SWAP CONTRACTS

1
 Banking Faculty Commercial Bank Division

OUTLINE

• Definition of swaps
1

• Interest rate swaps

2

• Currency swaps
3

2
 Derivatives
Banking Faculty market
Commercial Bank Division

Unit: trillion USD

800

700

600

500

400

300

200

100

0
2013 2014 2015 2016 2017 2018 2019 2020 2021
Forward Swap Future Option

Source: www.bis.org
 Banking Faculty Commercial Bank Division

What is swap ?

•A swap is an over-the-counter agreement between two companies 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.

4
 Banking Faculty Commercial Bank Division

Interest rate swap

1 Nature of interest rate swap

32 Quotes of interest rate swap

43 Valuation of interest rate swap

4 Hedging by interest rate swap

5
 Banking Faculty Commercial Bank Division

Interest rate swap

•The most common type of swap is a ‘‘plain vanilla’’ interest rate swap.
• One company agrees to pay to another company cash flows equal to
interest at a predetermined fixed rate on a notional principal for a pre-
determined number of years. In return, it receives interest at a floating
rate on the same notional principal for the same period of time from the
other company

6
 Banking Faculty Commercial Bank Division

Interest rate swap

Fixed rate
A B
Floating rate

Payer Receiver
Swap Swap
(Buyer) (Seller)
7
 Banking Faculty Commercial Bank Division

Interest rate swap

•Payment exchange
•Only exchange of net cash flow
•No exchange of principal

8
 Banking Faculty Commercial Bank Division

Illustration
•3-year swap initiated on March 5, 2017, be tween Microsoft and Intel. We
suppose Microsoft agrees to pay Intel an interest rate of 5% per annum on
a principal of $100 million, and in return Intel agrees to pay Microsoft the
6-month LIBOR rate on the same principal. Microsoft is the fixed-rate
payer ; Intel is the floating-rate payer . We assume the agreement specifies
that payment s are to be exchanged every 6 months and that the 5% interest
rate is quoted with semiannual compounding.
 Banking Faculty Commercial Bank Division

Illustration
5%
Microsoft Intel
6-month LIBOR

•
10
 Banking Faculty Commercial Bank Division

Cash Flows to Microsoft

---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar.5, 2017 4.2%
Sept. 5, 2017 4.8%
Mar.5, 2018 5.3%
Sept. 5, 2018 5.5%
Mar.5, 2019 5.6%
Sept. 5, 2019 5.9%
Mar.5, 2020 6.4% 11
 Banking Faculty Commercial Bank Division

Cash Flows to Intel

---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar.5, 2017 4.2%
Sept. 5, 2017 4.8%
Mar.5, 2018 5.3%
Sept. 5, 2018 5.5%
Mar.5, 2019 5.6%
Sept. 5, 2019 5.9%
Mar.5, 2020 6.4% 12
 Banking Faculty Commercial Bank Division

The Comparative Advantage Argument

•Suppose that two companies, A Corp and B Corp, both wish to borrow $100 million
for 5 years and have been offered the rates shown in Table. A Corp has a AAA credit
rating; BBBCorp has a BBB credit rating. We assume that B Corp wants to borrow
at a fixed rate of interest, whereas A wants to borrow at a floating rate of interest
linked to 6-month LIBOR.
•A and B can borrow by 2 ways:
•1: borrow from the bank for 5 years with floating rate, interest payment is made
every 6 months
•2: A and B can issue 5 years-bond with fixed rate, coupon payment is made
every 6 months

13
 Banking Faculty Commercial Bank Division

The Comparative Advantage Argument

Table 1: Borrowing rates that provide a basis for the comparative-
advantage argument

Floating Fixed Objectives

A Euribor 5,0 % Floating

B Euribor + 0,50 6,5 % Fixed

Euribor: European Interbank Offered Rate, an average interbank rate, calculated and published each day at 11.00
a.m. in Brussels from bid-prices of 43 European Banks.
14
 Banking Faculty Commercial Bank Division

Interest rate swap

Step 1: A and B choose to borrow the way they have comparative
advantage

Bond Bank

5% Euribor +
0,50%

A B
15
 Banking Faculty Commercial Bank Division
Interest rate swap
Step 2: A and B enter a swap agreement to ensure that A receives fixed rate of
5.50% and pay B Euribor

Bond Bank

5% Euribor +
0,50%

A B
Euribor
Swap Swap
5.50% 16
 Banking Faculty Commercial Bank Division

Interest rate swap

Cash Flow A
Fixed Floating
Bond - 5%
Swap + 5,5% - Euribor
Net + 0,5% - Euribor

• Net interest rate = Euribor – 0.5% < Euribor

Objectives: Floating rate
Net gain= 0.5%
17
 Banking Faculty Commercial Bank Division

Interest rate swap

Cash Flow B
Fixed Floating
Bank -(Euribor +0,5%)
Swap -5,5% + Euribor
Net -5,5% - 0,5%

• Net interest rate= 6 % < 6,5%

Objective: fixed rate
Net gain: 0.5% 18
 Banking Faculty Commercial Bank Division

Interest rate swap

What is the total gain from this interest rate swap arrangement ?

19
 Banking Faculty Commercial Bank Division

Interest rate swap

•The total gain from this type of interest rate swap arrangement:
Δ = | 0.5– 1.5| = 1%
•The total gain :
Δ = | Δ fix – Δfloat|
•The distribution of this gain depends on each party’s negotiation power

20
 Banking Faculty Commercial Bank Division

Interest rate swap- financial intermediaries involved

Bond Bank

5% Euribor +
0,50%
Euribor 5,75 %
A B

5,25 % Euribor

Financial intermediaries 21
 Banking Faculty Commercial Bank Division

Question:

•Net Cash flow of each party?

