Swaps and their Applications

1
Swaps and their Applications
2
Overview of Swaps

• Swaps Obligates two parties to exchange some
  specified cash flows at specified intervals over
  a specified time period. Like futures contracts,
  swaps can be viewed as a portfolio of forward
  contracts.
• Key Features
• Credit risk is two-sided but a swap is less risky
  than a forward (and more risky than futures)
  because a swap reduces the performance period
  (the time interval between cash payments) but
  does not require posting a margin.
• Swaps can be tailored exactly to customer needs
  and can be arranged for longer time periods than
  futures and forwards (e.g., 1-5 years vs. 1-2
  years for forwards/futures).

3
Basic Components of a Swap Contract

• Swaps can be created for all types of financial
  assets and commodities.
• Swaps have experienced explosive growth since the
  early 1980s due to the ability to custom-tailor
  payoffs over relatively long time periods.
• Notional Principal is used to define the
  magnitude of cash flows but this principal is
  never exchanged.
• Payments are netted at pre-specified settlement
  dates over the life of the swap.
• A difference check is sent to one of the two
  parties at each settlement date (reduces credit
  risk).

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Types of Swaps

• Interest Rate Swaps The most common swap is
  based on swapping fixed versus floating interest
  payments. Also, can create basis swaps and
  cross-currency swaps.
• Currency Swaps Enables two parties to exchange
  currencies at pre-specified dates over the life
  of the swap.
• Commodity Swaps Can receive or pay floating or
  fixed prices for commodities such as oil and
  natural gas.
• Equity Swaps Can exchange the return on a stock
  (or stock index) for the return on another asset
  (e.g., LIBOR).
• Credit Default Swaps Enables to exchange cash
  flows depending on changes in a borrowers credit
  rating.

5
Example of Motivation for Swaps

• Swaps can allow both parties to achieve lower
  financing costs.
• Example
• AAA can borrow at fixed rate (10.8) and swap
  with BBB in order to pay floating rate (L-0.1).
  Both parties can then split the 70 bps savings
  (120-50 bps).

Borrower AAA BBB
Fixed Rate 10.8 12.0
Floating Rate LIBOR 0.25 LIBOR 0.75
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Alternative Swap Example (Hi / AAA swaps
floating for fixed rate)

• Reduce borrowing costs by using interest rate
  swaps.
• Example Two firms with different credit
  ratings, Hi and Lo
• Hi can borrow fixed at 11.0 and floating at
  LIBOR 1.0.
• Lo can borrow fixed at 11.4 and floating at
  LIBOR 1.5.

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Hi wants fixed rate, but it will issue floating
and swap with Lo. Lo wants floating rate, but
it will issue fixed and swap with Hi. Lo also
makes side payment of 0.45 to Hi.
Hi Lo
CF to lender -(LIBOR1) -11.40
CF Hi to Lo -11.40 11.40
CF Lo to Hi (LIBOR1) -(LIBOR1)
CF Lo to Hi 0.45 -0.45
Net CF -10.95 -(LIBOR1.45)
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Rationales for why Swap Savings Exist

• Comparative Advantage predicts savings should
  disappear (but they dont!).
• Under-priced Credit Risk again, predicts
  savings disappear as market corrects
  under-pricing.
• Different Cash Flows interest rate swaps dont
  have call provisions, so savings are really the
  cost of the issuers option to call fixed rate
  debt (most plausible reason).
• Different Information Sets insiders can signal
  their beliefs about the true value of the firm.

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Rationales for why Swap Savings Exist (cont.)

• Different Taxation and Regulation can explain
  certain transactions but should disappear as
  governments close loopholes.
• Exposure Management more firms are actively
  managing their financial price risks and
  therefore swaps have grown in line with this
  trend.
• Synthetic Instruments as more issuers create
  synthetic instruments (or hybrids), more swaps
  are needed.
• Liquidity lower B-A spreads attract more
  investors and improves the liquidity of the
  market.

10
Pricing and Valuing a Swap

• A Swap can be decomposed into a portfolio of
  forward contracts (or short term loans).
• At origination, both types of loans/forwards
  (fixed and floating rate) have an E(NPV) 0.
• A swap is a combination of long position in one
  type of loan (e.g., long a fixed rate) and a
  short position in the other type (short a
  floating rate).
• Three yield curves (spot zero-coupon, forward
  zero-coupon, and spot par bond) are used to price
  the expected cash flows from a swap.

11
Applications of Swaps

• Types of Users
• Non-financial Corporations
• Financial Companies (CBs, IBs, Brokers,
  Insurance)
• Institutional Investors (Pension funds, Mutual
  funds)
• Governments (Federal and Municipal)
• Usually used to Modify Debt Obligations
• Match Interest Sensitivity of Assets
• Reduce Funding Costs
• Enhance Yield on Investments
• Increase Debt Capacity
• Protect Value of Investments from Interest Rate
  Risk

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Applications of Swaps (cont.)

• Also used to Modify Cash Flows
• Reduce Volatility of CFs to IR, FX, Commodity,
  Equity Price Movements
• Hedge on Inflows (Income, Receivables)
• Hedge on Outflows (Cost of Goods Sold, Operating
  Expenses)
• Macro Hedge of Both Inflows and Outflows (e.g.,
  A/L Mgmt.)
• Can also be used to Create Synthetic Instruments
• Inverse Floating Rate Notes
• Adjustable-rate Preferred Stock
• Synthesize Long-Dated Forward Contracts (can be
  cheaper)

13
FX Rate Risk and Swaps

• Typical Usage
• Firm borrows in one currency where interest rates
  are lower and then swaps cash flows into
  home/base currency.
• Hedge transaction exposures rather than macro
  hedges.
• Common Examples
• Company managing Foreign Inflows or Outflows
  (e.g., Import/Export business).
• Governments borrowing in international capital
  markets.
• To access long-term fixed rate capital in
  exotic currencies (e.g., McDonalds borrowing in
  New Zealand).

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Credit Default Swaps Infinite Leverage

• Like an insurance contract that pays in the event
  of default.
• FASB requires mark-to-market valuation.
• Collateral Call - Protection Buyers can call for
  partial payment if default event is likely.
  Determined by mark-to-market value.

Protection Seller
Protection Buyer
Premium Payments

• Does not usually own reference asset
• Going long
• Benefits when reference asset price INCREASES,
  max at Par

• Tends to own reference asset
• Hedging or going short
• Benefits when reference asset price DECREASES

Payment upon Default of Reference Asset
Reference Asset can be a MBS, CDO, Bond, or Loan