Swaps

Chapter 7

7.1
Goals of Chapter 7

 Introduce interest rate (IR) swaps (利率交換)

– Definition for swaps
– An illustrative example for IR swaps
– Discuss reasons for using IR swaps
– Quotes and valuation of IR swaps
 Introduce currency swaps (貨幣交換)
– Payoffs, reasons for using currency swaps, and
the valuation of currency swaps
 Credit risk of swaps
 Other types of swaps
7.2
7.1 Interest Rate (IR) Swaps

7.3
Definition of Swaps

 A swap is an agreement to exchange a series

of cash flows (CFs) at specified future time
points according to certain specified rules
– The first swap contracts were created in the early
1980s
 FYI, first futures contract appeared in 1864
– Swaps are traded in OTC markets
– Swaps now occupy an important position in OTC
derivatives markets
– The calculation of CFs can depend on the future
values of an interest rate, an exchange rate, or
other market variables 7.4
Interest Rate Swap

 The most common type of swap is a “plain

vanilla” IR swap
– One party agrees to pay CFs at a fixed rate on a
notional principal for several years
– The other party pay CFs at a floating rate on the
same notional principal for the same period of time
– The floating rate in most IR swaps depends on the
LIBORs with different maturities in major currencies
– An illustrative example: On Mar. 5 of 2013, Microsoft
(MS) agrees to receive 6-month LIBOR and pay a
fixed rate of 5% with Intel every 6 months for 3 years
on a notional principal of $100 million 7.5
Cash Flows of an Interest Rate Swap
---------Millions of Dollars---------
LIBOR Floating Fixed Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar. 5, 2013 4.2%
Sept. 5, 2013 4.8% +2.10 –2.50 –0.40
Mar.5, 2014 5.3% +2.40 –2.50 –0.10
Sept. 5, 2014 5.5% +2.65 –2.50 +0.15
Mar.5, 2015 5.6% +2.75 –2.50 +0.25
Sept. 5, 2015 5.9% +2.80 –2.50 +0.30
Mar. 5, 2016 +2.95 –2.50 +0.45

※ For each reference period, the 6-month LIBOR in the beginning of the
period determine the payment amount at the end of the period
– Therefore, there is no uncertainty about the first CF exchange
※ The principal is also known as the notional principal (名義本金或名目
本金), or just the notional
– Only net CFs change hands  not necessary to exchange the principal at
any time point 7.6
Cash Flows of an Interest Rate Swap
If the Principal was Exchanged
---------Millions of Dollars---------
LIBOR Floating Fixed Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar. 5, 2013 4.2%
Sept. 5, 2013 4.8% +2.10 –2.50 –0.40
Mar.5, 2014 5.3% +2.40 –2.50 –0.10
Sept. 5, 2014 5.5% +2.65 –2.50 +0.15
Mar.5, 2015 5.6% +2.75 –2.50 +0.25
Sept. 5, 2015 5.9% +2.80 –2.50 +0.30
Mar. 5, 2016 +102.95 –102.50 +0.45

※ If the principal were exchanged at the end of the life of the swap, the
nature (or said the net CFs) of the deal would not be changed in any way
※ An IR swap can be regarded as the exchange of a fixed-rate bond (with
the CFs in the 4th column) for a floating-rate bond (with the CFs in the
3rd column)
※ This characteristic helps to evaluate IR swaps (introduced later) 7.7
Interest Rate Swap

– Day count conventions for IR swaps in the U.S.

 Since the 6-month LIBOR is a U.S. money market rate, it is
quoted on an actual/360 basis
 As for the fixed rate, it is usually quoted as actual/365
 For the first CF exchange on Slide 7.6, because there are 184
days between Mar. 5, 2013 and Sep. 5, 2013, the accurate
CF amounts are
184
$100 mil.× 4.2% × = $2.1467 mil. (for the floating-rate CF)
360
184
$100 mil.× 5% × = $2.5205 mil. (for the fixed-rate CF)
365
 For clarity of exposition, this day count issue is ignored in the
rest of this chapter

7.8
Interest Rate Swap

 Reasons for using IR swaps

1. Converting a liability from
 fixed rate (originally) to floating rate
 floating rate (originally) to fixed rate
※ Intel (wants floating-rate debt) and MS (wants fixed-rate debt)
5% LIBOR + 0.1%
5.2% Intel MS
LIBOR

ቐ
ቐ

Original fixed- IR swap Original floating-

rate debt of Intel rate debt of MS

– The net borrowing rate for Intel’s liability is LIBOR + 0.2%

– The net borrowing rate for MS’s liability is 5.1% 7.9
Interest Rate Swap

2. Converting the investment income from

 fixed rate (originally) to floating rate
 floating rate (originally) to fixed rate
※ Intel (wants fixed-rate income) and MS (wants floating-rate income)

5% 4.7%
LIBOR – 0.2% Intel MS
LIBOR

ቐ
ቐ

Original floating- IR swap Original fixed-rate

rate asset of Intel asset of MS

– The net interest rate earned for Intel’s asset is 4.8%

– The net interest rate earned for MS’s asset is LIBOR – 0.3%
7.10
 Interest Rate Swap

