Swaps

Part-II

Transactions Equivalent to a Swap

Consider the following swap. Citibank has entered into a swap with a

notional principal of 50 MM USD. Today is 15 December 2003. Citi will pay a fixed rate of 7.5% per annum

on the 15th of March, June, September and December.

It will receive payments every quarter based on the 90 day LIBOR at the start of the period.

Equivalent (Cont…)

Interest will be computed based on the actual number of days in a given three month interval.

The year is assumed to consist of 360 days.

The ex-post payments made/received by Citibank are as described below.

Equivalent (Cont…)DATE LIBOR DAYS CITI

OwesCiti is Owed

Net Payment to Citi

15/12 7.68

15/3 7.50 90 937500 960000 22500

15/6 7.06 92 958333 958333 0

15/9 6.06 92 958333 902111 -56222

15/12 91 947917 765917 -182000

Equivalent (Cont…) Now instead of entering into this swap,

assume that Citi had issued a one year fixed rate note with a principal of 50MM, on which it has to make quarterly payments at the fixed rate of 7.5%.

Assume that the money is used to purchase a one year floating rate note with a face value of 50 MM, and which pays coupons on a quarterly basis based on the LIBOR at the beginning of the quarter.

Equivalent (Cont…) The net result is an interest rate swap. Notice that at the outset there is an

inflow of 50MM from the fixed rate note and an outflow of 50MM on account of the floating rate note.

Thus the net cash flow is zero. This is equivalent to a swap where the

principal is specified purely for computing the interest but is never exchanged.

Equivalent (Cont…) Similarly at the end 50MM will come in

when the floating note matures, and will be exactly the amount required to retire the fixed rate note.

Thus once again there is no exchange of principal.

As long as interest payments on both the fixed as well as floating notes are based on an ACT/360 basis, the net result is an interest rate swap.

Equivalent (Cont…) A swap can also be viewed as a spot

transaction combined with a series of FRAs.

On 15 December we know that Citi will receive a payment of 960,000 on 15 March and will have to make a payment of 937500 on that day.

This is equivalent to a spot transaction where the counterparty agrees to pay 22500 to Citi on March 15.

Equivalent (Cont…) The second payment is equivalent to a

FRA in which Citi agrees to pay fixed on 15 June and receive a payment on that day based on the LIBOR as of 15 March.

The remaining two exchanges of interest payments can also be viewed as FRAs with maturity dates on 15 September and 15 December respectively.

Pricing a Swap at the Outset. We will now see how the fixed rate for a

coupon swap is arrived at. A swap can be viewed as a combination

of a fixed rate and a floating rate bond. Since it involves no initial exchange of

cash it should have zero initial value. Consider the following data for a swap.

Pricing (Cont…) Quantum Electronics has entered into a

swap with a notional principal of 20MM. It promises to pay fixed and receive at

LIBOR every six months for a period of two years.

Assume that every six monthly period consists of 180 days and that the year consists of 360 days.

The current interest rate structure is as follows.

Term Structure

MATURITY LIBOR Effective Rate

6M 9.00 0.0920

12M 9.75 0.0990

18M 10.20 .1046

24M 10.50 .1078

Pricing (Cont…)

The floating rate note corresponding to the swap will have a value of 20MM.

The question is, what is the coupon rate that will make the fixed rate note have a value of 20MM.

If we denote the unknown semi-annual coupon by C, then:

Pricing (Cont…)

C C C_______ + ______ + _______(1.092).5 (1.099) (1.1046)1.5

C + 20,000,000+ _______________ = 20,000,000

(1.1078)2 C = 1,045,000 Annual coupon

rate = 10.45%

Pricing (Cont…)

Thus if Quantum agrees to pay at a fixed rate of 10.45% every six months and receive at LIBOR, the swap will have zero initial value.

Pricing a Swap During Its Life. At the outset a swap has zero initial value. That is, it is neither an asset nor a liability. Subsequently during its life it can attain a

positive or a negative value. Consider the swap from the perspective of the

party that is paying fixed but receiving floating.

Obviously it stands to benefit if rates were to rise subsequently but will lose if rates were to fall.

Example A company called Global Resources has

entered into a swap where it agrees to pay fixed at 10.67% and receive LIBOR.

The notional principal is 20MM. Payments are to be made every six

months for two years. Successive payment dates are exactly

180 days apart and the year consists of 360 days.

