SWAPS: Total Return Swap, Asset Swap and Swaption Jisook Shim Yonsei GSIS

Table of Contents QUICK REVIEW SWAPS SUMMARY Total Return Swaps Index Swaps Asset Swaps Swaptions SUMMARY

QUICK REVIEW A swap is an agreement between two parties to exchange cash flow in the future True/False Whereas a forward contract is equivalent to the exchange of cash flows on several future dates, swaps typically lead to cash flow exchanges taking place on just one future date. Swaps occupy a position of central importance in the derivatives exchange market.

TOTAL RETURN RECEIVER (INVESTOR) 1. TOTAL RETURN SWAPS Asset Total Return TOTAL RETURN PAYER TOTAL RETURN RECEIVER (INVESTOR) Floating-Rate Payments (Example: LIBOR + Fixed Spread) Total return swap let investors to receive all of the cash flow benefits of owning an asset without actually holding the physical asset on their balance sheet By not holding physical asset: Total return swaps make it possible to take a leveraged exposure to a credit Investors can be precluded for tax, political, or other reasons Total return swaps make it possible to short an asset without actually selling the asset

1. TOTAL RETURN SWAPS (cont.) During Swap Coupons from reference asset Total Return Payer Total Return Receiver (Investor) LIBOR + Fixed Spread At Maturity Any increase in the market value of the notional amount of the reference asset Total Return Payer Total Return Receiver (Investor) Any decrease in the market value of the notional amount of the reference asset

2. INDEX SWAPS Total return from Index over interest rate period TOTAL RETURN PAYER TOTAL RETURN RECEIVER (INVESTOR) Floating Interest Rate (Example: LIBOR + Fixed Spread) Index swaps are an efficient alternative to cash by following reasons; Asset managers with small capital can buy a much more diversified portfolio than is possible through the cash market Buying and selling index swaps may be more liquid than trading all of the underlying assets

3. ASSET SWAPS Asset swap is a combination of two transactions: the purchase of an asset, such as a bond or a bank loan, for cash coupled with an interest rate swap Investor buys a fixed-rate bond and then hedge out interest rate risk by swapping the fixed payments to floating The main reason for doing an asset swap: Credit investor can take exposure to the credit quality of a fixed-rate bond without having to take interest rate risk For banks, this has enabled them to match their assets to their liabilities Asset swaps can be used to take advantage of mispricing in the floating rate note market

3. ASSET SWAPS (cont.) Default Step 1. The investor purchases the asset for cash Investor Borrows the Purchase Price Dealer Asset Investor Investor Purchase Price Step 2. The dealer and the investor enter into an interest rate swap Dealer Floating-rate Payments Investor Fixed-rate Payments Result. The Investor has purchased a fixed-rate asset and converted it to a floating-rate asset Fixed-rate Payments Floating-rate Payments Dealer Investor Asset Default Fixed-rate Payments

4. SWAPTIONS Options on swaps It grants the option buyer the right to enter into an interest rate swap at a future date Swaption has the European-type exercise provision The option can only be exercised at the option’s expiration date Two types of swaptions: Payer swaption: the right to enter into an interest rate swap in which the buyer of the option pays a fixed rate and receives a floating rate Receiver swaption: the right to enter into an interest rate swap in which the buyer of the option pays a floating rate and receives a fixed rate

4. SWAPTIONS (cont.) Example: payer swaptions Strike rate: 7% Term: 3 years Swaption expires in 2 years (European-type exercise provision) Exercise the right to enter into a 3-year interest rate swap in which the buyer pays 7% and receives the reference rate Buy a payer swaption 0 year 1 year 2 year

4. SWAPTIONS (cont.) Loan Borrower Counter-party Bank Swap contract LIBOR + Fixed spread Loan Borrower Bank Counter-party 10% 10% Receiver Swaption If the commercial loan borrowers DEFAULT on their obligations or if the commercial loans are PREPAID The bank will enter into a receiver swaption, receiving fixed rate payments of 10% so as to offset the fixed rate it is obligated to pay under the initial swap

FOREIGN EXCHANGE RATE RISK SUMMARY Total Return Swap Index Swap CREDIT RISK Asset Swap FOREIGN EXCHANGE RATE RISK INTEREST RATE RISK Currency Swap Interest Rate Swap Swaption