 In practice, a financial intuition (F.I.) is involved

– Usually two nonfinancial companies do not contact
directly to arrange a swap
 It is unlikely for a company to find a trading counterparty
which needs the opposite position of the IR swap, i.e.,
another firm agrees with the principal and maturity but has a
different preference for the floating or fixed IR
 Thus, a F.I. matches the deal and earns a spread
4.985% 5.015% LIBOR + 0.1%
5.2% MS
Intel F.I.
LIBOR LIBOR

ቐ
ቐ

ቐ
ቐ

Original fixed- IR swap IR swap Original floating-

rate debt of Intel rate debt of MS 7.11
Interest Rate Swap
4.985% 5.015% 4.7%
LIBOR – 0.2% MS
Intel F.I.
LIBOR LIBOR

ቐ
ቐ

ቐ
ቐ
Original floating- IR swap IR swap Original fixed-rate
rate asset of Intel asset of MS

 The F.I. has two separate IR swaps and it has to honor the
both contracts even if Intel or MS defaults
 In most cases, Intel and MS do not even know whether the
F.I. has entered into an offsetting swap with another firm
 In OTC markets for swaps, there are many F.I.’s acting as
market markers (or said dealers) and always preparing to
trade IR swaps without having an offsetting swap
– They can hedge their unoffset swap positions with Treasury
bonds, FRAs, or other IR derivatives 7.12
Quotes By a Swap Market Maker

Maturity Bid (%) Offer (%) Swap Rate (%)

2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850
※ IR swaps are quoted as the rate for the fixed-rate side
– Bid rate: the fixed rate that the market maker pays for buying (receiving) a
series of CFs according to LIBOR
– Offer (or say ask) rate: the fixed rate the market marker earns for selling
(paying) a series of CFs according to LIBOR
– Swap Rate: the fixed rate such that the value of this swap is zero (introduced
later), and the bid-offer quotes usually center on the swap rate in practice
– Plain vanilla fixed-for-floating swaps are usually structured so that financial
institution can earn bid-ask spreads about 0.03% to 0.04% in the U.S. 7.13
Comparative Advantage Argument

 The comparative advantage argument

explains the popularity of the IR swaps
– AAA Corp. prefers to borrow at a floating rate and
BBB Corp. prefers to borrow at a fixed rate
– The fixed or floating IRs they need to pay are
Fixed Floating
AAA Corp. 4.00% 6-month LIBOR – 0.1%
BBB Corp. 5.20% 6-month LIBOR + 0.6%

 A key feature is that the difference between the two

fixed rates (1.2%) is greater than the difference between
the two floating rates (0.7%)
 AAA (BBB) Corp. has comparative advantage in
borrowing fixed-rate (floating-rate) debt 7.14
Comparative Advantage Argument

 An ideal win-win solution with a swap

– AAA Corp. borrows fixed-rate funds at 4%
– BBB Corp. borrows floating-rate funds at LIBOR + 0.6%
– Both enter into a fixed-for-floating IR swap to obtain the IRs
they prefer
4.35%
4% LIBOR + 0.6%
AAA BBB
LIBOR

ቐ
ቐ

ቐ
Borrow at a IR swap Borrow at a
fixed rate floating rate
 The net borrowing rate for AAA Corp. is LIBOR – 0.35%, which is
by 0.25% lower than LIBOR – 0.1% if it borrows at a floating rate
directly
 The net borrowing rate for BBB Corp. is 4.95%, which is by 0.25%
lower than 5.2% if it borrows at a fixed rate directly 7.15
Comparative Advantage Argument

– Suppose AAA and BBB cannot deal directly and a F.I. is involved

4.33% 4.37% LIBOR + 0.6%

4% BBB
AAA F.I.
LIBOR LIBOR

ቐ
ቐ

ቐ
ቐ
Borrow at a IR swap IR swap Borrow at a
fixed rate floating rate

 The net interest rate for AAA Corp. is LIBOR – 0.33%, which is by
0.23% lower than LIBOR – 0.1% if it borrows at a floating rate directly
 The net interest rate for BBB Corp. is 4.97%, which is by 0.23% lower
than 5.2% if it borrows at a fixed rate directly
 The spread earned by the F.I. is 0.04%
– In the both cases, the total gains of all participants is 0.5% , which
equals (1.2% – 0.7%), where 1.2% (0.7%) is the difference
between the fixed (floating) borrowing IRs for AAA and BBB Corp. 7.16
Criticism of the Comparative
Advantage Argument
 The comparative advantage arises from the
unmatched maturities for different IR rates
– The 4% and 5.2% rates available to AAA and BBB
are, for example, 5-year rates
– The LIBOR – 0.1% and LIBOR + 0.6% rates are
available to AAA and BBB for only 6 months
(The fixed IR level or the spread above or below the LIBOR
reflects the credit risks of AAA and BBB corporations)
 Why BBB, a worse credit-rating corp., has a comparative
advantage on borrowing at a short-term IR?
– The 6-month period is relatively short (compared with 5
years), the 6-month default prob. of BBB is significantly lower
than that that for 5 years
– The above effect is weak for AAA, a better credit-rating corp. 7.17
Criticism of the Comparative
Advantage Argument
 In practice, the floating-rate loan will be reviewed (so as the
creditworthiness of the borrower) and rolled over every 6
months, so the true cost to borrow at a floating rate is
෫ rather than (LIBOR + 0.6%) in the future
(LIBOR + spread)
෫ changes with the creditworthiness of BBB
– spread
– With the IR swaps on Slide 7.16, the net borrowing rate for BBB
is NOT FIXED at (LIBOR + 0.6%) + 4.37% – LIBOR = 4.97% for
෫ + 4.37% – LIBOR = 4.37% +
5 years, but is (LIBOR + spread)
෫ dependent on its future creditworthiness every 6 months
spread
– In contrast, if BBB borrows at a fixed IR, the borrowing rate is
fixed at 5.2% for 5 years, regardless of its future creditworthiness
– As a result, BBB cannot achieve its goal perfectly with an IR
swap if its creditworthiness changes in the future
※ The above inference disproves that the comparative advantage
argument can fully explain the popularity of IR swaps 7.18
The Nature of Swap Rates