Example (Cont…)

This swap was initially priced at 10.67%. However 1.25 years have now elapsed and interest rates have changed.

The LIBOR on the last payment date was 9.42%.

So the next receipt is 942,000. Each payment is of course 1,067,000.

Example (Cont…)

The best way to price this swap is by valuing the fixed as well as the floating rate notes that taken together are equivalent to the swap.

Assume that the discount rate for the payment to be made after .25 years is 9.12% and that for the payment after .75 years is 9.23%.

Example (Cont…) The value of the fixed rate bond is:

1,067,000 21,067,000_________+ __________ = 20761216

(1.0912).25 (1.0923).75

The value of the floating rate bond is:942,000 + 20,000,000__________________ = 20490005

(1.0912).25

Example (Cont…) The rationale is that the value of the

floating rate bond will reset to par on the next payment date.

As far as the company is concerned, its fixed rate obligations have a value of 20761216 whereas its floating rate receipts have a value of 20490005.

Thus the swap has a value of -271,211 and is therefore currently a liability.

Currency Swaps What is a currency swap? It is a contract which commits two

counterparties to an exchange, over an agreed period, two streams of payments in different currencies, each calculated using a different interest rate, and an exchange, at the end of the period, of the corresponding principal amounts, at an exchange rate agreed at the start of the contract.

Example Barclays Bank London agrees to pay Citibank

New York over a period of two years a stream of interest on 17MM USD.

The interest rate is fixed at the outset. Citibank in return agrees to pay interest on

10MM GBP at a rate agreed upon at the outset.

They also commit to exchange at the end of the two-year period the principal amounts of 17MM USD and 10MM GBP.

Differences Between Currency Swaps and IRS

Currency swaps involve an exchange of payments in two currencies.

Not only is interest exchanged, there is also an exchange of principal.

In this case the exchange of principal takes place only at maturity.

Thus the impact on the balance sheet is only at maturity.

Differences (Cont…)

Thus this kind of a swap is termed an off balance sheet (OBS) transaction.

The interest payments being exchanged may be computed on a: Fixed versus floating basis Floating versus floating basis Or a Fixed-Fixed basis

Motivation

Why may Barclays and Citibank want to enter into such a swap?

At maturity Barclays may have an amount in USD that it wishes to exchange for GBP.

Citibank on the contrary may have an amount in GBP that it wishes to exchange for USD.

Motivation (Cont…) In a currency swap the rate for the

exchange of principal will be fixed at the outset.

This rate is usually the spot exchange rate prevailing at that time.

But is subject to negotiations. By fixing the exchange rate the two

banks hedge each other against exchange rate risk.

Exchange of Principal at Inception?

By definition a currency swap only requires the exchange of principal at maturity.

However it can so be structured so that there is an exchange of currencies at the outset as well.

This kind of deal is also called a currency swap but is something more than just a swap.

Exchange (Cont…) A swap with an initial exchange of

principal is a combination of a risk and a hedge.

This is because to exchange currencies at the outset the two parties must have either borrowed or else accrued income in the respective currencies.

This is a source of risk. The actual swap itself is a hedging

device.

Mechanics Let us assume that Citibank and

Barclays were to exchange principal amounts at the outset.

Barclays would sell 10MM GBP to Citibank in exchange for 17MM USD.

The sterling sold by Barclays and the dollars sold by Citi would be borrowed by these banks specifically for the purpose of the swap.

Mechanics (Cont…) At maturity this exchange of principal

would be reversed. The re-exchange of principals at

maturity would be at the original exchange rate.

Such swaps are therefore termed as par swaps.

The sterling received by Barclays at expiration from Citi would be used to payoff its original borrowing.

Mechanics (Cont…) The periodic interest payments

received from Citi would be used by Barclays to service its sterling loan.

The dollars received by Citi at maturity would be used by it to retire its original borrowing.

The periodic interest payments received from Barclays would be used by Citi to service its dollar loan.

Mechanics (Cont…)

Thus, through a currency swap, each counterparty effectively services the debt of the other.

Important!

If there is an initial exchange of principal through a currency swap, the borrowings which are undertaken to fund this initial exchange are separate from the swap itself.

But the initial exchange would be a part of the currency swap documentation.

Terminology The term currency swap is generally used

to describe swaps involving two different currencies.

