Swaps Professor Brooks BA /3/08

Chapter 13 – Swaps Back to Forward Contracts Individually designed forward contracts International Swaps and Derivatives Association (ISDA) Provides some standardization of terms Provides basic swap contracts to reduce design costs Swap Facilitator Swap Broker Matches Swap Partners Swap Dealer (Swap Bank) has a portfolio of swap positions – this is usually a Swap Department of a Bank Interest Rate & Currency Exchange Basics

Plain Vanilla Interest Rate Swap Party Number 1 – Pays a fixed rate to bondholders, wants a floating rate Party Number 2 – Pays a floating rate to bondholders, wants a fixed rate Parties “sign” agreement to pay each other’s interest payments Set Notional Amount at $10,000,000 Floating Rate is LIBOR basis points Fixed Rate is 8.0% Term of Contract is 4 years with semi-annual payments

What will happen each six months? The difference in the interest payments will be paid to the other party… At end of six months…LIBOR is 7% Party One “owes” Party Two $10,000,000 x (7% %)/2 = $412,500 Party Two “owes” Party One $10,000,000 x (8%)/2 = $400,000 Party One sends $12,500 to Party One Each pay their bondholders directly: Party One pays $400,000 (net is $412,500), Party Two pays $412,500 (net is $400,000) This continues each six-month period for four years

Continuing with Plain Vanilla LIBOR RATES First Period – 7.0% Second Period – 6.75% Third Period – 7.75% Fourth Period – 7.25% Fifth Period – 7.50% Sixth Period – 6.75% Seventh Period – 6.25% Eighth Period – 6.50% End of Contract PAYMENT Party One pays $12,500 Neither Party Pays Party One pays $50,000 Party One pays $25,000 Party One pays $37,500 Neither Party pays Party Two pays $25,000 Party Two pays $12,500 End of Contract

Problem with these Swaps Counter-Party Risk When current interest rate favors one company (anticipated cash in flow) they will complete their part When current interest rates hurt one company (anticipate cash out flow) they will want to avoid the contract Principal never at risk, only interest payments Only difference of the interest payments at risk not entire interest payment

Interest Rate Swap Company A and Company B Company A rates: fixed at 8%, floating at LIBOR +30 Company B rates: fixed at 9%, floating at LIBOR +80 Company A has absolute advantage Company A and B can “split” the advantage Company B agrees to pay Company A, 8% + 0.5% Company A agrees to pay Company B, LIBOR + 55 Net cost of borrowing is now: Company B Fixed at 8.75% (improves 25 basis) Company A Floating at LIBOR + 5 (improves 25 basis)

Interest Rate Swap -- Continued First part Company A ended up floating rate and Company B ended up with fixed rate Can you have Company A with fixed rate and Company B with floating rate? NO Both companies must borrow in the relative “cheaper” market Can they both have lower fixed? NO Can they both have lower floating? NO

Foreign Currency Swap Current Exchange Rate is $1.44 to €1.0 USA Company has contract in Europe that requires delivery of €1,000,000 every six months for next five years… Choice One – Exchange $ for € at current exchange rate and put in Europe bank at fixed interest rate (say current fixed at 8%) Need to deposit €25,000,000 which takes $36,000,000 Problem…what value is the €25,000,000 at end of five years? Future currency rate will determine…

Foreign Currency Swap To avoid uncertainty of future value of the €25,000,000 Enter Swap with European Company that wants US floating rate investment or fixed rate investment Exchange $36,000,000 for €25,000,000 and agree to “return” principal in five years Deposit “foreign currency” in foreign bank at fixed rate (US Company) and floating or fixed for European country Each period US company gets the needed €1.0 m Each period European company gets $ interest At end of five years return principal at today’s FX rate

Interest Rate Options Caps and Floors Portfolio of call or put options that protect against rising or falling interest rates Each cap option is a European option and expires at “interest” payment time… If rates are above strike price, call is exercised and the call writer pays the interest rate difference Payment = Notional $ x (days/360) x (I – K) I is benchmark interest rate and K is strike rate

Interest Rate Options Example of a caplet Benchmark interest rate is 8.0% Notional borrowed amount is $500,000 Strike interest rate is 7.5% Days between interest payments (and caplet expirations) is 182 Call writer owes $500,000 x (182/360) x (0.08 – 0.075) = $1, If benchmark below 7.5% option expires…

Interest Rate Options Example of a floorlet Benchmark interest rate is 7.0% Notional borrowed amount is $500,000 Strike interest rate is 7.5% Days between interest payments (and floorlet expirations) is 182 Call writer owes $500,000 x (182/360) x (0.075 – 0.070) = $1, If benchmark above 7.5% option expires…

Collar Combination of caplet and floorlet Example – buy the caplet with a strike rate of 8% and sell the floorlet with a strike rate of 6%, proceeds of floorlet offset some of the price of the caplet (match each caplet and floorlet) Notional rate at $1,000,000 Payoff if rate at 8.5% Cost if rate at 6.5%

Swaption Option to get into a swap Payer Swaption – right to pay a fixed rate (and receive a floating rate) aka put swaption Receiver Swaption – right to pay a floating rate (and receive a fixed rate) aka call swaption These are like options on futures At exercise the swap contract starts So, if you have an option on a five year swap, the five years start at exercise not when swaption is purchased

Two Multinational Companies USA Company can borrow in the US at 9% and in England at 10%, has English project with 10% IRR (guaranteed) British Company can borrow in England at 9.0% and in the US at 10.0%, has US project with 10% IRR (guaranteed) US Co. has $10 million dollar project in England, British Co. has $10 million project in US Current exchange rate is $2 to ₤ US Borrows in US – British Borrow in England Swap Project Earnings (avoid exchange rate risk) Agree to return principal at the end…both borrow at lower fixed rate…proof

Foreign Exchange Swap USA Company borrows $10 million at 9% and gives to British Co. and promises to pay British Co. ₤250,000 every six months from project earnings Interest payment every six months is $450,000 but receive $500,000 from British Company Net $50,000 every six months British Company borrows ₤5,000,000 at 9% and gives to USA Co. and promises to pay USA Co. $500,000 every six months Interest payment every six months is ₤225,000 but receives ₤250,000 from USA Company Net ₤25,000 every six months