Chapter 12: Swaps

1. Chapter 12: Swaps Markets are an evolving ecology. New risks arise all the time. Andrew Lo CFA Magazine, March-April, 2004, p. 31 An Introduction to Derivatives and Risk Management, 8th ed.

2. Important Concepts in Chapter 12 • The concept of a swap • Different types of swaps, based on underlying currency, interest rate, or equity An Introduction to Derivatives and Risk Management, 8th ed.

3. Definition of a swap • Four types of swaps • Currency • Interest rate • Equity • Commodity • Characteristics of swaps • No cash up front • Notional principal (a measure of the size of a swap or derivative stated in units of currency on which the payments are calculated) • Settlement date, settlement period • Credit risk • Dealer market • See Figure 12.1, p. 409for growth in world-wide notional principal An Introduction to Derivatives and Risk Management, 8th ed.

4. Definition of a swap • Swaps is a financial derivative in which 2 parties make series of payments to each other at specific dates. • While a forward contract is a single payment, a swap is a series of payments. • E.g. In some cases, a party would like to make a series of purchase, instead of a single purchase, from the other at fixed price at various date (different dates). • Exclusively customized, over-the-counter instruments. An Introduction to Derivatives and Risk Management, 8th ed.

5. Swaps & Forward contracts(Similarities) • Swaps are similar to forward contracts -fixed payment or receive a floating payment at a future date. • Both swaps and forward contracts require no up­front payments, and both are subject to default risk. Thus, swaps have zero value at the start An Introduction to Derivatives and Risk Management, 8th ed.

6. Swaps Vs. Forward contracts • Swaps • Both sides of the first payment are known. Also, for a swap, all of the fixed payments are the same. • Forward contracts • each contract would be priced separately and would have different fixed rates An Introduction to Derivatives and Risk Management, 8th ed.

7. Types of Swaps • Interest rate Swaps • Series of interest payments between two parties. • The two parties agree to exchange a series of interest payments in the same currency at the various settlement dates. • more widely used than currency and equity swaps, because nearly all businesses face some form of interest rate risk. • A plain vanilla swap (a.k.a. vanilla swap) is a swap in which on party pays a fixed rate & the other pays a floating rate An Introduction to Derivatives and Risk Management, 8th ed.

8. Interest rate Swaps • Interest rate swaps are the primary means of managing that risk (interest rates risk). • A company will typically use interest rate swaps to limit, or manage, its exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate. • Widely used by corporations to manage interest rate risk. An Introduction to Derivatives and Risk Management, 8th ed.

9. Interest Rate Swaps (continued) • Interest Rate Swap Strategies • See Figure 12.5, p. 421for example of converting floating-rate loan into fixed-rate loan • Other types of swaps • Index amortizing swaps • Diff swaps • Constant maturity swaps An Introduction to Derivatives and Risk Management, 8th ed.

10. Types of swaps Currency Swaps • Involves the exchange of principal and interest in one currency for the same in another currency. • E.g. Supposed Malaysian based company needs to acquired Japanese Yen and a Japanese based company needs to acquire Malaysian Ringgit. These 2 companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and maturity date of exchange. • Often combined with interest rate swaps. An Introduction to Derivatives and Risk Management, 8th ed.

11. Currency Swaps (continued) • Currency Swap Strategies • A typical case is a firm borrowing in one currency and wanting to borrow in another. See Figure 12.8, p. 432for Reston-GSI example. Reston could get a better rate due to its familiarity to GSI and also due to credit risk. • Also a currency swap be used to convert a stream of foreign cash flows. This type of swap would probably have no exchange of notional principals. An Introduction to Derivatives and Risk Management, 8th ed.

12. Types of Swaps • Equity • Equity swaps are exchanges of cash flows in which at least one of the indices is an equity index. • An index equity is a measure of the performance of an individual stock or a basket of stocks. • Common equity indices with which the general investor is probably familiar include the S&P’s 500 Index, and Dow Jones Industrial Average. An Introduction to Derivatives and Risk Management, 8th ed.

13. Equity Swaps • Characteristics • One party pays the return on an equity, the other pays fixed, floating, or the return on another equity • Rate of return is paid, so payment can be negative • Payment is not determined until end of period An Introduction to Derivatives and Risk Management, 8th ed.

14. Equity Swaps (continued) • Equity Swap Strategies • Used to synthetically buy or sell stock • See Figure 12.9, p. 440for example. • Some risks • default • tracking error • cash flow shortages An Introduction to Derivatives and Risk Management, 8th ed.

15. Types of Swaps • Commodity Swaps • A swaps where exchanged cash flows are dependent on the price of an underlying commodity. • Usually use to hedge against the price of commodity. • The vast majority of commodity swaps involve oil. An Introduction to Derivatives and Risk Management, 8th ed.

16. Some Final Words About Swaps • Similarities to forwards and futures • Offsetting swaps • Go back to dealer • Offset with another counterparty • Forward contract or option on the swap An Introduction to Derivatives and Risk Management, 8th ed.

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