What are Swaps? Basic Idea of Swaps. What are Swaps? Advanced Corporate Finance

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1 Wat are Swaps? Spring 2008 Basic Idea of Swaps A swap is a mutually beneficial excange of cas flows associated wit a financial asset or liability. Firm A gives Firm B te obligation or rigts to someting it no longer wants to pay or receive in excange for someting it is more willing to pay or receive. A non-finance example I ave signed up for te Wine of te Mont Club and you ave signed up for te Beer of te Mont Club. As ockey season starts, I would like to ave beer and you would like to ave wine so we swap. You give me te beer you receive and, in excange, I give you te wine tat I receive. Wat are Swaps? An agreement between two parties to excange (or swap ) cas flows in te future. Initially based on te idea of parallel loans : Two parties take out loans. For example, party A borrows at a fixed interest rate and B at a floating rate. A swap occurs if party B makes te fixed payments for A and A te floating for B. Formally: one party agrees to pay te floating interest payment on te notional principal and receive te fixed interest payment on te same notional principal. Te oter party does te opposite. Tere is generally no excange of principal.

2 Size of Swap Market (billions of USD) $250,000 Notional Principal Outstanding in Billions of US Dollars $200,000 $150,000 $100,000 $50,000 $ Source: International Swap and Derivatives Association History of Swaps An early form of swaps was developed to circumvent foreign excange controls during te 1960s and 1970s. For example, tere were eavy taxes on te conversion of some currencies so it was very expensive to move currencies across national borders, especially te UK. How could a firm finance operations outside of te UK witout converting currencies? Consider a UK firm wit a US subsidiary. If te US subsidiary needs financing, wat were te alternatives? UK parent could borrow in te UK, convert te s to US dollars and provide tis to its subsidiary. But tis conversion was eavily taxed! US subsidiary could borrow directly, but it may ave a poor (or no) credit rating in te US. Also costly! Solution? History of Swaps cont d If a US firm wit a UK subsidiary ad te same problem, te parent firms could borrow in teir own countries and lend to te oter firm s subsidiary to avoid conversions. Te casflows for te U.S. parent firm would be: Year Get $ loan from US bank $2m -$0.2m -$0.2m -$0.2m -$0.2m -$2.2m Make $ loan to UK sub -$2m $0.2m $0.2m $0.2m $0.2m $2.2m Sub gets loan from UK firm 1m - 0.1m - 0.1m - 0.1m - 0.1m - 1.1m Net position 1m - 0.1m - 0.1m - 0.1m - 0.1m - 1.1m (Note: te US firm now as a loan in Britis Pounds, as desired, and its payments are based on te UK firm s AAA rating. Similarly, te UK firm as a loan in $ s based on te US firm s AAA rating)

3 Parallel Loans vs. Currency Swaps United Kingdom United States Britis Bank Britis Firm Agreement American Firm American Bank American Subsidiary Britis Subsidiary Difficulties of Parallel Loans Firms must find a partner were: Relative size of bot projects must be similar (e.g. te notional principal must be similar). Two firms in te appropriate countries must ave opposite interests. Considerable legal detail must be discussed due to te nature of all of te debt contracts and te corresponding payment obligations. Effect on financial statements must be tolerable. Types of Swaps Tere are many different types of swaps. In teory, one can swap (or excange) casflows generated from any type of financial asset for tose generated from anoter. Is tere a catc? Bot sides must feel tey are benefiting from te trade (i.e., tey must be appy ) since tey did not ave to do te swap. Te first swaps were used to circumvent te foreign excange controls and tus swapped te payments on loans in different currencies.

4 Foreign Currency Swaps A contractual agreement between two parties to swap payments of different currencies in te future. Eac party agrees to excange a specific amount of one currency for a specific amount of anoter currency at pre-defined intervals (Note: like a series of forwards). For example, A will pay 4.75 billion to B in excange for 20 million every 6 monts for te next 2 years. Te size of te payments is based on a notional principal and agreed upon swap rates (e.g., interest rates). Te expected value of eac side s payments are equal. Bot sides must be appy wit te terms. Foreign Currency Swaps Foreign Excange Swap It is similar to one or more forward contracts were te parties are transacting wit eac oter to swap future casflows in one currency for te reverse at some oter point in te future. Currency Swap Similar to te original parallel loan agreements. Bot parties take out loans in teir ome country (usually fixed rate), excange te principal, swap te payments and re-excange te principal at te end. Increases access to global capital markets. Foreign Currency Swap Receipt of US $ Payment of Yen Payment of Yen Receipt of Yen counter party financial institution firm Payment of US $ Payment of US $ Yen payment US $ payment

