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Chapter 1.

Overview of the Swap Market

Many innovative financial products have ap- an exchange of a fixed interest rate for LIBOR
peared (and disappeared) during the past couple (the London Interbank Offered Rate). Each set-
of decades. With the benefit of hindsight, it is tlement period, the two rates are compared and
now clear that one of the most important and the difference (times the transaction's notional
lasting innovations developed in this era is the principao is paid by one counterparty to the
over-the-counter swap contract. The interest other. A typical currency swap is an exchange of
rate and currency swap markets have become a fixed interest rate, say 8 percent in Canadian
enormous in the sheer number and size of dollars, for U.S. dollar LIBOR. An important
transactions and participants. Perhaps the most difference is that an interest rate swap does not
telling statement of impact is that swaps have involve an exchange of principal (hence the
attained "commodity status." These days, finan- term "notional" principal), whereas actual prin-
cial analysts routinely consider the effects of cipal amounts are usually traded at the inception
"swapping" into or out of a particular interest and maturity of a currency swap.
rate or currency exposure. Although our pri-
mary focus is on interest rate and currency
swaps, we show that the same contract design Historical Development of the
can be used to manage equity and commodity Swap Market
price risks as well. Swap contracting as we know it today is a
Broken down to its essential nature, a swap fairly recent phenomenon. The first swap agree-
contract is quite straightforward. Two counter- ment was negotiated in 1981 by Salomon Broth-
parties agree to a periodic exchange of cash ers on behalf of the World Bank and IBM and
flows for a set length of time based on a speci- involved an exchange of cash flows denomi-
fied amount of principal. Both cash flows in an nated in Swiss francs and deutschemarks. The
interest rate swap are denominated in the same first standard fixed-for-floatinginterest rate swap
currency; in a currency swap (sometimes called in the United States was executed in 1982 with
a cross-currency swap), the cash flows are ex- the Student Loan Marketing Association ("Sallie
pressed in different monetary units. In either Mae") as a counterparty.
type of contract, one of the cash flow streams These transactions raise two questions: First,
typically is based on a fixed interest rate set at given that firms have borrowed money from one
the inception of the deal, and the other is another (thereby creating interest rates) and
referenced to an index that varies over time. A have traded across national borders in different
standard, or "plain vanilla," interest rate swap is currencies (thereby creating foreign exchange
Interest Rate and Currency Swaps: A Tutorial

rates) for hundreds of years, why have we had of the swap markets that was spurred by these
interest rate and currency swaps for only a short events has been remarkable. Table 1.1presents
period of time? Second, why did the interest rate annual statistics on total dollar volume and
swap, which is the simpler of the two contracts number of contracts for interest rate and cur-
by virtue of having no foreign exchange compo- rency swaps. Also reported is average size of an
nent, develop after the currency swap? outstanding contract in each market. Several
The defining factor behind the timing of the aspects of these data are revealing. First, from
development of the swap markets is summa- 1987 (the first year for which this information
rized in a single word: volatility. In particular, was gathered in a systematic manner) to 1993,
what matters is the volatility of interest rates outstanding principal in the entire swap industry
(particularly in the United States) and exchange increased from less than $1trillion to more than
rates. Two recent events significantly reshaped $7 trillion. This growth is especially striking
the volatility of these two variables. The first was given that the volume prior to 1981 was effec-
the suspension in August 1971 of the Bretton tively zero. Second, interest rate swap activity is
Woods worldwide system of maintaining fixed substantially greater than that for currency
exchange rates linked to a gold standard. There- swaps. In 1993, for instance, total notional prin-
after, exchange rates throughout the world were cipal of interest rate swaps was seven times that
effectively allowed to float to market-determined for currency swaps. Third, the rate of expansion
levels (albeit with frequent central bank inter- in the two markets over this time frame d i e r s ;
vention). The second catalyzing event occurred the outstanding principal of interest rate agree-
in October 1979, when the U.S. Federal Reserve ments grew at an average annual rate of 44.36
Board of Governors, led by its chairman Paul percent compared with 30.43 percent for cur-
Volcker, in an attempt to reduce the inflation rency contracts. Finally, although the size of the
rate, elected to change its operating target to typical currency swap deal appears to have
focus on bank reserve growth rates rather than fluctuated around the $27 million mark for some
the level of short-term interest rates. time, interest rate swap transactions have been
The effect of each of these events on rate getting steadily larger in scale.
volatility is displayed rather emphatically in The primary users of swap agreements are
Figure 1.1. The top panel shows how the first corporate and institutional managers seeking to
difference (i.e., the current minus the previous hedge their underlying operating statement and
rate) of the monthly series of Japanese yen/U.S. balance sheet exposures to adverse movements
dollar exchange rates has evolved since January in interest rates or foreign exchange rates. In
1960. The most striking feature is the virtual fact, according to a 1991 survey of firms' chief
break in the constancy of the pattern that oc- financial officers by Institzktional Investor, three-
curred in the latter part of 1971, following the quarters of the firms with revenues of at least $3
breakdown of the Bretton Woods agreement. billion had used swaps at some point. Cited
The lower panel illustrates how the Federal motivations for using swaps included a corpo-
Reserve's policy change increased the volatility rate treasurer trying to keep the funding cost of
of the ten-year, constant-maturity 1J.S. Treasury a floating-rate debt issue from getting too high,
series in late 1979. When these charts are taken another treasurer protecting the home-currency
together, the answers to the questions about the revenue generated by product sold overseas, an
evolution of the swap markets become evident. insurance company executive attempting to
First, although corporations always had been align the interest rate sensitivities of the firm's
exposed to interest and exchange rates, the assets and liabilities, and a portfolio manager
financial instruments to hedge those risks only trying to execute a tactical asset allocation strat-
became available when volatility reached a level egy in a cost-effective way. Notice that these
at which market making would be profitable. motivations do not involve the pursuit of finan-
Second, volatility in the markets for foreign cial arbitrage. This omission is notable because
exchange increased well before the volatility of many swaps in the early years of the market
domestic interest rates increased. aimed to lower the end user's cost of borrowed
By any standard of measurement, the growth funds by attaching the swap to a newly issued
Chapter 1. Overview of the Swap Market

