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# Swaps explained for FRM/CFA level 1

## by Pristine , Web Evangelist at Neev Knowledge Management on Apr 30, 2013

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Swaps explained. Very useful for CFA and FRM level 1 preparation candidates. For a more detailed understanding, you can watch the webinar video on this topic. The link for the webinar video on this ...

Swaps explained. Very useful for CFA and FRM level 1 preparation candidates. For a more detailed understanding, you can watch the webinar video on this topic. The link for the webinar video on this topic is https://www.youtube.com/watch?v=JKBKnxM2Nj4

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## Swaps explained for FRM/CFA level 1Presentation Transcript

• Swaps
• 2Agenda• Introduction• The Comparative Advantage Argument• Interest rate swaps• Valuation of swaps• Currency swaps• Credit risk• Other types of swaps
• 3Introduction• A swap is an agreement between two parties to swap cash flows in the future.• The arrangement covers swaps on multiple dates.• Futures or forwards can be considered as a simple example of a swap where there is a cash flowexchange on one particular date.• Most common swaps are interest rate swaps (IRS) and currency swaps.• The legal agreement in which the two parties enter is called a confirmation, which covers thetermination date, calendar used, rates of payment, day count conventions etc.
• 4Agenda• Introduction• The Comparative Advantage Argument• Interest rate swaps• Valuation of swaps• Currency swaps• Credit risk• Other types of swaps
• 5)( FloatingFixed • Take the example of two firms X and Y where:– X wants to borrow floating– Y wants to borrow fixed• Table tells us that X can borrow fixed at 5% and Y can borrow fixed at 7%• Also X can borrow floating at LIBOR and Y can borrow floating at (LIBOR+100bps)• This implies that X has absolute advantage in borrowing over Y• The point to note here is that the difference in fixed borrowing rates for X and Y( is not the same forthe floating borrowing rates.• Combined benefit to both X and Y by using swap is which is 100 bps for X andY.Company Fixed Borrowing Floating BorrowingX 5% LIBORY 7% LIBOR+100bpsThe Comparative Advantage Argument
• 6The Comparative Advantage Argument (Cont…)X IB Y5%5.50%LiborLibor5.50%Libor +100bps• To reduce the borrowing rates X and Y enter into a swap shown below through the intermediarywhich is usually an investment bank (IB).• Assuming zero transaction charges for IB, X borrows at 5% and lends that money at 5.5% to Ythrough an investment banker.• Similarly Y borrows at LIBOR+100bps and lends to X at LIBOR.• Therefore the net borrowing rate for X becomes (LIBOR-50bps) which is lower than the original rateof LIBOR.• Similarly the net borrowing rate Y becomes 6.5% which is 50bps less than the original rate of 7%
• 7Question – Comparative AdvantageXYZ IB ABC10%10.00%LIBOR+100bpsLIBOR+250bps10.50%Libor +100bpsFollowing are the rates at which company ABC and XYZ can borrow from the market.How can they benefit from Interest Rate SWAP?Solution:XYZ and ABC both benefit by 50bps while the IB makes 200bps profitFixed Rate Floating RateABC 11% LIBOR+1%XYZ 10% LIBOR+3%+0.50%+150bps
• 8Agenda• Introduction• The Comparative Advantage Argument• Interest rate swaps• Valuation of swaps• Currency swaps• Credit risk• Other types of swaps
• 9Interest rate swaps• In the case of fixed-for-floating interest rate swaps two parties get into an agreement where one paysinterest on a floating rate to the other, while the other pays a fixed rate of interest on the same amount• LIBOR is the most common reference rate of floating interest• Notional principal is exchanged or basically no principal is exchanged• IRS can be used for– Changing a liability– Transforming a liabilityParty 1 Party 2Fixed RateFloating Rate
• 10Changing a liability• Party 1 avails a loan of 10% while party 2 avails a floating rate loan at LIBOR +0.3%• Party 1 is receiving a fixed rate of 8% from party 2• Party 1 pays floating interest rate– Party 1’s effective cash flow:• Net cash outflow is (LIBOR+2% )– Party 2’s effective cash flow:• Net cash outflow is 8.3 %• Point to note here is that Party 1’s fixed liability is changed to floating liability after the swap.• Party 2’s liability is changed from a floating liability to a fixed liability of 8.3%LIBOR+0.3%10%Party 1 Party 2LIBOR8%
