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Chapter 7

Swaps

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

Nature of Swaps
A swap is an agreement to exchange
cash flows at specified future times
according to certain specified rules

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

An Example of a Plain Vanilla Interest


Rate Swap
An agreement by Microsoft to receive 6month LIBOR & pay a fixed rate of 5% per
annum every 6 months for 3 years on a
notional principal of $100 million
Next slide illustrates cash flows that could
occur (Day count conventions are not
considered)
Options, Futures, and Other Derivatives, 9th Edition, Copyright
John C. Hull 2014

One Possible Outcome for Cash


Flows to Microsoft (Table 7.1, page 155)
Date

LIBOR

Floating Cash
Flow

Fixed Cash
Flow

Net Cash
Flow

Mar 5,
2014

4.20%

Sep 5, 2014 4.80%

+2.10

2.50

0.40

Mar 5,
2015

5.30%

+2.40

2.50

0.10

Sep 5, 2015 5.50%

+2.65

2.50

+ 0.15

Mar 5,
2016

5.60%

+2.75

2.50

+0.25

Sep 5, 2016 5.90%

+2.80

2.50

+0.30

2.50
Options, Futures, and+2.95
Other Derivatives, 9th Edition,
Copyright John C. Hull 2014

+0.45

Mar 5,
2017

Typical Uses of an Interest Rate


Swap
Converting a liability from
fixed rate to floating rate
floating rate to fixed rate

Converting an investment from


fixed rate to floating rate
floating rate to fixed rate

Options, Futures, and Other Derivatives, 9th Edition,


Copyright John C. Hull 2014

Intel and Microsoft (MS)


Transform a Liability (Figure 7.2, page 155)
5%
5.2%

Intel

MS
LIBOR+0.1%
LIBOR

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

Financial Institution is Involved


(Figure 7.4, page 157)

4.985%
5.2%

Intel
LIBOR

5.015%

F.I.

MS
LIBOR

LIBOR+0.1
%

Financial Institution has two offsetting


swaps

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

Intel and Microsoft (MS) Transform an


Asset (Figure 7.3, page 156)
5%
4.7%

Intel

MS

LIBOR-0.2%
LIBOR
Options, Futures, and Other Derivatives, 9th Edition, Copyright
John C. Hull 2014

Financial Institution is Involved


(See Figure 7.5, page 157)

4.985%

5.015%
4.7%

Intel

F.I.

MS

LIBOR-0.2%
LIBOR

LIBOR

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

Quotes By a Swap Market Maker


(Table 7.3, page 158)
Maturity
2 years

Bid (%)
6.03

Offer (%)
6.06

Swap Rate (%)


6.045

3 years

6.21

6.24

6.225

4 years

6.35

6.39

6.370

5 years

6.47

6.51

6.490

7 years

6.65

6.68

6.665

10 years

6.83

6.87

6.850

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

10

Day Count
A day count convention is specified for for
fixed and floating payment
For example, LIBOR is likely to be actual/360
in the US because LIBOR is a money market
rate

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

11

Confirmations
Confirmations specify the terms of a
transaction
The International Swaps and Derivatives has
developed Master Agreements that can be
used to cover all agreements between two
counterparties
Many interest rate swaps are now cleared
through a CCP such as LCH Clearnet or the
CME Group
Options, Futures, and Other Derivatives, 9th Edition, Copyright
John C. Hull 2014

12

The Comparative Advantage Argument


(Table 7.4, page 160)
AAACorp wants to borrow floating
BBBCorp wants to borrow fixed

Fixed

Floating

AAACorp

4.0%

6 month LIBOR 0.1%

BBBCorp

5.2%

6 month LIBOR + 0.6%

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

13

The Swap (Figure 7.6, page 161)


4.35%
4%
AAACorp

BBBCorp
LIBOR+0.6%
LIBOR

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

14

The Swap when a Financial


Institution is Involved (Figure 7.7, page 162)
4.33%

4.37%

4%
AAACorp

LIBOR

F.I
.