Figure 1.1 Volatility in the Exchange Rate and Interest Rate Markets
First Diflerence of Monthly YenlDollar Exchange Rate Series

First Difference of 10-Year (Constant-Maturity) U.S. Treasury Yield Series

Data Source: Federal Reserve System.

bond. The swap market, however, could not ally agreeable. The essential variables in a swap
have grown as large and as rapidly as it has if it contract include the level of the fixed rate, the
had to rely largely on continuing inefficiency in manner in which the variable reference rate is to
the capital market, an inefficiency that permits be determined, the scale of the transaction (i.e.,
the new-issue arbitrage opportunity. the notional principal), the currency of the cash
A key element to the swap market's success flows, the dates of the settlement payments, and
has been the flexibility of the contract itself. the events that define default. Although plain
Because each swap is negotiated in the over-the- vanilla terms of agreement have emerged, un-
counter market, there is no limit on the terms or conventional "structured" swaps also can be
conditions that can be written into the contract, transacted. This feature distinguishes swaps
assuming that the two parties find them mutu- from exchange-traded futures contracts, which
Interest Rate and Currency Swaps: A Tutorial

I Growth of the Interest Rate

Table I. ward collateralized arrangements has devel-
and Currency Swap Markets oped.
These two aspects of interest rate and cur-
Total Notional Average rency swaps-customization and credit risk-
Principal (USD Contract explain why commercial banks have played
equivalent, Total Size such a major role in the development of the
Year-End in millions) ContlOacts($millions) market. At first, banks acted as brokers to the
Interest Rate Swaps market, putting the corporate end users together
1987 $ 682,888 34,127 $20.01 and collecting an arrangement fee. Banks even-
1988 1,010,203 49,560 20.38 tually stepped in as intermediaries to the trans-
1989 1,539,320 75,223 20.46 actions and served as the counterparties to the
1990 2,311,544 102,349 22.58 end users. This arrangement facilitated growth
1991 3,065,065 127,690 24.00 of the swap market because commercial banks,
1992 3,850,806 151,545 25.41
1993 6,177,352 236,126 26.16 more than any other institution in the economy,
have the human and financial capital to assess
Currency Swaps and manage credit risk. Moreover, many mon-
1987 ey-center banks saw swaps as a natural replace-
1988 ment to the business they were losing as their
1989 best corporate customers accessed capital mar-
1990 kets to raise funds directly instead of indirectly
1991 via bank loans, a phenomenon dubbed "disinter-
1992 mediation." Over-the-counter derivatives, such
1993 as swaps, offered a means of "reintermediation"
Note: The currency swap total is adjusted for double- between commercial banks and corporations.
counting of contracts. Table 1.2 lists the biggest swap and derivatives
Source: The International Swaps and Derivatives Associa-
houses worldwide. Note that commercial banks
are not just market makers; they also tend to be
heavy end users of swap contracts to manage
their own balance sheet exposures.
have standardized terms. In fact, one of the main Another interpretation of the role of commer-
reasons for the extraordinary development of cial banks in the swap market is as an interme-
the swap market has been the extent to which diary between the futures industry and corpo-
the inherent flexibility of the co:ntract allows rate risk managers. Many swap contracts
corporate risk managers to custorrlize solutions compete directly with exchange-traded futures,
to their hedging needs. as in the case of a plain vanilla interest rate swap
Over-the-counter swaps d 8 e r from ex- exchanging a fixed rate for LIBOR versus a strip
change-traded futures contracts in another fun- of Eurodollar futures contracts. Because the
damental way. The daily mark-to-market valua- swap can be customized to the specific needs of
tion and settlement procedures of a futures the end user, in particular with regard to the
exchange limit credit risk dramatically. Given exact settlement dates, it can minimize the basis
that gains and losses are realized daily, no risk that remains even after executing the
unrealized value builds up over the lifetime of hedge. Many corporate end users prefer a more
the futures contract as it does on a. swap. Thus, exact hedge undertaken with a bank counter-
a swap contract is necessarily a risky instrument party rather than structuring the hedge itself
in that default by the counterparty could lead to with futures contracts, even if it costs a little
significant economic loss (although the amount more and entails bearing the bank's credit risk.
of notional principal can be a very deceptive The bank, in turn, can lay off the risk it assumes
measure of the extent of risk). Both counterpar- when entering the swap with the corporation by
ties to the swap bear this credit risk. Moreover, using the futures contracts themselves. In effect,
swaps have tended to be unsecured obligations, the bank intermediary acquires a futures posi-
although in recent years, a growing trend to- tion with its attendant daily mark-to-market set-
Chapter 1. Overview of the Swap Market

