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Swaps: Course: FINC6073 Lab Trading Simulation Effective Period: September 2016
Swaps: Course: FINC6073 Lab Trading Simulation Effective Period: September 2016
Simulation
Effective Period : September 2016
Swaps
Session 6
Acknowledgement
Example:
These slides have been adapted from:
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 3
Nature of Swaps
A swap is an agreement to
exchange cash flows at specified
future times according to certain
specified rules
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 4
An Example of a “Plain Vanilla”
Interest Rate Swap
An agreement by Microsoft to receive 6-
month LIBOR & pay a fixed rate of 5%
per annum every 6 months for 3 years
on a notional principal of $100 million
Next slide illustrates cash flows that
could occur (Day count conventions are
not considered)
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 5
Cash Flows to Microsoft
(See Table 7.1, page 160
---------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 6.4% +2.95 –2.50 +0.45
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 6
Typical Uses of an
Interest Rate Swap
Converting a liability from
fixed rate to floating rate
floating rate to fixed rate
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 7
Intel and Microsoft (MS)
Transform a Liability
(Figure 7.2, page 161)
5%
5.2%
Intel MS
LIBOR+0.1%
LIBOR
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 8
Financial Institution is Involved
(Figure 7.4, page 163)
4.985% 5.015%
5.2%
Intel F.I. MS
LIBOR+0.1%
LIBOR LIBOR
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 9
Intel and Microsoft (MS)
Transform an Asset
(Figure 7.3, page 162)
5%
4.7%
Intel MS
LIBOR−0.2%
LIBOR
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 10
Financial Institution is Involved
(See Figure 7.5, page 163)
4.985% 5.015%
4.7
Intel F.I. MS %
LIBOR−0.2%
LIBOR LIBOR
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 11
Quotes By a Swap Market Maker
(Table 7.3, page 164)
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 12
Day Count
A day count convention is specified for for
fixed and floating payment
For example, LIBOR is likely to be
actual/360 in the US because LIBOR is a
money market rate
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 13
Confirmations
Confirmations specify the terms of a
transaction
The International Swaps and Derivatives
has developed Master Agreements that
can be used to cover all agreements
between two counterparties
Central clearing is used for most standard
swaps
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 14
The Comparative Advantage
Argument (Table 7.4, page 166)
Fixed Floating
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 15
The Swap (Figure 7.6, page 167)
4.35%
4%
AAACorp BBBCorp
LIBOR+0.6%
LIBOR
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 16
The Swap when a Financial
Institution is Involved
(Figure 7.7, page 168)
4.33% 4.37%
4%
AAA F.I. BBB
LIBOR+0.6%
LIBOR LIBOR
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 17
Criticism of the Comparative
Advantage Argument
The 4.0% and 5.2% rates available to AAACorp
and BBBCorp in fixed rate markets are 5-year
rates
The LIBOR−0.1% and LIBOR+0.6% rates
available in the floating rate market are six-
month rates
BBBCorp’s fixed rate depends on the spread
above LIBOR it borrows at in the future
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 18
The Nature of Swap Rates
Six-month LIBOR is a short-term AA
borrowing rate
The 5-year swap rate has a risk
corresponding to the situation where 10 six-
month loans are made to AA borrowers at
LIBOR
This is because the lender can enter into a
swap where income from the LIBOR loans is
exchanged for the 5-year swap rate
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 19
Overnight Indexed Swaps
Fixed rate for a period is exchanged for the
geometric average of the overnight rates
Should the OIS rate equal the LIBOR rate? A
bank can
Borrow $100 million in the overnight market, rolling
forward for 3 months
Enter into an OIS swap to convert this to the 3-
month OIS rate
Lend the funds to another bank at LIBOR for 3
months
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 20
Overnight Indexed Swaps continued
...but it bears the credit risk of another bank in this
arrangement
The excess of LIBOR over the OIS rate is the
LIBOR-OIS spread. It is usually about 10 basis
points but spiked at an all time high of 364 basis
points in October 2008
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 21
OIS vs LIBOR discounting
Traditionally LIBOR rates (and swap rates
determined from swaps where LIBOR is
exchanged for fixed) have been used as risk-
free rates when derivatives are valued
Most market participants now use the OIS rate
as the discount rate when collateralized deals
are valued, but continue to use LIBOR rates for
discounting cash flows in non-collateralized
deals
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 22
Using Swap Rates to Bootstrap the
LIBOR/Swap Zero Curve when
LIBOR discounting is used
Consider a new swap where the fixed rate is the swap
rate
When principals are added to both sides on the final
payment date the swap is the exchange of a fixed rate
bond for a floating rate bond
The floating-rate rate bond is worth par. The swap is
worth zero. The fixed-rate bond must therefore also be
worth par
This shows that swap rates define par yield bonds that
can be used to bootstrap the LIBOR (or LIBOR/swap)
zero curve
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 23
Example of Bootstrapping the
LIBOR/Swap Curve (Example 7.3, page 173)
6-month, 12-month, and 18-month
LIBOR/swap rates are 4%, 4.5%, and 4.8%
with continuous compounding.
