CH 07 Hull Fundamentals 8 The D

Swaps
Chapter 7
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright John C. Hull1 2013
Nature of Swaps
A swap is an agreement to
exchange cash flows at specified
future times according to certain
specified rules
Options, Futures, and Other Derivatives, 8th Ed, Ch 7, Copyright John C. Hull22013
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 that
could occur (Day count conventions
are not considered)
Cash Flows to Microsoft

(See Table 7.1, page 160
---------Millions of Dollars--------LIBOR
FLOATING
FIXED
Net
Date
Rate
Cash Flow Cash Flow Cash Flow
Mar.5, 2013
4.2%
Sept. 5, 2013
4.8%
+2.10
2.50
0.40
Mar.5, 2014
5.3%
+2.40
2.50
0.10
Sept. 5, 2014
5.5%
+2.65
2.50
+0.15
Mar.5, 2015
5.6%
+2.75
2.50
+0.25
Sept. 5, 2015
5.9%
+2.80
2.50
+0.30
Mar.5, 2016
6.4%
+2.95
2.50
+0.45
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
Intel and Microsoft (MS)

Transform a Liability
(Figure 7.2, page 161)
5%
5.2%
Intel
MS
LIBOR+0.1%
LIBOR
Financial Institution is Involved

4.985%
5.2%
Intel
5.015%
F.I.
MS
LIBOR+0.1%
LIBOR
LIBOR
Intel and Microsoft (MS)

Transform an Asset
5%
4.7%
Intel
MS
LIBOR0.2%
LIBOR
Financial Institution is Involved

(See Figure 7.5, page 163)
4.985%
5.015%
F.I.
Intel
MS
LIBOR0.2%
LIBOR
LIBOR
4.7
%
Quotes By a Swap Market Maker

(Table 7.3, page 164)
Maturity
2 years
Bid (%)
6.03
Offer (%)
6.06
Swap Rate (%)

6.045
3 years
6.21
6.24
6.225
4 years
6.35
6.39
6.370
5 years
6.47
6.51
6.490
7 years
6.65
6.68
6.665
10 years
6.83
6.87
6.850
2013
Day Count
A
day count convention is specified for for

fixed and floating payment
For example, LIBOR is likely to be
actual/360 in the US because LIBOR is a
money market rate
2013
Confirmations
Confirmations
specify the terms of a
transaction
The International Swaps and Derivatives
has developed Master Agreements that
can be used to cover all agreements
between two counterparties
Central clearing is used for most standard
swaps
2013
The Comparative Advantage

Argument (Table 7.4, page 166)
AAACorp wants to borrow floating
BBBCorp wants to borrow fixed
Fixed
Floating
AAACorp
4.00%
6-month LIBOR 0.1%
BBBCorp
5.20%
6-month LIBOR + 0.6%
2013
The Swap (Figure 7.6, page 167)

4.35%
4%
AAACorp
BBBCorp
LIBOR+0.6%
LIBOR
2013
The Swap when a Financial

Institution is Involved
4.33%
4.37%
4%
AAA
F.I.
BBB
LIBOR+0.6%
LIBOR
LIBOR
2013
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 LIBOR0.1% and LIBOR+0.6% rates
available in the floating rate market are sixmonth rates
BBBCorps fixed rate depends on the spread
above LIBOR it borrows at in the future
2013
The Nature of Swap Rates

Six-month LIBOR is a short-term AA
borrowing rate
The 5-year swap rate has a risk
corresponding to the situation where 10 sixmonth loans are made to AA borrowers at
LIBOR
This is because the lender can enter into a
swap where income from the LIBOR loans is
exchanged for the 5-year swap rate
2013
Overnight Indexed Swaps

Fixed rate for a period is exchanged for the
geometric average of the overnight rates
Should the OIS rate equal the LIBOR rate? A
bank can
Borrow $100 million in the overnight market, rolling

forward for 3 months
Enter into an OIS swap to convert this to the 3month OIS rate
Lend the funds to another bank at LIBOR for 3
months
2013
Overnight Indexed Swaps continued
...but it bears the credit risk of another bank in this

arrangement
The excess of LIBOR over the OIS rate is the
LIBOR-OIS spread. It is usually about 10 basis
points but spiked at an all time high of 364 basis
points in October 2008
2013
OIS vs LIBOR discounting

Traditionally
LIBOR rates (and swap rates

determined from swaps where LIBOR is
exchanged for fixed) have been used as riskfree rates when derivatives are valued
Most market participants now use the OIS
rate as the discount rate when collateralized
deals are valued, but continue to use LIBOR
rates for discounting cash flows in noncollateralized deals
2013
Using Swap Rates to Bootstrap the