But strictly speaking the term applies only to those swaps in which both the interest streams are calculated using fixed rates.

A currency swap in which at least one of the interest streams is calculated using a floating rate is called a cross-currency swap.

Terminology (Cont…) There are two types of cross-currency

swaps. Coupon swaps involve a fixed-floating

swap. Basis swaps involve a floating-floating

swap. Currency swaps where there is an

initial exchange of principal are sometimes referred to as Cash Swaps.

Terminology (Cont…)

In practice, swapping directly between non-dollar currencies can be difficult, particularly when a floating rate is involved.

In such cases the desired swap can be achieved by going through a series of swaps involving an intermediate currency which is usually the dollar.

Terminology (Cont…) The link in such swaps is typically the

6M USD LIBOR. Thus is because while Eurodollar

deposits are very liquid, eurodeposits in other currencies are relatively illiquid.

A cocktail swap may involve multiple legs.

Some legs could involve two currencies, while others may be interest rate swaps.

A Circus Swap A circus swap is a very simple

cocktail swap. It consists of a cross-currency

coupon swap (fixed versus floating) and a single-currency (coupon swap).

Both floating streams are calculated using the same LIBOR.

This can be used to replicate a fixed-fixed currency swap.

Illustration An investment bank pays interest on Swiss

Francs at a fixed rate to UBS and receives interest based on the 6M LIBOR in US dollars.

At maturity the bank will deliver Swiss Francs to UBS and will receive the equivalent from it in dollars.

The bank then enters into an interest rate swap with JP Morgan Chase where it pays interest in USD based on the 6M LIBOR and receives a fixed interest in dollars.

The net result is that it is paying a fixed rate in Swiss Francs and receiving a fixed rate in dollars.

Counterparties

In the case of single currency swaps, counterparties are distinguished on the basis of who pays fixed and who receives fixed.

However in the case of currency or cross-currency swaps the relationship is complicated by the exchange of currencies.

Counterparties (Cont…)

Thus there is a need to describe each counterparty in terms of the interest rate and the currency that it pays, and the interest rate and the currency that it receives.

Credit Risk

In the case of Interest Rate Swaps, the risk is with respect to interest only.

However in the case of currency swaps credit risk is with respect to both interest as well as principal.

Credit Risk and IRS

The credit risk on an interest rate swap is basically an issue on non-payment of interest.

The size of a loss due to non-payment is a function of how interest rates move.

Thus credit risk is often expressed in terms of a wider concept called default risk.

Default Risk

Default risk is defined as:credit risk x interest rate risk

In other words credit risk measures the probability of a default, whereas default risk measures the probable loss due to default.

Interest Rate Risk While analyzing the interest rate risk

component, we need to distinguish between Current Risk and Future Risk.

Current risk refers to the interest loss which would be suffered in the event of an immediate default.

Future risk is the interest loss which would be suffered in the event of a default in the future.

Interest Rate Risk (Cont…)

The impact of an immediate swap default can be estimated with certainty.

The impact of a future default is uncertain because the date of default is unknown.

Matched Books

Dealers who arrange swaps try and maintain matched books.

The way to run a matched book is by hedging it as soon as possible with an equal and opposite swap.

Matching a swap in this fashion is called a reversal.

Matched Books (Cont…) A reversal will take care of the dealer’s

interest rate risk. But he is now exposed to default risk

from both sides. One way of avoiding this problem is by

terminating or canceling the original swap.

Of course such termination requires the consent of the counterparty.

Termination When a swap is terminated it is valued in

terms of its profitability to the counterparties.

As discussed earlier the profitability is the NPV of the fixed rate stream versus that of the floating rate stream.

The future values of LIBOR used to value the floating rate streams are usually determined from futures contracts or from FRAs.

Termination (Cont…)

For one party the NPV will be negative whereas for the other it will be positive.

The counterparty with the loss must compensate the party who is expected to make a profit with an upfront cash payment that is equal to the NPV of the two streams.

The Secondary Market and Assignments

Instead of reversing or terminating a swap it is possible to assign or sell it to a new counterparty.

In other word, the new buyer substitutes one of the existing counterparties.

For reasons of default risk, assignment requires approval of the buyer by the remaining counterparty.

Assignment

In recent years assignment has been replaced by Novation.

That is, the existing contract is terminated and a new identical contract is created between the remaining counterparty and the buyer.

