Swap Markets and Contracts Paper Please see the details in the word doc attached.I also attached 3 other documents that can help you solve this. Swap Finan

Swap Markets and Contracts Paper Please see the details in the word doc attached.I also attached 3 other documents that can help you solve this. Swap Finance Paper
For this paper, I want you to write 1-page single-space report that demonstrates SOLID
understanding of the Swap finance concept. Write it with the mindset of someone applying for
a swap officer position in a bank and trying to impress his/her future employer.
I have attached 1 pdf and excels sheets that will help you understand the Swap concept.
Please, be thorough as usual.
The Company needs
9,000,000 in foreign currency
The Company does not want to raise bonds in foreign currency
The company entres a swap as follows
The company issues bond to raise
The Company invests
The Company borrows from local bank
Here is the cash flows of the swap:
(assume payments are made
10,000,000 U.S. Dollars
10,000,000 U.S. Dollars
9,000,000 Foreign Currency
2 times every year)
Day one
10,000,000 U.S. Dollars
-10,000,000 U.S. Dollars
9,000,000 Foreign Currency
9,000,000 Foreign Currency
Each payment day
Pay interest to bond holders
Receive interest on investment
Pay interest on borrowed money
The net cash flow looks very similar to issuing a bond to raise
Additional Question
If exchange rate of the foreign currency is
assume that the swap is for
$1.20 , what is the rate that this com
10 years
Financial Calculator Inputs
FV =
-9,000,000 foreign currency
-241,333 foreign currency (take the $ payment, divide it by exchange rate a
20 Payments
PV =
9,000,000 foreign currency
Solve for rate to get
2.68% per period
5.36% per year (nominal)
Effectively this company borrowed in foreign currency at a rate
If the company could issue bonds in the foreign country at less than that, ignore the swap and issue bonds in
If the company could issue bonds in the foreign country at more than that, take the swap
-300,000 U.S. Dollars
275,000 U.S. Dollars
-220,500 Foreign Currency
-25,000 U.S. Dollars
-220,500 Foreign Currency
Expiration (which is also a payment day)
-10,000,000 U.S. Dollars
10,000,000 U.S. Dollars
-9,000,000 Foreign Currency
-9,000,000 Foreign Currency
hat is the rate that this company is actually borrowing at?
divide it by exchange rate and add it to the foreign currency payment)
he swap and issue bonds in foreign country
? Last invented type of derivatives.
? In June 2001
? the size of the derivative market was $100 trillion
? about $57 trillion is interest rate swaps
? about $4 trillion is currency swaps
? A swap is agreement between two parties to exchange
a series of future cash flows
? One party makes floating (or variable) payment (determined
by random outcome such as interest rate, currency rate,
equity return, commodity price)
? The other party makes floating or fixed payment
? The “long” and “short” terminology is not used. Instead,
we say floating-rate payer and fixed-rate payer.
? Most involve a series of payments
? A forward contract is a swap with a single payment
? Agreement to buy something over a period of time for a price
that is variable or fixed, uncertain or known
? No initial payment ? zero value at start
? This is a convention not a necessity
? In currency swaps, the parties exchange notional principal in
different currencies
? Each date on which the parties make payments is called a
settlement date (or payment date)
? The time between payments is called settlement period.
? Cash settled: on a settlement date,
? In theory, the two parties should exchange payment
? In practice, they exchange the net amount only – a practice called
? In currency swaps, netting is not possible
? The date of the final payment is called termination date.
? The original time to maturity is sometimes called the tenor
of the swap.
? Over-the-counter market
? Customized
? subject to default risk
? Similar to what we have seen in forward contracts but it can be
somewhat complicated in swaps
? Assume that A owes B in a given settlement date
? Party A may be illiquid or bankrupt.
? But it may be the case that market value of the swap (PV of remaining
payments) is positive to A and negative to B. In that case, B owes A for the
remaining payments
? There are future contracts on swaps: based on the rates that
will prevail in the swap market in the future
? They may serve as substitutes of swaps but their volume is
? Much like a party selling a bond before it matures or selling an option
before it expires.
? Several ways
? Payment
? A party holding a swap with a positive (negative) market value can terminate
it by receiving (paying) the market value from (to) the counterparty.
? Must be agreed to by both parties.
? Offsetting
? Entering into a separate and offsetting swap
? For example,
? A corporation is engaged in a swap to make fixed payments of 5 percent and receive
floating payments based on LIBOR
? enter into a swap in which it makes floating payments based on LIBOR and receives a
fixed rate
The fixed rate on the new swap is not likely to match the fixed rate on the old swap (but the difference is
known), but the effect of this transaction is simply to have the unknown floating payments offset.