LIBOR/Swap Zero Curve when
LIBOR discounting is used
Consider a new swap where the fixed rate is the swap

rate
When principals are added to both sides on the final
payment date the swap is the exchange of a fixed rate
bond for a floating rate bond
The floating-rate rate bond is worth par. The swap is
worth zero. The fixed-rate bond must therefore also be
worth par
This shows that swap rates define par yield bonds that
can be used to bootstrap the LIBOR (or LIBOR/swap)
zero curve
2013
Example of Bootstrapping the

LIBOR/Swap Curve (Example 7.3, page 173)
6-month, 12-month, and 18-month
LIBOR/swap rates are 4%, 4.5%, and 4.8%
with continuous compounding.
Two-year swap rate is 5% (semi-annual)
2.5e 0.040.5 2.5e 0.0451.0 2.5e 0.0481.5 102.5e 2 R 100
The 2-year LIBOR/swap rate, R, is 4.953%
2013
Valuation of an Interest Rate

Swap
Initially
interest rate swaps are worth

close to zero
At later times they can be valued as a
portfolio of forward rate agreements
(FRAs)
2013
Example
Receive six-month LIBOR, pay 3% (s.a.
compounding) on a principal of $100 million
Remaining life 1.25 years
LIBOR rates for 3-months, 9-months and 15months are 2.8%, 3.2%, and 3.4% (cont comp)
6-month LIBOR on last payment date was 2.9%
(s.a. compounding)
2013
Valuation Assuming LIBOR

Discounting
Each
exchange of payments in an interest

rate swap is an FRA
The FRAs can be valued on the
assumption that todays forward rates are
realized
The forward rates can be calculated
directly from the LIBOR/swap zero curve
2013
Forward Rates
The
forward rates with semiannual

compounding are
3.429% for the 3 to 9 month period
3.734% for the 9 to 15 month period
2013
Valuation of Example Using FRAs

and LIBOR discounting (Example 7.2 ,
page 172)
Time
Fixed
cash flow
Floating
cash flow
Net Cash
Flow
Disc
factor
PV
Bfl
0.25
-1.5
+1.4500
-0.0500
0.9930
-0.0497
0.75
-1.5
+1.7145
+0.2145
0.9763
+0.2094
1.25
-1.5
+1.8672
+0.3672
0.9584
+0.3519
Total
+0.5117
2013
Valuation in Terms of Bonds

using LIBOR discounting
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
2013
Value of Floating Rate Bond

(L=Principal)
Value = PV
of L+k* at t*
Value =
L+k*
0
Valuation
Date
Value = L
t*
First Pmt
Date
Floating
Pmt =k*
Second
Pmt Date
Maturity
Date
2013
Example (Example 7.6, page 177)

Time
Bfix cash
flow
Bfl cash
flow
Disc
factor
PV
Bfix
PV
Bfl
0.25
1.5000 101.4500
0.9930
1.4895 100.7423
0.75
1.5000
0.9763
1.4644
1.25
101.5000
0.9584
97.2766
Total
100.2306 100.7423
Swap value = 100.7423 100.2306 = 0.5117
2013
Valuation of Swaps Using OIS

discounting
Zero
rates are bootstrapped from OIS

rates (This is similar to the way the
LIBOR/swap zero curve is produced)
Forward LIBOR rates are then calculated
so that so that swaps entered into at the
current swap rate are worth zero (See
Example 7.5, page 176)
2013
Valuation of Swaps Using OIS

discounting continued
The
swap is valued by assuming that

forward LIBOR is realized and discounting
at the OIS rate
There is no simple way of valuing the
swap in terms of bonds
2013
An Example of a Fixed-for-Fixed
Currency Swap
An agreement to pay 5% on a sterling
principal of 10,000,000 & receive 6%
on a US$ principal of $15,000,000
every year for 5 years
2013
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
2013
The Cash Flows (Table 7.5, page 180)

Date
Dollar Cash Flows Sterling cash flow

(millions)
(millions)
Feb 1, 2011
-15.00
+10.00
Feb 1, 2012
+0.90
0.50
Feb 1, 2012
+0.90
0.50
Feb 1, 2014
+0.90
0.50
Feb 1, 2015
+0.90
0.50
Feb 1, 2016
+15.90
10.50
2013
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
2013
Comparative Advantage May Be

Real Because of Taxes
General Electric wants to borrow AUD
Quantas wants to borrow USD
Cost after adjusting for the differential
impact of taxes
USD
AUD
General Electric
5.0%
7.6%
Quantas
7.0%
8.0%
2013
Valuation of Fixed-for-Fixed
Currency Swaps
Fixed for fixed currency swaps can
be valued either as the difference
between 2 bonds or as a portfolio of
forward contracts
2013
Example (pages 182-184)