Assignment Valuation When a swap is assigned it is valued in

terms of its profitability to the seller. The method of valuation is the same as

for termination. If the value of the swap to be assigned

is negative, then compensation must be paid to the buyer.

This will be in the form of an upfront cash payment.

Assignment Valuation (Cont…)

Else if the NPV is positive then compensation must be paid to the seller.

Assignability

Assignment has been facilitated by the emergence of standardized swap documentation, which has made swaps more transparent and transferable.

New swap documentation typically includes an assignment clause which allows either counterparty to assign the swap.

Managing Default Risk One of the ways of containing exposure to

default risk is by adopting a procedure known as netting.

What is netting? It is the offsetting of several separate

payments outstanding between the same two counterparties and the settlement of the overall difference as a single net amount paid in one direction, rather than several gross amounts paid in both directions.

Netting (Cont…) Netting between separate swaps involves the

netting of the net interest payments due on separate swaps.

Thus if two counterparties have transacted a number of swaps with each other and each counterparty has at least one profitable swap, then the opposing net payments due on the separate swaps can be offset against each other and only the overall net difference between the individual amounts need be actually settled.

Netting (Cont…)

Netting between swaps is automatically achieved in the event of default.

A cross-default clause ensures that all outstanding swaps between two parties are netted in the event of one defaulting.

Cross-default is enforced by subsuming all contracts within an ISDA type Master agreement.

Netting (Cont…) Market participants have sought to

enforce netting in the case of default in order to limit their default risk.

Without netting the administrators of a bankrupt company can maintain those contracts which are profitable and default on the unprofitable swaps even if they are with the same counterparty.

This is called Cherry Picking.

Netting (Cont…) Netting is a standard practice within a swap. This of course is feasible only if interest

payments between the counterparties occur on the same dates.

Often to facilitate netting payment frequencies will be rearranged.

For instance, annual fixed rate payments may be split and paid semi-annually to match semi-annual floating rate payments.

Credit Enhancement

What is credit enhancement? The term refers to any technique which

reduces the default risk on a transaction by providing protection against any loss due to default by a counterparty.

The principal techniques are: Collateralization Insurance by a third party

Collateralization

One or both swap counterparties can be protected against loss due to a default by the other by: The pledging of suitable assets

(usually government securities or marketable collateralized assets)

Or on the basis of highly reliable third parties.

Collateralization (Cont…)

There are two basic approaches to collateralization.

The weaker counterparty posts collateral at the inception of the swap and subsequently adds further collateral to cover any increase above this initial amount in the value of the swap to the stronger counterparty.

Collateralization (Cont…) The other approach entails mutual

collateralization by both counterparties.

This involves the posting of collateral at inception by both counterparties, and the subsequent addition by either counterparty of further collateral to cover any significant increases above the initial amounts in the value of the swap to the other counterparty.

Collateralization (Cont…) Swaps involving collateral which is

periodically adjusted are known as mark-to-market swaps.

Collateralization emerged in the US as a technique to allow smaller banks to participate in the swap market.

Mortgage lenders in the US like S&Ls lend at fixed rates but raise funds at floating rates.

Collateralization (Cont…)

They therefore have a natural need for interest rate swaps.

They also have ready access to marketable securities like mortgage backed assets which can be used as collateral.

Insurance

In 1986 the World Bank arranged insurance cover to cover default exposure on specified interest rate and cross currency swaps with AA and A rates counterparties.

It pays a commitment fee and an exposure related premium for such coverage.

Insurance (Cont…) The executive board of the Bank had

imposed a condition restricting it to swaps with AAA rated counterparties.

Such insurance permits the bank to circumvent such restrictions and diversify its swap portfolio.

Such diversification is required to prevent concentration of deals with just a few counterparties.

Illustration of a Reversal Let us go back to an earlier example

where GRI is obligated to pay fixed at 10.67% and receive LIBOR in return.

After 1.25 years, two payments were remaining and the swap had a value of -271,211.

Now assume that GRI enters into an offsetting swap where it receives fixed and pays LIBOR.

Illustration (Cont…)

The fixed rate would of course be a function of current market conditions.

The existing swap liability would not be erased by the new swap.

This is because while the existing swap has a value of -271,211 the new swap has a value of zero.