BBBCorp
LIBOR+0.6%
LIBOR

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

15

Criticism of the Comparative


Advantage Argument
The 4.0% and 5.2% rates available to AAACorp
and BBBCorp in fixed rate markets are 5-year
rates
The LIBOR0.1% and LIBOR+0.6% rates
available in the floating rate market are sixmonth rates
BBBCorps fixed rate depends on the spread
above LIBOR it borrows at in the future
Options, Futures, and Other Derivatives, 9th Edition, Copyright
John C. Hull 2014

16

The Nature of Swap Rates


Six-month LIBOR is a short-term AA borrowing
rate
The 5-year swap rate has a risk corresponding to
the situation where 10 six-month loans are made
to AA borrowers at LIBOR
This is because the lender can enter into a swap
where income from the LIBOR loans is
exchanged for the 5-year swap rate

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

17

The Discount Rate


Pre-crisis derivatives cash flows were
discounted at LIBOR
As Chapter 9 explains, this has changed
Here we illustrate the valuation methodology
by assuming that LIBOR is the discount rate

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

18

Using Swap Rates to Bootstrap the


LIBOR/Swap Zero Curve
Consider a new swap where the fixed rate is the
swap rate
When principals are added to both sides on the final
payment date the swap is the exchange of a fixed
rate bond for a floating rate bond
The floating-rate rate bond is worth par assuming
LIBOR discounting is used. The swap is worth zero.
The fixed-rate bond must therefore also be worth par
This shows that swap rates define par yield bonds
that can be used to bootstrap the LIBOR (or
LIBOR/swap) zero curve
Options, Futures, and Other Derivatives, 9th Edition, Copyright
John C. Hull 2014

19

Example of Bootstrapping the


LIBOR/Swap Curve (Example 7.1, page 164)
6-month, 12-month, and 18-month
LIBOR/swap rates are 4%, 4.5%, and 4.8%
with continuous compounding.
Two-year swap rate is 5% (semiannual)

2.5e 0.040.5 2.5e 0.0451.0 2.5e 0.0481.5


2 R
102.5e
100
The 2-year LIBOR/swap rate, R, is 4.953%
Options, Futures, and Other Derivatives, 9th Edition, Copyright
John C. Hull 2014

20

Valuation of an Interest Rate Swap


Initially interest rate swaps are worth close
to zero
At later times they can be valued as the
difference between the value of a fixed-rate
bond and the value of a floating-rate bond
Alternatively, they can be valued as a
portfolio of forward rate agreements (FRAs)

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

21

Valuation in Terms of Bonds


The fixed rate bond is valued in the usual way
The floating rate bond is valued by noting that
it is worth par immediately after the next
payment date

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

22

Valution of Floating-Rate Bond


Value = PV
of L+k* at t*
Value =
L+k*
0
Valuation
Date

Value = L

t*
First Pmt
Date
Floating
Pmt =k*

Second
Pmt Date

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

Maturity
Date

23

Example
Receive six-month LIBOR, pay 3% (s.a.
compounding) on a principal of $100 million
Remaining life 1.25 years
LIBOR zero rates for 3-months, 9-months and
15-months are 2.8%, 3.2%, and 3.4% (cont
comp)
6-month LIBOR on last payment date was
2.9% (s.a. compounding)
Options, Futures, and Other Derivatives, 9th Edition, Copyright
John C. Hull 2014

24

Valuation Using Bonds (page 166)


Time Bfix cash
flow

Bfl cash
flow

0.25

1.5

0.75
1.25
Total

Disc
factor

PV
Bfix

PV
Bfl

101.450 0.9930

1.4895

100.742
3

1.5

0.9763

1.4644

101.5

0.9584

97.2766
100.230
6

100.742
3

Swap value = 100.7423 100.2306 = 0.5117

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

25

Valuation in Terms of FRAs


Each exchange of payments in an interest
rate swap is an FRA
The FRAs can be valued on the
assumption that todays forward rates are
realized

