Chapter 16 Swap Markets Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Learning Objectives Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Swaps swap – an agreement between two parties to a series of exchanges of future cash flows there are two basic types of swaps: interest rate swap – an agreement between two parties to finance part or all of each other’s interest payments based upon a specified notion principal amount currency swap – an agreement between two parties to exchange a notional principal amount and interest rate payments for the equivalent in another currency 1981: the first swap – a currency swap was made between World Bank and IBM 1985: the International Swaps and Derivatives Association (ISDA) has become the governing body of the swap market website isda.org Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Growth of the Swap Market Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Potential Swap Scenarios Restructuring debt company A: initially issued a debt at a floating interest and intends to convert it into a fixed interest payment debt company B: initially issued a fixed rate debt and now prefers floating debt it might be easier, cheaper and quicker for A and B to exchange interest rate obligations than to repay the outstanding debt and reissue debt in their preferred forms Hedging interest rate risk the TB rate is currently 9% bank A: lent out £100m at 10% for 5 years, financing this from the issue of 6-month certificates of deposit at TB rate + 60 bps ⇒ spread of 40 bps bank B: raised £100m at 9% and lent out at TB rate + 90 bps ⇒ spread of 90 bps since bank A fears a rise in the TB rate and bank B fears a fall, both will benefit if bank A agrees to pay bank B a fixed 9.8% in return for floating payments the TB rate + 80 bps Reducing the cost of raising finance Chinese company: wishes to raise dollar funds at a floating rate US company: wishes to raise yen funds at a fixed rate in case when Japanese investors are not willing to work with the US companies directly there might be a swap opportunity Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Interest Rate Swap A typical interest rate swap counterparty 1: agrees to pay a fixed interest rate payment at specified dates counterparty 2: agrees to pay a floating rate of interest based upon a reference rate of interest, usual reference rates: LIBOR, Treasury bill rates, certificate of deposit rates, etc. notional principal amount – the pre-specified amount of money upon which a swap agreement is based Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Managing Interest Rate Risk Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Managing Interest Rate Risk Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Interest Rate Swap An absolute advantage swap plain vanilla swap – a simple interest rate swap in which one party swaps a fixed coupon payment for a floating rate payment with another party A comparative advantage swap comparative advantage swap – a swap between two parties in which one of the parties has an absolute advantage at raising funds at both fixed and floating rates of interest but its advantage is greater in one of the markets Keith Pilbeam ©: Finance and Financial Markets 4th Edition

A Comparative Advantage Swap Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Currency Swap British company: wishing to raise $150m for 10 years at a floating rate for the investment in the USA German company: wishing to raise £100m for 10 years at a fixed rate for investment in the UK the spot exchange rate is $1.50/£1 prior to the development of the swap markets such arbitrage opportunities were undertaken by hedging the position in the forward exchange market the UK company would raise funds at floating rates in the UK, convert them into dollars and then use a forward exchange rate to hedge the foreign exchange risk Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Currency Swap Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Role of Intermediary identification of potential swap opportunities arranging swap agreements balancing the transaction between two parties when notional principals differ Party A is interested in £100m Party B is interested in £80m The Intermediary will frequently undertake the difference of £20m meanwhile hedging the position in another market to reduce its risk exposure guarantee of the swap payments, for an appropriate fee, should one of the parties fail to honour its obligations Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Role of Intermediary Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Swap Rates Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Secondary Market There is no formal secondary swap market. The party that wishes to terminate the swap agreement may use the following methods: swap reversal – a deal whereby a party to a swap contract enters a new swap arrangement with a new counterparty that cancels out its arrangements with its original counterparty swap sale – a deal whereby a party to a swap contract pays money to or receives money from another party to take over its obligations buy-back – a deal whereby a party to a futures contract pays or receives a sum of money from the other party to cancel the future obligations inherent in the contract quality spread – the difference between the advantages held by one party at fixed and floating interest rates Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Futures and Swaps Markets exchange-traded futures are of a much shorter duration (1 year or less) the vast majority of swap contracts have a very long duration (5-20 years or more) futures contracts are highly standardized with swap contract the party is able to obtain a highly specific agreement with a time horizon and payment schedule matched closely to its needs futures are highly regulated contracts that come under control of the futures exchange and relevant authorities swap market is fairly lightly regulated the exchange guarantees the obligations should one of the parties default there is the risk that one of the parties will not fulfil its obligations, unless the counterparties ensure the agreement is underwritten by a third party there is an active secondary market so that obligations can be easily terminated by buying /selling the contract to another party there is a far less active secondary market due to a non-standardized nature of swaps – need to use reversal trade, buy-back or swap sale Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Reasons for the Existence of Swaps the fundamental reason for the existence of the swap market is that it is transactionally efficient and enables firms to exploit arbitrage opportunities resulting from imperfections in the capital market differing time horizons of floating and fixed markets floating rates market – short-run, fixed rates markets – long-run home country preference it might be cheaper to raise funds in domestic currency (domestic investors may prefer to invest with domestic companies for the reason of information advantages) regulatory considerations there may be regulations about the holding of debt that mean more domestic debt is held by domestic holders - this enables domestic firms to issue debt at lower rates differing preferences between banks and the rest of the capital market lower-grade companies tend to have a comparative advantage in the bank loan market, while higher-grade companies tend to have a comparative advantage in the capital market Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Innovations there are numerous types of innovative swap contracts aimed at meeting specific customer needs zero coupon swap – a swap on which a fixed-rate payer makes one final lump sum interest payment, while the floating-rate payer makes regular periodic payments at a higher rate forward rate swap – an agreement between two parties to do a swap which will take place at a predetermined date basis swap – a swap in which both parties exchange floating interest rate payments, but the base contract is different callable swap – a swap which allows one of the parties to extend the swap contract for a specified period putable swap – a swap which gives one of the parties the right to terminate the swap contract prior to maturity Keith Pilbeam ©: Finance and Financial Markets 4th Edition