 The n-year swap rate is a constant interest rate

corresponding to a credit risk for lending 2n
consecutive 6-month LIBOR loans to AA-rated
companies
– First, the LIBOR is the lending rate for an AA-rated
borrower
– Second, a F.I. can earn the n-year swap rate by
1. Lending for the first 6-month loan to an AA-rated borrower
and relending it for successive 6-month periods to another
AA-rated borrowers, and continue this process for n years
2. Entering into a IR swap to exchange the LIBOR income in
the above step for the constant CFs at the n-year swap rate7.19
The Nature of Swap Rates

– Note that the n-year swap rates are lower than n-

year AA-rating lending rates
 For the swap rate, the credit rating of the borrowers is
always AA for the whole n-year period
 For n-year AA-rating lending rates, it is only known that
the initial credit rating of the borrower is AA at the
beginning of the n-year period
※Credit risk comparison: n-year swap contract < n-year AA-
rating lending
※IR level comparison: n-year swap rate < n-year AA-rating
lending rate
※Furthermore, since the credit risks of AA-rated companies
are very minor in practice, it can be inferred that the swap
7.20
rates are even closer to risk-free
Valuation of IR Swaps

 There are two approaches to price IR swaps

1. Regard the value of an IR swap as the
difference between the values of a fixed-rate
bond and a floating-rate bond (see Slide 7.7)
2. Regard an IR swap as a portfolio of forward rate
agreements (FRAs)
 For the Intel and MS 3-year IR swap, it can be
regarded separately as 5 FRAs (excluding the first
exchange)

7.21
Valuation of IR Swaps

 Valuation in terms of bond prices

– For a swap where fixed CFs are received and
floating CFs are paid, its value can be expressed as
𝑉swap = 𝐵fix − 𝐵fl ,
where 𝐵fix and 𝐵fl denote the values of a fixed-rate
and floating-rate bonds
– The value of a fixed-rate bond (Bfix) can be derived
with the traditional discounted cash flow method
– The value of a floating-rate bond (Bfl) that pays 6-
month LIBOR is equal to its par value immediately
after each coupon payment date (if it is discounted
semiannually) 7.22
Valuation of IR Swaps

 Price Bfl (with the face value to be $100) with 1.5 years to
maturity in one possible scenario for the 6-month LIBOR
$100+$2
$3 $4

6% 8% 4%

t=0 t=0.5 t=1 t=1.5

$2  $100
$100 (  )
1  4 %  0 .5
$4  $100 $4 $102
$100 (    )
1  8%  0.5 1  8%  0.5 (1  8%  0.5)((1  4%  0.5)

$3  $100 $3 $4 $102
$100 (     )
1  6%  0.5 1  6%  0.5 (1  6%  0.5)(1  8%  0.5) (1  6%  0.5)(1  8%  0.5)(1  4%  0.5)

※ Note that in any scenario for LIBOR and for different life time of
bonds, the Bfl is worth its par value on the issue date and on each
date immediately after the coupon payment date 7.23
Valuation of IR Swaps

 Generalization for pricing a Bfl (with the principal (or said

par value) L) at any time point 𝑡
Value = L = PV
Value = L
of L+k* at t = 0

Value =
L+k*

0 t t*

Last Valuation First Pmt Second Maturity

Pmt Date Date Date Pmt Date Date
(Floating
CF = k*)

∗
※ A Bfl is worth the PV of (𝐿 + 𝑘 ∗ ) at 𝑡, i.e., 𝐿 + 𝑘 ∗ 𝑒 −𝑟(𝑡 −𝑡) ,
where 𝐿 + 𝑘 ∗ is the value of the Bfl on the next payment date
and 𝑟 is the continuously compounding zero rate corresponding
to the time to maturity of (𝑡 ∗ − 𝑡) 7.24
Valuation of IR Swaps

 An example for pricing pay-floating-receive-

fixed IR swaps
– For the party to pay the six-month LIBOR and
receive fixed 8% (semi-annual compounding) on a
principal of $100 million
– Remaining life of the IR swap is 1.25 years
– LIBOR rates for 3-months, 9-months and 15-
months are 10%, 10.5%, and 11% (continuously
compounding)
– The 6-month LIBOR on the last payment date was
10.2% (semi-annual compounding)
7.25
Valuation of IR Swaps

