Ch 7 - Swaps Flashcards
Swap contracts
Swap definition
An OTC derivative agreement between two parties to exchange cash flows at specified times in the future according specific rules
What does a swap CONTRACT do?
The agreement defines the dates when cash flows are paid and the ways in which they are calculated
Plain vanilla interest rate swap
A company pays cash flows equal to interest at a predetermined fixed rate on a notional principal for the predetermined number of years. Receives floating rate on same notional principal for same period of time.
NOTE: Notional principle not actually swapped.
LIBOR definition
reference interbank (AA rated +) deposit (loan) rate - Eurocurrency market
What LIBOR rate is payment calculated from if the LIBOR is 6mo and it is September the 5th today (a payment date)?
The rate set 6 months prior, the March the 5th rate
How is final payment handled at specified payment dates?
It is net settled i.e. the difference is paid from the party that owes more to the party that owes less
In a plain vanilla interest rate swap, using the 6mo LIBOR rate, when is the floating rate certain?
6 months prior to payment
Why are swaps popular?
They are versatile; they can be used to transform the nature of assets or liabilities
Fixed –> floating
&
floating –> fixed
Do non-financial companies trade directly?
They do not because they go through a bank or a financial institution
How do Financial Institutions make money by facilitating swaps?
They charge a percentage fee that is split evenly between the parties of the swap
How can an interest rate swap be used to change a liability?
A fixed rate liability can be changed to a floating rate liability i.e. paying fixed –> paying floating
A floating rate liability can be changed to a fixed rate liability i.e. paying floating –> paying fixed
How does a financial intermediary facilitate a swap contract?
It creates two separate contracts with the two parties and effectively offsets them.
These do not occur simultaneously; FI is prepared to enter swap without counter party i.e. market maker
How does default of one party affect a financial intermediary?
FI still has to pay the other party
At what price does a price taker sell/buy fixed rates?
Sell=bid i.e. receive fixed & pay floating
buy=offer i.e. receive floating & pay fixed
What is the day count for LIBOR?
actual/360
What is the day count for a fixed rate normally?
actual/365 or 30/360
How do we adjust LIBOR to make it directly comparable to fixed?
LIBOR x 365/360
How do we adjust fixed to make it directly comparable to LIBOR?
Fixed x 360/365
What is a confirmation in the context of a swap?
The legal agreement underlying a swap. Is signed by representatives of the two parties.
What is an ISDA master agreement?
It details the terms and conditions underlying the swap agreement
Why use swaps in general?
Acquire a lower interest rate than a company would otherwise be able to obtain –> comparative advantage
How is comparative advantage used?
A company will borrow in the market where it has a comparative advantage (fixed or floating) and then transform it into the type of loan it needs (floating or fixed)
Why do comparative advantages arise between different companies?
Due to differing credit ratings the companies have differing borrowing opportunities available.
What are the primary criticisms of the Comparative Advantage Argument?
LIBOR rates are shorter than fixed rate i.e. 6mo. vs 5 year rates
Creditworthiness can change, for example if credit downgrade then floating rate borrowing at increases then fixed rate increases too
What is a Fixed-for-Fixed currency swap?
Exchange pf principal and interest payments in one currency for principal and interest payments in another currency.
A currency swap requires the principal to be specified in each of the two currencies
In a fixed-for-fixed currency swap, when are principal amounts normally exchanged?
At the beginning and the end of the swap
How are the principal amounts chosen in a fixed-for-fixed currency swap?
Normally, principal amounts are chosen to be approximately equivalent using the exchange rate at the swaps initiation.
Why is a fixed-for-fixed currency swap called fixed-for-fixed?
The interest rate in each currency is at a fixed rate.
What is the major difference between an interest rate swap and a currency swap wrt principal amounts?
In an interest rate swap the principal is not exchanged
In a currency swap the principal is exchanged
What is the primary reason for a currency swap?
Each company’s need for funds denominated in another currency.
Do parties to a currency swap pay the full amount of interest of each leg over to one-another?
No, they net-off the payments at the then prevailing exchange rate
What are the typical uses of a currency swap?
- Convert a liability in one currency to a liability in another
- Convert an investment in one currency to an investment in another
Are currency swaps motivated by comparative advantage?
Yes, interest rates vary in different countries leading to comparative advantage differences. Examples of other sources of comparative advantage are tax differences and the credit ratings of companies.
What are the market risks of swaps and how can they be mitigated?
- Market variables such as int. rates and exchanges rates could move to make that the value of the contract to FI becomes negative
- Can be hedged by offsetting transactions
What are the legal risks of swaps?
- Contract could be declared void by govt. if contract not taken out correctly
- Limited by ISDA agreements that outlines the terms and conditions of the transaction between counterparties
What are the credit risks of swaps? How could this affect financial intermediaries?
- one party to a swap could default leaving FI in position where it needs to honour its commitment to the other party that has not defaulted
What is a swap worth at inception and how does the value of a swap affect its credit risk?
- Swap worth zero to a company initially
- value develops positively or negatively over life of contract
- The company only has credit risk exposure when its value is positive
What other currency swaps are there other than fixed-for-fixed?
Fixed-for-floating
Floating-for-floating
What swaps exist where the notional principal changes? Describe them.
Amortizing - decreasing notional amount (designed to correspond to an amortization schedule on a loan)
Step-up - increasing notional amount - underlying (construction industry) (correspond to drawdowns on a loan agreeement)
Compounding swap - cash flows resets do not get settled but added to the notional amount (overnight index swaps) only one payment at the end
What ‘delayed’ swaps are there?
Deffered/forward swap - Swap where parties do not begin to exchange the interest payments until some agreed future date
LIBOR-in-arrears swap - LIBOR rate on payment date used instead of previous rest LIBOR
What is an equity swap?
Agreement to exchange the total return index for either a fixed or floating rate of interest
What is a commodity swap?
Series of forward contracts on a commodity with different maturity dates and the same delivery prices
What is a volatility swap?
There is a series of time periods
One side pays the pre-agreed volatitly while the other side pays the historical volatility realized during the period
They settle in cash based on the difference between the realized volatility and the volatility strike.
Suppose a company negotiates a fixed interest rate of 5.2% by borrowing at LIBOR + 1.5% and swapping for LIBOR 3.7%. Is this rate truly fixed? Why/why not ?
The rate is not truly fixed and is subject to changes in credit ratings e.g. if the credit rating of the company declines it will not be able to rollover it’s floating rate borrowings, as a result the effective interest rate will increase
Give the general formula for calculating the LIBOR-based floating-rate cf on a swap payment date.
Lrn/360
Where:
L =principal amount
r=relevant LIBOR rate
n=number of days since the last payment date