5 Evolution of Swaps As foreign excange restrictions were relaxed in te mid- 1970s, te use of parallel loans (essentially currency swaps) decreased. Te interest rate swap market really started to develop in te early 1980s because of differences in U.S. dollar interest rates inside and outside of te U.S. Te Fed ad a tigt monetary policy so interest rates in te US were very ig, but tey were muc lower on Eurodollars wic were not subject to Fed restrictions. Interest rate swaps were a way to decrease borrowing costs. US-based firms would borrow in te Eurocurrency market and swap tis for a European bank s US dollar loan in te US. Eurocurrency Market Review Originally centered in London. Now also in Baamas, Singapore, Hong Kong, US, and Japan Started in London wit borrowing/lending $US outside te US and Britis Pounds outside te UK. Now it involves almost all major currencies outside teir ome country. Main advantages: less government regulation, less disclosure, more anonymity and less conditions on borrowing. Main disadvantages: less government regulation, less disclosure, more anonymity and less conditions on borrowing. Most common quote: LIBOR rate at wic London banks will lend to eac oter Definition of Interest Rate Swaps A contractual agreement between two parties to excange (or swap ) cas flows according to a pre-determined formula at pre-determined dates in te future. Te formula was initially based on te notion of parallel loans. If party A borrows at a fixed interest rate and party B borrows at a floating rate, a swap occurs if party B makes te fixed payments for A and A te floating for B. Formally: one party agrees to pay te floating interest payment on te notional principal and receive te fixed interest payment on te same notional principal. Te oter party does te opposite. Tere is generally no excange of principal.

6 Interest Rate Swaps Eac party agrees to make te interest payments on te oter s debt. Te rates are set so te expected value of eac party s future payments are equal (i.e., so bot sides are appy ). Te size of te payments is based on a notional principal and agreed upon interest rates. Actual payments are typically netted. Eac party remains legally liable for its original debt. Plain Vanilla Interest Rate Swap fixed payments at x% fixed payments at x% counter party financial institution firm floating payments at LIBOR + y% floating payments at LIBOR + y% fixed rate debt floating rate debt Numerical Example (Plain Vanilla Swap) Witout Swap Fixed Rate Financing Floating Rate Financing Seeks Co. A (AAA rated) 12% Prime + 2.5% Floating Co. B (BBB rated) 14% Prime + 3.5% Fixed Wit Swap Fixed Rate Payments at 13.5% Company A Company B Floating Rate Payments at Prime + 3.5% Fixed Rate Financing Floating Rate Financing at 12% at Prime + 3.5% Eac company as borrowed at te best rate tat tey could and tey are swapping payments. Are tey appy wit tis arrangement?

7 Swap Example (Plain Vanilla cont d) To see tat bot sides are appy consider teir payments: Company A: Pays its lender +12% (fixed rate) Pays floating to Company B +(Prime + 3.5%) Receives from Company B -13.5%. Net being paid by A Prime + 2% (vs Prime+2.5%) Company B: Pays its lender +Prime + 3.5% (floating) Pays fixed to Company A +13.5% Receives from Company B - (Prime + 3.5%) Net being paid by B 13.5% (vs. 14.0%) Bot are paying less interest tan tey would ave witout te swap AND tey ave te type of interest payments tey wanted! Swap Example (Plain Vanilla cont d) Would A ave swapped if it ad only been promised 13.25% in return for paying Prime + 3.5%? If it ad been promised 13.75%? Wat about B, ow would it feel about tese new terms? Company A: Pays its lender +12% (fixed rate) Pays floating to Company B +(Prime + 3.5%) Receives from Company B %. Net being paid by A Prime % (vs Prime+2.5%) Company B: Pays its lender +Prime + 3.5% (floating) Pays fixed to Company A % Receives from Company B - (Prime + 3.5%) Net being paid by B 13.25% (vs. 14.0%) How do you tink tese terms are determined? Total Return Swap A contractual agreement between two parties to receive or pay casflows to one anoter from different financial securities at regular intervals. Eac party agrees to excange te casflows it receives from one financial asset for tose received by te oter party from a different financial asset. Te size of te payments is based on a notional principal combined wit te rate of return on one financial security (e.g. te S&P500) being swapped for te return on anoter security (e.g. LIBOR).

8 Total Return Swap payments at LIBOR + x% payments at LIBOR + x% counter party financial institution firm payments based on S&P500 payments based on S&P500 Swap Payments Payments are structured suc tat bot sides of te deal are appy wit te expected values tey will pay or receive based on te contract. Te value of eac part sould be at least as good if not better tan tey could ave ad witout te swap. We can solve for te fixed interest rate loan wose present value is equal to te expected present value of te floating interest rate loan. Note: as interest rates cange, one party will benefit and te oter will lose. Te expected values are based on te best available information. May be extracted from te yield curve or from te forwards market. Example 1: Plain Vanilla Swaps Have a 3 year $10 million loan at LIBOR plus 1% to be paid every 6 monts. Investment bank proposed a swap to pay a fixed 9.75% every six monts on a notional principal of $10 million for tree years. For te floating rate loan te forecasted interest expenses are: LIBOR Interest Expense Expected Payment Today 8.00% 9.00% $450,000 6 Monts 8.50% 9.50% $475, Monts 9.00% 10.00% $500, Monts 9.25% 10.25% $512, Monts 9.40% 10.40% $520, Monts 8.50% 9.50% $475,000 For te fixed rate loan te expected costs are: every 6M 9.75% $487,500