Time 𝑩𝐟𝐢𝐱 CF 𝑩𝐟𝐥 CF Discount Factor PV of 𝑩𝐟𝐢𝐱 PV of 𝑩𝐟𝐥

(yr) CF CF
0.25 $4 $105.1 𝑒 −10%∙0.25 = 0.9753 $3.901 $102.505
0.75 $4 𝑒 −10.5%∙0.75 = 0.9243 $3.697
1.25 $104 𝑒 −11%∙1.25 = 0.8715 $90.640
Total $98.238 $102.505

※ For per $100 principal

– The coupon payment of 𝐵fl after 3 months is 0.5 × 10.2% ×
$100 = $5.1
– The value of 𝐵fl today is $100 + $5.1 𝑒 −10%∙3/12 = $102.505
according to the formula on Slide 7.24
– 𝑉swap = 𝐵fix − 𝐵fl = $98.238 − $102.505 = −$4.267
7.26
Valuation of IR Swaps

 Valuation in terms of FRAs

– Each exchange in an IR swap is an FRA
 Note that for a newly issued IR swap, the first exchange
of payments is known when the swap is negotiated
 For each of other exchanges, it can be regarded as a
FRA applied for a future period of 6 months
– Recall that for a FRA applied in [𝑇1 , 𝑇2 ], the payoff of the
lender at 𝑇2 is 𝐿(𝑅𝐾 − 𝑅𝑀 ) 𝑇2 − 𝑇1 (see Slide 4.34), where
𝐿 is the principal, 𝑅𝐾 is the fixed IR specified in the FRA
contract, and 𝑅𝑀 is the actual LIBOR for [𝑇1 , 𝑇2 ]
– Considering a pay-floating-receive-fixed IR swap with the
principal 𝐿, for each 6 months, the swap holder can receive
the net payoff of 𝐿 𝑅𝐾 − 𝑅𝑀 ×0.5, where 𝑅𝑀 is the actual 6-
month LIBOR for that period and 𝑅𝐾 is the fixed IR specified
in the swap contract 7.27
Valuation of IR Swaps

– The value of any derivative equals the present

value of its expected payoff
 This approach has been used to price FRAs on Slide 4.37
 To evaluate the expected payoff of an exchange in an IR
swap, the expectation of the future LIBOR is needed
𝑒 −𝑅2 𝑇2 𝐸 𝐿 𝑅𝐾 − 𝑅𝑀 𝑇2 − 𝑇1
= 𝑒 −𝑅2 𝑇2 𝐿 𝑅𝐾 − 𝐸[𝑅𝑀 ] 𝑇2 − 𝑇1
= 𝑒 −𝑅2 𝑇2 𝐿[𝑅𝐾 𝑇2 − 𝑇1 − 𝐸[𝑅𝑀 ] 𝑇2 − 𝑇1 ]
 It is known that the expected future LIBORs equal the
forward rates (𝑅𝐹 ) based on today’s term structure of IRs:
Value of an exchange = 𝑒 −𝑅2 𝑇2 𝐿[𝑅𝐾 𝑇2 − 𝑇1 − 𝑅𝐹 𝑇2 − 𝑇1 ]
= 𝑒 −𝑅2 𝑇2 𝐿(𝑅𝐾 − 𝑅𝐹 ) 𝑇2 − 𝑇1
※ The above formula is identical to the FRA pricing formula on Slide 4.37 7.28
Valuation of IR Swaps

– Consider the pay-floating-receive-fixed IR swap

example on Slide 7.25. For per $100 principal,
Time Fixed Expected Expected Discount PV of expected
(yr) CF floating CF net CF factor net CF
0.25 $4 $5.100 –$1.100 0.9753 –$1.073
0.75 $4 $5.522* –$1.522 0.9243 –$1.407
1.25 $4 $6.051** –$2.051 0.8715 –$1.787
Total –$4.267
∗ 10.5%×0.75−10%×0.25
𝑅𝐹 = = 10.75% (cont. comp.) ⇒ 11.044% (semi-annual comp.)
0.5
Expected cash outflow at 𝑡 = 0.75 is $100 × 11.044% × 0.5 = $5.522
∗∗ 11%×1.25−10.5%×0.75
𝑅𝐹 = = 11.75% (cont. comp.) ⇒ 12.102% (semi-annual comp.)
0.5
Expected cash outflow at 𝑡 = 1.25 is $100 × 12.102% × 0.5 = $6.051
7.29
Valuation of IR Swaps

 An IR swap is worth zero when it is first initiated

– When a swap contract is first negotiated, the swap
rate (the fixed rate 𝑅𝐾 ) is determined such that the
value of the swap is zero initially
 This feature is similar to set the delivery prices of futures
contracts to be the futures prices such that the futures
contracts are worth zero when they are initiated
– With the passage of time, the value of an IR swap
emerges and can be either positive or negative
 One party’s gains are the other party’s losses, so two
parties of a swap have opposite viewpoints on the value of
the same IR swap
7.30
Valuation of IR Swaps

