Wat are Swaps? Spring 2013
Basic Idea of Swaps I ave signed up for te Wine of te Mont Club and you ave signed up for te Beer of te Mont Club. As winter approaces, I would like to ave beer but you would like to ave wine. We could swap. You give me te beer you receive and, in excange, I give you te wine tat I receive. In Finance, 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.
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More Formally, 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 party A makes te floating payments 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.
Size of Swap Market (notional amounts, billions of USD) 600,000 500,000 400,000 Credit default swaps Interest rate swaps Currency swaps Forwards and forex swaps 300,000 200,000 100,000 0 Source: International Swap and Derivatives Association 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Hutcison Wampoa Limited 2011 Annual Report (Capital Resources and Liquidity section) Te Group s treasury policies are designed to mitigate te impact of fluctuations in interest rates and excange rates on te Group s overall financial position and to minimise te Group s financial risks. Interest Rate Exposure Te Group manages its interest rate exposure wit a focus on reducing te Group s overall cost of debt and exposure to canges in interest rates. Wen considered appropriate, te Group uses derivatives suc as interest rate swaps and forward rate agreements to manage its interest rate exposure. Te Group s main interest rate exposure relates to US dollar, Britis Pound, Euro and HK dollar borrowings. At 31 December 2011, approximately 34% of te Group s total principal amount of bank and oter debts were at floating rates and te remaining 66% were at fixed rates. Te Group as entered into various interest rate agreements wit major financial institution counterparties to swap (fixed and floating principal) After taking into consideration tese interest rate swaps, approximately 66% of te Group s total principal amount of bank and oter debts were at floating rates and te remaining 34% were at fixed rates at 31 December 2011.
History of Swaps An early form of swaps was developed to circumvent foreign excange controls during te 1960s and 1970s. Tere were eavy taxes on te conversion of some currencies. For example, it was very expensive to convert Britis Pounds. Problem: How could a firm finance operations outside of te UK witout converting currencies? Consider a UK firm wanting to set up a US subsidiary. If te US subsidiary needs financing, wat were te alternatives? Solution? UK parent could borrow in te UK, convert te s to US dollars and provide tese to its subsidiary. But tis conversion was eavily taxed! US subsidiary could borrow itself in te US directly, but it may ave a poor (or no) credit rating in te US. Also costly!
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. Consider te situation for te American parent: Year 0 1 2 3 4 5 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)
Parallel Loans vs. Currency Swaps United Kingdom United States Britis Bank Britis Firm Agreement American Firm American Bank American Subsidiary Britis Subsidiary
Difficulties wit Parallel Loans Firms must find a partner were: Te firms must be in te appropriate countries and ave almost perfectly opposite interests. For example, te relative size of bot projects (i.e. te notional principals) and te maturities must be similar. Considerable legal detail must be worked out tere are a large number of contracts to cover te different payment obligations and commitments. Te effect on te parent firms financial statements must be tolerable as it is borrowing for te subsidiary(s?).
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 any oter. 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 tey swapped te payments on loans in different currencies.
General Outline of a Swap counter party financial institution firm
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 or future excange 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
Evolution of Swaps As foreign excange restrictions were relaxed in te mid- 1970s, te use of parallel loans (essentially currency swaps) decreased. Te swap market really started to develop in te early 1980s because of differences in US dollar interest rates inside and outside of te US. Te Fed ad a tigt monetary policy so sort-term interest rates in te US were very ig, but tey were muc lower on Eurodollars wic were not subject to Fed restrictions. Swaps were a way to decrease borrowing costs. A US-based firm would borrow floating (ST) in te Eurodollar market and swap tis for a European bank s fixed (LT) US dollar loan in te US.
Eurocurrency Market Review Originally centered in London. Now also in countries suc as te Baamas, Singapore, Hong Kong, US, and Japan. Started in London wit borrowing/lending US$ outside te US. 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
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 wen te swap is signed). 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% fixed rate debt floating payments at LIBOR + y% floating rate debt
Numerical Example (Plain Vanilla Swap) Witout Swap Fixed Rate Financing Floating Rate Financing Seeks Co. A (AAA rated) 6% Prime + 1.5% Floating Co. B (BBB rated) 8% Prime + 2.5% Fixed Wit Swap Fixed Rate Payments at 7.5% Company A Company B Floating Rate Payments at Prime + 2.5% Fixed Rate Financing Floating Rate Financing at 6% at Prime + 2.5% Eac company as borrowed at te best rate tat tey could and tey are swapping payments. Are tey appy wit tis arrangement?
Swap Example (Plain Vanilla cont d) To see tat bot sides are appy consider teir payments: Company A: Pays its lender +6% (fixed rate) Pays floating to Company B +(Prime + 2.5%) Receives from Company B -7.5%. Net being paid by A Prime + 1% (vs Prime+1.5%) Company B: Pays its lender +Prime + 2.5% (floating) Pays fixed to Company A +7.5% Receives from Company B - (Prime + 2.5%) Net being paid by B 7.5% (vs. 8.0%) 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 7.25% in return for paying Prime + 2.5%? If it ad been promised 7.75%? Wat about B, ow would it feel about tese new terms? Company A: Pays its lender +6% (fixed rate) Pays floating to Company B +(Prime + 2.5%) Receives from Company B -7.25%. Net being paid by A Prime + 1.25% (vs Prime+1.5%) Company B: Pays its lender +Prime + 2.5% (floating) Pays fixed to Company A +7.25% Receives from Company B - (Prime + 2.5%) Net being paid by B 7.25% (vs. 8.0%) How are tese terms 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).
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 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 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% $475,000 12 Monts 9.00% 10.00% $500,000 18 Monts 9.25% 10.25% $512,500 24 Monts 9.40% 10.40% $520,000 30 Monts 8.50% 9.50% $475,000 For te fixed rate loan te expected costs are: every 6M 9.75% $487,500
Example 1 cont d Net Cas flows Discount Rate PV of Casflows Today -$37,500 9.75% -$37,500 6 Monts -$12,500 9.75% -$11,932 12 Monts $12,500 9.75% $11,390 18 Monts $25,000 9.75% $21,744 24 Monts $32,500 9.75% $26,982 30 Monts -$12,500 9.75% -$9,906 Wy net casflows? Wy is te discount rate 9.75%? Is tis swap fairly priced? Would you enter into it? Total $777.36
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
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 + 0.10) = (1 + ½(0.08)) ( 1 + ½ R 6 to 12 ) (1 + ½ R 6 to 12 ) = (1 + 0.10)/(1 + 0.04) 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)] / (1 + 0.08/2) + [100(0.115/2)] / (1 + 0.10) = $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 Want to borrow Pounds. Te alternatives are: 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) + 3.75M/(1+r) 2 +. + 103.75M/(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 = 1.0764 or 7.64%.
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 + + 12.5/(1+r) 5 + 160/(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) 1 + + 3.65M/(1+r) 10 + 100M/(1+r) 10 Te IRR for tis is 3.65% semi-annually or 7.43% annually. Tis is better tan te term loan!
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%(in ) Wit Swap, your interest rate becomes your firm IRR 7.43% (in ) Make annual 12.5M, and 160M in 5 yrs Britis Company Make semi-annual 3.65M, and 100M in 5 yrs (counterparty) Note: our firm now as a bond in Euros on its Balance Seet. Wy would te counter-party be willing to do tis?
Swap Pro s and Con s Advantages: Simplicity Cost-effective Flexibility to cange our economic exposure Accounting treatment Off-balance seet Disadvantages Credit risk (counter-party risk) Timing risk Balance seet effects economic versus accounting exposure