Swaps

Question 1

Swap

Answer 1

An agreement between counterparties to exchange a specific periodic cash flows in the futures based on specific prices / interest rates.
Swaps allow financial market participants to better manage risk in their relevant preferred habitat markets.

Question 2

4 Types of swaps

Answer 2

• Interest rate swaps
• Equity swaps
• Currency swaps
• Commodity swaps
• Credit risk swap

Question 3

Interest rate swaps

Answer 3

The swapping of differing interest obligations between two parties via a facilitator.
An agreement between two parties to exchange a series of fixed rate cash flows for a series of floating rate cash flows in the same currency.
Also called a coupon swap.

Question 4

Buyer of interest rate swap

Answer 4

The party that agrees to make fixed interest rate payments.

Question 5

Seller of interest rate swap

Answer 5

The party that agrees to undertake the floating rate payments.

Question 6

Motivation for interest rate swaps

Answer 6

• Interest rate risk

- Comparative advantage

Question 7

Basis swaps

Answer 7

A swap where two floating rates are swapped.

Question 8

Amortising swap

Answer 8

A swap with a notional value that reduces over the life of the swap in a predetermined way.

Question 9

Accreting swap (step-up swap)

Answer 9

A swap in terms of which the notional amount increase in a predetermined manner during the term of the swap.

Question 10

Roller-coaster swap

Answer 10

A swap in terms of which the notional amount increases and decreases during the term of the swap.

Question 11

Deferred swap (forward start swap)

Answer 11

A swap where the counterparties do not start exchanging interest payments until a future date.

Question 12

Extendable swap

Answer 12

A swap where one party has the option to extend the life of the swap beyond the term of the swap, according to predetermined conditions.

Question 13

Puttable swap

Answer 13

A swap where one party has the option to terminate the swap prior to maturity date, according to predetermined conditions.

Question 14

Constant maturity swap

Answer 14

A swap where a floating rate is exchanged for a specific rate.

Question 15

Index amortizing rate swap (indexed principle swap)

Answer 15

A swap where the notional amount reduces in a way that is dependent on the level of interest rates.

Question 16

Timing-mismatched swap

Answer 16

A swap with a timing mismatch.

Question 17

Currency swaps

Answer 17

The exchange of principal and interest payments in one currency for principal and interest payments in another currency.
The amounts involved are usually of equal magnitude and the are exchanged with interest at the beginning and end of the life of the swap.

Question 18

Cross currency swap (currency coupon swap)

Answer 18

The exchange of a floating rate in one currency for a fixed rate in another currency.

Question 19

Differential swap (diff swap)

Answer 19

The exchange of a floating rate in the domestic currency for the floating rate in a foreign currency.

Question 20

Fixed for equity swap

Answer 20

Similar to interest rate swap. Difference lies therein that the floating rate is linked to the return on a specified share index.

Question 21

Floating-for-equity equity swap

Answer 21

An equity swap with one leg benchmarked against a floating rate of interest and the other leg benchmarked against an equity index.

Question 22

Asset allocation equity swap

Answer 22

An equity swap where the equity leg is benchmarked against the greater of the two indices.

Question 23

Quantro equity swap

Answer 23

An equity swap with two equity legs, the return on one equity index is swapped for the return on another equity index.

Question 24

Blended-index equity swap

Answer 24

An equity swap where the floating leg is an average (weighted or otherwise) of two or more equity indices.

Question 25

Rainbow-blended-index equity swap

Answer 25

An equity swap where the floating leg is an average (weighted or otherwise) of two or more equity indices, but the indices are different foreign indices.

Question 26

Commodity swaps

Answer 26

Where parties exchange fixed for floating prices on a stipulated quantity of a commodity.

Question 27

The agreed notional amount in a swap is exchanged at the start of the swap and at the maturity of the swap. True or false?

Answer 27

False. The notional amount is not exchanged.

Question 28

The party that agrees to make fixed interest rate payments is called the buyer and the party that undertakes to make floating rate payments is called the seller. True or false?

Answer 28

True

Question 29

The three main reasons for an interest rate swap are: transforming a liability, transforming an asset and speculation. True or false?

Answer 29

False. The main motivations for an interest rate swap are transforming a liability, transforming an asset and comparative advantage.

Question 30

The intermediary bank that arranges a swap transaction assumes the counterparty risk because it interposes itself between the clients (the two parties to the swap), and undertakes to receive and pay the relevant interest amounts. True or false?