– Although the swap is zero initially, it does not mean

that the value of each individual FRA is zero initially
 The initial zero value of a swap means that the sum of the
values of all FRAs underlying the swap is zero
 For a pay-fixed-receive-floating swap on the issue date,
– If the zero curve is upward sloping  forward rates ↑ with T
 The forward rates with shorter times to maturity < the swap rate
 negative values for shorter-maturity FRAs
 The forward rates with longer times to maturity > the swap rate
 positive values for longer-maturity FRAs
– If the zero curve is downward sloping  forward rates ↓ with T
 The forward rates with shorter times to maturity > the swap rate
 positive values for shorter-maturity FRAs
 The forward rates with longer times to maturity < the swap rate
 negative values for longer-maturity FRAs 7.31
Determine LIBOR Zero Curve with
Eurodollar Futures and IR Swaps
 Construct the LIBOR zero curve
(It is important since traders commonly use LIBORs as
proxies for risk-free rates when trading derivatives)
– 𝑇 < 1: the quotes of spot LIBOR (given different 𝑇)
provided by financial institutions are used
– 𝑇 in [1,2] (or in [1,5]): the quotes of Eurodollar
futures are used to derive LIBOR zero rates
 Suppose the zero rate 𝑅1 for 𝑇1 is known
 With the convexity adjustment, the forward rates (𝑅𝐹 ) for
[𝑇1 , 𝑇2 ] can be derived from the futures rates implied from
the quotes of Eurodollars futures (𝑍)
 Finally, we can deduce 𝑅2 through
𝑅2 𝑇2 −𝑅1 𝑇1 𝑅𝐹 𝑇2 −𝑇1 +𝑅1 𝑇1
𝑅𝐹 = ⇒ 𝑅2 = 7.32
𝑇2 −𝑇1 𝑇2
Determine LIBOR Zero Curve with
Eurodollar Futures and Swaps
– For longer 𝑇: the quotes of swap rates are used to
derive the LIBOR zero rate
 Consider a pay-floating-receive-fixed IR swap with the swap
rate of 5%, principal of $100, and 2 years to maturity
 Suppose the 6-month, 12-month, and 18-month LIBOR zero
rates are 4%, 4.5%, and 4.8% with cont. compounding
 Since the initial value of a swap is zero, then 𝑉swap = 𝐵fix −
𝐵fl = 𝐵fix − $100 = 0 and thus
2.5𝑒 −4%∙0.5 + 2.5𝑒 −4.5%∙1 + 2.5𝑒 −4.8%∙1.5 + 102.5𝑒 −𝑅∙2 = 100
 Solve for the 2-year LIBOR zero rate to be 4.953%
 The above equation also demonstrates that the swap rate =
par yield (refer to Slide 4.19 for the definition of the pay yield)
※Similar to the bootstrap method, LIBOR rates for shorter 𝑇
should be solved first before solving LIBOR rates for longer 𝑇 7.33
 Overnight Indexed Swaps (OISs)

 An OIS is a swap where a fixed rate (𝑟)ҧ is

exchanged for the geometric average (𝑟𝑔ǁ ) of the
overnight rates during a period
92
–𝐿 1 + 𝑟𝑔ǁ /365 − 1 ⟷ 𝐿 92/365 𝑟ҧ for a 92-day period
– The fixed rate 𝑟ҧ is referred to as the OIS rate,
determined such that an OIS is worth zero initially
– OISs tend to have short lives (≤ 3 months)
– Longer-term OISs are typically divided into 3-month
sub-periods
 At the end of each sub-period, the net of the actual geometric
average of the overnight rates during the sub-period and the
fixed OIS rate will be exchanged 7.34
Overnight Indexed Swaps (OISs)

– 3-month OIS rate ≤ 3-month LIBOR rate

1. Borrow 𝐿 from a AA-rated bank in the overnight market, and roll the
interest and principal forward every day for 3 months (92 days)  pay
the geometric average of the overnight rates at the period end
2. Convert the geometric average of the overnight rates to the 3-month
OIS rate by entering into an OIS contract
3. Lend the borrowed 𝐿 to another AA-rated financial institution for 3
months at LIBOR
※ Payoff = 𝐿 × (92/365) × (LIBOR − OIS rate) > 0 in reality
※ OIS rates correspond to continually refreshed overnight rates
(always lend or borrow daily with AA-rated financial institutions)
※ To earn 3-month LIBORs, the bank bears the default risk of its
trading counterparty, which is rated AA initially
※ Thus, OIS rates, lower than LIBOR rates, are even closer to risk-free
interest rates 7.35
Overnight Indexed Swaps (OISs)

– In practice, many derivatives dealers choose to use

OIS zero rates for discounting collateralized
transactions (less risky) and use LIBOR zero rates for
discounting noncollateralized transactions (more risky)
– The (LIBOR – OIS) spread
 Defined as the 3-month LIBOR rate over the 3-month OIS rate
 Can be used to measure the degree of stress in financial
markets
– In normal market condition, this spread is about 10 basis points
– In Oct. 2009, this spread spiked to an all-time high of 364 basis
points because banks are reluctant to lend to each other for three-
month periods
– In Dec. 2011, due to the concern of the crisis in Greece, this
spread rose to 50 basis points 7.36
 Determine Zero Curve Using OISs

