Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 1 Chapter 12: Swaps Markets are an evolving ecology. New risks arise all the time. Andrew Lo CFA Magazine, March-April, 2004, p. 31

Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 2 Important Concepts in Chapter 12 n The concept of a swap n Different types of swaps, based on underlying currency, interest rate, or equity

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 3 n Definition of a swap n Four types of swaps u Currency u Interest rate u Equity u Commodity n Characteristics of swaps u No cash up front u Notional principal (a measure of the size of a swap or derivative stated in units of currency on which the payments are calculated) u Settlement date, settlement period u Credit risk u Dealer market n See Figure 12.1, p. 409 for growth in world-wide notional principal Figure 12.1, p. 409Figure 12.1, p. 409

Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 4 Definition of a swap n Swaps is a financial derivative in which 2 parties make series of payments to each other at specific dates. n While a forward contract is a single payment, a swap is a series of payments. u E.g. In some cases, a party would like to make a series of purchase, instead of a single purchase, from the other at fixed price at various date (different dates). n Exclusively customized, over-the-counter instruments.

Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 5 Swaps & Forward contracts (Similarities) n Swaps are similar to forward contracts -fixed payment or receive a floating payment at a future date. n Both swaps and forward contracts require no up­front payments, and both are subject to default risk. Thus, swaps have zero value at the start

Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 6 Swaps Vs. Forward contracts n Swaps u Both sides of the first payment are known. Also, for a swap, all of the fixed payments are the same. n Forward contracts u each contract would be priced separately and would have different fixed rates

Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 7 Types of Swaps u Interest rate Swaps F Series of interest payments between two parties. F The two parties agree to exchange a series of interest payments in the same currency at the various settlement dates. F more widely used than currency and equity swaps, because nearly all businesses face some form of interest rate risk. F A plain vanilla swap (a.k.a. vanilla swap) is a swap in which on party pays a fixed rate & the other pays a floating rate

Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 8 Interest rate Swaps F Interest rate swaps are the primary means of managing that risk (interest rates risk). F A company will typically use interest rate swaps to limit, or manage, its exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate. F Widely used by corporations to manage interest rate risk.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 9 Interest Rate Swaps (continued) u Interest Rate Swap Strategies F See Figure 12.5, p. 421 for example of converting floating-rate loan into fixed-rate loan Figure 12.5, p. 421Figure 12.5, p. 421 F Other types of swaps Index amortizing swapsIndex amortizing swaps Diff swapsDiff swaps Constant maturity swapsConstant maturity swaps

Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 10 Types of swaps Currency Swaps u Involves the exchange of principal and interest in one currency for the same in another currency. u E.g. Supposed Malaysian based company needs to acquired Japanese Yen and a Japanese based company needs to acquire Malaysian Ringgit. These 2 companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and maturity date of exchange. u Often combined with interest rate swaps.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 11 Currency Swaps (continued) u Currency Swap Strategies F A typical case is a firm borrowing in one currency and wanting to borrow in another. See Figure 12.8, p. 432 for Reston-GSI example. Reston could get a better rate due to its familiarity to GSI and also due to credit risk. Figure 12.8, p. 432Figure 12.8, p. 432 F Also a currency swap be used to convert a stream of foreign cash flows. This type of swap would probably have no exchange of notional principals.

Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 12 Types of Swaps u Equity F Equity swaps are exchanges of cash flows in which at least one of the indices is an equity index. F An index equity is a measure of the performance of an individual stock or a basket of stocks. F Common equity indices with which the general investor is probably familiar include the S&P’s 500 Index, and Dow Jones Industrial Average.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 13 Equity Swaps u Characteristics F One party pays the return on an equity, the other pays fixed, floating, or the return on another equity F Rate of return is paid, so payment can be negative F Payment is not determined until end of period

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 14 Equity Swaps (continued) u Equity Swap Strategies F Used to synthetically buy or sell stock F See Figure 12.9, p. 440 for example. Figure 12.9, p. 440Figure 12.9, p. 440 F Some risks defaultdefault tracking errortracking error cash flow shortagescash flow shortages

Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 15 Types of Swaps n Commodity Swaps u A swaps where exchanged cash flows are dependent on the price of an underlying commodity. u Usually use to hedge against the price of commodity. u The vast majority of commodity swaps involve oil.

Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 12: 16 Some Final Words About Swaps u Similarities to forwards and futures u Offsetting swaps F Go back to dealer F Offset with another counterparty F Forward contract or option on the swap

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