Table 1.2 Outstanding Notional ter Agreement documents for interest rate and
Principal of Leading currency swaps that spell out precisely, among
Derivatives Dealers, 1993 other aspects, the language of the deal, how
agreements need to be confirmed, what happens
in the event of a counterparty default, and how
Financial Institution
the parties to the transaction should treat the
Chemical Bank $2,416 swap for tax purposes.
Bankers Trust 1,982
Citicorp 1,981
J.P. Morgan 1,660 Interest Rate Swaps: Basic
Union Bank of Switzerland
Swiss Bank
Product Design and Market
Societe Generale Conventions
Mitsubishi Bank At first glance, swap market terminology can
Credit Lyonnais be a confusing blend of banking, capital market,
Chase Manhattan and futures market vocabulary. Several conven-
Credit Suisse
tions, however, have emerged to standardize the
BankAmerica language necessary to negotiate and understand
Banque Indosuez swap transactions. Figure 1.2 illustrates several
Merrill Lynch of these conventions for a plain vanilla, U.S.-
Goldman Sachs dollar-denominated interest rate swap agree-
Barclays 751 ment. The two counterparties have arranged to
Paibas 742 make periodic exchanges of cash flows based on
National Westminster 577 a common notional principal and two separate
Royal Bank of Canada 554
interest rates, one that remains fixed for the life
Note: German and most Japanese banks do not disclose of the agreement and one that is reset (ime.,
derivative position sizes.
Source: Fortune, March 7 , 1994. "floats") according to changing market condi-
tions. The two parties to the transaction are
referred to as the p a y a d (Counterparty A) and
tkment procedures and passes it on to the mceive-fxed (Counterparty B) sides of the deal.
corporation as a contract that settles up only
periodically. In fact, the growth of trading activ-
ity in futures contracts has been just as dramatic
as that of the swap market in recent years, which Figure 1.2 Swap NIarket Pricing
indicates that the over-the-counter swap market Mechanics
and futures exchanges complement one another At Origination
as much as they compete.
Negotiate Terms of the Transaction
An important institutional presence in the (Including Notional Principal, Maturity, etc.)
swap market is the International Swaps and
No Exchange of Cash Flows
Derivatives Association (ISDA) . This organiza-
tion, which was originally known as the Interna-
tional Swap Dealers Association, is an industry On Each Settlement Date
trade group that provides its members with
Floating Reference Rate
many services, ranging from periodic surveys of (e.g., Six-Month LIBOR)
trends in the market to advocacy on regulatory
issues. Easily the most important contribution Counterparty A Counterparty B
ISDA has made to the growth of the industry
was to create a set of standardized terminology
Swap Fixed Rate =
and conditions that has governed virtually every
Treasury Swap
market transaction since 1987. Specifically, Note + Spread
ISDA developed (and continues to update) Mas- Yield
Interest Rate and Currency Swaps: A Tutorial

No exchange of cash flows takes place at origi- pays the fixed rate and the offer side when it
nation of the swap. receives the fixed rate.
The fixed-rate payer is sometimes said to Table 1.3 lists a representative set of quoted
have "bought" the swap or, equivalently, taken fixed rates on swaps based on six-month LIBOR.
the long position, which would then leave the Two aspects of this table are noteworthy. First,
fixed-rate receiver as the "seller,'kr short posi- as the swap maturity lengthens, the absolute
tion. In fact, nothing is actually bought or sold, level of the swap spread tends to rise. This
because at inception, the swap is neither an phenomenon suggests that the swap spread has
asset nor a liability. Each party has entered a a separate term structure from the usual matu-
zero-sum contract that might, ark.! probably will, rity term structure built into the Treasury yield
take on positive value to one side; if it does, the curve. Second, across the entire list of swap
other side will have a corresponding amount of maturities-which is representative of the ten-
negative value. The expressions "buy" and "sell" ors commonly available in the market-the bid-
arise from interpreting the floating reference ask differential on the swap spread quote never
rate as the commodity that the two counterpar- exceeds 4 basis points. This differential repre-
ties are trading; the swap's fixed rate is the price sents the market maker's profit margin on a pair
for this recurring transaction. That is, Counter- of "matched" deals (i.e., simultaneously exe-
party B can be viewed as having agreed to sell cuted pay-fixed and receive-fixed transactions
the reference rate on each settlement date for having the same notional principal and settle
the fixed rate agreed upon at the outset. ment dates), so apparently the plain vanilla
Notice also that the floating-rate side of the segment of the swap market is quite competi-
transaction is quotedflat; any modification to the tive. These bid-ask spreads were much wider in
price of the swap typically is negotiated as an the formative years of the swap market.
Figure 1.3 illustrates a matched pair of five-year
adjustment to the fixed rate. For example, a
agreements using these quotes, with Counter-
market maker might set a lower pay-fixed rate
party C now serving the role of the second
when transacting with a weaker counterparty
corporate end user.
than with a stronger one; the receive-fixed side Several important standards govern the pro-
is LIBOR flat in each case. The reference rate on cess for calculating the periodic settlement pay-
the swap can be any mutually agreeable index ments. The most important is that settlements
(e.g., LIBOR, the prime rate, a commercial are made on a net basis; that is, although
paper index, or the average of certificate of Figures 1.2 and 1.3 suggest that two cash flows
deposit rates). Nevertheless, a recent ISDA sur- will change hands each settlement period on
vey reported that about 90 percent of the U.S.-
dollar-based contracts used either three- or six-
month LIBOR as the floating rate. Table 1.3 Representative Quotes for
Another important convention shown in Plain Vanilla Interest Rate
Figure 1.2 is that the fixed-rate side of the Swaps Based on Six-Month
contract is broken down into two components: a LIBOR
Treasury note yield and a swap spread. The Bid Ask Effective
particular Treasury note yield selected depends Swap Treasury Swap Swap Fixed Swap
on the maturity, or tenor, of the swap. The usual Maturity Yield Spread Spread Rate
practice is to use the yield of the on-the-run (i.e., (years) (%I (bps) (bps) (%)
the most recently issued) security maturing
closest to the swap's final settlement date. A
convenient facet of these conventions is that the
market maker's quoted price for the agreement
is reduced to the swap spread, because all
market participants can monitor the current
Treasury yield. In fact, a market maker usually
quotes two swap spreads-the bid side when it Source: Chemical Securities, Inc.
Chapter 1, Overview of the Swap Market