 Similar to constructing a LIBOR zero curve with

swap rates, one can derive a zero curve using
OIS quotes (a better proxy for the term structure
of the risk-free interest rate)
– 𝑇 < 3 months: the quotes of OIS rates are used
– For a longer 𝑇 (assuming there are periodic
settlements (usually every 3 months) in OIS contracts)
 The OIS rate defines a par yield bond if the daily
discounting frequency is considered
 For a 1.25-year OIS contract with the OIS rate to be 4%, it
can be regarded as a bond paying a quarterly coupon at a
rate of 4% per annum and sold at par 7.37
 Determine Zero Curve Using OISs

 Suppose the 3-, 6-, 9-, and 12-month OIS zero rates are 3%,
3.5%, 4%, and 4.5% with continuous compounding
 The 1.25-year OIS zero rate 𝑅 is 3.9798% by solving

1𝑒 −3%∙0.25 + 1𝑒 −3.5%∙0.5 + 1𝑒 −4%∙0.75 + 1𝑒 −4.5%∙1 + 101𝑒 −𝑅∙1.25 = 100

– For a 𝑇 being so long such that the quotes of OIS
rates are not available or unreliable, e.g., 𝑇 > 5 years
 Note that LIBOR-based IR swaps are traded for longer
maturities than OIS
 Assume the (LIBOR – OIS) spread is constant and as it is for
the longest OIS maturity for which there is reliable data, e.g.,
for the 5-year time point, the corresponding (LIBOR – OIS)
zero-rate spread is 20 basis points
 Use the LIBOR zero curve minus a constant (LIBOR – OIS)
spread to derive the OIS rate zero curve 7.38
7.2 Currency Swaps

7.39
 Currency Swap

 Currency swap is another popular type of swaps

– It involves exchanging principal and interest
payments in one currency for principal and interest
payments in another currency
 Different from IR swaps, the principal amounts (in
different currencies) are exchanged at the beginning and
at the end of the life of a currency swap
 The principal amounts are chosen to be approximately
equivalent using the exchange rate at the swap’s initiation
– An example of a currency swap: IBM pays 5% on a
principal of £10,000,000 and receive 6% on a
principal of $15,000,000 from British Petroleum (BP)
every year for 5 years 7.40
Currency Swap

£10 mil. Year Dollar CF Sterling CF

IBM BP for IBM for IBM
(millions) (millions)
$15 mil.
2013 –15.00 +10.0
2014 +0.90 –0.5
Dollar 6% 2015 +0.90 –0.5
IBM BP
2016 +0.90 –0.5
Sterling 5% 2017 +0.90 –0.5
2018 +15.90 –10.5
※ A currency swap can be regarded as two
$15 mil. parallel loans denominated in different
IBM BP currencies
£10 mil. ※ The values of $15 mil. and £10 mil. are set to be
equivalent initially (in this case, £1 =$1.5 initially)
⇒ Two parties lend loans with equivalent values
to each other ⇒ The net value of the currency 7.41
Currency Swap

 Typical uses of a currency swap is to

– Convert a liability in one currency to a liability in
another currency
Dollar 6% Sterling 5%
Dollar 6%
IBM BP
Sterling 5%

– Convert an investment in one currency to an

investment in another currency
Dollar 6% Dollar 6%
IBM BP
Sterling 5%
Sterling 5%
7.42
Comparative Advantage
Arguments for Currency Swaps

 The comparative advantage argument

explains the popularity of the currency swaps
– General Electric (GE) prefers to borrow AUD and
Qantas Airways (QA) prefers to borrow USD
– The USD and AUD borrowing IRs they face are
USD AUD
General Electric (GE) 5.0% 7.6%
Qantas Airways (QA) 7.0% 8.0%

※ GE has a comparative advantage in the USD market,

whereas QA has a comparative advantage in the AUD
market 7.43
Comparative Advantage
Arguments for Currency Swaps

 Exploit the comparative advantage with

currency swaps
– Suppose that GE intends to borrow 20 mil. AUD
and QA intends to borrow 15 mil. USD, and the
current exchange rate is 0.75USD per AUD
– GE borrows USD, QA borrows AUD, and they use
currency swaps to transform GE’s USD loan into
a AUD loan and QA’s AUD loan into a USD loan
USD 5.0% USD 6.3% AUD 8.0%
USD 5.0% QA
GE F.I.
AUD 6.9% AUD 8.0%
※ GE pays 6.9% in AUD (0.7% better off) and QA pays 6.3%
in USD (0.7% better off) 7.44
Comparative Advantage
Arguments for Currency Swaps
– Different ways to arrange the currency swaps
1. QA bears some foreign exchange risk
USD 5.0% USD 5.2% AUD 8.0%
USD 5.0% QA
GE F.I.
AUD 6.9% AUD 6.9%

2. GE bears some foreign exchange risk

USD 6.1% USD 6.3% AUD 8.0%

USD 5.0% QA
GE F.I.
AUD 8.0% AUD 8.0%

※ These two alternatives are unlikely to be adopted in

practice because the firms prefer to eliminate the foreign
exchange risk with currency swaps thoroughly 7.45
Valuation of Currency Swaps

