11 - Forwards, Futures, And Swaps(1)

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CHAPTER 11CHAPTER 11Forwards, Futures, andForwards, Futures, and

SwapsSwaps



CHAPTER 11 ± Forwards, Futures and Swaps 11 - 2

Forward versus Spot ContractsForward versus Spot ContractsBasic CharacteristicsBasic Characteristics

AA spot contract spot contract is a price that is established today foris a price that is established today forimmediate delivery.immediate delivery.

± ± Immediate delivery depends on the nature of the underlyingImmediate delivery depends on the nature of the underlyingcontract.contract.

AA forward contract forward contract is a price that is established today foris a price that is established today for future delivery. future delivery.

± ± Can be specified for almost any future date because forwardCan be specified for almost any future date because forwardcontracts are custom contracts between two parties.contracts are custom contracts between two parties.

± ± These types of contracts date back to the Roman Empire.These types of contracts date back to the Roman Empire.

(Table 11(Table 11 ± ± 1 illustrates foreign exchange quotes for spot and forward delivery)1 illustrates foreign exchange quotes for spot and forward delivery)




Forex Forward ContractsForex Forward ContractsBasic CharacteristicsBasic Characteristics

Foreign Exchange Rates (Canadian dollars per foreign currency)

US ($) GB (£) JAP (¥) Euro (¼)

Spot 1.107 2.040 0.009721 1.3991

1 month 1.1063 2.0393 0.009754 1.4007

3 month 1.1044 2.0383 0.009821 1.4039

6 month 1.1017 2.0368 0.009920 1.4082

1 year 1.0971 2.0340 0.010116 1.4159

3 year 1.0697 n/a n/a n/a

5 year 1.0622 n/a n/a n/a

10 year 1.0312 n/a n/a n/a

Source: Data f rom Bank of Montreal (BMO) Nesbitt Burns, Globe and Mail , June 10, 2006.

Table 11-1 Foreign Exchange QuotesReflects theimportance of theUS as a Canadiantrading partner.(Remember,

forward contractsoccur betweencorporations andtheir Canadianbanks.)

Reflects the timevalue of

money«forwardrates the priceTODAY for futuredelivery«so thefurther away, thelower the presentvalue.




Forex Forward ContractsForex Forward ContractsBasic CharacteristicsBasic Characteristics

Forex forward contracts are bank instruments:Forex forward contracts are bank instruments:

± ± There is no organized exchange (they are an OTC instrument)There is no organized exchange (they are an OTC instrument)

± ± Requires that the customer have a banking relationship.Requires that the customer have a banking relationship.

Involves credit risk for the bank when investors suffer losses.Involves credit risk for the bank when investors suffer losses. Banks will only sell forward contracts for legitimate businessBanks will only sell forward contracts for legitimate business

purposes.purposes.

Will only sell up to a company¶s approved credit limit.Will only sell up to a company¶s approved credit limit.

Consequently, forward contracts are used for hedging purposes byConsequently, forward contracts are used for hedging purposes by

fir m

s wishing tom

itigate exposure to specific risks.fir m

s wishing tom

itigate exposure to specific risks. ± ± As customized instruments Forwards can be tailored to any As customized instruments Forwards can be tailored to any

specific date in the future and for any amount of money.specific date in the future and for any amount of money.

± ± ContractsContracts mustmust be fulfilled.be fulfilled.




Using Forward ContractsUsing Forward Contracts

Like all derivative securities, forward contractsLike all derivative securities, forward contractscan be used (theoretically) to:can be used (theoretically) to: ± ± H

edgeH

edge ± ± m

itigate or elim

inate risk.m

itigate or elim

inate risk. ± ± SpeculateSpeculate ± ± make an educated guess about the futuremake an educated guess about the future

value of something in hopes of profiting from it.value of something in hopes of profiting from it.