? Sell to a third counterparty
? Receive (pay) its market value
? Needs the permission of the original counterparty.
? Not commonly used.
? Swapation
? An option to enter a swap
? A party could use it to enter into an offsetting swap as described above.
? Like forward and OTC options markets
? Dealers
? Banks and investment banking firms
? Market makers
? Take either side of the transaction and layoff by engaging in an
offsetting transaction.
? End users
? Corporations with risk management problems
? Major players
? See exhibit 1
? Each party makes interest payment to the other in
different currencies.
? Example:
? TGT needs €9 million and would like to issue a €-denominated
? The bank accepts the issue but tells TGT that it should issue in
$ (because the company is not well known in Europe) and use a
swap to convert to €
? TGT would enter into a swap with the bank.
? Assume:
? TGT can borrow $ at 6.0% (issue bond)
? TGT can invest $ at 5.5% (deposit at the bank)
? TGT can borrow € at 4.9% (from the bank)
? Example (continued):
? Day one
? TGT receive $10 million from issuing bond at 6%
? TGT pays the $10 to bank at 5.5%
? TGT receives €9 million it needs from bank at 4.9%
? Net Effect: TGT gets the €9 million it needs
? Example (continued):
? Each payment day
? TGT pays bondholders $10 ?? × 0.06 ×
? TGT receives $10 ?? × 0.055 ×
? TGT pays the bank €9 ?? × 0.049 ×
= $300,000
= $275,000 from bank
? Net Effect: TGT pays $25,000 and €220,500
= €220,500
? Example (continued):
? Expiration
? A single interest payment is still due plus the principals:
? TGT pays $10 million to bondholders
? TGT receives the $10 from bank
? TGT pays the bank €9 million
? Net Effect: TGT pays the €9 million
? Example (continued):
? Notes:
? TGT issued a $ denominated bond and convert it to a € denominated bond.
? The transaction looks just like TGT issuing a bond in €.
? What are the benefits:
? Issue in U.S. where the company is well known.
? What are the costs:
? Assuming credit risk (the bank may default)
? Additional Analysis (not in the textbook)
? The transaction looks just issuing a bond in €
? So what is the rate?
? See my excel sheet
? The examples above represent a swap of fixed-rate loan in $ to a fixed-
rate bond in €. The company can choose a floating-rate in either
currency. There are four types of currency swaps:
TGT pays € at a fixed rate and receives $ at a fixed rate (examples above)
TGT pays € at a fixed rate and receives $ at a floating rate
TGT pays € at a floating rate and receives $ at a floating rate
TGT pays € at a floating rate and receives $ at a fixed rate
? Reversing the flow, we obtain:
? TGT receives € at a fixed rate and pays $ at a fixed rate
? TGT receives € at a fixed rate and pays $ at a floating rate
? TGT receives € at a floating rate and pays $ at a floating rate
? TGT receives € at a floating rate and pays $ at a fixed rate
? Combining pairs from the 8 types above, we obtain,
? TGT pays $ at a floating rate and receives $ at a fixed rate
? TGT pays $ at a fixed
rate and receives $ at a floating rate
? TGT pays € at a floating rate and receives € at a fixed rate
? TGT pays € at a fixed rate and receives € at a floating rate
A swap in which both sets of payments are made in the same currency, is
called interest rate swap. See next.
? Of course, one can create them by combining two other swaps as shown above
but no one would do that.
? Why? Because, they actually evolved into their own market that became much
bigger than the currency swap market.
? Two main types:
? Basic swap:
? The two parties pay floating rate
? Plain vanilla swap
? Interest rate swap in which one party pays fixed rate and the other pays floating rate
in the same currency ($ or €)
? Usually on the same notional principal
? The most common derivative
If the two parties pay fixed, it is a meaningless transaction.
There is no need to exchange principals at the beginning and at the end
Interest payments are almost always netted ? reduce credit risk
How to adjust interest rate payments for compounding:
? Monthly, quarterly, and semi-annual payments are made based on actual days counts or
on simplified 30,90, 180 day counts
? Payments are made based on 360 or 365 days per year
? Parties agree on how interest is computed.
? Example:
? GE borrowed $25 million for a year (from BOA = Bank 1)
? the rate is floating (LIBOR+0.25%)
? quarterly payments based on the day count of 90/360.
? GE fears a rise in LIBOR ? approaches JPM (Bank 2) for a swap so that:
? Pays at fixed rate (6.2%)
? Receives floating (LIBOR+0%)
? quarterly payments based on the day count of 90/365 for the payment due and
90/360 for the received payment
? Example (continued):
? if LIBOR the day before the first payment is 5.9% ?