Figure 1.3 A Matched Pair of Five-Year Swap Transactions

Six-Month Six-Month

f 4
Counterparty B
Counterparty A (the swap dealer) Counterparty C

> >

each deal, in reality, the counterparty owing the one period to another if the settlement periods
larger of the two amounts will simply pay the themselves have different numbers of days.
difference. Second, the fixed and floating rates Note, however, that fixed-rate payments based
specified in the swap agreement might not be on a 30/360 day count will not vary at all. Finally,
directly comparable. For instance, the fixed rate the reference rate used to settle at date t is
typically is a semiannually compounded rate actually determined one period in arrears (i.e.,
quoted on a bond basis (consistent with a at date t - 1). This convention, which matches
quoted Treasury yield). The day-count conven- the usual practice for determining interest pay-
tion for the swap fixed rate used for partial-year ments in the floating-rate note and bank loan
cash flows typically is either "actua1/365" or markets, ensures that both cash flows will al-
"30/360." In contrast, U.S. dollar LIBOR is a ways be known one full settlement period in
money-market rate based on a 360-day year; its advance. With these definitions, the net settle-
partial-year cash flows are calculated on an ment obligation is defined in a straightforward
"actua1/360" basis. Assuming an actua1/365 day manner as the difference between the fixed-rate
count for the fixed-rate payment, the formulas and floating-rate payments.
for the settlement calculations under these con- Table 1.4 demonstrates the settlement date
ditions are as follows: cash flows from the perspective of the fixed-rate
payer in the five-year swap illustrated in
(Fixed-rate payment), = (Swap fixed rate) Figure 1.3. Specifically, assume that after the
initial agreement was negotiated, the terms of
(Numb;w;f days
1 the transaction were confirmed as follows:

Origination date: September 30, 1994

x (Notional principal) Maturity date: September 30, 1999
and Notional principal: U.S. $30 million
Fixed-rate payer: Counterparty A
(Floating-rate payment), = (Reference rate) ,-, Swap fixed rate: 7.56 percent (semiannu-
al, actual/365 bond basis)
(Numbf;; days
i Fixed-rate receiver: Counterparty B (the
swap dealer)
Floating rate: Six-month LIBOR (money-
x (Notional principal),
market basis)
where the subscript denotes the settlement pe- Settlement dates: September 30th and
riod date. Notice three important features of March 30th of each year
these equations. First, the principal involved in LIBOR determination: Determined in ad-
the interest rate swap transaction is never ex- vance, paid in arrears
changed; it is notional (or hypothetical) in the
sense that it is used only as a scale factor to The third column of Table 1.4 lists an assumed
translate a percentage rate into a cash amount. path that the six-month spot LIBOR follows over
Second, the fixed-rate payment might vary from the course of the contract. As the fixed-rate
Interest Rate and Currency Swaps: A Tutorial

Table 1.4 Settlement Cash Flows for the Fixed Payer on a Five-Year Interest Rate
Fixed-Rate Floating-Rate Counterparty A's
Settlement Number Assumed Payment Receipt Net Payment
Date of Days Current LIBOR (Counterparty A) (Counterparty B) (Receipt)

payer, Counterparty A makes (receives) the net plain vanilla currency swap is assumed to ex-
settlement payment whenever the day-count- change a fixed rate in the foreign currency for
adjusted level of LIBOR is less than (exceeds) U.S. dollar LIBOR. This structure is shown in
the swap fixed rate of 7.56 percent. This net Figure 1.4.
settlement amount is shown in the last column Notice in this diagram that two distinct types
of the table as the difference between the coun- of exchanges take place: principal on both orig-
terparties' cash flows. ination and maturity, and coupon interest on all
of the settlement dates. Customarily, both prin-
Currency Swaps: Basic Product cipal exchanges are executed at the spot foreign
Design and Market Conventions exchange (FX)rate prevailing at the initiation
Two factors make the cross-currency swap date, regardless of subsequent market EX rates.
agreement a more difficult transaction to ana- Furthermore, as in the interest rate swap, the
lyze than the single-currency agreement consid- floating-rate side of the coupon exchanges in the
ered above. First, because the associated cash standard currency swap is usually quoted flat.
flows are denominated in different monetary Thus, the dollar cash flow paid by Counterparty
units, the principal amounts are usually ex- E on each settlement date is determined by
changed at the origination and maturity dates of multiplying the relevant LIBOR (which would
the contract. Second, because two currencies once again have been determined at the previ-
are involved, the interest rates defining the ous settlement date) by the U.S. dollar principal
transaction can be expressed on either a fixed- amount, adjusted by the day-count factor. The
rate or a floating-rate basis in either or both periodic cash flow that Counterparty D is obli-
currencies. Assuming that the U.S. dollar is one gated to pay is simply the product of the quoted
of the currencies involved in the deal, this leaves fixed rate and the foreign-currency-based princi-
the following four possibilities: (1) a fixed rate in pal amount. Because the cash flows differ in
the foreign currency versus a fixed rate in U.S. denomination, currency swaps do not settle on a
dollars, (2) a fixed rate in the foreign currency net basis.
versus a floating rate in U.S. dollars, (3) a Table 1.5 lists a representative set of quotes
floating rate in the foreign currency versus a for various maturities and the main international
fixed rate in U.S. dollars, or (4) a floating rate in currencies. For comparative purposes, quotes
the foreign currency versus a floating rate in for plain vanilla U.S. dollar interest rate swaps
U.S. dollars. Although all of these formats are are presented in the last row of the table. These
used in practice, the predominant quotation rates represent the fixed foreign interest rates
convention in the market is the second; that is, a that a market maker would receive for payment
Chapter 1. Overview of the Swap Market

