swaps swaps involve exchange of one set of financial obligations with another e.g. fixed rate of...

Swaps

Swaps involve exchange of one set

of financial obligations with another e.g. fixed rate of interests with floating rate of interest, one currency obligation to another, a floating price of a commodity to fixed price etc.

History of Swaps

First currency swap was engineered in

London in 1979, but the next deal structured by

Salomon Brothers in 1981 in London involving

organizations of the stature of World bank and

IBM, not only ended the 2-year obscurity but

also gave credibility to the instrument, so

necessary for its extremely fast growth.

History of Swaps

First Interest rate swap was engineered

in London in 1981and was introduced in

the US in 1982 by Student Loan

Marketing Association (Sallie Mae).

Commodity swaps were first engineered

in 1986 by Chase Manhattan Bank.

Purpose of a Swap

Reduce cost of capital Manage risk Exploit economies of scale Arbitrage across capital markets Enter new markets Create synthetic instruments

Basic Types of Swap

Interest Rate Swaps Currency Swaps Commodity Swaps

Interest rate swaps and currency swaps

are together known as Rate Swaps.

Rate Conventions

Swaps are most often tied to LIBOR. It is quoted “actual over 360”, as though the

year is of 360 days. This raises the effective rate for a period and has compounding effect.

Bond equivalent yields are quoted on actual over 365 days.

For comparison, adjustments can be made by multiplication of a rate differential by 365/360 or by 360/365.

Cash Market Transactions

Swaps are used in conjunction with

following basic cash market transactions:

Obtain actuals from cash market Make/receive payments to/from cash

market Supply actuals to cash market

Initial Exchange of Notionals(Optional).

Counterparty ASwap Dealer

Counterparty B

Notionals

Notional

Notionals

Notionals

Periodic Usage or Purchase Payments (Required).

Counterparty ASwap Dealer

Counterparty B

Fixed Price

Floating Price

Fixed Price

Floating Price

Re-exchange of Notionals(Optional).

Counterparty ASwap Dealer

Counterparty B

Notionals

Notionals

Notionals

Notionals

Interest Rate Swap

A, desirous of 10-yr fixed rate debt (available at 11.25% sa) has access to cheap floating rate financing (LIBOR + 50bp).

B, desirous of a 10-yr floating rate financing (available at LIBOR) has access to cheaper fixed rate financing (10.25% sa).

A dealer available can be a floating rate payer or receiver at LIBOR and a fixed rate payer at 10.40% sa and receiver at 10.50% sa.

Interest Rate Swap

.

Counterparty A Counterparty BSwap Dealer

Debt market(Floating Rate)

Debt Market(Fixed Rate)

SWAP

CASH MARKET TRANSACTIONS

Principal

Principal

Interest Rate Swap

.

Counterparty A Counterparty BSwap Dealer

Debt market(Floating Rate)

Debt Market(Fixed Rate)

SWAP

CASH MARKET TRANSACTIONS

10.50% (sa) 10.40% (sa)

6-M LIBOR 6-M LIBOR

10.25% (sa)

6-M LIBOR +50bps

Interest Rate Swap

.

Counterparty A Counterparty BSwap Dealer

Debt market(Floating Rate)

Debt Market(Fixed Rate)

SWAP

CASH MARKET TRANSACTIONS

Principal

Principal

Currency Swap

A, needing floating rate dollars, can borrow euros at 9.0% fixed and dollars at 1-yr LIBOR floating.

B, needing fixed rate euros, can borrow euros at 10.1% fixed and dollars at 1-yr LIBOR floating.

Swap dealer can pay 9.45% fixed on euros against dollar LIBOR and dollar LIBOR against 9.55% fixed on euros.

Currency Swap.

Counterparty A Counterparty BSwap Dealer

Debt market(Euro)

Debt Market($)

SWAP

CASH MARKET TRANSACTIONS

9.45% 9.55%

LIBOR LIBOR

LIBOR

9%

Commodity Swap

A crude oil producer wants to fix a price to be received for 5 years on production of 8000 barrels p.m. He agrees to pay average of preceding month price to swap dealer against a receipt of $68.20/barrel.

An oil refiner wants to fix the price he pays for oil for 5 years on his average need of 12000 barrels. He agrees to pay $68.40 against market price of $69.50/barrel for an average price of preceding month.

Commodity Swap.

Counterparty A Counterparty BSwap Dealer

SpotOil

Market

SWAP

CASH MARKET TRANSACTIONS

$68.20/barrel $68.40/barrel

Spot Price(average)

Spot Price(average)

Spot PriceSpot Price

Actuals Actuals

Oil Producer Refiner

Why a Swap Dealer?

If A and B attempted a swap with each

other directly, it would have failed due

to different requirements. Swap dealer

can be a fixed-rate payer on 4000

barrels and till such time he can hedge

in futures.

Swaption

When a firm doesn’t want a swap now but can lock-in the terms of swap now by buying an option on swap called Swaption.

Case Study

B. F. Goodrich - Rabobank

Issues in the case

Why was the need for swap felt? How could the rate of borrowing be

reduced for Goodrich? Describe the structure of the Swap

diagrammatically. Comment on the role of financial

innovations with reference to the case.

Interest Rate Swap

.

B.F. Goodrich RabobankMorgan

Bank

US Bond(Floating Rate)

Eurobond(Fixed Rate)

SWAP

CASH MARKET TRANSACTIONS

11% 11%

LIBOR-x LIBOR-x

11%(10.7%)

3-M LIBOR +50bps

Calculations

Cost for B.F.Goodrich:

LIBOR + 50bp +11 – LIBOR + x = 11.5 +x (i.e. 11.6 to 11.875) as against 12 to 12.5% (a saving of 40 to 60 bps approx.)

Cost for Rabobank:

8.75 – x as against 10.70%

Morgan Bank gets: one time fees ($125000 + annual fees)