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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

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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 Extensions: Forward Swaps, Swaptions, Credit Default Swaps & others Contents**SWAPS**Nature and History**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).**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**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**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 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 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 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 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 !!!**SWAPS**How it Works The Mechanics of a Plain Vanilla Interest Rate Swap**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.**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 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.**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.**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.**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:**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**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**SWAPS**SWAP – Markets andSWAP Quotations**SWAP Market 1996 – 6/2008(Notional Amount Outstanding in**Bio USD)**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**SWAP – Quotations (Example)**Swap Quotations are mostly close to risk free market returns**SWAPS**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 (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.**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 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**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**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.**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.

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