Canadian banks however, will only provideCanadian banks however, will only provide forward contracts for legitimate business forward contracts for legitimate businesspurposes (hedging), so speculative purposespurposes (hedging), so speculative purposesaren·t not supported.aren·t not supported.




Using Forward ContractsUsing Forward ContractsHedging vs. SpeculatingHedging vs. Speculating

Hedging using a forward contract requires that Hedging using a forward contract requires that the investor have an opposite exposure to thethe investor have an opposite exposure to the

contract.contract. ± ± This is a µcovered¶ position.This is a µcovered¶ position.

Speculation on a forward contract requires that Speculation on a forward contract requires that

the investor NOT own the underlying asset.the investor NOT own the underlying asset. ± ± This is a µnaked¶ positionThis is a µnaked¶ position ± ± a position that leaves thea position that leaves the

investor exposed to changes in the value of theinvestor exposed to changes in the value of theunderlying asset.underlying asset.



Using Forward ContractsUsing Forward ContractsExample of Long Position in the U.S. Dollar Example of Long Position in the U.S. Dollar

This Canadian firm expects to receiveThis Canadian firm expects to receive$1million US in accounts receivable one$1million US in accounts receivable oneyear from nowyear from now

Initial ConditionsInitial Conditions Canadian dollar is at par with U.S.Canadian dollar is at par with U.S. Both spot and 1Both spot and 1--year forward rates are both at 1.0 (this impliesyear forward rates are both at 1.0 (this implies

a ratio of 1:1)a ratio of 1:1)

ExposureExposure The fir m is long US$ because it ³owns´ them in the future.The fir m is long US$ because it ³owns´ them in the future. If the value of the US$ falls relative to the Canadian $, the fir m If the value of the US$ falls relative to the Canadian $, the fir m

will collect fewer Canadian $ once the conversion is madewill collect fewer Canadian $ once the conversion is made





Forward ContractsForward ContractsLong Position in U.S. DollarsLong Position in U.S. Dollars

11 - 1 FIGURE

F = 1.0

profit

loss

C$ 1.0 per US $

The payoff islinear.

45 degree angle.

Passes through theforward rate F.

If spot exchangerate in the futureexceeds theforward rate by$0.01, then the

speculator earns$0.01 profit for every Canadiandollar sold forwardfor U.S. dollars.



Using Forward ContractsUsing Forward Contracts A Short Position in the U.S. Dollar to Hedge A Short Position in the U.S. Dollar to Hedge

In order to remove this exposure, the firm needsIn order to remove this exposure, the firm needsto take on a short US$ position of an equalto take on a short US$ position of an equal

amount amount

If the value of the US dollar falls, the fir m losesIf the value of the US dollar falls, the fir m losesmoney on the receivable but makes the exactmoney on the receivable but makes the exactsame amount in profits from selling US $ forwardsame amount in profits from selling US $ forward(a short position)(a short position)





Forward ContractsForward ContractsShort Position in U.S. DollarsShort Position in U.S. Dollars

11 ± 2 FIGURE

F = 1.0

profit

loss

C$ 1.0 per US $

The payoff from anaked sale of U.S.forward.

If U.S. $1 million is

sold forward for C$1.0 million, andthe Canadian dollar depreciates toC$1.20 then theforward contractloses money.

The profit (loss) of the short positionis identicallyopposite of thelong position.




Forward ContractsForward ContractsLong and Short Forward Positions in U.S. DollarsLong and Short Forward Positions in U.S. Dollars

11 - 3 FIGURE

F = 1.0

profit

loss

C$ 1.0 per US $

Long Exposure

Short Exposure

Offsettinglong andshort

exposuresinsulate thefir m for foreignexchangerisk during

the life of thecontract.

The fir m islong in theunderlyingasset, so a

short forwardcontractgives this netposition.

Long US $exposure is

whatCanadianexportersface.




