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1、Lecture # 5:,Swaps,A s an agreement between two or more parties to exchange sets of cash flows over a period in the future. The parties that agree to the s known as counter-parties. The cash flows that the counter-parties make are generally tired to the value of debt instruments or to the value of f
2、oreign currencies. Therefore, the two basic kinds of swaps are interest rate swaps and currency swaps., The Swaps Market,- Swaps are custom tailored to the needs of the counter-parties. - The swaps market has virtually no government regulation. - Default risk - Value of Outstanding Swaps ($ Billion
3、of Principal),- Plain Vanilla Swaps Interest rate swaps Currency Swaps - Motivations for swaps,Commercial needs: As an example of prime candidate for an interest rate swaps, consider a typical savings and loan association. Savings and loan associations accept deposits and lend those funds for long-t
4、erm mortgages. Because depositors can withdraw their funds on shot notice deposit rates must adjust to changing interest rate conditions. Most mortgagors wish to borrow at a fixed rate for a long time in US. Is there any interest risk? Can swaps contract help?,Comparative advantage: In many situatio
5、ns, one firm may have better access to the capital market than another firm. For example, a U.S. firm may be able to borrow easily in the U.S., but it might not have such favorable access to the capital market in Germany. Similarly, a German firm may have good borrowing opportunities domestically bu
6、t poor opportunities in the States., Interest Rate Swaps,- Two Parties exchange periodic interest payments over a period. Typically, one partys payments are based on a fixed rate whereas its counterpartys payments are based on a floating rate. Interest payments are computed using a notional principa
7、l.,- Example: Both A and B need to borrow $100 million for 3 years. The financing rates facing them are summarized as follows:,- It is comparatively cheaper for A to use the floating rate debt. For B, fixed rate borrowing will be cheaper. Why? 1. If A desires the floating rate debt and B prefers the
8、 fixed rate debt, there is no need for them to engage in a swap. 2. If A desires the fixed rate debt and B prefers the floating rate debt, A should still borrow floating rate and B borrow fixed rate. They can then enter a s better both parties.,6.3% Company Company | | LIBOR+ A B 6.3% 0.85% LIBOR a.
9、 Company A: Borrows floating rate and enters the above swap. b. Company B: Borrows fixed rate and enters the above swap,- The results Company A: On a semiannual basis, receives (LIBOR-6.3%)*50m from the swap, and pays the floating rate debt service (LIBOR+0.85%)*50m. The net payment is 7.15%*50m, wh
10、ich is less than 7.5%*50m. Company B: On a semiannual basis, receives (6.3%-LIBOR)*50m from the swap, and pays the fixed rate debt service 6.3%*50m. The net payment is LIBOR*50m, which is less than (LIBOR+0.25%)*50m.,- Note: S refers to fixed rate swap. - Swaps through an intermediary 6.4% 6.25% Com
11、pany Swap Company | | LIBOR+ A Dealer B 6.3% 0.85% LIBOR LIBOR,- The results Company A: On a semiannual basis, receives (LIBOR-6.4%)*50m from the swap, and pays the floating rate debt service (LIBOR+0.85%)*50m. The net payment is 7.25%*50m, which is less than 7.5%*50m. Company B: On a semiannual bas
12、is, receives (6.25%-LIBOR)*50m from the swap, and pays the fixed rate debt service 6.3%*50m. The net payment is (LIBOR+0.05%)*50m, which is less than (LIBOR+0.25%)*50m. S: Makes (6.4%-6.25%)*$50m=$75,000,- Pricing Schedules The fixed rate in the s quoted as a certain number of basis points above the
13、 T-note yield. Table: Indication pricing for interest rate swaps at 1:30pm, New York Time on May 11, 1995,- Netting: interest payments are made by one counter-party to the other after netting out the fixed and floating interest payments. Assume: Notional amount = Q; fixed rate payment = k; Floating
14、rate used in time t=Rt-1(LIBOR at time t-1). NET payment at time t: Fixed rate at time t: Fixed-rate payer receives (Rt-1Q-k) and floating-rate payer receives (k-Rt-1Q). The following is a possible scenario of cash flows for the fixed-rate payer under a $100 million, 5-year s 5.6% with semiannual ca
15、sh flow exchanges.,- What is the implication of netting about credit (default risk)? - Pricing interest rate swaps: Set the fixed rate of s that the s a zero value at the time of initiation. This is called par swap. Suppose that payment dates are t1,t2,tn. The value of a s time t, Vt, from the persp
16、ective of the floating-rate payer: Vt=B1t-B2t,B1t: value of fixed-rate bond underlying the s titti+1, B1t= nj=i+1ke-r(t,tj)(tj-t)+Qe-r(t,tn)(tn-t). B2t: value of floating-rate bond underlying the swap. At the floating rate resetting day, i.e., t=t1,t2,tn, immediately after the payment is made, B2t=Q. Why? In between, i.e., titti+1, B2t=(Q+k*)exp-r(t,ti+1)(ti+1-t), where k* is the floating r