Illustration (Cont…)

Both swaps would still be in effect. So GRI would be exposed to credit

risk on both swaps. If the swap had had a positive value

then it would remain on the books of GRI as an asset.

The new swap would once again have a zero value.

Illustration of an Assignment

GRI would find another party which agrees to take over its obligations and accept its receipts on the swap.

Since the new party is taking over a swap with a negative value, GRI would have to pay it 271,211.

Had the swap had a positive value, the buyer would have paid GRI.

Illustration (Cont…)

In this case, the original counterparty would have to approve the sale of the swap to the buyer.

Illustration of Buy Back or Close Out.

GRI could always buy back the swap by paying 271,211 to the original counterparty.

Of course the other party would have to agree to accept the swap if lieu of continuing with the swap.

Uses of Swaps We will first explore arbitrage

opportunities between swaps and cash instruments.

What is arbitrage? It refers to the simultaneous

purchase and sale of the same commodity at different prices in order to realize a fixed profit.

Uses (Cont…) But while using interest rate swaps with

cash instruments, aren’t we using two different instruments?

Yes we are. However the two instruments represent

the same commodity in the sense that they both generate interest payments calculated using interest rates of the same maturity.

Example A company has access to fixed rate

funding at an interest rate which is low compared to the prevailing swap rate of the same maturity.

It can enter into a coupon swap where it receives fixed and pays LIBOR.

The difference between the fixed rate received by it and the lower fixed rate paid on its borrowings is a source of arbitrage profits.

Example (Cont…) Assume that the company can

borrow at 8.50% fixed. However it can enter into a coupon

swap whereby it receives 8.75% fixed and pays out LIBOR.

By borrowing and entering into a coupon swap it can effectively take a loan at LIBOR – 0.25%.

New Issue Arbitrage

This type of swap arbitrage is usually undertaken in the case of new bond issues and is known as new issue arbitrage.

Since this kind of arbitrage can lead to significant cost reductions, swap opportunities have become a crucial consideration in bond issuance.

New Issue (Cont…) It has been estimated that up to 70% of

international bond issues are swap driven.

This means that the choice of an international bond issue in terms of currency and maturity, as well as issue timing, are determined by the availability of such arbitrage opportunities.

New Issue (Cont…)

Whenever such opportunities exist it will result in increased bond issuance, and increased demand from issuers to transact swaps through which they receive fixed rates.

Increased issuance will force up the yields on bonds.

New Issue (Cont…) At the same time increased demand for

swaps paying the fixed rate will force swap rates down.

Bond yields and swap rates will therefore converge and such arbitrage opportunities will eventually disappear.

Thus swap rates and bond yields for the same maturity tend to be closely aligned.

New Issue

In order to monitor such arbitrage opportunities intermediaries make continuous comparisons between swap rates and bond yields.

When swap rates are sufficiently higher than bond yields, there should be an opportunity for new issue arbitrage.

Comparisons

In some markets, particularly in dollar markets, comparisons between swap rates and corporate bond yields are not made in terms of full percentage rates, but in terms of their spreads over a common benchmark such as a government bond yield.

Comparisons (Cont…)

We know that in some markets, swap rates are quoted in terms of swap spreads rather than in the form of all-in rates.

In such markets corporate bond yields also tend to be quoted in terms of a spread over a benchmark yield.

Comparison (Cont…)

For example the quoted yield on a 5 year corporate bond is T+60.

This means that it is yielding 60 basis points over the current yield on the most recently issued T-note.

Assume that the 5-year swap spread is T+80.

Comparison (Cont…)

So if there is a corporate borrower willing and able to issue a bond yielding T+60, he should have an arbitrage opportunity of 20 basis points.

Why? Why should such opportunities exist? Some swaps pay floating interest rates

linked to an index that is based on the average borrowing rate in a particular market.

It is therefore possible for better than average institutions to borrow floating rate funds at a cheaper rate than what they receive on such index-linked swaps.

Why? (Cont…)

Take the case of the US Commercial Paper market.

Swaps are available in which the floating rate is the Federal Reserve Bank of New York’s weekly USCP Index for issuers rated A-1 by S&P or P-1 by Moody’s. This is called the H-15 index.

Why? (Cont…)

Some counterparties can issue CP at better rates than the average represented by the index.

Thus they can make arbitrage profits by issuing CP and then entering into a swap where they receive floating and pay fixed.

