Swaps and their Applications

2 Overview of Swaps Swaps – Obligates two parties to exchange some specified cash flows at specified intervals over a specified time period. Like futures contracts, swaps can be viewed as a portfolio of forward contracts. Swaps – Obligates two parties to exchange some specified cash flows at specified intervals over a specified time period. Like futures contracts, swaps can be viewed as a portfolio of forward contracts. Key Features: Key Features: Credit risk is two-sided but a swap is less risky than a forward (and more risky than futures) because a swap reduces the “performance period” (the time interval between cash payments) but does not require posting a margin. Credit risk is two-sided but a swap is less risky than a forward (and more risky than futures) because a swap reduces the “performance period” (the time interval between cash payments) but does not require posting a margin. Swaps can be tailored exactly to customer needs and can be arranged for longer time periods than futures and forwards (e.g., 1-5 years vs. 1-2 years for forwards/futures). Swaps can be tailored exactly to customer needs and can be arranged for longer time periods than futures and forwards (e.g., 1-5 years vs. 1-2 years for forwards/futures).

3 Basic Components of a Swap Contract Swaps can be created for all types of financial assets and commodities. Swaps can be created for all types of financial assets and commodities. Swaps have experienced explosive growth since the early 1980s due to the ability to custom-tailor payoffs over relatively long time periods. Swaps have experienced explosive growth since the early 1980s due to the ability to custom-tailor payoffs over relatively long time periods. Notional Principal is used to define the magnitude of cash flows but this principal is never exchanged. Notional Principal is used to define the magnitude of cash flows but this principal is never exchanged. Payments are netted at pre-specified settlement dates over the life of the swap. Payments are netted at pre-specified settlement dates over the life of the swap. A difference check is sent to one of the two parties at each settlement date (reduces credit risk). A difference check is sent to one of the two parties at each settlement date (reduces credit risk).

4 Types of Swaps Interest Rate Swaps: The most common swap is based on swapping fixed versus floating interest payments. Also, can create basis swaps and cross-currency swaps. Interest Rate Swaps: The most common swap is based on swapping fixed versus floating interest payments. Also, can create basis swaps and cross-currency swaps. Currency Swaps: Enables two parties to exchange currencies at pre-specified dates over the life of the swap. Currency Swaps: Enables two parties to exchange currencies at pre-specified dates over the life of the swap. Commodity Swaps: Can receive or pay floating or fixed prices for commodities such as oil and natural gas. Commodity Swaps: Can receive or pay floating or fixed prices for commodities such as oil and natural gas. Equity Swaps: Can exchange the return on a stock (or stock index) for the return on another asset (e.g., LIBOR). Equity Swaps: Can exchange the return on a stock (or stock index) for the return on another asset (e.g., LIBOR). Credit Default Swaps: Enables to exchange cash flows depending on changes in a borrower’s credit rating. Credit Default Swaps: Enables to exchange cash flows depending on changes in a borrower’s credit rating.

5 Example of Motivation for Swaps Swaps can allow both parties to achieve lower financing costs. Swaps can allow both parties to achieve lower financing costs. Example: Example: AAA can borrow at fixed rate (10.8%) and swap with BBB in order to pay floating rate (L-0.1%). Both parties can then split the 70 bps savings ( bps). AAA can borrow at fixed rate (10.8%) and swap with BBB in order to pay floating rate (L-0.1%). Both parties can then split the 70 bps savings ( bps). Borrower:AAABBB Fixed Rate 10.8%12.0% Floating Rate LIBOR % LIBOR %

6 Alternative Swap Example (‘Hi’ / AAA swaps floating for fixed rate): Reduce borrowing costs by using interest rate swaps. Reduce borrowing costs by using interest rate swaps. Example: Two firms with different credit ratings, Hi and Lo: Example: Two firms with different credit ratings, Hi and Lo: Hi can borrow fixed at 11.0% and floating at LIBOR + 1.0%. Hi can borrow fixed at 11.0% and floating at LIBOR + 1.0%. Lo can borrow fixed at 11.4% and floating at LIBOR + 1.5%. Lo can borrow fixed at 11.4% and floating at LIBOR + 1.5%.

7 Hi wants fixed rate, but it will issue floating and “swap” with Lo. Lo wants floating rate, but it will issue fixed and swap with Hi. Lo also makes “side payment” of 0.45% to Hi. Hi Lo CF to lender-(LIBOR+1%)-11.40% CF Hi to Lo-11.40%+11.40% CF Lo to Hi+(LIBOR+1%)-(LIBOR+1%) CF Lo to Hi+0.45%-0.45% Net CF-10.95%-(LIBOR+1.45%)

8 Rationales for why Swap “Savings” Exist Comparative Advantage – predicts savings should disappear (but they don’t!). Comparative Advantage – predicts savings should disappear (but they don’t!). Under-priced Credit Risk – again, predicts savings disappear as market corrects under-pricing. Under-priced Credit Risk – again, predicts savings disappear as market corrects under-pricing. Different Cash Flows – interest rate swaps don’t have call provisions, so “savings” are really the cost of the issuer’s option to call fixed rate debt (most plausible reason). Different Cash Flows – interest rate swaps don’t have call provisions, so “savings” are really the cost of the issuer’s option to call fixed rate debt (most plausible reason). Different Information Sets – insiders can signal their beliefs about the true value of the firm. Different Information Sets – insiders can signal their beliefs about the true value of the firm.