Figure 1.4 A Basic Currency Swap principal in dollars). Notice that in each market,
Transaction the swap yield curve is upward sloping.
At Originafion To see how these rate conventions translate
into cash flows, suppose Counterparty D has
Foreign Currency agreed to pay the dealer (Counterparty E) 8.65
Principal percent on the four-year sterling swap. Assume
further that the transaction has the following
Counterparty D Counterparty E
U.S. Dollar
Principal Origination date: November 15, 1994
Maturity date: November 15, 1998
Notional principal: GBP 20 million and
On Each Settlement Date (Including Maturity) USD 34.4 million
Fixed-rate payer: Counterparty D
Foreign Currency Swap fixed rate: 8.65 percent in pounds
Fixed-Coupon Rate
sterling (semiannual bond basis)
Counterparty D Counterparty E Fixed-rate receiver: Counterparty E (the
swap dealer)
U.S. Dollar Floating rate: Six-month LIBOR in U.S.
dollars (money-market basis)
Settlement dates: November 15th and

May 15th of each year
At Maturity LIBOR determination: Determined in ad-
Foreign Currency
vance, paid in arrears
r-----l The initial and ultimate principal exchanges are
Counterparty D Counterparty E based on the dollar/pound spot exchange rate of
4 USD 1.72/GBP that is assumed to have pre-
U.S. Dollar L

vailed at the swap origination date. With the
preceding customs, the pound-denominated
coupon settlement payments are computed as
of U.S. dollar LIBOR. For instance, on a four- [0.0865 x (Number of days/365) x GBP 20
year contract, a corporate counterparty would million], and the dollar-based cash flows are
have to pay the currency swap dealer 4.12 determined by [LIBOR x (Number of days/
percent in Japanese yen (times the principal in 360) x USD 34.4 million]. These amounts are
yen) to receive U.S. dollar LIBOR (times the shown in Table 1.6 from the perspective of
Counterparty D (i.e., the fixed-rate payer).
Table 1.S Representative Quotes for Although the plain vanilla form of a currency
Plain Vanilla Currency swap is of the fixed foreign currency/floating
Swaps Based on Six-Month dollar variety, that is not always the most useful
U.S. Dollar LIBOR for Two-, way to package cash flows in order to satisfy a
Three, and Four-Year corporate end user. For instance, what if Coun-
Maturities terparty D in the previous example had wanted
to receive a fixed rate in U.S. dollars, instead of
Currency 2 Years 3 Years 4 Years LIBOR, in exchange for fixed sterling payments?
Yen 3.27% 3.78% 4.12% Fortunately, the standard fixed/floating cur-
Sterling 8.13 8.55 8.65 rency swap can easily be repackaged by com-
Swiss franc 5.07 5.24 5.38 bining it with a floating/fixed U.S. dollar interest
Deutschemark 6.43 6.92 7.21 rate swap. This objective can be accomplished
U.S. dollar 7.79 7.97 8.08 by negotiating the following two transactions
Source: Chemical Securities, Inc. with the swap market maker:
Interest Rate and Currency Swaps: 12 Tutorial

Table 1.6 Settlement Cash Flows for the Fixed-Payer on a Four-Year, British
Pound Sterling Currency Swap
Number Assumed Fixed-Rate Floating-Rate
Settlement Date of Days Current LIBOR Payment (millions) Receipt (millions)
- - - - - -

Initial Exchange of Principal

11/15/94 USD 34.400 GBP 20.000
Coupon Exchanges
5/ 15/95 GBP 0.858 USD 0.994
11/15/95 0.872 1.055
5/15/96 0.863 1.087
11/15/96 0.872 1.178
5/15/97 0.858 1.254
11/15/97 0.872 1.187
5/15/98 0.858 1.167
Final Coupon and Principal Exchange
11/15/98 GBP 0.872 USD 0.967
and GBP 20.000 and USD 34.400