Why? (Cont…)

The next result is a fixed rate CP issue which is subsidized by the arbitrage profit made between the two floating rates.

Why? (Cont…)

Another source of cheap funding resulting in arbitrage opportunities is found in cases where borrowers have access to subsidies.

For instance exporters often receive export credit at rates below commercial borrowing rates.

Why? (Cont…)

If such borrowers can enter into a swap where they receive a commercial fixed rate, they can lock in the subsidy as an arbitrage profit between the two fixed rates.

The arbitrage profit is then used to subsidize the floating rate which the exporter is effectively paying.

Why? (Cont…) Arbitrage opportunities can arise because

of differences in the speed with which the swap market and some bond markets respond to the same information.

For instance dollar rates tend to respond rapidly to changes in US Treasury yields whereas dollar denominated eurobonds tend to lag behind.

Why? (Cont…)

Thus when interest rates rise, eurobonds can often be issued at rates which are lower than swap rates, thereby allowing new issue arbitrage.

Why? (Cont…) Supply-demand imbalances can also

generate swap opportunities. For example lack of bond issues in a

particular currency by a particular issuer may encourage investors to accept lower yields when such bonds are issued, since it gives them the opportunity to diversify the overall risk of their portfolio.

Why? (Cont…) For instance in the late 1980s in the

US, building societies were allowed to issue bonds for the very first time.

These issuers were not only credit worthy but were also a completely new source of bonds.

At that time there was a strong demand for sterling in the eurobond market.

Why? (Cont…)

Thus building societies were able to issue sterling eurobonds at low rates and then swap these into floating rate funds, and thereby were often able to get funds at below LIBOR.

Why? (Cont…) Segments of the capital market at times

differ with respect to how sensitive they are to differences in the creditworthiness of issuers.

In particular, bond markets dominated by retail investors tend to be averse to default risk and must be offered disproportionately higher yields to invest in less creditworthy bonds as compared to wholesale investors like fund managers and banks.

Why? (Cont…) Thus the difference between the rates

paid by weaker and stronger parties tends to be higher in the bond market as compared to the bank loan market.

In other words the comparative cost of funds is higher in the bond market as compared to the credit market.

In other words the stronger party has a comparative advantage.

Why? (Cont…)

The fact that the relative default risk on the same counterparties is priced differently in the two markets is an anomaly.

And can be arbitraged.

Mechanics

The stronger credit will issue fixed rate bonds and the weaker credit will take a floating rate bank loan.

They will then enter into a swap where the weaker credit will pay fixed and receive floating.

Illustration

Take the case of two companies Alpha and Beta.

Alpha has a stronger credit rating than beta.

Both companies can either issue bonds at a fixed rate or take bank loans at a floating rate.

Illustration (Cont…)

The costs in the two markets are:Company Fixed FloatingAlpha 10% LIBOR +100bpBeta 12% LIBOR + 160bpDifferential 200bp 60bp

Illustration (Cont…)

The relative funding costs are such that Alpha can obtain funds at 200bp cheaper in the fixed rate market but at only 60bp cheaper in the floating rate market.

Thus Alpha has a comparative advantage of 140bp in the bond market as compared to the credit market.

Arbitrage

In order for a win-win transaction the following steps are required.

First establish the comparative advantage.

In this case it is clear than Alpha has a comparative advantage of 140bp in the bond market.

Arbitrage (Cont…)

The stronger counterparty should then borrow in the market where it has a comparative advantage while the weaker counterparty should borrow in the other.

In this case Alpha will issue bonds while beta will take a bank loan.

Arbitrage (Cont…)

In the next step the two parties will swap interest obligations on their liabilities.

In this case the swap will be such that Alpha will receive fixed and pay floating.

Arbitrage (Cont…)

Calculate the minimum fixed interest rate through the swap which is necessary for Alpha to make a gain.

Alpha is paying 10% fixed. It is receiving fixed interest from

the swap. It is paying LIBOR on the swap.

Arbitrage (Cont…) The net cost to Alpha must be less

than the LIBOR + 100bp that it would have had to pay, had it borrowed floating.

This will be the case if Alpha were to receive at least 9% on the swap.

Thus 9% is the minimum fixed rate payable by Beta for Alpha to have a gain.

Arbitrage (Cont…) The next step is to calculate the

maximum fixed rate which Beta can pay on the swap and still make a gain.

