Chapter 3:

Swaps

3.1 Interest rate swaps

3.1.1 Mechanics of interest rates swaps
3.1.2 Using interest rates swaps
3.2 Currency swaps
3.2.1 Mechanics of currency swaps
3.2.2 Using currency swaps

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3.1 Interest rate swaps

3.1.1 Mechanics of interest rates swaps

► Definition
■ A swap is an OTC traded agreement between two parties (called legs) to exchange
cash flows in the future. The agreement defines the dates when the cash flows are
to be paid and the way in which they are to be calculated.

■ An interest rate swap is an agreement between two parties whereby one leg (A)
commits to pay to the other leg (B) a cash flow based on a fixed interest rate
and leg B commits to pay to leg A a cash flow based on a variable interest rate,
on the basis of the same principal (or notional), at several regular points in time
for a predetermined period.

Fixed rate

A B
2
Variable rate
 → Example : plain vanilla interest rate swap signed on March 5th year N with
notional of 100 million USD maturity 6 years
• payments to be exchanged once a year from March 5th N+1 on, up to March 5th
N+6
• A commits to pay to B a fixed rate of 5% (out of the principal of 100 million $)
• B commits to pay to A Libor_3M : floating-rate payments are calculated using
the 3-month Libor rate observed at the payment date (out of the principal of 100
million $) The London Interbank
5% Offered Rate (LIBOR) is
a benchmark interest rate at
A B which major global banks
lend to one another in the
Table of cash flows for A Libor international interbank
market for short-term loans.

Observed Inflow A Outflow A Net Cash Flow

time libor_3M in $ million in $ million in $ million

5 March N
5 March N+1 4.8% +4.8 –5 –0.2
5 March N+2 5.3% +5.3 –5 +0.3
5 March N+3 4.7% +4.7 –5 -0.3
5 March N+4 5.6% +5.6 –5 +0.6
5 March N+5 5% +5 –5 0 3
5 March N+6 5.2% +5.2 –5 +0.2
3.1.2 Using interest rates swaps

► general principle : turning a variable rate loan into a fixed rate loan
Initial situation : loan Interest rate swap

fixed
variable A B
variable

Example : using a swap to turn a variable rate loan at [Libor_3M +1%] into a fixed
rate loan at 6%:
Total payoff = [payoff initial situation] + [payoff swap]
= -[Libor +1%] + [Libor – 5%] = -6%

Interest rate swap

Initial situation
5%
Libor+1% A B
4
Libor
► using the swap to transform a liability with financial intermediary

→ Consider the following case

Initial situation for A Interest rate swap Initial situation for B

5% 5,2%
Libor+0,1%
A B
Libor

→ For A, the swap could turn a variable rate loan into a fixed rate loan. Suppose
that A has initially arranged to borrow on 3 years $100 million at Libor_3M plus 10
basis points (Libor_3M + 0,10%)

→ For B, the swap could turn a fixed rate loan into a variable rate loan. Suppose that
B has initially a 3 years $100 million loan outstanding on which it pays 5.2%.

→ Two nonfinancial companies such as A and B do not get in touch directly to

arrange a swap. They each deal with a financial intermediary such as a bank or other
financial institution. The financial institution earns about 3 or 4 basis points
(0.03% or 0.04%) on a pair of offsetting transactions. 5
→ The financial institution enters into two offsetting swap transactions with A and B.
Assuming that both companies honor their obligations, the financial institution is
certain to earn 0.03% (3 basis points) per year times the principal of $100 million.
This amounts to $30000 per year for the 3-year period.

FI earns 1.5 bp 5.015% 4.985% FI earns 1.5 bp

Libor+0.1% 5.2%
A F.I. B

Libor Libor

→ A ends up borrowing at : -(Libor +0,1) + Libor – (5 + 0,015) = -5,115%

→ B ends up borrowing at : -5,2 – Libor + (5 – 0,015) = -(Libor+0,215%)
→ FI earns a total of 3 basis points or 0,03% (out of 100million USD) for
arranging the swap between legs A and B

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► using a swap to profit from comparative advantages

■ identifying the comparative advantages

Two companies, AAACorp and BBBCorp, both wish to borrow $10 million for 5
years and have been offered the following rates:

Spread on Fixed Floating Spread on

fixed rates: AAACorp 4.0% Libor + 0.25% floating rates:
+1.2% Libor + 0.95% +0.7%
BBBCorp 5.2%
→ AAACorp wants to borrow at a floating rate of interest, whereas BBBCorp
wants to borrow at a fixed rate of interest
→ BBBCorp pays a higher rate of interest than AAACorp in both fixed and floating
markets : AAA has an absolute advantage for borrowing at both rates
→ BBBCorp pays 1.2% more than AAACorp in fixed-rate markets and only
0.7% more than AAACorp in floating-rate markets:
AAACorp has a comparative advantage in fixed-rate markets
BBBCorp has a comparative advantage in floating-rate

→ Problem : each company wants to borrow in the rate where it does not have the
comparative advantage
A financial institution FI can get each company to borrow cheaper by structuring7a
swap
■ Structuring the comparative-advantage swap