•Net interest rate of each party?
•The net gain of each party?
•The total gain?
 Banking Faculty Commercial Bank Division

Interest rate swap

A cash flow B cash flow
Fixed Floating Fixed Floating
Bond Bank
Swap Swap
Net CF Net CF

Cash Flow – Financial intermediaries

A
B
Net CF
23
 Banking Faculty Commercial Bank Division

Setting up a swap when no financial intermediary is involved

A and B are offered fixed rate on a notional principal of $20m for 5 years
relatively 12% and 13.5%; floating rate of Euribor +0.1% and Euribor
+0.6%.
A wants to borrow floating rate loan, B wants to borrow fixed rate loan.
Setting up a swap without financial intermediary and the gain from swap
is equally shared among two parties

24
 Banking Faculty Commercial Bank Division

A swap when a financial intermediary is involved

A and B are offered fixed rate on a notional principal of $20m for 5 years
relatively 12% and 13.4%; floating rate of Euribor +0.1% and Euribor
+0.6%.
A wants to borrow floating rate, B wants to borrow fixed rate.
Setting up a swap when a financial intermediary receives 0.1%/annum
from swap and that will appear equally attractive to both companies

25
 Banking Faculty Commercial Bank Division
Application of interest rate swap

Transform an asset
Interest rate risk

Transform a liability

26
 Banking Faculty Commercial Bank Division
Transform a liability

•Example
Consider the balance sheet of the bank ? What risk does the bank
exposure to and when ?

Asset Liability
Loan: Euribor + 1% Deposit: 8%
(6 month floating interest rate) (5 years)

27
 Banking Faculty Commercial Bank Division
Transform a liability

•To hedge interest rate risk, bank needs to reduce the duration of liability
•Banks should sell 5 years – swap, in which
Receive fixed rate of 8%/annum
Pay floating rate of (Euribor – 1%)
•The payment is made every 6 months.

28
 Banking Faculty Commercial Bank Division
Transform an asset

•Example
Consider the balance sheet of the bank ? What risk does the bank
exposure to and when ?
Asset Liability
Loan: 10% Deposit: Euribor - 1%
5 years (6 month floating interest rate)

29
 Banking Faculty Commercial Bank Division
Transform an asset

•To hedge interest rate risk, bank needs to reduce the duration of asset
•Banks should buy 5 years – swap, in which
Pay fixed rate of 8%/annum
Receive floating rate of (Euribor – 1%)
•The payment is made every 6 months.

30
 Banking Faculty Commercial Bank Division
Currency swaps

11 Click
Natureto of
add Title
currency swaps

22 Click to addofTitle
Valuation currency swap

13 Click to add Title

Application of currency swap

31
 Banking Faculty Commercial Bank Division
Currency swap

• Exchanging principal and interest payments at a fixed rate in one

currency for principal and interest payments at a fixed rate in another
currency.
•The principal amounts are usually exchanged at the beginning and at the
end of the life of the swap
•The principal amounts are chosen to be approximately equivalent using
the exchange rate at the swap’s initiation.

32
 Banking Faculty Commercial Bank Division
Currency swap

5-year currency swap agreement between IBM and British Petroleum

entered into on February 1, 2017. We suppose that IB M pays a fixed
rate of interest of 5% in sterling and receives a fixed rate of interest of
6% in dollars from British Petroleum. Interest rate payment s are made
once a year and the principal amounts are $15 million and £10 million
5% GBP
IBM British
Petroleum
6 % USD
 Banking Faculty Commercial Bank Division

Comparative Advantage Arguments for Currency Swaps

•Suppose that General Motors wants to borrow 20 million AUD in 5 years and
Quantas Airway wants to borrow 12 million USD for the same period.
•Interest rate posted to 2 companies are as follows:
USD AUD Objectives
General Motors 5,0% 12,6% 20 m AUD
Qantas Airways 7,0% 13,0% 12 mUSD
•The current exchange rate (1 AUD in terms of USD) is 0,600.

34
 Banking Faculty Commercial Bank Division
Currency swap

•Step 1: GM and QA each borrow in the market where they have a

comparative advantage. That is,
•GM borrows USD 5%
•QA borrows AUD 13%

•Step 2: Then they use a currency swap with a financial institution

(premium 0.2%):
•GM and QA’s gain from SWAP: (1.6% - 0.2%)/2 = 0.7%
•GM transform its loan into an AUD loan
•QA transform its loan into an USD loan
35
 Banking Faculty Commercial Bank Division
Currency swap

Financial institution bears foreign exchange risk

(2) AUD 11,9% (1) AUD 13%

USD @ 5% AUD @ 13,0%

GM TGTC QA

Objective: AUD Objective : USD

(1) USD 5% (2) USD 6,3%

36
 Banking Faculty Commercial Bank Division
Applications of currency swaps

•A currency swap might be used to transform a loan from this currency

to other without changing the principal
•Currency swap can be used to hedge exchange rate risk when there is a
currency mismatch in the balance sheet

37
 Banking Faculty Commercial Bank Division
Applications of currency swaps

•Example
Consider the balance sheet of an American bank:
Asset Liability
Loan: USD
Deposit: 50 m GBP
(Fixed interest rate)
(fixed interest rate 10%/year,
4 years)

38
 Banking Faculty Commercial Bank Division
Applications of currency swaps

•Example
Consider the balance sheet of an American bank:
: Asset Liability
Loan: GBP
Deposit: 100 m USD
(fixed interest rate)
(fixed interest rate 10%/year,
4 years)

39
GV. ĐỖ THU HẰNG

40