Pricing Forward ContractsPricing Forward ContractsInterest Rate Parity ConditionInterest Rate Parity Condition

The general condition is that investors canThe general condition is that investors cancreate a forward position in a storablecreate a forward position in a storable

commodity by buying it spot and holding it forcommodity by buying it spot and holding it for future delivery. future delivery.

The only difference between the spot price (The only difference between the spot price (SS))

and forward (and forward (FF) should be the ´costs of carryµ) should be the ´costs of carryµ(interest costs on financing the purchase and(interest costs on financing the purchase andcosts of storing for future delivery).costs of storing for future delivery).




Pricing Forward ContractsPricing Forward ContractsCommodity Pricing ModelCommodity Pricing Model

± ± The Commodity Pricing Model is equation 11The Commodity Pricing Model is equation 11 ± ± 5 and shows5 and showsthat the cost of carry links the Forward and Spot prices:that the cost of carry links the Forward and Spot prices:

Where:Where:

c c =

the cost of carry, as percentage of =

the cost of carry, as percentage of S S , over the period in question., over the period in question.= storage costs + financing costs= storage costs + financing costs

S S = spot price= spot price

F F = forward price= forward price

S)1(F v! c

[11-5]




Futures ContractsFutures ContractsThe Mechanics of Futures ContractsThe Mechanics of Futures Contracts

Futures contracts are a standardized exchangeFutures contracts are a standardized exchange--tradedtradedcontract in which the seller agrees to deliver acontract in which the seller agrees to deliver acommodity to the buyer at some point in the future.commodity to the buyer at some point in the future.

Organized futures exchanges with standardized futuresOrganized futures exchanges with standardized futures

contracts:contracts: ± ± Reduce credit risk through:Reduce credit risk through:

Clearing corporation being the counterparty in all transactionsClearing corporation being the counterparty in all transactions

margin requirements (both initial and maintenance margins) andmargin requirements (both initial and maintenance margins) and

daily markdaily mark--toto--market daily resettlement.market daily resettlement.

± ± Allow the contract features and volumes to be reported Allow the contract features and volumes to be reported

± ± Allow the futures positions to be liquid (executing offsetting Allow the futures positions to be liquid (executing offsettingtransaction to cancel the futures position) increasing thetransaction to cancel the futures position) increasing theflexibility in their use.flexibility in their use.




Futures ContractsFutures ContractsFutures Contracts MarketsFutures Contracts Markets

The term of the contract is set by individual exchanges but The term of the contract is set by individual exchanges but are generally standardized for simplificationare generally standardized for simplification

Delivery months are March, June, September, December Delivery months are March, June, September, December The exchange sets how much of the asset is traded in each contract. (ie.The exchange sets how much of the asset is traded in each contract. (ie.

The notional amount)The notional amount)

For financial futures, most exchanges follow the lead of theFor financial futures, most exchanges follow the lead of themajor markets in Chicago:major markets in Chicago:

± ± Chicago Board of Trade (CBOT)Chicago Board of Trade (CBOT) ± ± Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME)

Commodity futures trading in Canada is concentrated on theCommodity futures trading in Canada is concentrated on theWinnipeg Commodity Exchange (WCE)Winnipeg Commodity Exchange (WCE)

Financial futures trading is concentrated since 2000 on theFinancial futures trading is concentrated since 2000 on theMontreal Exchange (ME) in Canada.Montreal Exchange (ME) in Canada.




Futures Contracts and MarketsFutures Contracts and MarketsWhere things tradeWhere things trade

Underyling Asset ExchangeCommodities

Wheat/oats/soybeans Chicago Board of Trade (CBOT)

Cattle/pigs/lumber Chicago Mercantile Exch. (CME)

Crude oil/heating oil/natural gas New York Merchantile ExchangeCotton/orange juice NY Cotton Exchange

Gold/silver/copper The Commodity Exchange (Comex)

Lead/nickel/tin London Metal Exchange (LME)

