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