SwapsSwaps involve exchange of one set of financial obligations with another e.g. fixed rate of interests with floating rate of interest, one currency obligation to another, a floating price of a commodity to fixed price etc.

History of SwapsFirst currency swap was engineered inLondon in 1979, but the next deal structured bySalomon Brothers in 1981 in London involvingorganizations of the stature of World bank andIBM, not only ended the 2-year obscurity butalso gave credibility to the instrument, sonecessary for its extremely fast growth.

History of SwapsFirst Interest rate swap was engineeredin London in 1981and was introduced inthe US in 1982 by Student LoanMarketing Association (Sallie Mae).Commodity swaps were first engineeredin 1986 by Chase Manhattan Bank.

Purpose of a SwapReduce cost of capitalManage riskExploit economies of scaleArbitrage across capital marketsEnter new marketsCreate synthetic instruments

Basic Types of SwapInterest Rate SwapsCurrency SwapsCommodity Swaps

Interest rate swaps and currency swaps are together known as Rate Swaps.

Rate ConventionsSwaps are most often tied to LIBOR.It is quoted actual over 360, as though the year is of 360 days. This raises the effective rate for a period and has compounding effect.Bond equivalent yields are quoted on actual over 365 days.For comparison, adjustments can be made by multiplication of a rate differential by 365/360 or by 360/365.

Cash Market TransactionsSwaps are used in conjunction with following basic cash market transactions:

Obtain actuals from cash marketMake/receive payments to/from cash marketSupply actuals to cash market

Initial Exchange of Notionals(Optional).Counterparty ASwap DealerCounterparty BNotionalsNotionalNotionals Notionals

Periodic Usage or Purchase Payments (Required).Counterparty ASwap DealerCounterparty BFixed PriceFloating PriceFixed Price Floating Price

Re-exchange of Notionals(Optional).Counterparty ASwap DealerCounterparty BNotionalsNotionalsNotionals

Notionals

Interest Rate SwapA, desirous of 10-yr fixed rate debt (available at 11.25% sa) has access to cheap floating rate financing (LIBOR + 50bp).B, desirous of a 10-yr floating rate financing (available at LIBOR) has access to cheaper fixed rate financing (10.25% sa).A dealer available can be a floating rate payer or receiver at LIBOR and a fixed rate payer at 10.40% sa and receiver at 10.50% sa.

Interest Rate Swap.Counterparty ACounterparty BSwap DealerDebt market(Floating Rate)

Debt Market(Fixed Rate)SWAPCASH MARKET TRANSACTIONSPrincipalPrincipal

Interest Rate Swap.Counterparty ACounterparty BSwap DealerDebt market(Floating Rate)

Debt Market(Fixed Rate)SWAPCASH MARKET TRANSACTIONS10.50% (sa)10.40% (sa)6-M LIBOR6-M LIBOR10.25% (sa)6-M LIBOR +50bps

Interest Rate Swap.Counterparty ACounterparty BSwap DealerDebt market(Floating Rate)

Debt Market(Fixed Rate)SWAPCASH MARKET TRANSACTIONSPrincipalPrincipal

Currency SwapA, needing floating rate dollars, can borrow euros at 9.0% fixed and dollars at 1-yr LIBOR floating.B, needing fixed rate euros, can borrow euros at 10.1% fixed and dollars at 1-yr LIBOR floating.Swap dealer can pay 9.45% fixed on euros against dollar LIBOR and dollar LIBOR against 9.55% fixed on euros.

Currency Swap.Counterparty ACounterparty BSwap DealerDebt market(Euro)

Debt Market($)SWAPCASH MARKET TRANSACTIONS9.45% 9.55%LIBORLIBORLIBOR9%

Commodity SwapA crude oil producer wants to fix a price to be received for 5 years on production of 8000 barrels p.m. He agrees to pay average of preceding month price to swap dealer against a receipt of $68.20/barrel.An oil refiner wants to fix the price he pays for oil for 5 years on his average need of 12000 barrels. He agrees to pay $68.40 against market price of $69.50/barrel for an average price of preceding month.

Commodity Swap.Counterparty ACounterparty BSwap DealerSpotOilMarketSWAPCASH MARKET TRANSACTIONS$68.20/barrel $68.40/barrelSpot Price(average)Spot Price(average)Spot PriceSpot PriceActualsActualsOil ProducerRefiner

Why a Swap Dealer?If A and B attempted a swap with each other directly, it would have failed due to different requirements. Swap dealercan be a fixed-rate payer on 4000barrels and till such time he can hedgein futures.

SwaptionWhen a firm doesnt want a swap now but can lock-in the terms of swap now by buying an option on swap called Swaption.

Case Study

B. F. Goodrich - Rabobank

Issues in the caseWhy was the need for swap felt?How could the rate of borrowing be reduced for Goodrich?Describe the structure of the Swap diagrammatically.Comment on the role of financial innovations with reference to the case.

Interest Rate Swap.B.F. GoodrichRabobankMorgan BankUS Bond(Floating Rate)

Eurobond(Fixed Rate)SWAPCASH MARKET TRANSACTIONS11%11%LIBOR-xLIBOR-x11%(10.7%) 3-M LIBOR +50bps

CalculationsCost for B.F.Goodrich:LIBOR + 50bp +11 LIBOR + x = 11.5 +x (i.e. 11.6 to 11.875) as against 12 to 12.5% (a saving of 40 to 60 bps approx.)

Cost for Rabobank:8.75 x as against 10.70%

Morgan Bank gets: one time fees ($125000 + annual fees)