Swaps: A Primer By A.V. Vedpuriswar September 30, 2016
Introduction Swaps are agreements to exchange a series of cash flows on periodic settlement dates over a certain time period (e.g., quarterly payments over two years). Swaps are typically customised OTC instruments. The value of the swap is the present value of inflows minus the present value of the outflows. At the time of initiation, the value of the swap is usually zero for both the counterparties. But with the passage of time and change in market parameters such as interest rates, stock indices or currency rates, one party will be in the money while the other will be out of the money.
Structure At each settlement date, the inflows and outflows are netted so that only one (net) payment is made. The party with the greater liability makes a payment to the other party. The contact ends on the termination date. A swap can be decomposed into a series of forward contracts (FRAs) that expire on the settlement dates. The simplest type of swap is one variation of interest rate swaps. One party makes fixed-rate interest payments on the notional principal specified in the swap in return for floating-rate payments from the other party.
Termination There are four ways to terminate a swap prior to its original termination date. Mutual termination. A cash payment can be made by one party that is acceptable to the other party. Offsetting contract. If the terms for early termination are unacceptable, the alternative is to enter an offsetting swap. Resale. It is possible to sell the swap to another party, with the permission of the counterparty to the swap. This is less likely if the secondary market is not functioning well. Swaption. A swaption is an option to enter into a swap. The option to enter into an offsetting swap provides an option to terminate an existing swap.
Interest rate swaps The plain vanilla interest rate swap involves trading fixed interest rate payments for floating-rate payments. Notional principal is generally not swapped in single currency interest rate swaps. The difference between the fixed-rate payment and the variable-rate payment is paid to the appropriate counterparty.
Currency swaps In a currency swap, one party makes payments denominated in one currency, while the payments from the other party are made in a second currency. Typically, the notional amounts, expressed in both currencies at the current exchange rate, are exchanged at contract initiation and returned on the termination date. The notional principal is swapped at initiation. Full interest payments are exchanged at each settlement date, each in a different currency. The notional principal is swapped again at the termination of the agreement.
Equity swaps In an equity swap, the return on a stock, a portfolio, or a stock index is paid each period by one party in return for a fixed-rate payment. The return can be the capital appreciation or the total return including dividends on the stock, portfolio, or index. Uniquely among swaps, equity swap payments can be floating on both sides and the payments are not known until the end of the quarter.
This can be distributed suitably between A & B. Problem A and B can borrow from the markets as follows: Fixed 10% 8% Floating LIBOR + 1% LIBOR + 0.5% A is looking for fixed rate funding. Is a swap possible? B will borrow in fixed rate market, cost = 8% A B funding and B for floating rate A will borrow in floating rate market, cost = LIBOR + 1% Total cost of borrowing = 8 + LIBOR + 1 = LIBOR + 9% If A had borrowed in fixed rate market and B in floating market, Total cost of borrowing = 10 + LIBOR + 0.5 = LIBOR + 10.5% Net saving = 10.5 9 = 1.5%
Problem A company wants to convert a floating rate liability into a fixed rate exposure. It enters into a two year quarterly $ 4,000,000 fixed for floating rate swap. Work out the cash flows if the fixed rate is 6% and floating rate is currently LIBOR + 1%. Realisations are: Annualised LIBOR Current 5.0% In 1 st Quarter 5.5% In 2 nd Quarter 5.4% In 3 rd Quarter 5.8% In 4 th Quarter 6.0% Current floating rate = 5 + 1 = 6%; Fixed rate = 6% So no net payment takes place on the first quarterly date. On the second quarterly date, Floating rate = 5.5 + 1 = 6.5%; Fixed rate = 6% So the company has to pay (6.5-6.0)/100 (4,000,000)(¼) = $5000 The final quarterly payment can be worked out as follows: Floating rate = 6+1 = 7%; Fixed rate = 6% The company has to pay (7.0 6.0)/100 x (4,000,000) (¼)= $10,000
Problem I enter into a 2 year quarterly swap as the fixed rate payer and will receive the return on the S&P 500. The fixed rate is 8% and the index is currently at 1000. At the end of the next two quarters, the index level is 1050, 1102.5. What is the net payment for the next two quarters? Fixed payment = 8/4 = 2% per quarter Index returns = 5% for quarter 1 Index returns = 5% for quarter 2 So I will receive 5% - 2% = 3% for quarter 1 5% - 2% = 3% for quarter 2
Problem Borrowing Rate Company USD AUD A 10% 7% B 9% 8% A needs USD and B needs AUD. The exchange rage is 2 AUD / USD How can a swap be structured?
Solution B borrows USD 1 million for 9%. Interest = 90,000 USD A borrows AUD 2 million for 7%. Interest = 140,000 AUD A gives AUD 2 million to B B gives USD 1 million to A B pays (0.08)2 = AUD 160,000 to A every year A pays (1) (.10) = USD 100,000 to B every year A Pays AUD 140,000 to Bank Receives AUD 160,000 from B Net cash flow = + AUD 20,000 B Pays USD 90,000 to Bank Receives USD 100,000 from A Net USD 10,000 This is the net gain for A, B every year After 5 years, B gives AUD 2 million to A A gives USD 1 million to B The original loans from the respective banks are now squared.
Problem A is in need of Euros. It floats a $10 million bond at a rate of 6% and enters into a swap arrangement with B. The agreement is that B will pay in US Dollars @ 5.5% and A will pay in Euros @ 4.9% on March 15 th & September 15 th for 5 years. The swap starts on September 15 th. What will be the pattern of cash flows? Assume the notional principals are $10 million and Euro 9 million. September 15 : A pays B $ 10 million : B pays A Euro 9 million March 15: A pays B.[049/2] (9) million = Euro 220,500 B pays A [.055/2] (10) million = $275,000 This will be repeated on different settlement dates. On expiration date, A will pay B Euro 9 million and B will pay A $10 million.
Problem An American company, A needs sterling funding. It enters into a currency swap with a counterparty B. The notional principals are $ 50 million and 30 million. The fixed interest rates are 5.6% in dollars and 6.25% in pounds. What will be the cash flows if payments are made every 6 months? Initial exchange : A pays B $ 50 million B pays A 30 million After 6 months : A pays B (30) (.0625)/2 = 937,500 B pays A (50) (.056)/2 = $ 1,400,000 This continues every 6 months. At the end of the swap, A pays B 30 million, B pays A $ 50 million.
Problem I want to reduce my exposure to fixed income securities and increase my exposure to large cap stocks. Under an equity swap, I agree to pay the dealer at a fixed rate of 4.5% and the dealer agrees to pay me the return on a large cap index. The notional principal is $25 million, payments are made every 180 days and there are 365 days in a year. If the index moves up by 7.61% over the next 6 months, what are the cash flows involved? I will pay (25,000,000) (.045)X180 (365) = $ 554,795 I will receive (25,000,000) (.0761) = $1,902,500 So the net payment I receive = $ 1,347,705