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SWAPS Structure, Function and Mechanics of the World‘s Largest Component of OTC Derivative Markets Swaps – Nature and History 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

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swaps

SWAPS

Structure, Function and Mechanics of the World‘s Largest Component of OTC Derivative Markets

contents
Swaps – Nature and History

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

Contents
swaps3

SWAPS

Nature and History

slide4

Nature of Swaps

  • In general “to swap” means, to exchange something.
  • In financial markets a swap commonly is an agreement to exchange cash flows at specified future times according to certain specified rules.
  • Thus, in a very basic case, two parties may exchange variable interest payments in one currency against fixed interest in the same currency (plain-vanilla-swaps).
nature of swaps

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 Swaps

A

B

the history of swaps
David Hume (1711) can be seen asthe originator of the theory of compa-rative advantage. He had close con-tacts with Adam Smith and influenced Smith‘s (1759) ideas about the advantages of the division of labour.The Historyof Swaps
  • After the Congress of Vienna (1815) at the end of the Napoleon Aera international trade became pos-sible, as the blockade of England has been suspen-ded. In 1817 David Ricardo explained the compa-rative advantage of international trade (On the Prin-ciples of Political Economy and Taxation).
  • More than 150 years later this idea has been picked up to introduce the first financial swaps.
david ricardo and the theory of comparative advantages
David Ricardo and The Theory of Comparative Advantages

Comparing Portugal with England, Portugal is clearly more efficiently producing than England. Seemingly there is no incentive for cooperation between Portugal and England:

david ricardo and the theory of comparative advantages8
David Ricardo and The Theory of Comparative Advantages

Comparing the absolute production costs (time needed for production per unit) the picture remains the same. Portugal is superior and has no incen-tives to cooperate with England:

david ricardo and the theory of comparative advantages9
David Ricardo and The Theory of Comparative Advantages

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.

david ricardo and the theory of comparative advantages10
David Ricardo and The Theory of Comparative Advantages

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.

david ricardo and the theory of comparative advantages11
David Ricardo and The Theory of Comparative Advantages

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 !!!

swaps12

SWAPS

How it Works

The Mechanics of a Plain Vanilla Interest Rate Swap

slide13

B

A

Basic Concept Plain Vanilla Interest Rate Swap

Fixed Rate

Variable Rate

The party paying the fixed rate is called to be in a Payer-Swap-position, while the party receiving fixed rates takes the Receiver-Swap-position.

Valuation: When the contract is signed, the N.P.V. of both cash flows, the variable and the fixed equal zero.

slide14

Plain-Vanilla 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 bid-prices of 43 European Banks.

plain vanilla interest rate swap example
Plain-Vanilla Interest Rate SwapExample

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.

slide16

Issue fixed rateBond

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

Plain-Vanilla 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.

slide17

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 %

Plain-Vanilla Interest Rate Swap

2. Step:A and B sign a swap-contract, with A receiving a fixed rate of 5.5 % from B and paying EURIBOR to B.

slide18

TotalCash Flow

BOND

Floating Loan

EUR – 0.5%

6 %

EURIBOR+ 0.50 %

5% Fixed Rate

Euribor

B

A

SWAP

SWAP

Fixed rate 5.5 %

Plain-Vanilla Interest Rate Swap

Balance of Payment A:

Balance of Payment B:

slide19

Floating Rate Loan

Bond

EUR+ 0.50 %

5% fixed

5.75 % fixed

EUR

B

A

5.25 %fixed

EURIBOR

Plain-Vanilla Interest Rate Swap

More realistic: A und B contract a Swap – agreement by a financial intermediator (JPSwap).

JPSWAP

slide20

5% FIXED

5.75 % Fest

EUR

A

5.25 %FIXED

EURIBOR

JPSWAP

Plain-Vanilla Interest Rate Swap

Balance JPSwap:

Balance B:

Balance A:

Straight Bond

Floating Rate Note

EUR+ 0.50 %

B

swaps21

SWAPS

SWAP – Markets andSWAP Quotations

slide23

SWAP – Quotations (Example)

Banks publish their swap-conditions. The fixed rates offered referring payer or receiver-swaps are determined by the current term structure of interest rates:

WestLB (as of Dec 26th 2005 vs. Oct, 5th 2008

slide24

SWAP – Quotations (Example)

Swap Quotations are mostly close to risk free market returns

swaps25

SWAPS

Typical SWAP - Application

slide26

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 (deprecia-tions). Secondly, in case of rising rates, A is not proper-ly invested which may affect her competetive position.Risk management may prevent A from losses.

slide27

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.

slide28

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 Payer-Swap (paying a fixed rate of 8%, receiving a floating rate at 12-m-Euribor. 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: 12-M-EURIBOR

swap valuation

Long

Short

Swap Valuation

In 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).

example risk management with asset swaps
Example: Risk Management with Asset Swaps

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 €:

slide31

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.

slide32

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.

example risk management with asset swaps offset by 2nd swap
Example: Risk Management with Asset Swaps Offset by 2nd Swap

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.