7.2 Nature of Swaps A swap is an agreement to exchange cash
flows at specified future times according to certain specified
rules
Slide 3
7.3 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
Slide 4
7.4 ---------Millions of Dollars--------- LIBORFLOATINGFIXEDNet
DateRateCash Flow Mar.1, 19984.2% Sept. 1, 19984.8%+2.102.500.40
Mar.1, 19995.3%+2.402.500.10 Sept. 1, 19995.5%+2.652.50+0.15 Mar.1,
20005.6%+2.752.50+0.25 Sept. 1, 20005.9%+2.802.50+0.30 Mar.1,
20016.4%+2.952.50+0.45 Cash Flows to Microsoft (See Table 7.1)
Slide 5
7.5 Typical Uses of an Interest Rate Swap Converting a
liability from fixed rate to floating rate floating rate to fixed
rate Converting an investment from fixed rate to floating rate
floating rate to fixed rate
Slide 6
7.6 Intel and Microsoft (MS) Transform a Liability (Figure 7.2)
IntelMS LIBOR 5% LIBOR+0.1% 5.2%
Slide 7
7.7 Financial Institution is Involved (Figure 7.4) F.I. LIBOR
LIBOR+0.1% 4.985% 5.015% 5.2% Intel MS Dealer spread =.03% evenly
split
Slide 8
7.8 Intel and Microsoft (MS) Transform an Asset (Figure 7.3)
Intel MS LIBOR 5% LIBOR-0.20% 4.7%
Slide 9
7.9 Financial Institution is Involved (See Figure 7.5) Intel
F.I.MS LIBOR 4.7% 5.015%4.985% LIBOR-0.20% Dealer spread =.03
%
Slide 10
7.10 The Comparative Advantage Argument (Table 7.4) AAACorp
wants to borrow floating BBBCorp wants to borrow fixed
FixedFloating AAACorp 4.0%6-month LIBOR + 0.30% BBBCorp 5.2%6-month
LIBOR + 1.00%
Slide 11
7.11 The Comparative Advantage Argument AAACorp has absolute
advantage in both markets But a comparative advantage in fixed
BBBCorp has comparative advantage in floating If AAA borrows fixed,
the gain is 1.2% If BBB borrows floating, the gain is reduced by.7%
Therefore, we have a net gain of 1.2 -.7 =.5% If the gain is split
evenly, we have a gain per party of: G = (1.2 -.7)/2 =.25%
Slide 12
7.12 Swap Design Design the swap so AAAs borrowing rate equals
the comparative disadvantage (CD) rate minus the gain: LIBOR +.3
-.25 Do the same thing for BBB BBBs rate with swap: 5.2 -.25 = 4.95
Now, draw the diagram
Slide 13
7.13 The Swap (Figure 7.6) AAA BBB LIBOR LIBOR+1% 3.95% 4% The
floating rate leg should be LIBOR
Slide 14
7.14 Swap Design with FI Adjust swap gain for dealer spread
Suppose dealer spread =.04% Then gain: G = (1.2 -.7 -.04)/2 =.23%
AAAs rate with swap: LIBOR +.3 -.23 = LIBOR +.07 BBBs rate with
swap: 5.2 -.23 = 4.97% Draw swap diagram
Slide 15
7.15 The Swap when a Financial Institution is Involved (Figure
7.7) AAA F.I.BBB 4% LIBOR LIBOR+1% 3.93% 3.97% Check that dealer
spread =.04%
Slide 16
7.16 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+0.3% and LIBOR+1% rates
available in the floating rate market are six- month rates BBBCorps
fixed rate depends on the spread above LIBOR it borrows at in the
future
Slide 17
7.17 Valuation of an Interest Rate Swap Interest rate swaps can
be valued as the difference between the value of a fixed-rate bond
and the value of a floating-rate bond
Slide 18
7.18 Valuation in Terms of Bonds 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
Slide 19
7.19 An Example of a Currency Swap An agreement to pay 5% on a
sterling principal of 10,000,000 & receive 6% on a US$
principal of $18,000,000 every year for 5 years
Slide 20
7.20 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
Slide 21
7.21 Three Cash Flow Components t = 0: exchange principal based
upon current exchange rates Pay: $18 M Rcv: 10 M t = 1, 2, 3, 4, 5:
Pay:.05x10 = .5 M Rcv:.06x18 = $1.08 M t = 5: Pay: 10 M Rcv: $ 18
M
7.23 Typical Uses of a Currency Swap Conversion from a
liability in one currency to a liability in another currency
Conversion from an investment in one currency to an investment in
another currency
Slide 24
7.24 Comparative Advantage Arguments for Currency Swaps (Table
7.6) General Electric wants to borrow AUD Qantas wants to borrow
USD USDAUD General Motors 5.0% 7.6% Qantas 7.0% 8.0%
Slide 25
7.25 Comparative Advantage GE has absolute advantage in both
markets But GE has comparative advantage in dollars Qantas has
comparative advantage in Australian dollars So GE should borrow
dollars and Qantas Australian dollars Then swap cash flows to earn
gain from comparative advantage
Slide 26
7.26 Comparative Advantage Gain per party: G = (2 -.4)/2 =.8%
GEs rate with swap: 7.6 -.8 = AUD 6.8% Qantas rate with swap: 7 -.8
= USD 6.2%
7.31 Valuation of Currency Swaps Like interest rate swaps,
currency swaps can be valued either as the difference between 2
bonds or as a portfolio of forward contracts
Slide 32
7.32 Swaps & Forwards A swap can be regarded as a
convenient way of packaging forward contracts The plain vanilla
interest rate swap in our example consisted of 6 Fraps The fixed
for fixed currency swap in our example consisted of a cash
transaction & 5 forward contracts
Slide 33
7.33 Swaps & Forwards (continued) The value of the swap is
the sum of the values of the forward contracts underlying the swap
Swaps are normally at the money initially This means that it costs
nothing to enter into a swap It does not mean that each forward
contract underlying a swap is at the money initially
Slide 34
7.34 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