 Like IR swaps, currency swaps can be valued

either as the difference between 2 bonds or as
a portfolio of forward contracts
– Valuation in terms of bond prices
 For a receive-dollar-pay-foreign-currency currency swap,
then
𝑉swap = 𝐵𝐷 − 𝑆0 𝐵𝐹 ,
where 𝐵𝐷 is the domestic bond defined by the remaining
USD CFs, 𝐵𝐹 is the bond defined by the remaining foreign-
currency CFs, and 𝑆0 is the spot exchange rate (expressed
as dollars for per unit of foreign currency)
 In contrast, for a pay-dollar-receive-foreign-currency
currency swap, then 𝑉swap = 𝑆0 𝐵𝐹 − 𝐵𝐷 7.46
Valuation of Currency Swaps

 An example for pricing currency swaps

– All Japanese LIBOR zero rates are 4% (foreign
IR)
– All USD LIBOR zero rates are 9% (domestic IR)
– A currency swap is to received 5% in yen and pay
8% in dollars. Payments are made annually
– Principals are $10 million and 1,200 million yen
– Swap will last for 3 more years
– Current exchange rate is 110 yen per dollar

7.47
Valuation of Currency Swaps

Time Cash Flows of PV of 𝑩𝑫 Cash flows of PV of 𝑩𝑭

(yr) 𝑩𝑫 (million $) (million $) 𝑩𝑭 (million (million yen)
(discounted yen) (discounted at
at 9%) 4%)
1 0.8 (=10×8%) 0.7311 60 (=1,200×5%) 57.65
2 0.8 (=10×8%) 0.6682 60 (=1,200×5%) 55.39
3 0.8 (=10×8%) 0.6107 60 (=1,200×5%) 53.22
3 10 7.6338 1,200 1,064.30
Total 9.6439 1,230.55

1,230.55
※ 𝑉swap = 𝑆0 𝐵𝐹 − 𝐵𝐷 = − 9.6439 = 1.543 (million $)
110

7.48
Valuation of Currency Swaps

– Valuation in terms of forward contracts

 Each exchange of payments (including the first one) in a
currency swap is a foreign exchange (FX) forward contract
– FX forwards is an agreement to trade an amount of a foreign
currency at a fixed price on a predetermined future date
– FX forwards are similar to the foreign currency futures contracts
(introduced in Ch. 5) except that FX forwards are traded in OTC
markets and thus there is no daily settlement requirement
– The principal is 𝐿 foreign dollars (𝐿=￥60 or ￥1260 mil. in our
example) and the fixed trading price is 𝐾 (expressed as
domestic dollars / per foreign dollar) (𝐾 = 0.8/60 or 10.8/1260 in
our example)
– Payoff of a FX forwards to purchase the foreign currency at 𝑇 is
𝐿 𝑆𝑇 − 𝐾 = 𝐿𝑆𝑇 − 𝐿𝐾, where 𝑆𝑇 is the domestic-dollar price of
the foreign currency (or said the FX rate) at 𝑇 7.49
Valuation of Currency Swaps

– The value of a FX forward is the PV of its expected payoff

𝑒 −𝑟𝑇 𝐸 𝐿𝑆𝑇 − 𝐿𝐾 = 𝑒 −𝑟𝑇 (𝐿𝐸 𝑆𝑇 − 𝐿𝐾)
– The forward (or futures) price of the foreign currency provide
the unbiased approximation for 𝐸 𝑆𝑇 based on the information
of IRs today
– Since the forward price of the foreign currency is 𝐹0 =
𝑆0 𝑒 (𝑟−𝑟𝑓)𝑇 (introduced on Slide 5.23), we obtain 𝐸 𝑆𝑇 = 𝐹0 =
𝑆0 𝑒 𝑟−𝑟𝑓 𝑇
– Thus, the value of a FX forward is
𝑒 −𝑟𝑇 (𝐿𝐹0 − 𝐿𝐾)
– The forward FX rates of Japanese Yen, 𝐹0 , in the example on
Slide 7.47 are
Time (yr) 1 2 3
Forward FX rate 1 (9%−4%)∙1 1 (9%−4%)∙2 1 (9%−4%)∙3
𝑒 𝑒 𝑒
($/per Yen) 110 110 110
= 0.009557 = 0.010047 = 0.010562 7.50
 Valuation of Currency Swaps

– Take the first exchange in the currency swap for example: it can
be regarded as a FX forward to purchase ￥60 million with $0.8
million
– Value of the first exchange = 𝑒 −9%∙1 ￥60 ∙ 𝐸 𝑆1 − $0.8
= 𝑒 −9%∙1 ￥60 ∙ 0.009557 − $0.8
= −0.2071 (million $)
Time Dollar CF Yen CF Expected future Yen CF Net CF PV of net
(yr) (mil. $) (mil. Yen) FX rate = in dollar (mil. $) CF (mil. $)
forward FX rate (mil. $) (discounted
at 9%)
1 –0.8 60 0.009557 0.5734 –0.2266 –0.2071
2 –0.8 60 0.010047 0.6028 –0.1972 –0.1647
3 –0.8 60 0.010562 0.6337 –0.1663 –0.1269
3 –10 1,200 0.010562 12.6746 +2.6746 +2.0417
Total +1.5430
7.51
7.3 Credit Risk of Swaps