9 Example 1 cont d Net Cas flows Discount Rate PV of Casflows Today -$37, % -$37,500 6 Monts -$12, % -$11, Monts $12, % $11, Monts $25, % $21, Monts $32, % $26, Monts -$12, % -$9,906 Wy net casflows? Wy is te discount rate 9.75%? Is tis swap fairly priced? Would you enter into it? Total $ Example 2: Pricing a Swap Assume: Notional principal = $100 Maturity = 1 year Floating rate = LIBOR Payments = semi-annual Wat would be te corresponding fixed rate wit te same semi-annual payment arrangement for tis swap? Example 2 cont d How to estimate te floating payments? Yield Curve Yield to maturity 10% 8% 6 mo 12 mo Time to Maturity For LIBOR wit: 8% annualized rate for 6 mont LIBOR 10% annualized rate for 12 mont LIBOR

10 Example 2 cont d First payment is based on 6 mont LIBOR: 100[(0.08/2)] = $4.00 Second payment? To be indifferent between rolling over after 6 monts and investing for 1 year from te outset: (1 + R 0 to 12 ) = (1 + ½ R 0 to 6 ) ( 1 + ½ R 6 to 12 ) ( ) = (1 + ½(0.08)) ( 1 + ½ R 6 to 12 ) (1 + ½ R 6 to 12 ) = ( )/( ) R 6 to 12 = 11.5% Second payment is 100 [(0.115/2)] = $5.75 Example 2 cont d Wat fixed rate is equivalent to tis? Te discounted value of te floating rate loan payments: [100(0.08/2)] / ( /2) + [100(0.115/2)] / ( ) = $4/(1.04) + $5.75/(1.10) = $9.07 If te swap is properly priced, te discounted value of tis sould be equal to te discounted value of te fixed rate loan : $9.07 = 100(x/2)/(1 + x/2) + 100(x/2)/(1 +x) x = 9.71% Note: tis is te semi-annual rate wereas 10% was for an annual payment. Example 3: Valuing a Swap Alternatives: 1) take out a Pound Term loan, or 2) issue a EuroECU bond and swap te Euros to Pounds. 1) Te Pound Term Loan: te principal was 100M wit repayment at te end of 5 years. te payments were 3.75M every 6 monts for 5 years. Wat is te actual, all-in interest rate for tis loan? 100M = 3.75M/(1+r) M/(1+r) M/(1+r) 10 Using an internal rate of return (IRR) calculation, te semi-annual rate of return for tis loan is 3.75%. te corresponding annualized rate is: (1.0375) 2 = or 7.64%.

11 Example 3 cont d 2) For te five year EuroECU Bond: te principal is 160M to be repaid at te end of five years te payments are 12.5M every year for 5 years Wat is te actual interest rate being paid on tis loan? 160M = 12.5/(1+r) /(1+r) /(1+r) 5 Te IRR or te cost of te 160 M bond is 7.81 % (already an annualized rate of return since te payments are made annually). Given tese costs, it appears tat tis company would simply want to take te Pound term loan te interest rate (IRR) is lower. Is tere anyting else to consider? Example 3 cont d To compare apples to apples, we need to compare loans in te same currency. Te proposed swap as: A Britis firm willing to make te 12.5M annual payments and pay 160M in 5 years in excange for 3.65M every six monts and 100M in 5 years. Te cost of te swapped pound loan would be: 100M = 3.65M/(1+r) M/(1+r) M/(1+r) 10 Te IRR for tis is 3.65% semi-annually or 7.43% annually. Tis is better tan te term loan! Wy would anyone be willing to take te oter side of tis swap? Example 3 cont d If te firm on te oter side can borrow pounds at 7.20% and it is receiving 3.65 M every 6 monts, tis is a good ting for tis firm. Wy? For tis firm, te 3.65M payments can finance more tan a 100M loan. It could finance about M wit tese payments. Te 103.2M is te notional principal for te Britis firm. At te current spot rate of 1.60 ECU/ tis is equivalent to te Britis firm aving received a loan wit a notional principal of about 165.1M. On tis loan it is making annual payments of 12.5M ECU and at te end it as to make a payment of interest and principal of 172.5M ECU: 165.1M = 12.5M/(1+r) M/(1+r) M /(1+r) 5 Te Britis firm as an all-in-cost of about 7.03% per annum.

12 Example 3 cont d Witout Swap, your coices are Fixed Rate Financing IRR Pound Term Loan Principal 100M, semi-annual 3.75M, repayment 5 yrs 7.64% Euro Bond Principal 160M, annual 12.5M, repayment 5 yrs 7.81% Wit Swap, your interest rate becomes Make annual 12.5M, and 160M in 5 yrs your firm Britis Company Make semi-annual 3.65M, and 100M in 5 yrs (counterparty) IRR 7.43% IRR 7.03% Bot are paying less interest tan tey would ave witout te swap AND tey ave te type of interest payments tey wanted! But, our firm now as a bond in Euros on its Balance Seet. Swap Pro s and Con s Advantages: Simplicity Cost-effective Flexibility to cange our economic exposure Accounting treatment Disadvantages Credit risk (counter-party risk) Timing risk