→ Total gain = spread fixed rates – spread variable rates

= (5.2% - 4%) – [Libor+0.95% - (Libor+0.25%)] = 1,2% - 0,7% = 0.5%

→ Sharing the total gain between the parties

FI set its earnings at 4 bp or 0,04%
0.23% for A and 0.23% for B

→ Ending up conditions for A (wants to borrow variable) and B (wants to borrow

fixed) :
A will end up at [Libor+0.25%] - 0.23% = Libor+0.02%
B will end up at [5.2%] - 0.23% = 4,97%

→ Arrangement
• FI tells A to go borrow where it has the comparative advantage : fixed rate at 4%
• FI tells B to go borrow where it has the comparative advantage : floating rate at
Libor+0,95%
• FI makes A and B enter into a swap with it to turn those loans into targeted loans
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 A pays Libor
Structuring the swap as follows:
A receives a fixed x
to be determined
Payoff A = -4% - Libor + x = -(Libor+0.02%)
⇔ x = 4% -0.02% = 3,98% objective for A

Payoff B = -(Libor+0.95%) + Libor – y = -4,97%

⇔ y = 4,97% - 0.95% = 4.02%

Libor Libor
4% Libor+0.95%
AAAcorp IF BBBcorp

x= 3,98% y=4,02%

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3.2 Currency swaps

3.2.1 Mechanics of currency swaps

► definition
It is an OTC agreement between two legs involving exchanging principal and
interest payments in one currency for principal and interest payments in
another.
→ In an interest rate swap the principal is not exchanged.
→ In a currency swap the principal is exchanged at the beginning and the end of the
swap’s life.

► illustration : 5-year currency swap between A and B signed on February 1, N.

→ Exchange of principals at the outset of the swap: A pays 18 million USD to B and
B pays 10 million GBP to A
→ Exchange of interest each year during the life of the swap :
A pays a fixed interest rate of 5% in GBP and receives from B a fixed interest rate of
6% in USD : A pays 0,5 million GBP and B pays 1,08 million USD
This is termed a fixed-for-fixed currency swap because the interest rate in each10
currency is at a fixed rate.
At the outset exchange of principals 18 USD

A B
10 GBP

Each year during the life of the swap 0,5 GBP

exchange of interest
A B
1,08 USD

0,5 GBP
At the end last exchange of
interest and exchange of
principals 1,08 USD

A B
18 USD

10 GBP 11
► Using of a Currency Swap to Transform Liabilities

→ Initial situation
A can issue USD denominated bonds for 18 million USD at 6% interest rate
coupon
A would like to issue GBP denominated bonds but cannot

→ Effect of entering into the currency swap

The swap has the effect of transforming this transaction into one where A has
borrowed 10 million GBP at 5% interest rate :

• The initial exchange of principal converts the proceeds of the bond issue from
USD to GBP.
• The subsequent exchanges in the swap have the effect of swapping the interest
and principal payments from USD to GBP

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Bond issue in million SWAP in million
18 USD 18 USD

A B
10 GBP

0,5 GBP

A B
1,08 USD
1,08 USD

0,5 GBP

1,08 USD
1,08 USD
A B
18 USD
18 USD

10 GBP 13
► Using a currency swap to profit from comparative advantages
■ identifying comparative advantages
→ GM wants to borrow 20 million AUD and Qantas wants to borrow 15 million USD
Current exchange rate = 0,75 USD per AUD : principals are equivalent
GM and Qantas have been offered the following rates for borrowing in USD and AUD
on a 5-years period :
USD AUD
Spread Spread
on USD
GM 5% 7.6%
on AUD
: +2% Qantas 7% 8% : +0.4%

→ Qantas pays a higher rate of interest than GM in both currencies : GM has an

absolute advantage for borrowing in both currencies
→ Qantas pays 2% more than GM in USD and only 0.4% more than GM in
AUD :
GM has a comparative advantage in borrowing in USD
Qantas has a comparative advantage in borrowing in AUD

→ Problem : each company wants to borrow in the currency where it does not
have the comparative advantage
A financial institution FI can get each company to borrow cheaper by structuring a
currency swap 14
■ Structuring the comparative-advantage swap

→ Total gain = spread USD rates – spread AUD rates

= (7% - 5%) – (8% - 7,6%) = 1,6%

→ Sharing the total gain between the parties

FI set its earnings at 0,2%
0.7% for GM and 0.7% for Qantas

→ Ending up conditions for GM (wants to borrow AUD) and Qantas (wants to

borrow USD) :
GM will end up at [7,6%] - 0.7% = 6,9% in AUD
Qantas will end up at [7%] – 0,7% = 6,3% in USD

→ Arrangement
• FI tells GM to go borrow where it has the comparative advantage : USD at 5%
• FI tells Qantas to go borrow where it has the comparative advantage : AUD at
8%
• FI makes GM and Qantas enter into a currency swap with it to turn those loans
into targeted loans
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 Arranging the swap

5% USD 6.3% USD

5% USD
GM F.I. Qantas
8% AUD
6.9% AUD 8% AUD

→ Evaluating the exchange rate risk exposure for the FI :

Each year during the lifetime of the swap the cash flows for the FI are :
• (6.3% -5%)×15 million USD = +195 000 USD
• (6,9% - 8%)×20 million AUD = -220 000 AUD

If FI is a euro area bank (working currency EUR) it could hedge this risk exposure
by entering into a forward contract to sell 195000 USD for t+1 to t+5 and into an
other forward contract to buy 220000 AUD t+1 to t+5 (pedagogicaly closing the
loop)
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