7.52
Credit Risk

 Contracts such as swaps or forwards that are

private arrangements between two parties
entail credit risk
– A swap is worth zero to both counterparties initially
– At a future time point, its value is possible to be
either positive or negative
– A swap trader has credit risk exposure only when
the value of its swap position is positive
 The trading counterparty has the chance not to honor his
losses, which results in the credit risk
– Potential losses from defaults on a swap are much
less than the potential losses from defaults on a
loan/bond with the same principal 7.53
Credit Risk

 Since the value of a swap is the difference between two

parallel bonds, the value of a swap is usually a small
fraction of its notional principal
– Potential default losses on a currency swap are
greater than those on an IR swap because the
principal amounts in different currencies are
exchanged at the end of the life of a currency swap
– Credit vs. Market risks
 Credit risk arises from the possibility of a default, but the
market risk arises from the changes of the market
variables, such as IR and FX rates
 Market risk can be hedged by entering into offsetting
contracts (e.g., duration matching hedge), but credit risk
is more difficult to hedge 7.54
Credit Risk

 Credit default swaps (信用違約交換) (CDSs)

– Invented by JPMorgan in 1997
– A CDS is an insurance policy with payoffs depending
on the occurrence of the default event of a corporate
bond or loan
– CDSs can shift the default risk from the protection
buyer to the protection seller (see the next slide)
– CDSs allow financial institutions to hedge credit risks
in the same way that they have hedged market risks
– The total size of outstanding CDS contracts reaches
a peak of $63 trillion before the 2008-2009 credit
crisis (US GDP is about $14 trillion per year) 7.55
Credit Risk

※ When the default event occurs, the protection seller should compensate the
protection buyer any losses on principal in the default event
※ For the protection buyer, CDS provides insurance against the possibility that
a borrower (the reference entity (參考實體)) might not pay
※ For the protection seller, CDS provides a way to earn profits by bearing
default risk without ever holding credit instruments physically 7.56
7.4 Other Types of Swaps

7.57
Other Types of Swaps

 Variations on IR swaps
– The tenors (i.e., the payment frequency) for the
floating- and fixed-rate sides could be different
 Quarterly LIBOR vs. semiannual fixed rate payments
– Other floating rates, like the commercial paper rate,
could be used
– Amortizing (攤銷) (or step up) swaps
 The principal amount reduces (or increases) in a
predetermined way
– Deferred (延遲) swaps
 Also known as the forward-start swap, where the parties
do not begin to exchange interest payments until some
future date 7.58
Other Types of Swaps
– Constant maturity swaps (CMS)
 An agreement to exchange (LIBOR + spread) (or a constant
IR) for a fixed-maturity swap rate
 For example, exchange the 6-month LIBOR + 0.1% (or 5.5%)
for 10-year swap rates every 6 months for the next 5 years
– Constant maturity Treasury swaps
 Exchange 6-month LIBOR + 0.15% for the 2-year Treasury
par yield every 6 months for the next 3 years
– Par yield: a coupon rate that causes the bond price to equal its
face value
– Compounding swaps
 Interests on one or both sides are compounded to the end of
the life of the swap and thus there is only one payment at the
end of the life of the swap 7.59
Other Types of Swaps
– LIBOR-in-arrears (遞延) swaps
 The LIBOR observed on the payment date is used
immediately to calculate the payment on that date
 Note that for standard IR swaps, the 6-month LIBOR
prevailing six months ago determines the current floating
payment
– Accrual (累積) swaps
 The interests on one side accrue only when the floating
reference rate is in a certain range (The fixed-rate side
pays in a standard way)
 For example, only when the LIBOR rate is between
[1%,2%], the interests on that day is accumulated
– For every 6 months, the number of days where the specified
condition is met determines the floating CF 7.60
Other Types of Swaps

 Other currency swaps

– Fixed-for-floating currency swaps
 A LIBOR in one currency is exchanged for a fixed rate in
another currency
 A combination of a fixed-for-floating IR swap and a fixed-
for-fixed currency swap
 It is also known as a cross-currency interest rate swap
– Floating-for-floating currency swaps
 A LIBOR in one currency is exchanged for a LIBOR in
another currency
 A combination of two fixed-for-floating IR swaps and a
fixed-for-fixed currency swap
7.61
Other Types of Swaps

– Differential Swaps
 For example, for an amount of notional principal in USD,
exchange LIBOR in USD with LIBOR in yen
 Note that theoretically the LIBOR in yen should be applied
to the principal in yen rather than the principal in USD
 It is also known as quanto swap (匯率保障交換)
 Other types of swaps
– Equity swaps
 Exchange the total return (dividends plus capital gains)
realized on an equity index for either a fixed or a floating IR
 Used by portfolio managers to purchase a series of equity
index returns with a fixed or floating IR
 Useful to escape from the capital controls of some nations 7.62
Other Types of Swaps

– Commodity swaps
 An agreement where a floating (or market or spot) price
based on an underlying commodity is exchanged for a
fixed price for a following period
 It can be decomposed into a series of forward contracts on
a commodity with different maturity dates and identical
delivery price
– Volatility swaps
 Volatility is defined as the standard deviation of the rates of
return of the underlying asset price in a reference period
 At the end of each reference period, one side pays
principal × pre-agreed volatility (e.g., 20%), and the other
side pays principal × the actual volatilities (e.g., 23%) in
the past reference period 7.63