? With BOA
? the rate is 5.9%+.25% = 6.15% ? pay $25 ?? × 0.0615 ×
? With JPM
? Pays
$25 ?? × 0.062 × 365 = $382,192
$25 ?? × 0.059 × 360 = $368,750
? Net is paying $ 13,442 to JPM
? Receives
? Total payment is $384,375+ $ 13,442 =$397,817
= $384,375
? Example (continued):
? More important than the actual payment is the fact that:
? GE pays
? GE pays
? GE receives
? GE pays
0.25% to the first bank
6.20% to the second bank
0.00% from the second bank
6.45% fixed
? To verify:
397,817 365
= 6.45% ?
$25 ??
? It can be shown that you can assume ANY LIBOR rate and
GE still end up paying the same $ (and %)
? See next slide and my Excel sheet
? Example (continued):
? Try any LIBOR rate and you will always get the same
payment (see my Excel sheet)
? Example (continued):
? Notes
? Why BOA and JPM would accept to do this?
? The first bank is exposed to LIBOR risk (goes down)
? The second bank is exposed to LIBOR risk (goes up)
? Do not worry about Banks!
? Banks do not actually assume the risk! They only “trade” it and charge the spread…
isn’t that awesome?
? For BOA, there is no need to hedge because, floating rate loans are made using funds
obtained at floating rate
? For JPM, they can offset it by selling Eurodollar futures
? Could GE have gotten a fixed rate loan at a better rate (less than
? Yes, but it is very unlikely.
? In this example, what could have happened is that GE got an offer for
fixed rate loan at, say 6.75%, but found that it has an advantage in the
floating rate market. So it took this advantage and convert it to the fixed
rate market
? One party pays fixed rate (or any other rate)
? The other pays return on a stock or stock index
? Distinguishing features:
? The party paying fixed could end up paying both fixed and
variable if the stock or index falls
? Payment is not known until the return on the stock is known
? The rate of return is often structured to include both dividends
and capital gains
? Example:
? Asset manager wants to sell $100 million in stocks and to invest the proceeds at
fixed rate but he is concerned about the huge transaction cost (or he has some
reason not to sell the stock e.g. family stocks).
? He can achieve the same results by a swap where he:
? pays total return on S&P 500 and
? receives a fixed rate of 6.5% (made using actual day count/365 conversion)
? the position is held for a year with quarterly payments
? Example (continued):
? cash flow
? Pay returns on S&P 500 computed as
? $100,000,000 × ????&?? 500 where the return is
? The ??&??500?????? of one quarter becomes the ??&??500?????? of the next
? Receive fixed payments
? 31 March:
$100,000,000(0.065)(90/365) = $1,602,740
? 30 June:
$100,000,000(0.065)(91/365) = $1,620,548
? 30 September:
$100,000,000(0.065)(92/365) = $1,638,356
? 31 December:
$100,000,000(0.065)(92/365) = $1,638,356
? Obviously, only the differences will be paid
? Example (continued):
? Example (continued):
? Notes:
? The manager could have structured a swap to receive any
rate including: fixed-rate (the example), floating rate, or the
return on some other equity index.
? For instance, he would receive the return on the S&P 500 Small Cap
600 Index. This is equivalent to asset allocation from large-cap-stocks
to small-cap stocks
? Or he could receive the return on FTSE 100 Index. This is equivalent to
asset allocation from U.S. large-cap to U.K. large-cap (additional
exposure to currency risk).
? Example (continued):
? Anything that has a random outcome can be used to structure
? Very commonly used:
? Airlines enter into swaps to hedge their future purchases of jet fuel.
? Pay fixed payments
? Receive payments determined by the price of jet fuel
? Gold mining companies use swaps to hedge future deliveries of gold.
? Swaps can be based on non-storable commodities, like
electricity and the weather (amounts of rain, snowfall, or
weather- related damage).
Coming Next!
Pricing and Valuation of Swaps
Notional Principal
GE Perspective
GE pays Bank 1
$25,000,000 at
GE pays Bank 2
Bank 2 pays GE
$25,000,000 at
$25,000,000 at
Bank2 pays bank 1
Bank1 pays bank 2
$25,000,000 at
$25,000,000 at
Net with Bank 2
Net with both banks
Additional – Banks Perspectives
the basis is:
90 /
360 =>
($328,125) Pay 1
the basis is:
the basis is:
90 /
90 /
365 =>
360 =>
($382,192) Pay 2
$312,500 Rec 2
($69,692) net of Pay 2 and Rec 2
($397,817) which is equivalen to
the basis is:
the basis is:
90 /
90 /
365 =>
360 =>
($382,192) Pay 2
$312,500 Rec 2
Net =
Bank 1
Bank 2
receives from GE
pays bank 2
receives from GE
Pays GE
Pays bank 1
receives from bank 1

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