• 11Financial intermediaries• In the practical world most swaps are traded in the OTC market where financial institutions act asmarket makers .• In the diagram above you can see that the financial institution is making a 3 basis point spread on thefixed payment of the transaction• In such cases the bank has separate contract with party 1 and party 2.• Party 1 and party 2 might not even know that they are on the other sides of the same swap.• Bank creates a market by creating both bid and offer positions so that it can seek clients on eitherside of the swap• It is exposed to certain credit risks in case it is unable to find a counter party for a swapLIBOR+0.3%10%Party 1 Party 2LIBOR9.985%LIBOR10.015%FinancialInstitution
• 12Swap rates• The swap rate is the average of– The fixed rate a market maker is prepared to pay in exchange for a receiving LIBOR ( its bid rate)– The fixed rate it is willing to receive in return for a payment of a floating rate ( its offer rate)• Like LIBOR swap rates are not risk free rates but close to risk free rates
• 13Agenda• Introduction• The Comparative Advantage Argument• Interest rate swaps• Valuation of swaps• Currency swaps• Credit risk• Other types of swaps
• 14Valuation of swaps• There are 2 ways to value a swap.– Considering it as a difference of two bonds– Considering it as a portfolio of FRAs• Value using bonds– Consider an example in which the swap lasts for n years. If the payments are made at the end of eachyear then :– If the principal is exchanged between the 2 parties at the end of the swap, then Party 1’s cash flowsuggests that it’s long a fixed rate bond and short a floating rate bond.– Party 2 is short a fixed bond and long a floating rate bond.– We can value the swap by looking at the pay offs of either party.• Hence the value of the swap can be given as:V = Bfix – Bfl– Where,• Bfix= PV of payments• Bfl = (P+AI)e-rt– Value of a floating bond is equal to the par value at coupon reset dates and equals to the Present Valueof Par values (P) and Accrued Interest (AI)
• 15Valuation of swaps• Value using portfolio of FRAs• In this case we assume that each payment at a future date is a forward rate agreement.• For payment at time t, the rate used is the rate for the period between t-1 and t. This rate would beFRA at t-1.
• 16QuestionCalculate the fixed rate of interest on the swap.Interest rate swapWe enter into a swap where we receive floating rates in return for fixed rate pay outsContract details as belowNotional Principal \$5,000,000Term(Years) 4Settlement 6 monthlyFloating Rate LIBOR 6moLIBOR forward rates and spot rates given:Time (Years)6mo LIBOR FwdRateLIBOR SpotRate0.00 2.8300 0.00000.50 3.1120 2.67681.00 3.2230 3.11351.50 4.5680 3.29502.00 4.1897 3.79532.50 4.3196 3.74413.00 3.9648 3.85233.50 5.0128 3.79974.00 4.0910
• 17AnswerCalculation of fixedratebased on LIBOR forward rates we receive the following 8 cash inflows.We discount each using the [LIBOR] spot rates.Time (Years)6mo LIBOR FwdRate Cash Flow InLIBORSpot RateDiscountFactor PVof Cash In0.00 2.8300 0 0.0000 0 00.50 3.1120 \$141,500 2.6768 0.9868 \$139,6311.00 3.2230 \$155,600 3.1135 0.9696 \$150,8661.50 4.5680 \$161,150 3.2950 0.9522 \$153,4412.00 4.1897 \$228,400 3.7953 0.9276 \$211,8552.50 4.3196 \$209,485 3.7441 0.9114 \$190,9323.00 3.9648 \$215,980 3.8523 0.8918 \$192,6193.50 5.0128 \$198,240 3.7997 0.8766 \$173,7714.00 \$250,640 4.0910 0.8505 \$213,157\$1,426,272In no arbitrage case the PV of fixed payment should be:\$1,426,272 .Hence,\$1,426,272 = annual payment * Sum ( Discountfactors )\$1,426,272 = annual payment* 7.3664\$193,619 = annual paymentThus, the fixed interest rate is \$193,619 / \$5,000,0003.87%Total PV of Floating Payments
• 18Agenda• Introduction• The Comparative Advantage Argument• Interest rate swaps• Valuation of swaps• Currency swaps• Credit risk• Other types of swaps
• 19Currency swaps• Currency swap involves exchanging principal and interest payment in one currency with the principaland interest payments in other currency• In this case the principal needs to be specified and it is exchanged in the beginning as well as the endof the swap• Consider a currency swap between party 1 and 2. In this case Party 1 is in India and can borrow inINR and party 2 is in Australia and can borrow competitively in AUDs at 6%. Party 1 borrows Rs380,000 at 12% and exchanges the principal with party2 for 100,000 AUDs (which it borrows inAustralia). The principal is exchanged back at the end of the life of the swap and the life of the swap is5 years• What is the net payout for party 1 and party 2?6% AUD12% INRParty 1 Party 25.1%AUD12%INR5% AUD12.1%INRFinancialInstitution
• 20• Which of the following statements is correct when comparing an Interest rate Swap with a CurrencySwap?A. At maturity there is no exchange of principal between the counterparties in IRS and there is anexchange of principal in Currency Swaps.B. At maturity there is no exchange of principal between the counterparties in Currency Swaps and there isan exchange of principal in IRS.C. The counterparty in an IRS needs to consider fluctuation in exchange rates, while currency swapcounterparties are only exposed to fluctuations in interest rates.D. Currency swaps counterparties are exposed to less counterparty credit risk due to offsetting effect ofcurrency risk and interest rate risk embedded within the transaction.Questions
