Chapter 12: Swaps

Let us not forget there were plenty of financial disasters

before quants showed up on Wall Street, and the
subsequent disasters (including the current one) had
plenty of help from the non-quants.

Aaron Brown
Risk Professional, April 2010, p. 18

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 Important Concepts in Chapter 11

 The concept of a swap

 Different types of swaps, based on underlying currency,
interest rate, or equity
 Pricing and valuation of swaps
 Strategies using swaps

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  Four types of swaps
 Currency
 Interest rate
 Equity
 Commodity (not covered in this book)
 Characteristics of swaps
 No cash up front
 Notional amount
 Settlement date, settlement period
 Credit risk
 Dealer market

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Interest Rate Swaps
 The Structure of a Typical Interest Rate Swap
 Example: On December 15 XYZ enters into $50

million notional amount swap with ABSwaps.

Payments will be on 15th of March, June,
September, December for one year, based on
LIBOR. XYZ will pay 7.5% fixed and ABSwaps
will pay LIBOR. Interest based on exact day count
and 360 days (30 per month). In general the cash
flow to the fixed payer will be
 Days 
(Notional amount)(LIBOR - Fixed rate)  
360 or 365 

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Interest Rate Swaps (continued)
 The Structure of a Typical Interest Rate Swap
(continued)
 The payments in this swap are
 Days 
($50,000,000)(LIBOR - 0.075) 
 360 
 Payments are netted.
 See Figure 11.1 for payment pattern
 See Table 11.1 for sample of payments after-the-
fact.

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Interest Rate Swaps (continued)
 Interest Rate Swap Strategies
 See Figure 11.4 for example of converting floating-

rate loan into fixed-rate loan

 Other types of swaps

• Index amortizing swaps

• Diff swaps
• Constant maturity swaps

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Currency Swaps
 Example: Reston Technology enters into currency swap
with GSI. Reston will pay euros at 4.35% based on NP
of €10 million semiannually for two years. GSI will
pay dollars at 6.1% based on NP of $9.804 million
semiannually for two years. Notional amounts will be
exchanged.
 See Figure 11.5.

 Note the relationship between interest rate and currency

swaps in Figure 11.6.

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Currency Swaps (continued)
 Pricing and Valuation of Currency Swaps
 Let dollar notional amount be NP$. Then euro notional amount is

NP€ = 1/S0 for every dollar notional amount. Here euro notional
amount will be €10 million. With S0 = $0.9804, NP$ =
$9,804,000.
 For fixed payments, we use the fixed rate on plain vanilla swaps

in that currency, R$ or R€.

 No pricing is required for the floating side of a currency swap.

 See Table 11.6.

 During the life of the swap, we value it by finding the difference

in the present values of the two streams of payments, adjusting

for the notional amounts, and converting to a common currency.
Assume new exchange rate is $0.9790 three months later.
 See Table 11.7 for calculations of values of streams of payments

per unit notional amount.

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Currency Swaps (continued)
 Pricing and Valuation of Currency Swaps (continued)
 Dollars fixed for NA of $9.804 million

= $9,804,000(1.01132335) = $9,915,014
 Dollars floating for NA of $9.804 million

= $9,804,000(1.013115) = $9,932,579
 Euros fixed for NA of €10 million

= €10,000,000(1.00883078) = €10,088,308
 Euros floating for NA of €10 million

= €10,000,000(1.0091157) = €10,091,157

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Currency Swaps (continued)
 Pricing and Valuation of Currency Swaps (continued)
 Value of swap to pay € fixed, receive $ fixed

• $9,915,014 – €10,088,308($0.9790/€) = $38,560

 Value of swap to pay € fixed, receive $ floating

• $9,932,579 – €10,088,308($0.9790/€) = $56,125

 Value of swap to pay € floating, receive $ fixed

• $9,915,014 – €10,091,157($0.9790/€) = $35,771

 Value of swap to pay € floating, receive $ floating

• $9,932,579 – €10,091,157($0.9790/€) = $53,336

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Currency Swaps (continued)
 Currency Swap Strategies
 A typical case is a firm borrowing in one currency

and wanting to borrow in another. See Figure 11.7

for Reston-GSI example. Reston could get a better
rate due to its familiarity to GSI and also due to
credit risk.
 Also a currency swap be used to convert a stream of

foreign cash flows. This type of swap would

probably have no exchange of notional amounts.

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Equity Swaps
 Characteristics
 One party pays the return on an equity, the other

pays fixed, floating, or the return on another equity

 Rate of return is paid, so payment can be negative

 Payment is not determined until end of period

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Equity Swaps (continued)
 The Structure of a Typical Equity Swap
 Cash flow to party paying stock and receiving fixed
  Days  
(Fixed rate)   
(Notional amount)  360 or 365  
 
Return on stock over settlement period 
 Example: IVM enters into a swap with FNS to pay
S&P 500 Total Return and receive a fixed rate of

3.45%. The index starts at 2710.55. Payments every
90 days for one year. Net payment will be
  90  
($25,000,000) .0345   Return on stock index over settlement period 
  360  

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Equity Swaps (continued)
 The Structure of a Typical Equity Swap (continued)
 The fixed payment will be

• $25,000,000(.0345)(90/360) = $215,625
 See Table 11.8 for example of payments. The first

equity payment is
 2764.90 
$25,000,000  1  $501,282
 2710.55 
 So the first net payment is IVM pays $285,657.

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Equity Swaps (continued)
 The Structure of a Typical Equity Swap (continued)
 If IVM had received floating, the payoff formula

would be
 Days  
(LIBOR)   
(Notional amount)   360  
 
Return on stock over settlement period 
 If the swap were structured so that IVM pays the

return on one stock index and receives the return on
another, the payoff formula would be
(Notional amount) Return on one stock index - Return on other stock index 


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Equity Swaps (continued)
 Pricing and Valuation of Equity Swaps
 For a swap to pay fixed and receive equity, we replicate as follows:

• Invest $1 in stock
• Issue $1 face value loan with interest at rate R. Pay interest on
each swap settlement date and repay amount at swap
termination date. Interest based on q = days/360.
• Example: Assume payments on days 180 and 360.
– On day 180, stock worth S180/S0. Sell stock and withdraw
S180/S0 – 1
– Owe interest of Rq
– Overall cash flow is S180/S0 – 1 – Rq, which is equivalent
to the first swap payment. $1 is left over. Reinvest in the
stock.

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Equity Swaps (continued)
 Equity Swap Strategies
 Used to synthetically buy or sell stock

 See Figure 11.8 for example.

 Some risks

• default
• tracking error
• cash flow shortages

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 Summary

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 When the swap is initiated, when the swap is
initiated, LIBOR on December 15 determines the
floating payment on March 15.

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