Derivatives
Lecture 13
SWAPS
Birth 1981Definition - An agreement between two firms, in which each firm agrees to exchange the “interest rate characteristics” of two different financial instruments of identical principalKey pointsSpread inefficienciesSame notation principalOnly interest exchanged
SWAPS
“Plain Vanilla Swap” - (generic swap)fixed rate payerfloating rate payercounterpartiessettlement datetrade dateeffective datetermsSwap Gain = fixed spread - floating spread
SWAPS
Example (vanilla/annually settled)XYZ ABCfixed rate 10% 11.5%floating rate libor + .25 libor + .50Q: if libor = 7%, what swap can be made 7 what is the profit (assume $1mil face value loans)A:XYZ borrows $1mil @ 10% fixedABC borrows $1mil @ 7.5% floatingXYZ pays floating @ 7.25%ABC pays fixed @ 10.50%
SWAPS
Example (vanilla/annually settled)XYZ ABCfixed rate 10% 11.5% LIBOR = 7.0%floating ratelibor+ .25libor+ .50
XYZ
ABC
- 10.50+ 11.50+ 7.25- 7.25
- 10.00 *+ 10.50+ 7.25- 7.25
1,000,000x
SWAPS
Example -contBenefit to XYZ Net Positionfloating + 7.25 -7.25 0fixed +10.50 -10.00 +.50Net gain +.50%Benefit ABC Net Positionfloating + 7.25 - 7.50 -0.25fixed -10.50 + 11.50 +1.00net gain +0.75%
SWAPS
Example -contSettlement dateABCpmt10.50 x 1mil = 105,000XYZpmt7.25 x 1mil = 72,500net cashpmtby ABC = 32,500ifliborrises to 9%settlement dateABCpmt10.50 x 1mil = 105,000XYZpmt9.25 x 1mil = 92,500net cashpmtby ABC = 12,500
SWAPS
transactionsrarely done directbanks = middlemanbank profit = part of “swap gain”example - same continuedXYZ & ABC go to bank separatelyXYZ term = SWAP floating @ libor + .25 for fixed @ 10.50ABC terms = swap floating libor + .25 for fixed 10.75
SWAPS
Example - contsettlement date - XYZBank pmt 10.50 x 1mil = 105,000XYZ pmt 7.25 x 1mil = 72,500net Bank pmt to XYZ = 32,500settlement date - ABCBank pmt 7.25 x 1mil = 72,500ABC pmt 10.75 x 1mil = 107,500net ABC pmt to bank = 35,000bank “swap gain” = +35,000 - 32,500 = +2,500
SWAPS
Example - contbenefit to XYZfloating 7.25 - 7.25 = 0fixed 10.50 - 10.00 = +.50 net gain .50benefit to ABCfloating 7.25 - 7.50 = - .25fixed -10.75 + 11.50 = + .75 net gain .50benefit to bankfloating +7.25 - 7.25 = 0fixed 10.75 - 10.50 = +.25 net gain +.25total benefit = 12,500 (same as w/o bank)
Currency Swaps
Similar to interest rate swapsSame type loan, just diff currencyWHY?example:you have an investment in JapanProject is financed with US bondsYou look for SWAP partner so you can emulate holding Japanese bondsJava Yahoo principalYen loan 11% 12% $ 1 mil$ loan 8% 11.1% or Y120
Currency Swaps
example - continuedJava borrows $1mil @ 8%Yahoo borrows Y120mil @ 12%Intl. Bank arranges swapJava swaps 8% $ loan for 10.3% yen loan w/bankYahoo swaps 12% yen loan for 10.4% $ loan w/banktotal available benefit = (11.1-8) - (12-11) = 2.1%
Currency Swaps
example - continuedbenefit to Java$ loan +8 - 8 = 0Yen loan +11 - 10.3 = .7 net gain +.7%benefit to Yahoo$ loan 11.1 - 10.4 = +.7yen loan -12 + 12 = 0 net gain = .7%benefit to bank$ loan +10.4 - 8 = +2.4yen loan - 12 + 10.3 = -1.7 net gain + .7%
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