap Quotations are mostly close to risk free market returns
Typical SWAP  Application
Example: Risk Management with Asset Swaps
Corporation A receives interest revenues generated by a 100 Mio. € bond investment (6y to maturity, 8% coupon). The bonds have been put on the assets side at their costs of purchase (100%). The financial management of A forcasts the interest rates to rise by 1.5 % over the next year.
Rising rates will lead to declining prices (depreciations). Secondly, in case of rising rates, A is not properly invested which may affect her competetive position.Risk management may prevent A from losses.
Example: Risk Management with Asset Swaps – Efficiency
If interest rates rise as forcasted, the value of the 100 Mio. bonds investment will decrease to 97,961 Mio €:
A necessary depreciation will affect the future profit and loss account by an additional loss of 2.038.655 € (100 Mio € purchase price minus 97,961,345 € current market price).
To prevent the corporation from this risk, a swap contract could be used. Expecting rising rates, the corporation may become a fixed rate payer receiving floating rates.
Example: Risk Management with Asset Swaps
Payer Swap
Bond Debtor
8 % fixed rate
8% fixed rate
Swapbank
Corporation A
Euribor
To manage the forecasted interest rate related risk, A enters a 6y PayerSwap (paying a fixed rate of 8%, receiving a floating rate at 12mEuribor. The contract volume mirrors the nominal value of the risky asset (100 Mio €):
Notional amount: 100 Mio €Maturity: 6 yearsType: Payer SwapFixed Rate: 8%Ref. Rate: 12MEURIBOR
Short
Swap ValuationIn general the value of a swap is the Net Present Value (NPV) of all future cash flows. Initially, the terms of a SWAP contract are such that the NPV of all future cash flows is equal to zero. That means, when the SWAP starts, there is no advantage to each of the parties, neither to the Long – nor to the Short side.
For practical reasons we will assume, that the Present Value of the variable Cash Flows always approaching 0. That means, we alway value the SWAP at it‘s Roll Overs (directly, when the variable rate is adjusted).
If the interest rate will rise as predicted, the Present Value of the Bond, based on 5 future cash flows, will decrease to 97,961,370€:
Compared with the book value, Corporate A has to depreciate the Bonds by 2,038,630 € to their current market value of 97,961,370 €:
Example: Risk Management with Asset Swaps – Close Out
If, one year later, the interest rates has been risen by linearly 1.5 %, the future cash flows referring the 100 Mio € Swap (which now matures in 5y !) could be valued using the new spot rates:
The value of the swap contract (= P.V. of fixed interest payments) is at 2,038,630 Mio €. To close out, A will be paid the SWAP‘s present value by the SWAP  Bank.
Example: Risk Management with Asset Swaps Offset by 2nd Swap
1st. Payer Swap
Theoretically, after one year A could enter a second swap, where she becomes a fixed rate receiver (5y at 8,5%)
Bond Market
 8 % fixed rate
 8% fixed rate
Swapbank 1
Corporation A
+ Euribor
+ 8,5%fixed rate

Euribor
2nd. Receiver Swap
Swapbank 2
The advantage of the 2nd Swap position is to receive now 0.5% or 500 T€ over a period of 5 years.
Another way to lock in the profits requires a 2nd SWAP, by which the older Long Position (Payer SWAP) is now offset using a Short Position (Receiver SWAP). Doing so, Corporate A will continously generate a positive 500,000 USD Cash Flow over the next five years:
The Present Value of this continously gained advantage (2,038 Mio €) equals the Present Value of the SWAP.