Answer 30

True

Question 31

Most swaps in reality involve well known benchmark rates, such as the LIBOR in the UK, the Fedfunds rate in the US, the ROD or JIBAR rates in South Africa, and so on, which the fixed and floating rates in the swap are based in each payment period. True or false?

Answer 31

False. The fixed leg is not benchmarked because it is an agreed number.

Question 32

Comparative advantage will exist when the one party in the exchange has an absolute advantage in one market and the other party an absolute advantage in the other market. True or false?

Answer 32

False. One party may have (and often does) an absolute advantage in both markets. Comparative advantage is possible if there is a relative difference in the absolute advantage that the one party might have in the two markets.

Question 33

A basis swap is where two floating rates are swapped. True or false?

Answer 33

True

Question 34

A currency swap in its simplest form involves the exchange of interest payments in one currency for interest payments in another currency. True or false?

Answer 34

False. A currency swap in its simplest form involves the exchange of principal and interest payments in one currency for principal and interest payments in another currency.

Question 35

Define a swap.

Answer 35

A swap may be defined as an agreement between counterparties (usually two but there can be more parties involved in some swaps) to exchange specific periodic cash flows in the future based on underlying assets or prices. The interest calculations are made with reference to an agreed notional amount.

Question 36

What is a swap called when two floating rates are exchanged?

Answer 36

A basis swap.

Question 37

Company A has borrowed R1 million through the issuing of 91-day commercial paper (which is re-priced every 91 days at the then prevailing rate), while Company B has borrowed R1 million by the issuing of corporate bonds at a fixed rate of 8.0% pa for a 3-year period. A bank now arranges a swap between the parties who agrees that the bank will earn 0.1% on the fixed interest leg of the transaction. Assume a floating rate for the first two 91-day periods after the swap agreement of 8.5 and 8.6 respectively. What amounts will Company A and Company B pay to the bank in each of these first two periods?

Answer 37

First 3-month period:
Company A pays bank: R0 {fixed interest is paid every six months}
Company B pays bank: R21 192 {1 000 000 x [0.085 x (91 / 365)]}
Second 3-month period:
Company A pays bank: R40 500 {1 000 000 x [(0.081 / 2)]}
Company B pays bank: R21 441 {1 000 000 x [0.086 (91 / 365)]}.

Question 38

Company A has invested R1 million in 91-day commercial paper (which is re-priced every 91 days at the then prevailing rate), while Company B
has invested R1 million in corporate bonds at a fixed rate of 8.0% pa for a 3-year period. A bank now arranges a swap between the parties who
agree that the bank will earn 0.1% on the fixed interest leg of the transaction. Assume a floating rate for the first two 91-day periods after the swap agreement of 8.5 and 8.6 respectively. What amounts will Company A and Company B receive from the bank in each of these first two periods?

Answer 38

First 3-month period, receipts from bank:
Company A receives: R0 {fixed interest is paid every six months}
Company B receives: R21 192 {1 000 000 x [0.085 x (91 / 365)]}
Second 3-month period, receipts from bank:
Company A receives: R39 500 {1 000 000 x [(0.079 / 2)]}
Company B receives: R21 441 {1 000 000 x [0.086 (91 / 365)]}

Question 39

Two companies can borrow as follows:
Fixed market Floating market
Company A 6.5 6.9
Company B 5.4 5.5
Which company has got an absolute advantage in the fixed market and how big is that advantage? Which company has got an absolute advantage in the floating market and how big is that advantage?

Answer 39

Company B has an absolute advantage in the fixed market; the advantage is 1.1% pa (= 6.5 – 5.4). Company B has an absolute advantage in the floating market; the advantage is 1.4% pa (= 6.9 – 5.5).

Question 40

Two companies can borrow as follows:
Fixed market Floating market
Company A 6.5 6.9
Company B 5.4 5.5
Which company has a comparative advantage in the fixed market and how big is that advantage? Which company has a comparative advantage in the floating market and how big is that advantage?

Answer 40

Company B has a comparative advantage in the floating market: it is able to borrow at 1.4% pa lower than Company A compared to 1.1% pa lower than Company A in the fixed market (a difference of 0.3% pa.). Company A has a comparative advantage in the fixed market: it is able to borrow at 1.1% pa higher than Company B compared to 1.4% pa higher than Company B in the floating market (a difference of 0.3% pa).