Receive dollar LIBOR in. exchange for Recent Trends in the Use of Swap
paying the sterling given rate of 8.65 Contracts
percent, and In recent years, swap contracting has ex-
pay dollar LIBOR in exchange for receiv- panded into new markets, as well as into new
ing a dollar fured rate, assumed to be 8.04 versions of the basic product. For instance, it is
percent. now possible to trade both interest rate and
currency swaps that are denominated in more
than 18 different currencies. New nonplain va-
Because the second of these swaps involves only nilla swap designs and related products include
dollar-based cash flows, physical exchange of prin-
cipal is required only for the first transaction.
Figure 1.5 illustrates the sequence of cash flow Oflmayket swaps, which set the fixed rate
exchanges that will occur on the settlement dates. to be something other than the prevailing
As a practical matter, if both of these trans- "at-market" level in order to create an
actions were executed simultaneously with the initial payment at the origination of the
same market maker, the corporate end user agreement;
Varying notional principal swaps, in which
(Counterparty D) would not undertake two sep-
the size of the deal either expands or
arate transactions. Rather, to minimize the req-
contracts from one settlement date to the
uisite documentation and bookkeeping, the next according to a predetermined sched-
swap intermediary in this case would undoubt- ule;
edly offer the counterparty a direct, blended Indexed amortizing rate swaps, in which
quote of "receive U.S. dollar 8.04 percent, pay the notional principal varies in response
sterling 8.65 percent," leaving LIBOR out alto- to changes in some market index (such
gether. Moreover, using U.S. dollar LIBOR as as the level of LIBOR) during the agree-
the base facilitates computation of the full range ment;
of fixed/fixed nondollar swaps--for instance, a Entry and exit options on swaps (known as
fixed rate in Swiss francs versus a fixed rate in swaptions), which give the holder the
deutschemarks. These fked/fixed swaps were right, but not the obligation, to get either
once known as CIRCUS swaps, which stood for into or out of a swap at prearranged
"combined interest rate and currency swaps." terms;
Chapter 1. Overview of the Swap Market

Figure 1.5 Creating a U.S. Dollar, British Pound Sterling FixedlFixed Currency
Swap (Settlement Date Payments)
Pay Fixed SterlinglReceive Dollar LIBOR

Counterparty E
Counterparty D (swap market maker)


Receive Fixed DollarlPay Dollar LIBOX

U.S. Dollar 8.04%

Counterparty E
Counterparty D (swap market maker)

U.S. Dollar

Net Transaction: Pay Fixed SterlinglReceive Fixed Dollar

Sterling 8.65%
Counterparty E
Counterparty D (swap market maker)

U.S. Dollar 8.04%

e Basis swaps, calling for the exchange of and receive-fixed sides of the swap con-
two different floating rates (e.g., LIBOR tract itself;
vs. prime); Collars, corridors, and participation agree-
"Di#"swaps, which can be thought of as ments, which are combinations of caps
cross-currency basis swaps in that the and floors; and
cash flows are linked to floating rates in Equity and commodity swaps, which define
different countries but are denominated one of the cash flows of the swap in terms
in the same base currency; of the return to an equity (e.g., Standard
Cap and floor agreements, which are the & Poor's 500) or a commodity (e.g., West
respective option analogs to the pay-fixed Texas Intermediate Oil) index.
Interest Rate and Currency Swaps: A Tutorial

We will discuss these innovations in subsequent be centered on the currencies of the Western
chapters. European countries, including the European
To get a better idea of the range of the swap Currency Unit basket. Transactions in Canadian
industry, consider Table 1.7, which is based on a dollars and in currencies of Pacific Rim coun-
recent ISDA market survey. The table shows the tries (Australia, New Zealand, and Hong Kong)
total outstanding notional principal for both in- account for a relatively small part of these
terest rate and currency swaps of all varieties at markets.
year-end 1993. Also shown are the percentages Growth in the market for over-the-counter
of the various total outstanding volumes repre- interest rate option products has paralleled that
sented by each currency. These figures, which of the swap industry. Table 1.8 summarizes an
are listed in rank order by currency for interest ISDA report on the use of caps, floors, combina-
rate swap contracts, show clearly that although tion agreements (i.e., collars, corridors, and
U.S. dollar transactions are easily the largest participations), and swaptions as of year-end
single presence in either product market, they 1992. The display lists the number of contracts
are far from dominant. Indeed, roughly two- transacted (both long and short), as well as the
thirds of the deals in each group are negotiated total notional principal of dollar-denominated
in a nondollar currency. In particular, about one agreements. Perhaps most notable is the small
in five transactions across the two markets is size of the interest rate option market relative to
denominated in Japanese yen, with another 20 the swap market itself. Recall from Table 1.1that
percent coming from a combination of deals total interest rate swap volume for 1992 was in
done in Swiss francs, German deutschemarks, excess of $3.85 trillion with 151,545 contracts
or British pounds. In fact, if the US.-dollar- and traded; the dollar-denominated portion of the
Japanese-yen-based activity were removed, the market exceeded $1.76 trillion in 52,258 con-
vast majority of swap activity in the world would tracts. In this light, the market for over-the-

Table 1.7 Swap Activity by Currency as of Year-End 1993

Interest Rate Swaps Currency Swaps
Dollar Equivalent Percent of Dollar Equivalent Percent of
Currency (millions) Total (millions) Total
U.S. dollar
Japanese yen
French franc
British sterling
Swiss franc
Italian lira
Euro currency unit
Australian dollar
Canadian dollar
Dutch guilder
Spanish peseta
Swedish krona
Belgium franc
Hong Kong dollar
Danish krone
New Zealand dollar
0ther currencies
- -

Note: The currency swap total is unadjusted for double-counting of contracts.