Two-year swap rate is 5% (semi-annual)
2.5e 0.040.5 2.5e 0.0451.0 2.5e 0.0481.5 102.5e 2 R 100
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 24
Valuation of an Interest Rate
Swap
Initially interest rate swaps are worth
close to zero
At later times they can be valued as a
portfolio of forward rate agreements
(FRAs)
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 25
Example
Receive six-month LIBOR, pay 3% (s.a.
compounding) on a principal of $100 million
Remaining life 1.25 years
LIBOR rates for 3-months, 9-months and 15-
months are 2.8%, 3.2%, and 3.4% (cont comp)
6-month LIBOR on last payment date was 2.9%
(s.a. compounding)
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 26
Valuation Assuming LIBOR
Discounting
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 27
Forward Rates
The forward rates with semiannual
compounding are
3.429% for the 3 to 9 month period
3.734% for the 9 to 15 month period
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 28
Valuation of Example Using FRAs
and LIBOR discounting (Example 7.2 ,
page 172)
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 29
Valuation in Terms of Bonds
using LIBOR discounting
The fixed rate bond is valued in the usual
way
The floating rate bond is valued by noting
that it is worth par immediately after the
next payment date
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 30
Value of Floating Rate Bond
(L=Principal)
Value = PV
of L+k* at t*
Value = Value = L
L+k*
0 t*
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 31
Example (Example 7.6, page 177)
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 32
Valuation of Swaps Using OIS
discounting
Zero rates are bootstrapped from OIS
rates (This is similar to the way the
LIBOR/swap zero curve is produced)
Forward LIBOR rates are then calculated
so that so that swaps entered into at the
current swap rate are worth zero (See
Example 7.5, page 176)
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 33
Valuation of Swaps Using OIS
discounting continued
The swap is valued by assuming that
forward LIBOR is realized and discounting
at the OIS rate
There is no simple way of valuing the
swap in terms of bonds
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 34
An Example of a Fixed-for-Fixed
Currency Swap
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 35
Exchange of Principal
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
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 36
The Cash Flows (Table 7.5, page 180)
Date Dollar Cash Flows Sterling cash flow
(millions) (millions)
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 37
Typical Uses of a
Currency Swap
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 38
Comparative Advantage May Be
Real Because of Taxes
General Electric wants to borrow AUD
Quantas wants to borrow USD
Cost after adjusting for the differential
impact of taxes
USD AUD
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 39
Valuation of Fixed-for-Fixed
Currency Swaps
Fixed for fixed currency swaps can
be valued either as the difference
between 2 bonds or as a portfolio of
forward contracts
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 40
Example (pages 182-184)
All Japanese LIBOR/swap rates are 4%
All USD LIBOR/swap rates are 9%
5% is received in yen; 8% is paid 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
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 41
Valuation in Terms of Bonds
(Example 7.7, page 183)
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 42
Valuation in Terms of Forwards
(Example 7.8, page 184)
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 43
Other Currency Swaps
Fixed-for-floating: equivalent to a fixed-for-
fixed currency swap plus a fixed for
floating interest rate swap
Floating-forfloating: equivalent to a fixed-
for-fixed currency swap plus two floating
interest rate swaps
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 44
Swaps & Forwards
A swap can be regarded as a
convenient way of packaging forward
contracts
When a swap is initiated the swap has
zero value, but typically some forwards
have a positive value and some have a
negative value
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 45
Credit Risk
A swap is worth zero to a company initially
At a future time its value is liable to be either positive or negative
The company has credit risk exposure only when its value is
positive
Some swaps are more likely to lead to credit risk exposure than
others
What is the situation if early forward rates have a positive value?
What is the situation when the early forward rates have a negative
value?
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 46
Credit Default Swaps: A Quick
First Look
Notional principal (e.g. $100 million) and
maturity (e.g. 5 yrs) specified
Protection buyer pays a fixed rate (e.g. 150 bp)
on the notional principal (the CDS spread)
If the reference entity (a country or company)
defaults protection seller buys bonds issued by
the reference entity for their face value and the
spread payments stop. Total face value of bonds
bought equals notional principal
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 47
Other Types of Swaps
Amortizing/ step up
Compounding swap
Constant maturity swap
LIBOR-in-arrears swap
Accrual swap
Equity swap
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 48
Other Types of Swaps continued
Cross currency interest rate swap
Floating-for-floating currency swap
Diff swap
Commodity swap
Variance swap
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright © John C. Hull 2013 49