All Japanese LIBOR/swap rates are 4%
All USD LIBOR/swap rates are 9%
5% is received in yen; 8% is paid in dollars.
Payments are made annually
Principals are $10 million and 1,200 million yen
Swap will last for 3 more years
Current exchange rate is 110 yen per dollar
2013
Valuation in Terms of Bonds

(Example 7.7, page 183)
Time
Cash Flows ($)
PV ($)
Cash flows (yen)
PV (yen)
0.8
0.7311
60
57.65
0.8
0.6682
60
55.39
0.8
0.6107
60
53.22
10.0
7.6338
1,200
1,064.30
Total
9.6439
Value = 1230.55/1109.6439 = 1.5430
2013
1,230.55
Valuation in Terms of Forwards

(Example 7.8, page 184)
Time
$ cash
flow
Yen cash
flow
Forward
Exch rate
Yen cash
flow in $
Net
Cash
Flow
Present
value
-0.8
60
0.009557
0.5734
-0.2266
-0.2071
-0.8
60
0.010047
0.6028
-0.1972
-0.1647
-0.8
60
0.010562
0.6337
-0.1663
-0.1269
-10.0
1200
0.010562
12.6746
+2.6746
2.0417
Total
2013
1.5430
Other Currency Swaps

Fixed-for-floating:
equivalent to a fixed-forfixed currency swap plus a fixed for

floating interest rate swap
Floating-forfloating: equivalent to a fixedfor-fixed currency swap plus two floating
interest rate swaps
2013
Swaps & Forwards

A
swap can be regarded as a

convenient way of packaging forward
contracts
When a swap is initiated the swap has
zero value, but typically some forwards
have a positive value and some have a
negative value
2013
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
Some swaps are more likely to lead to credit risk
exposure than others
What is the situation if early forward rates have a
positive value?
What is the situation when the early forward rates have
a negative value?
2013
Credit Default Swaps: A Quick

First Look
Notional principal (e.g. $100 million) and
maturity (e.g. 5 yrs) specified
Protection buyer pays a fixed rate (e.g. 150 bp)
on the notional principal (the CDS spread)
If the reference entity (a country or company)
defaults protection seller buys bonds issued by
the reference entity for their face value and the
spread payments stop. Total face value of bonds
bought equals notional principal
2013
Other Types of Swaps

Amortizing/
step up
Compounding swap
Constant maturity swap
LIBOR-in-arrears swap
Accrual swap
Equity swap
2013
Other Types of Swaps continued

Cross
currency interest rate swap

Floating-for-floating currency swap
Diff swap
Commodity swap
Variance swap
2013

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CH 07 Hull Fundamentals 8 The D

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Swaps

An Example of a Plain Vanilla

agreement by Microsoft to receive

Cash Flows to Microsoft

Cash Flow Cash Flow Cash Flow

Intel and Microsoft (MS)

Financial Institution is Involved

Intel and Microsoft (MS)

Financial Institution is Involved

Quotes By a Swap Market Maker

Swap Rate (%)

day count convention is specified for for

specify the terms of a

The Comparative Advantage

6-month LIBOR 0.1%

6-month LIBOR + 0.6%

The Swap (Figure 7.6, page 167)

The Swap when a Financial

Criticism of the Comparative

The Nature of Swap Rates

Overnight Indexed Swaps

Borrow $100 million in the overnight market, rolling

Overnight Indexed Swaps continued

...but it bears the credit risk of another bank in this

OIS vs LIBOR discounting

LIBOR rates (and swap rates

Using Swap Rates to Bootstrap the

Consider a new swap where the fixed rate is the swap

Example of Bootstrapping the

2.5e 0.040.5 2.5e 0.0451.0 2.5e 0.0481.5 102.5e 2 R 100

The 2-year LIBOR/swap rate, R, is 4.953%

Valuation of an Interest Rate

interest rate swaps are worth

Valuation Assuming LIBOR

exchange of payments in an interest

forward rates with semiannual

Valuation of Example Using FRAs

Valuation in Terms of Bonds

fixed rate bond is valued in the usual

Value of Floating Rate Bond

Example (Example 7.6, page 177)

Swap value = 100.7423 100.2306 = 0.5117

Valuation of Swaps Using OIS

rates are bootstrapped from OIS

Valuation of Swaps Using OIS

swap is valued by assuming that

an interest rate swap the

The Cash Flows (Table 7.5, page 180)

Dollar Cash Flows Sterling cash flow

Conversion from a liability in one currency

Conversion from an investment in one

Comparative Advantage May Be

Example (pages 182-184)

Valuation in Terms of Bonds

Cash Flows ($)

Cash flows (yen)

Value = 1230.55/1109.6439 = 1.5430

Valuation in Terms of Forwards

Other Currency Swaps

equivalent to a fixed-forfixed currency swap plus a fixed for

Swaps & Forwards

swap can be regarded as a

A swap is worth zero to a company initially