Source: International Swaps and Derivatives Association.
Chapter 1. Overview of the Swap Market

Table 1.8 Cap, Floor, Combination, and Swaption Activity as of Year-End 1992
Activity Caps Floors Options Swaptions Total
Transaction Volume
Number of contracts bought
Number of contracts sold

U.S. Dollar Notional Principal

Long positions $ 81,450 $25,341 $ 3,932 $16,193 $126,916
Short positions 150,446 36,904 9,789 15,139 212,278
Total $231,896 $62,245 $13,721 $31,332 $339,194
Note: Positions have been adjusted for double-counting of contracts.
Source: International Swaps and Derivatives Association.

counter interest rate option products was fall), measured in either dollar or contract vol-
roughly one-tenth the size of the whole interest ume. Although the distribution of long and short
rate swap market, and the total number of option positions is largely a function of interest rate
contracts traded represented only about one- expectations that prevailed at the time, the prev-
fifth of the volume in swaps. Notice also that cap alence of caps is consistent with the notion that
agreements, which protect the contract's holder these contracts are used extensively by liability
against rising interest rates, were more popular managers seeking protection against increases
than floor contracts (which pay off when rates in their borrowing costs.
Interest Rate and Currency Swaps: A Tutorial

Exercise 1.1: With the interest rate swap quotations shown in Table 1.3, use a
box-and-arrow diagram to illustrate a matched set of seven-year, plain vanilla interest
swap transactions from a dealer's point of view (i.e., the simultaneous acquisition of
pay-fixed and receive-fixed transactions having the same notional principal and
settlement dates). Also, calculate the swap dealer's profit on each settlement date,
assuming a notional principal of $25 million and, for simplicity, settlement dates that
are exactly 182.5 days apart.
Solution: With bid and offer fixed rates for the seven-year deals quoted at 7.77 percent
and 7.81 percent, respectively, the transaction can be illustrated as in Figure E-1.1.
Notice that, barring default by one of the corporate counterparties, the dealer is not
concerned with the actual level of LIBOR on any settlement date. If LIBOR is greater
(less) than 7.81 percent, the dealer will make (receive) the net settlement payment to
Firm X but receive (make) a payment from Firm Y when LIBOR is greater (less) than
7.77 percent. Thus, on every settlement date, the dealer will receive the difference
between the bid and offer fixed rates prorated to the appropriate number of days in the
settlement period and scaled to the notional principal amount. In this case, the
calculation is given by

Thus, the dealer will receive $5,000 every six months for the next seven years from this
pair of transactions.

Figure E-1.1 A Matched Set of Seven-

Year Swaps
Six-Month LIBOR Six-Month LIBOR
Financial 4
Firm Y
-) Institution
7.81% 7.77%

Exercise 1.2: Using the interest rate swap quotations listed in Table 1.3, calculate the
swap cash flows from the standpoint of the fmed-rate receiver on a three-year swap
with a notional principal of $40 million. (Assume the relevant part of the settlement
date pattern and the realized LIBOR path shown in Table 1.4 for the five-year
agreement. Also, calculate fixed-rate payments on an actual/365 day-count conven-
Solution: Given that no principal is exchanged at the origination of a plain vanilla
interest rate swap on September 30,1994, the first settlement will take place on March
30, 1995. As the fixed-rate receiver, the counterparty in question will calculate the
following gross cash flows on this date:

Floating-rate payment = (0.0550) x (g) x ($40,000,000) = $1,106,111


Fixed-rate receipt = (0.0714) x

-- x ($40,000,000) = $1,416,263.
Chapter 1. Overview of the Swap Market

Thus, the net receipt due the receive-fixed counterparty is $310,152 (i.e., $1,416,263 -
$1,106,111). Notice that the value for six-month LIBOR used in the floating-rate
calculation is determined by the September 30, 1994, value of that rate; the swap fixed
rate is 7.14 percent, the bid side of the dealer's three-year quote. The complete list of
settlement cash flows is given in Table E-1.I.

Table E- 1.1 Settlement Cash Flows, Fixed-Rate Receiver

- - - - - - - - - -

Settlement Number Assumed Fixed-Rate Floating-Rate Receiver's Net
Date of Days Current LIBOR Receipt Payment Receipt (Payment)

Exercise 1.3: As a swap dealer, you have just been contacted by a prospective
corporate counterparty who wishes to do a three-year "fixed/fixed" yen/sterling
currency swap. In particular, the corporation needs to pay a fixed interest rate in
Japanese yen and to receive a fixed rate in British pounds. Your current spot FX and
three-year currency swap quotes (versus six-month U.S. dollar LIBOR) are as follows:

Japanese Yen British Pound

Spot Exchange Rate JPY 127.47/USD USD 1.82/GBP
Currency Swap Bid 4.85% 9.83%
Offer 4.92% 9.93%
These quotes imply that you would be willing to pay 4.85 percent in yen to receive U.S.
dollar LIBOR, but you would need to receive 4.92 percent in yen when paying LIBOR.
Your bid-offer spread is 7 basis points in yen. Note that the bid-offer spread is h-igher
in sterling because each basis point is not worth as much, given that sterling would be
at a forward discount to yen.
(a) Describe the sequence of transactions necessary to construct this swap from the
counterparty's perspective, including your quotes for both of the fxed rates.
(b) Construct a table similar to Table 1.6 summarizing the cash flow exchanges on
each exchange date, again adopting the end-user's viewpoint. In this analysis, assume
that the deal is to be scaled to a transaction size of USD 25 million and that the number
of days in the settlement payments alternates between 182 and 183, starting with 183
days between the origination date and the first settlement date.
Solution: First of all, recognize that at the current exchange rates, USD 25 million
translates into JPY 3,186,750,000 (the product of USD 25,000,000 and.JPY 127.47/USD)
and GBP 13,736,264 (USD 25,000,000 divided by USD 1.82/GBP). These become the
principal amounts governing the transaction. Then:
(a) The desired swap could be accomplished by combining the following currency
Pay 4.92 percent Japanese yen, receive U.S. dollar LIBOR, and
Interest Rate and Currency Swaps: A Tutorial

receive 9.83 percent British sterling, pay U.S. dollar LIBOR.

