Publish on 04th November 2019
Category: Birds
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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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Derivatives - Matt Will