Ch 7 - Swaps

Question 1

Swap definition

Answer 1

An OTC derivative agreement between two parties to exchange cash flows at specified times in the future according specific rules

Question 2

What does a swap CONTRACT do?

Answer 2

The agreement defines the dates when cash flows are paid and the ways in which they are calculated

Question 3

Plain vanilla interest rate swap

Answer 3

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.

Question 4

LIBOR definition

Answer 4

reference interbank (AA rated +) deposit (loan) rate - Eurocurrency market

Question 5

What LIBOR rate is payment calculated from if the LIBOR is 6mo and it is September the 5th today (a payment date)?

Answer 5

The rate set 6 months prior, the March the 5th rate

Question 6

How is final payment handled at specified payment dates?

Answer 6

It is net settled i.e. the difference is paid from the party that owes more to the party that owes less

Question 7

In a plain vanilla interest rate swap, using the 6mo LIBOR rate, when is the floating rate certain?

Answer 7

6 months prior to payment

Question 8

Why are swaps popular?

Answer 8

They are versatile; they can be used to transform the nature of assets or liabilities
Fixed –> floating
&
floating –> fixed

Question 9

Do non-financial companies trade directly?

Answer 9

They do not because they go through a bank or a financial institution

Question 10

How do Financial Institutions make money by facilitating swaps?

Answer 10

They charge a percentage fee that is split evenly between the parties of the swap

Question 11

How can an interest rate swap be used to change a liability?

Answer 11

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

Question 12

How does a financial intermediary facilitate a swap contract?

Answer 12

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

Question 13

How does default of one party affect a financial intermediary?

Answer 13

FI still has to pay the other party

Question 14

At what price does a price taker sell/buy fixed rates?

Answer 14

Sell=bid i.e. receive fixed & pay floating

buy=offer i.e. receive floating & pay fixed

Question 15

What is the day count for LIBOR?

Answer 15

actual/360

Question 16

What is the day count for a fixed rate normally?

Answer 16

actual/365 or 30/360

Question 17

How do we adjust LIBOR to make it directly comparable to fixed?

Answer 17

LIBOR x 365/360

Question 18

How do we adjust fixed to make it directly comparable to LIBOR?

Answer 18

Fixed x 360/365

Question 19

What is a confirmation in the context of a swap?

Answer 19

The legal agreement underlying a swap. Is signed by representatives of the two parties.

Question 20

What is an ISDA master agreement?

Answer 20

It details the terms and conditions underlying the swap agreement

Question 21

Why use swaps in general?

Answer 21

Acquire a lower interest rate than a company would otherwise be able to obtain –> comparative advantage

Question 22

How is comparative advantage used?

Answer 22

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)

Question 23

Why do comparative advantages arise between different companies?

Answer 23

Due to differing credit ratings the companies have differing borrowing opportunities available.

Question 24

What are the primary criticisms of the Comparative Advantage Argument?

Answer 24

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

Question 25

What is a Fixed-for-Fixed currency swap?

Answer 25

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

Question 26

In a fixed-for-fixed currency swap, when are principal amounts normally exchanged?

Answer 26

At the beginning and the end of the swap

Question 27

How are the principal amounts chosen in a fixed-for-fixed currency swap?

Answer 27

Normally, principal amounts are chosen to be approximately equivalent using the exchange rate at the swaps initiation.

Question 28

Why is a fixed-for-fixed currency swap called fixed-for-fixed?

Answer 28

The interest rate in each currency is at a fixed rate.

Question 29

What is the major difference between an interest rate swap and a currency swap wrt principal amounts?

Answer 29

In an interest rate swap the principal is not exchanged | In a currency swap the principal is exchanged

Question 30

What is the primary reason for a currency swap?

Answer 30

Each company's need for funds denominated in another currency.

Question 31

Do parties to a currency swap pay the full amount of interest of each leg over to one-another?

Answer 31

No, they net-off the payments at the then prevailing exchange rate

Question 32

What are the typical uses of a currency swap?

Answer 32

- Convert a liability in one currency to a liability in another - Convert an investment in one currency to an investment in another

Question 33

Are currency swaps motivated by comparative advantage?

Answer 33

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.

Question 34

What are the market risks of swaps and how can they be mitigated?

Answer 34

- 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

Question 35

What are the legal risks of swaps?

Answer 35

- 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

Question 36

What are the credit risks of swaps? How could this affect financial intermediaries?

Answer 36

- 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

Question 37

What is a swap worth at inception and how does the value of a swap affect its credit risk?

Answer 37

- 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

Question 38

What other currency swaps are there other than fixed-for-fixed?

Answer 38

Fixed-for-floating | Floating-for-floating

Question 39

What swaps exist where the notional principal changes? Describe them.

Answer 39

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

Question 40

What 'delayed' swaps are there?

Answer 40

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

Question 41

What is an equity swap?

Answer 41

Agreement to exchange the total return index for either a fixed or floating rate of interest

Question 42

What is a commodity swap?

Answer 42

Series of forward contracts on a commodity with different maturity dates and the same delivery prices

Question 43

What is a volatility swap?

Answer 43

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.

Question 44

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 ?

Answer 44

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

Question 45

Give the general formula for calculating the LIBOR-based floating-rate cf on a swap payment date.

Answer 45

L*r*n/360 Where: L =principal amount r=relevant LIBOR rate n=number of days since the last payment date