The result is a pay 4.92 percent yen, receive 9.83 percent sterling swap, which
represents your offer swap rate in yen and your bid rate in sterling.
(b) After swapping principal amounts at the origination date, the cash flow exchanges
on first settlement date from the counterparty's standpoint are calculated as follows:

Yen payment = (0.0492) x /El X (JPY 3,186,750,000)= JPY 78,608,828


Pound receipt = (0.0983) x (El x ((GBP 13,736,264) = GBP 686,390.

The full set of cash exchanges, which will be known at the inception of the deal, is
shown in Table E-1.2.

Table D l.2 Cash Flow Exchanges, Counterparty

Settlement Days in Payments Receipts
Date Settlement (millions) (millions)
Initial GBP 13.736 JPY 3,186.75
1 JPY 78.61 GBP 0.69
2 78.18 0.68
3 78.61 0.69
4 78.18 0.68
5 78.61 0.69
Final JPY 3,186.75 GBP 13.736
and JPY 78.18 and GBP 0.68

Exercise 1.4: Suppose that on September 30, 1994, the treasurer for Company X
wishes to restructure the coupon payments of one of her outstanding debt issues. The
bond in question is scheduled to pay semiannual interest on September 30th and
March 30th each year until September 30, 1999, and has a coupon rate of 8 percent
with a face value of $35 million. On the same day, the treasurer for Company Y wants
to restructure the interest payments on his $50 million, four-year, floating-rate note
having a coupon reset each September 30th and March 30th to a reference rate of
LIBOR flat. The maturity of this floating-rate bond is September 30, 1998.
(a) Using the representative plain vanilla interest rate swap quotes in Table 1.3,
describe how both treasurers, working with a market maker, can use a swap
agreement to alter synthetically their current cash flow obligations. Specifically,
assume that Company X wishes to wind up with floating-rate exposure and Company
Y desires fixed-rate debt.
(b) Assuming that the market maker negotiates these swap transactions simulta-
neously, will they represent a matched book? If not, describe two remaining sources
of market exposure that the dealer still faces.
Solution: Although the timing of the coupon payments for the two companies is
comparable, the terms of the swaps they seek are not. Specifically, Company X needs
a five-year, receive-fixed swap for a notional principal of $35 million and Company Y
desires a four-year, pay-fixed, $50 million deal.
Chapter 1. Overview of the Swap Market

(a) Company X could synthetically alter its fixed-rate payments by entering into a
receive-fixed swap, accepting the market maker's five-year bid quote of 7.53 percent.
The transaction is shown in Figure E-1.2.

Figure E-1.2 Company X's Synthetic

Debt Conversion
Six-Month LIBOR

Company X 1/ Marzrzaker

Pay 8%

To calculate the resulting synthetic floating rate that Company X will be obligated to
pay, recall that in the U.S. dollar market, LIBOR is quoted on a 360-day basis, but the
swap fixed rate, which is linked to Treasury yields, is on a 365day basis. Adjusting for this
discrepancy so that the net cost of funds is expressed on a money-market basis, we have

Fixed-rate debt coupon payment = (8.00%) x (360/365) = 7.89%

LIBOR payment = LIBOR
Fixed receipt = (7.53%) x (360/365) = (7.43%)
Net cost of funds = LIBOR + 0.46%.

The treasurer at Company X can expect her semiannual interest cost to be 46 basis
points higher than the level of six-month LIBOR set one period in arrears. Similarly,
taking the offered side of the four-year market, the pay-fixed swap necessary to convert
Company Ys' floating-rate debt and the resulting synthetic fixed-rate funding cost (on
a 365-day basis) is shown in Figure E-1.3. The result is a net funding cost for Company
Y of [(LIBOR) X (365/360)] + (7.45%) - [(LIBOR) X (365/360)] = 7.45%.

Figure E-1.3 Company Y's Synthetic

Debt Conversion
Six-Month LIBOR

Company Y
Market Maker

Interest Rate and Currency Swaps: A Tutorial

(b) Although this arrangement may appear to be a matched set of transactions, the
market maker has two distinct interest rate exposures. First, the swaps are different in
maturity by one year, so the dealer is left with an unhedged commitment to pay the
fixed rate of 7.53 percent to Company X in Year 5. If LIBOR during this period is less
than 7.53 percent, the dealer will have to make a net settlement payment with no
compensating cash inflow on the other side. Second, during the four years common to
both swaps, the contracts are written for different notional principal amounts. One way
to see the problem this arrangement creates is to split the $50 million swap with
Company Y into: (1) a $35 million swap to match the transaction with Company X and
(2) an unhedged residual deal of $15 million. If LIBOR exceeds 7.45 percent during the
first four years, the market maker would have to pay out on this unmatched portion
with no offsetting inflow. Figure E-1.4 depicts these two exposures.

Figure E-1.4 Market Maker's Swap Exposures

Years 1 4
$35 million

Company Y

Company X
lrket Maker
y 7.45%

$35 million
7.53% 1
Company Y
$15 million

Year 5


Market Maker
Swap I
I l l
Company Y

$35 million