• 21Valuation of currency swaps• Just like IRS this swap can be valued using bonds approach and FRA approach• Valuation using bonds– Party 1 is receiving payments in Rupees while paying in AUDs. Hence we can say that he is long a rupeebond and short an AUD bond– The value of the swap will be the difference in the PV of the bonds.Vswap= BRs – S0BAUD– Where,• S0 is the current spot exchange rate between Rs and AUDs• Valuation as a portfolio of forward contracts– In this case we determine the forward exchange rate at each point when the swap payments occur– The foreign currency is converted using the forward exchange rate– In the example above the 1 year, 2 year, 3 year, 4 year forward rate for INR-AUD exchange is used forconverting AUD cash flows to INR every year– This is then discounted back to the present value to give the value of the swap.
• 22QuestionThe US\$ interest rate is 6% per annum and the INR rate is 8% per annum. Assume that the termstructure of interest rates is flat in the US and India. Assume current value of INR to be 0.02 US\$.Company ABC, under the terms of a swap agreement, pays 7% per annum in INR and receives 3% perannum in US\$. The principal in the US is \$10million and that in India is 550million INR. Payments areexchanged each year and the swap will last for 3 more years. Determine the value of swap assumingcontinuous compounding in all interest rates.
• 23SolutionValuation of currency swap in terms of bonds (millions):Value of swap in million \$ = 531.278*0.02 – 9.1519 = \$1.4737 million.
• 24Agenda• Introduction• The Comparative Advantage Argument• Interest rate swaps• Valuation of swaps• Currency swaps• Credit risk• Other types of swaps
• 25Credit risk (Covered in detail in VaR later)• A financial institution has a credit risk exposure from a swap only when the value of the swap isgreater than zero.• Potential losses from a swap are much less than losses from defaults on a loan with the sameprincipal.• Potential losses from a currency swap are much higher than losses from an interest rate swap.
• 26Agenda• Introduction• The Comparative Advantage Argument• Interest rate swaps• Valuation of swaps• Currency swaps• Credit risk• Other types of swaps
• 27Other types of swaps• LIBOR is the most common floating rate in IRS; however there can be other floating rates like,commercial paper (CP) rates.• In floating for floating swaps: rates of one type (LIBOR) can be swapped with floating rates ofanother type (CP)• In an amortizing swap the principal amount reduces in a predetermined amortization rate• In a step up swap the principal increases in a predetermined way• In Credit default swaps (CDS) the buyer of the swaps pays premium to the seller of the swap till thetime the underlying does not default. If the underlying defaults then the seller of the swap makes apayment to the buyer and the CDS is terminated.• In a compounding swap the interest on one or both sides is compounded forward to the end of thelife of the swap and there is only one payment at the end of the contract.• In a fixed for floating currency swap the fixed rate of interest in one currency is swapped for afloating rate of interest in another currency• An equity swap is an agreement to exchange the total returns (dividends and capital gains) from anequity index for a fixed/floating rate of interest.• In a puttable swap one party has the option of terminating the contract early.• Swaptions are options on swaps which provide one party with the right at a future time to enter into aswap where a predetermined fixed rate is exchanged for floating.
• 28• Which of the following achievable swap positions could be used to transform a floating-rate asset intoa fixed-rate asset?A. Receive the floating-rate leg and receive the fixed-rate leg of a plain vanilla interest-rate swapB. Pay the fixed-rate leg and receive the floating-rate leg of a plain vanilla interest-rate swap.C. Pay the floating-rate leg and pay the fixed-rate leg of a plain vanilla interest-rate swapD. Pay the floating-rate leg and receive the fixed-rate leg of a plain vanilla interest-rate swapQuestions
• Five Minute Recap29Party 1 Party 2Fixed RateFloating RateInterest rate swaps:Types of swaps:•Credit default swaps•Compounding swap•Fixed floating currency swap•Equity swap•Amortizing swapValue of the swap:V = Bfix – BfloHere: Bfix= PV of paymentsBflo = (P+AI)e-rt