1. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Swaps Chapter 7 Pages: 157-168, 175-178 (top),180 (bottom)-185 1

2. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Nature of Swaps A swap is an agreement to exchange cash flows at specified future times according to certain specified rules 2

3. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 An Example of a “Plain Vanilla” Interest Rate Swap An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million Next slide illustrates cash flows 3

4. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 ---------Millions of Dollars--------- LIBORFLOATINGFIXEDNet DateRateCash Flow Mar.5, 20104.2% Sept. 5, 20104.8%+2.10–2.50–0.40 Mar.5, 20115.3%+2.40–2.50–0.10 Sept. 5, 20115.5%+2.65–2.50+0.15 Mar.5, 20125.6%+2.75–2.50+0.25 Sept. 5, 20125.9%+2.80–2.50+0.30 Mar.5, 20136.4%+2.95–2.50+0.45 Cash Flows to Microsoft (See Table 7.1, page 159 4

5. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Typical Uses of an Interest Rate Swap Converting a liability from fixed rate to floating rate floating rate to fixed rate Converting an investment from fixed rate to floating rate floating rate to fixed rate 5

6. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Intel and Microsoft (MS) Transform a Liability (Figure 7.2, page 160) IntelMS LIBOR 5% LIBOR+0.1% 5.2% 6

7. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Financial Institution is Involved (Figure 7.4, page 162) F.I. LIBOR LIBOR+0.1% 4.985% 5.015% 5.2% IntelMS 7

8. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Intel and Microsoft (MS) Transform an Asset (Figure 7.3, page 161) Intel MS LIBOR 5% LIBOR-0.2% 4.7% 8

9. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Financial Institution is Involved (See Figure 7.5, page 163) Intel F.I.MS LIBOR 4.7% 5.015%4.985% LIBOR-0.2% 9

10. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Quotes By a Swap Market Maker (Table 7.3, page 163) MaturityBid (%)Offer (%)Swap Rate (%) 2 years6.036.066.045 3 years6.216.246.225 4 years6.356.396.370 5 years6.476.516.490 7 years6.656.686.665 10 years6.836.876.850 10

11. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 The Comparative Advantage Argument (Table 7.4, page 166) AAACorp wants to borrow floating BBBCorp wants to borrow fixed FixedFloating AAACorp4.00%6-month LIBOR − 0.1% BBBCorp5.20%6-month LIBOR + 0.6% 11

12. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 The Swap (Figure 7.6, page 166) AAACorpBBBCorp LIBOR LIBOR+0.6% 4.35% 4% 12

13. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 The Swap when a Financial Institution is Involved (Figure 7.7, page 167) AAAF.I.BBB 4% LIBOR LIBOR+0.6% 4.33% 4.37% 13

14. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Criticism of the Comparative Advantage Argument The 4.0% and 5.2% rates available to AAACorp and BBBCorp in fixed rate markets are 5-year rates The LIBOR−0.1% and LIBOR+0.6% rates available in the floating rate market are six- month rates BBBCorp’s fixed rate depends on the spread above LIBOR it borrows at in the future 14

15. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 The Nature of Swap Rates Six-month LIBOR is a short-term AA borrowing rate The 5-year swap rate has a risk corresponding to the situation where 10 six- month loans are made to AA borrowers at LIBOR This is because the lender can enter into a swap where income from the LIBOR loans is exchanged for the 5-year swap rate 15

16. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 An Example of a Currency Swap An agreement to pay 5% on a sterling principal of £10,000,000 & receive 6% on a US$ principal of $15,000,000 every year for 5 years 16

17. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Exchange of Principal In an interest rate swap the principal is not exchanged In a currency swap the principal is exchanged at the beginning and the end of the swap Thus exchange rate risk exists but can be hedged 17

18. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 The Cash Flows (Table 7.5, page 176) Year DollarsPounds $ ------millions------ 2010 –18.00 +10.00 2011 +1.08 –0.5 2012 +1.08 –0.5 2013 +1.08 –0.5 2014 +1.08 –0.5 2015+19.08 –10.5 £ 18

19. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Typical Uses of a Currency Swap Conversion from a liability in one currency to a liability in another currency Conversion from an investment in one currency to an investment in another currency 19

20. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Comparative Advantage Arguments for Currency Swaps (Table 7.6, page 176) General Electric wants to borrow AUD Qantas wants to borrow USD USDAUD General Motors 5.0%7.6% Qantas 7.0%8.0% 20

21. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Valuation of Currency Swaps Like interest rate swaps, currency swaps can be valued either as the difference between 2 bonds or as a portfolio of forward contracts (See Examples 7.6 and 7.7) 21

22. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Swaps & Forwards A swap can be regarded as a convenient way of packaging forward contracts When a swap is initiated the swap has zero value, but typically some forwards have a positive value and some have a negative value 22

23. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Credit Risk A swap is worth zero to a company initially At a future time its value is liable to be either positive or negative The company has credit risk exposure only when its value is positive 23

24. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Other Types of Swaps Amortizing/ step up Compounding swap Constant maturity swap LIBOR-in-arrears swap Accrual swap Equity swap 24

25. Options, Futures, and Other Derivatives, 7th Ed, Ch 7, Copyright © John C. Hull 2010 Other Types of Swaps continued Cross currency interest rate swap Floating-for-floating currency swap Diff swap Commodity swap Variance swap 25

26. Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull 2007 7.26 Suggested Practice Problems 7.1 7.3 7.8 7.9 7.12 7.15 7.16 7.22