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

26

Valuation of Example Using FRAs


(page 167)
Time

Fixed
cash
flow

Floating
cash
flow

Net Cash
Flow

Disc
factor

PV
Bfl

0.25

1.5000

+1.4500

0.0050

0.9930

0.0497

0.75

1.5000

+1.7145

+0.2145

0.9763

+0.2094

1.25

1.5000

+1.8672

+0.3672

0.9584

+0.3519

Total

+0.5117

Options, Futures, and Other Derivatives, 9th Edition,


Copyright John C. Hull 2014

27

An Example of a Currency Swap


An agreement to pay 5% on a sterling
principal of 10,000,000 & receive 6% on
a US$ principal of $15,000,000 every year
for 5 years

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

28

Exchange of Principal
In an interest rate swap the principal is not
exchanged
In a currency swap the principal is usually
exchanged at the beginning and the end of
the swaps life

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

29

The Cash Flows (Table 7.7, page 170)


Date

Dollar Cash
Flows
(millions)

Sterling cash
flow
(millions)

Feb 1, 2014

15.00

+10.0

Feb 1, 2015

+0.90

0.50

Feb 1, 2016

+0.90

0.50

Feb 1, 2017

+0.90

0.50

Feb 1, 2018

+0.90

0.50

Feb 1, 2019

+15.90

10.50

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

30

Typical Uses of a
Currency Swap
Convert a liability in one currency to
a liability in another currency
Convert an investment in one
currency to an investment in
another currency

Options, Futures, and Other Derivatives, 9th Edition,


Copyright John C. Hull 2014

31

Comparative Advantage May Be


Real Because of Taxes

General Electric wants to borrow AUD


Quantas wants to borrow USD
Costs after adjusting for the differential
impact of taxes:
USD

AUD

General Electric

5.0%

7.6%

Quantas

7.0%

8.0%

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

32

Valuation of Currency Swaps


Like interest rate swaps, currency swaps can
be valued either as the difference between 2
bonds or as a portfolio of forward contracts

Options, Futures, and Other Derivatives, 9th Edition, Copyright


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33

Example
All Japanese LIBOR/swap rates are 4%
All USD LIBOR/swap rates are 9%
5% is received in yen; 8% is paid in dollars.
Payments are made annually
Principals are $10 million and 1,200 million
yen
Swap will last for 3 more years
Current exchange rate is 110 yen per dollar
Options, Futures, and Other Derivatives, 9th Edition, Copyright
John C. Hull 2014

34

Valuation in Terms of Bonds (Table 7.9,


page 173)
Time

Cash Flows
($)

PV ($)

Cash flows
(yen)

PV (yen)

0.8

0.731
1

60

57.65

0.8

0.668
2

60

55.39

0.8

0.610
7

60

53.22

10.0

7.633
1,200
Value of Swap = 1230.55/1108 9.6439 = 1.5430
Total

9.643
9
Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014

1,064.30
1,230.55

35

Valuation in Terms of Forwards


(Table 7.10, page 174)
Time $ cash
flow

Yen cash Forward


flow
Exch
rate

Yen cash
flow in $

Net
Cash
Flow

Presen
t value

-0.8

60

0.009557

0.5734

-0.2266

-0.2071

-0.8

60

0.010047

0.6028

-0.1972

-0.1647

-0.8

60

0.010562

0.6337

-0.1663

-0.1269

-10.0

1200

0.010562

12.6746

+2.6746

2.0417

Total

1.5430

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

36

Swaps & Forwards


A swap can be regarded as a convenient
way of packaging forward contracts
Although the swap contract is usually
worth close to zero at the outset, each of
the underlying forward contracts are not
worth zero

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

37

Credit Risk: Single Uncollateralized


Transaction with Counterparty
A swap is worth zero to a company initially
At a future time its value is liable to be either positive or negative
The company has credit risk exposure only when ithe value is
positive
Some swaps are more likely to lead to credit risk exposure than
others
What is the situation if early forward rates have a positive value?
What is the situation when the early forward rates have a negative
value?

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

38

Other Types of Swaps

Floating-for-floating interest rate swaps


amortizing swaps
step up swaps
forward swaps
constant maturity swaps
compounding swaps
LIBOR-in-arrears swaps
accrual swaps
diff swaps
cross currency interest rate swaps
equity swaps
extendable swaps
puttable swaps
swaptions
commodity swaps
volatility swaps
etc etc

Options, Futures, and Other Derivatives, 9th Edition, Copyright


John C. Hull 2014

39