Lecture 2: Swaps Nattawut Jenwittayaroje, Ph.D., CFA 01135532: Financial Instrument NIDA Business School and Innovation National Institute of Development Administration 1 Topics Covered The concept of a swap Basic characteristics of different types of swaps, based on the underlying: interest rate and currency Pricing of swaps Strategies using swaps 2 1
Introduction Definition of a swap A swap is a transaction in which two parties agree to pay each other a series of cash flows over a specified period of time. For example, a forward/futures contract can be viewed as a simple example of a swap. Forward and futures contracts are commitments for one party to buy something from another at a fixed price at a future date. Suppose it is March 1, 2008, and a company enters into a forward contract to buy 100 ounces of gold for $850 per ounce in one year. The company can sell the gold in one year as soon as it is received. The forward contract is, therefore, equivalent to a swap agreement where the company pays a cash flow of $85,000 on March 1, 2009, and receives a cash flow equal to 100 S on the same date, where S is the market price of one ounce of gold on March 1, 2009. 3 In some cases, a party would like to make a series of purchases, instead of a single purchase, from the other at a fixed price at various future dates. The party could agree to a series of forward or futures contracts, each expiring at different dates. But it is highly likely the contracts would each have a different price. A better way to construct this type of strategy is to enter into a single agreement for one party to make a series of equal payments to the other party at specific dates and receive a “good” (e.g., a payment) from the other party. This type of transaction, specifically characterized by a series of regularly scheduled payments, is called a swap . The parties are said to be swapping payments or assets. 4 2
Four types of swaps Interest rate swap : the two parties make a series of interest payments to each other, with both payments in the same currency. One payment is variable, and the other payment can be fixed or variable. The principal on which the payments are based is not exchanged. Currency swap : the parties make either fixed or variable interest payments to each other in different currencies. There may or may not be a principal payment. 5 Four types of swaps Equity swap (not covered): one of the two parties makes payments determined by the price of a stock, the value of a stock portfolio, or the level of a stock index. The other payment can be determined by another stock, portfolio, or index, or by an interest rate, or it can be fixed. Commodity (not covered): one set of payments is determined by the price of a commodity, such as oil or gold. The other payment is typically fixed. The commodity swap is usually used to hedge against the price of the commodity. 6 3
The Figure below shows the growth in world-wide notional principal of swaps There has been steady growth in the use of interest rate swaps, which had notional principal at the end of 2005 of about $173 trillion. Currency swaps had notional principal at the end of 2005 of about $8.5 trillion. The reason that interest rate swaps are more widely used than currency swaps is that virtually every business borrows money and is, therefore, exposed to some form of interest rate risk. 7 Basic Characteristics of swaps Initiation date, termination date, and the dates on which the payments are to be made. No cash up front: similar to forward and futures contracts, swaps have zero value at the start. Settlement date, settlement period: the day on which a payment occurs is called the settlement date, and the period between settlement dates is called the settlement period. Notional principal: the interest payments are based on the multiplication of an interest rate times a principal amount. In interest rate swaps this principal amount is never exchanged. That is why it is termed the notional principal . Over the counter and dealer markets: swaps are exclusively customized, over-the-counter instruments. Swap dealers quotes prices and rates at which they will enter into either side of a swap transaction. 8 4
