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

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

3. 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.

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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