Beta is borrowing at LIBOR + 160. It is receiving LIBOR on the swap. It is paying fixed on the swap. Had it borrowed fixed it would have

paid 12%.

Arbitrage (Cont…) Thus if it pays less than 10.40% on

the swap it will make a gain. Thus the fixed rate has to be

between 9% and 10.40% if the two parties are to both make a gain.

The closer the rate is to 10.40 the better it is for Alpha whereas the closer it is to 9% the better it is for beta.

Arbitrage (Cont…)

The actual rate has to be determined by negotiations between the two parties.

Assume that the two parties agree on 10.20 as the fixed rate for the swap.

So the cost of funds for Alpha will be LIBOR -20bp while the cost of funds for Beta will be 11.8%.

Asset Swaps What is an asset swap? It is an interest rate or a currency

swap that is attached to an asset. The distinguishing feature of an asset

swap is that it is attached to an asset. Thus asset swaps are used by

investors. On the other hand, liability swaps are

used by borrowers.

Using Asset Swaps to Take Risk If an investor is anticipating a hike

in interest rates he can swap the fixed interest that he receives for an asset for a floating rate through the swap.

If rates go up as anticipated he will profit.

The net result is the creation of a synthetic floating rate loan.

Using Asset Swaps to Hedge

Suppose an investor has invested in a floating rate asset and expects rates to fall.

He can hedge himself by entering into a swap where he pays floating and receives fixed.

Using Asset Swaps for Arbitrage

In the case of the arbitrage we saw earlier the aim was to reduce the cost of borrowings.

Asset swaps can be used to earn enhanced returns.

Illustration

A party is receiving 8.20% from a bond.

However it is in a position to enter into a swap where it pays fixed at 8% and receives LIBOR.

The net result is a synthetic floating rate loan on which it earns LIBOR + 20bp.

Illustration-2 A party which has invested in a

floating rate loan can also do arbitrage.

Suppose Alpha is receiving LIBOR+25bp from a floating rate loan.

Assume that it can pay LIBOR and receive 8.5% on a swap.

The net result is a fixed rate investment yielding 8.75%.

Accessing Markets

Swaps can be used to create synthetic instruments by exchanging floating rate payments for fixed and vice versa.

Thus swaps provide access to assets which may otherwise not be available.

Investor Asset Swaps The kind of asset swaps that we have

illustrated are called investor asset swaps.

In this case the investor in the asset is himself a counterparty to the swap.

An intermediary may in such cases sell the asset to the investor, and then propose a swap with itself as a counterparty.

Investor Asset Swaps (Cont…) However the investor is

responsible for the administration of the cash flows.

He is exposed to default risk on the part of the issuer of the asset as well as the swap counterparty.

Accounting is usually complex involving separate treatment of the asset and the swap.

Investor Asset Swaps (Cont…)

The liquidity of the asset swap would depend on the liquidity of the swap as well as the asset.

Consequently two sets of transactions costs will be involved.

Synthetic Securities

In order to avoid the problems associated with investor asset swaps, intermediaries usually organize swaps on behalf of the investors and take their place at the centre of the transaction.

In these cases the asset being swapped is held for safekeeping by the intermediary on behalf of the investor.

Synthetic Securities (Cont…) The coupons from the asset are legally

assigned to the intermediary to ensure availability of cash flows for the swap.

The investor sees only the swapped cash flow and not the cash flow from the underlying asset.

As for as far as it is concerned the asset that it has purchased is producing the final cash flow directly.

Synthetic Securities (Cont…) Such swaps are therefore called

packaged asset swaps. The advantages are: The investor is involved in the

administration of only the synthetic cash flow.

The default risk exposure is limited to one party.

Synthetic Securities (Cont…)

The accounting will be simplified as the transaction can be reported as a single asset.

Repackaged Securities

In this type of an asset swap, the investor receives not only the cash flow from the swap but also a negotiable security which can be sold.

These repackaged securities are also known as securitized asset swaps.

Repackaged Securities (Cont…)

A special purpose vehicle SPV is incorporated.

The SPV buys and holds the asset to be swapped and becomes the counterparty to the swap itself.

It then issues new securities which are backed by the swapped asset.

Repackaged Securities (Cont…)

The new issue is known as an asset backed security.

The proceeds of the new issue are used to fund the asset being acquired.