Question 41

Two companies can borrow as follows:
Fixed market Floating market
Company A 6.5 6.9
Company B 5.4 5.5
What is the potential gain to be derived from a swap (and which will have to be shared by the parties to the swap arrangement)? If the gain is shared equally after the bank that arranged the swap has taken a commission of 0.1%, what rate will each party end up paying the bank (assuming that this rate is adjusted to apportion the gain correctly and assuming the floating rate doesn't change)?

Answer 41

The potential gain from a comparative advantage swap is 0.3% (= 1.4 –1.1). The bank will receive 0.1% of this leaving 0.2% to be shared equally by A and B. Each one will therefore gain 0.1%. Company A will initially borrow in the fixed market but will pay the bank after the swap a floating rate of 6.8%. Company B will initially borrow in the floating market but will pay the bank after the swap a fixed rate of 5.3%.

Question 42

The UK financial intermediary company has GBP 100 million of its liabilities in USD (2-year 10% pa fixed bond issue in USD = USD 180 million). In a similar fashion, a US financial intermediary has USD 180
million of GBP liabilities (2-year 10% pa fixed GBP-denominated bond = GBP 100 million). Interest on both bonds is payable annually. A currency swap is done for two years at the exchange rate applicable at the time. If at the end of year 2 the exchange rate is 1.9 USD for 1 GBP, i.e. the GBP has appreciated (more USD per GBP), how much did the UK company gain or lose from the swap?

Answer 42

The UK company is worse off than it would have been in the absence of the swap. In the absence of the swap the UK company would have had to buy USD 198 million for GBP 104.21 million (1 / 1.9 x USD 198
million), compared with GBP 110 million (1 / 1.8 x USD 198 million) it paid with the swap.

Question 43

A SA company (SACO) wants to borrow USD 100 million at a floating rate for 10 years in order to make an investment in the US. A US company (USCO) wants to raise ZAR 650 million for 10 years at a fixed rate for investment in SA. The exchange rate is ZAR 6.5 to one USD.
The following terms are available to them:
• SACO: USD 100 million at LIBOR + 0.75%
• USCO: ZAR 650 million at 7.5% fixed.
Their banker advises them that they should not borrow on these terms, but rather as follows which they are able to:
• SACO: borrow USD 100 million at a fixed rate of 7% for 10 years
• USCO: borrow ZAR 650 million at LIBOR + 0.25%
and that they simultaneously undertake to swap the principal and the obligations (interest is payable every six months). They borrow as advised, and the swap takes place. Assume that each of the two parties
gives up 0.1% of its benefit from the swap to pay the 0.2% commission that the bank charges for arranging the swap. What is the net interest rate that each will pay every six months after the swap?

Answer 43

Net interest rate paid by SACO: LIBOR + 0.35% on USD 100m.

Net interest rate paid by USCO: 7.1% fixed rate on ZAR 650m.

Question 44

Define a cross currency swap.

Answer 44

A cross currency swap (also called currency coupon swap) involves the exchange of a floating rate in one currency for a fixed rate in another currency.

Question 45

Investor A has R100 million invested in government bonds at 9.6% pa, payable every six months, but would prefer to get a return on equity for
the next two years. Investor B has got R100 million invested in equity, but would prefer a fixed return for the next two years. A bank arranges an equity swap at a commission of 0.2%. What will be the cash flows (in
return terms, not in rand) to and from the bank for the two investors every six months?

Answer 45

Investor A:
Payment to bank: 9.6% pa fixed rate every six months
Payment by bank: return on all share index every six months.
Investor B:
Payment to bank: return on all share index every six months
Payment by bank: 9.4% pa fixed rate every six months.

Question 46

A SA maize producer wishes to fix the price on 100 tons of the coming season’s production. A SA mill wants to fix the price on 100 tons of maize
that it will require in the coming season for its milling operations. What will be the price expectations of the two parties for a swap to be desirable?

Answer 46

The maize producer wishes to fix a price on its production (100 tons), because it is of the opinion that the price of maize is about to fall (wants to receive fixed, i.e. a fixed price, and pay floating, i.e. the spot rate). On the other hand, the miller who has to buy the maize believes that the price of maize is about to rise sharply (wants to pay fixed, i.e. fixed price, and receive floating, i.e. spot price).