9 Rationales for why Swap “Savings” Exist (cont.) Different Taxation and Regulation – can explain certain transactions but should disappear as governments close loopholes. Different Taxation and Regulation – can explain certain transactions but should disappear as governments close loopholes. Exposure Management – more firms are actively managing their financial price risks and therefore swaps have grown in line with this trend. Exposure Management – more firms are actively managing their financial price risks and therefore swaps have grown in line with this trend. Synthetic Instruments – as more issuers create synthetic instruments (or hybrids), more swaps are needed. Synthetic Instruments – as more issuers create synthetic instruments (or hybrids), more swaps are needed. Liquidity – lower B-A spreads attract more investors and improves the liquidity of the market. Liquidity – lower B-A spreads attract more investors and improves the liquidity of the market.

10 Pricing and Valuing a Swap A Swap can be decomposed into a portfolio of forward contracts (or short term loans). A Swap can be decomposed into a portfolio of forward contracts (or short term loans). At origination, both types of loans/forwards (fixed and floating rate) have an E(NPV) = 0. At origination, both types of loans/forwards (fixed and floating rate) have an E(NPV) = 0. A swap is a combination of long position in one type of loan (e.g., long a fixed rate) and a short position in the other type (short a floating rate). A swap is a combination of long position in one type of loan (e.g., long a fixed rate) and a short position in the other type (short a floating rate). Three yield curves (spot zero-coupon, forward zero- coupon, and spot par bond) are used to price the expected cash flows from a swap. Three yield curves (spot zero-coupon, forward zero- coupon, and spot par bond) are used to price the expected cash flows from a swap.

11 Applications of Swaps Types of Users: Types of Users: Non-financial Corporations Non-financial Corporations Financial Companies (CB’s, IB’s, Brokers, Insurance) Financial Companies (CB’s, IB’s, Brokers, Insurance) Institutional Investors (Pension funds, Mutual funds) Institutional Investors (Pension funds, Mutual funds) Governments (Federal and Municipal) Governments (Federal and Municipal) Usually used to Modify Debt Obligations: Usually used to Modify Debt Obligations: Match Interest Sensitivity of Assets Match Interest Sensitivity of Assets Reduce Funding Costs Reduce Funding Costs Enhance Yield on Investments Enhance Yield on Investments Increase Debt Capacity Increase Debt Capacity Protect Value of Investments from Interest Rate Risk Protect Value of Investments from Interest Rate Risk

12 Applications of Swaps (cont.) Also used to Modify Cash Flows: Also used to Modify Cash Flows: Reduce Volatility of CF’s to IR, FX, Commodity, Equity Price Movements Reduce Volatility of CF’s to IR, FX, Commodity, Equity Price Movements Hedge on Inflows (Income, Receivables) Hedge on Inflows (Income, Receivables) Hedge on Outflows (Cost of Goods Sold, Operating Expenses) Hedge on Outflows (Cost of Goods Sold, Operating Expenses) “Macro Hedge” of Both Inflows and Outflows (e.g., A/L Mgmt.) “Macro Hedge” of Both Inflows and Outflows (e.g., A/L Mgmt.) Can also be used to Create Synthetic Instruments: Can also be used to Create Synthetic Instruments: Inverse Floating Rate Notes Inverse Floating Rate Notes Adjustable-rate Preferred Stock Adjustable-rate Preferred Stock Synthesize Long-Dated Forward Contracts (can be cheaper) Synthesize Long-Dated Forward Contracts (can be cheaper)

13 FX Rate Risk and Swaps Typical Usage: Typical Usage: Firm borrows in one currency where interest rates are lower and then swaps cash flows into home/base currency. Firm borrows in one currency where interest rates are lower and then swaps cash flows into home/base currency. Hedge transaction exposures rather than “macro hedges”. Hedge transaction exposures rather than “macro hedges”. Common Examples: Common Examples: Company managing Foreign Inflows or Outflows (e.g., Import/Export business). Company managing Foreign Inflows or Outflows (e.g., Import/Export business). Governments borrowing in international capital markets. Governments borrowing in international capital markets. To access long-term fixed rate capital in “exotic” currencies (e.g., McDonalds borrowing in New Zealand). To access long-term fixed rate capital in “exotic” currencies (e.g., McDonalds borrowing in New Zealand).

14 Credit Default Swaps – Infinite Leverage  Does not usually own reference asset  Going “long”  Benefits when reference asset price INCREASES, max at Par  Tends to own reference asset  Hedging or going “short”  Benefits when reference asset price DECREASES Protection SellerProtection Buyer Payment upon Default of Reference Asset Premium Payments Reference Asset can be a MBS, CDO, Bond, or Loan Like an insurance contract that pays in the event of default. Like an insurance contract that pays in the event of default. FASB requires mark-to-market valuation. FASB requires mark-to-market valuation. Collateral Call - Protection Buyers can call for partial payment if default event is likely. Determined by mark-to-market value. Collateral Call - Protection Buyers can call for partial payment if default event is likely. Determined by mark-to-market value.