An Example of a “Plain Vanilla” Interest Rate Swap Consider a three-year swap initiated on March 1, 1998, Company B agrees pay to company A an interest rate of 5% per annum on a notional principal of $100 million Company A agrees to pay to company B the 6-month LIBOR rate on the same notional principal. Assume that the payments are to be exchanged every six months. This swap is represented diagrammatically in the figure below. 5% Company Company A B LIBOR 9 What is LIBOR? LIBOR is the London Interbank Offer Rate. LIBOR is the rate of interest offered by banks on deposits from other banks in Eurocurrency markets. For example, one- (three-) month LIBOR is the rate offered on one- (three-) month deposits. LIBOR rates are determined by trading between banks and change continuously as economic conditions change. LIBOR is frequently a reference rate of interest for loans in international financial markets. For example, a loan with a rate of interest specified as six-month LIBOR plus 1.5% per annum. The life of the loan is divided into six-month periods. For each period, the rate of interest is set at 1.5% per year above the six- month LIBOR rate at the beginning of the period. Interest is paid at the end of the period. 10 5
An Example of a “Plain Vanilla” Interest Rate Swap Table 1 : Cash Flows (in $ millions) to Company B ---------Millions of Dollars--------- ---------Millions of Dollars--------- ---------Millions of Dollars--------- ---------Millions of Dollars--------- ---------Millions of Dollars--------- (--------Millions of Dollars--------) ---------Millions of Dollars--------- LIBOR LIBOR LIBOR LIBOR LIBOR LIBOR LIBOR FLOATING FLOATING FLOATING FLOATING FLOATING FLOATING FLOATING FIXED FIXED FIXED FIXED FIXED FIXED FIXED Net Net Net Net Net Net Net Settlement Date Date Date Date Date Date Date Rate Rate Rate Rate Rate Rate Rate Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Settled Mar.1, 1998 Mar.1, 1998 Mar.1, 1998 Mar.1, 1998 Mar.1, 1998 Mar.1, 1998 Mar.1, 1998 4.2% 4.2% 4.2% 4.2% 4.2% 4.2% 4.2% every Sept. 1, 1998 Sept. 1, 1998 Sept. 1, 1998 Sept. 1, 1998 Sept. 1, 1998 Sept. 1, 1998 Sept. 1, 1998 4.8% 4.8% 4.8% 4.8% 4.8% 4.8% 4.8% +2.10 +2.10 +2.10 +2.10 +2.10 +2.10 +2.10 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 –0.40 –0.40 –0.40 –0.40 –0.40 –0.40 –0.40 six months Mar.1, 1999 Mar.1, 1999 Mar.1, 1999 Mar.1, 1999 Mar.1, 1999 Mar.1, 1999 Mar.1, 1999 5.3% 5.3% 5.3% 5.3% 5.3% 5.3% 5.3% +2.40 +2.40 +2.40 +2.40 +2.40 +2.40 +2.40 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 –0.10 –0.10 –0.10 –0.10 –0.10 –0.10 –0.10 Sept. 1, 1999 Sept. 1, 1999 Sept. 1, 1999 Sept. 1, 1999 Sept. 1, 1999 Sept. 1, 1999 Sept. 1, 1999 5.5% 5.5% 5.5% 5.5% 5.5% 5.5% 5.5% +2.65 +2.65 +2.65 +2.65 +2.65 +2.65 +2.65 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 +0.15 +0.15 +0.15 +0.15 +0.15 +0.15 +0.15 Mar.1, 2000 Mar.1, 2000 Mar.1, 2000 Mar.1, 2000 Mar.1, 2000 Mar.1, 2000 Mar.1, 2000 5.6% 5.6% 5.6% 5.6% 5.6% 5.6% 5.6% +2.75 +2.75 +2.75 +2.75 +2.75 +2.75 +2.75 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 +0.25 +0.25 +0.25 +0.25 +0.25 +0.25 +0.25 Sept. 1, 2000 Sept. 1, 2000 Sept. 1, 2000 Sept. 1, 2000 Sept. 1, 2000 Sept. 1, 2000 Sept. 1, 2000 5.9% 5.9% 5.9% 5.9% 5.9% 5.9% 5.9% +2.80 +2.80 +2.80 +2.80 +2.80 +2.80 +2.80 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 +0.30 +0.30 +0.30 +0.30 +0.30 +0.30 +0.30 Mar.1, 2001 Mar.1, 2001 Mar.1, 2001 Mar.1, 2001 Mar.1, 2001 Mar.1, 2001 Mar.1, 2001 6.4% 6.4% 6.4% 6.4% 6.4% 6.4% 6.4% +2.95 +2.95 +2.95 +2.95 +2.95 +2.95 +2.95 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 +0.45 +0.45 +0.45 +0.45 +0.45 +0.45 +0.45 11 An Example of a “Plain Vanilla” Interest Rate Swap The first exchange of payments would take place on Sep 1, 1998. B would receive from A the six-month LIBOR rate prevailing six months prior to Sep 1, 1998 – that is, on Mar 1, 1998. Thus B would receive from A = $2.1 million (0.5x0.042x$100) B would pay A = $2.5million. The second exchange of payments would take place on Mar 1, 1999. B would receive from A the six-month LIBOR rate prevailing six months prior to Mar 1, 1999 – that is, on Sep 1, 1998. Thus B would receive from A = $2.4 million (0.5x0.048x$100) B would pay A = $2.5million. See Table 1 12 6
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