Canola/western barley/wheat Winnipeg Commodity Exchange

Financial Futures

Treasury notes and bonds/DJI A CBOT

S&P index/Nikkei225 / C$ / ¼ / £ CME

BAs/Canada bonds/TSX/S&P 60 index Montreal ExchangeGer man bonds/European equities Euronext/Liffe

Other

Weather derivatives CME

Table 11- 2 Futures Contracts and Markets




Futures ContractsFutures ContractsTypes of FuturesTypes of Futures

Commodity futures include:Commodity futures include: ± ± Traditional agricultural products such as corn, wheat, hogs, etc.Traditional agricultural products such as corn, wheat, hogs, etc. ± ± Energy productsEnergy products ± ±

Basem

etalsBasem

etals

Financial futuresFinancial futures ± ± S&P index / BAs/Canada bonds/S&P TSX 60 indexS&P index / BAs/Canada bonds/S&P TSX 60 index

OtherOther ± ± Weather derivativesWeather derivatives ± ± Futures contracts on real estateFutures contracts on real estate ± ± Futures contracts on the consumer price index (CPI)Futures contracts on the consumer price index (CPI)




Futures ContractsFutures ContractsFutures ExchangesFutures Exchanges

There is significant competition acrossThere is significant competition acrossexchanges, however, some are separated byexchanges, however, some are separated bydifferent time zones.different time zones.

Competition is a source of innovation:Competition is a source of innovation: ± ± New types of contracts are developedNew types of contracts are developed

± ± As interest declines or needs change, some die out. As interest declines or needs change, some die out.

Interest in futures has grown dramatically asInterest in futures has grown dramatically ascompanies learn to hedge their risk exposurescompanies learn to hedge their risk exposuresthrough these instruments.through these instruments.




Futures ContractsFutures ContractsMarked to Market ProcessMarked to Market Process

To limit their exposure to counterTo limit their exposure to counter--party credit party credit risk, all profits and losses on a futures contract risk, all profits and losses on a futures contract are credited to investors· accounts every dayare credited to investors· accounts every day

by the exchange to calculate their equityby the exchange to calculate their equityposition.position. If the equity increases, these profits can beIf the equity increases, these profits can be

withdrawn.withdrawn.

When the equity position drops below theWhen the equity position drops below themaintenance margin (usually 50maintenance margin (usually 50--75% of the initial75% of the initialmargin) the investor will receive a margin call and bemargin) the investor will receive a margin call and beforced to contribute more money to increase theforced to contribute more money to increase theequity position.equity position.




Trading/Hedging with Futures ContractsTrading/Hedging with Futures ContractsExample of a Bond Portfolio Manager Example of a Bond Portfolio Manager

A fixedA fixed--income portfolio manager holds aincome portfolio manager holds adiversified portfolio of bonds that arediversified portfolio of bonds that arepredominantly Government of Canada.predominantly Government of Canada.

The manager believes interest rates will rise,The manager believes interest rates will rise,causing the each bond price to fall.causing the each bond price to fall.

The manager can: ( too high transaction cost: bidThe manager can: ( too high transaction cost: bid--ask spread + transac fee)ask spread + transac fee)1.1. Sell bonds and hold cash till the threat of rising interest ratesSell bonds and hold cash till the threat of rising interest rates

pass, or until the change in rates has occurred, and thenpass, or until the change in rates has occurred, and thenrepurchase the bondsrepurchase the bonds2.2. Sell long ter m bonds and replace with shorter ter m bondsSell long ter m bonds and replace with shorter ter m bonds

(reducing the portfolio duration and thereby limiting the losses if (reducing the portfolio duration and thereby limiting the losses if interest rates riseinterest rates rise ± ± duration hedging)duration hedging)

3.3. OR«.OR«.



Trading/Hedging with Futures ContractsTrading/Hedging with Futures ContractsExample of a Bond Portfolio Manager Example of a Bond Portfolio Manager

3.3. Hold the portfolio and use aHold the portfolio and use a short hedgeshort hedge (short(shortposition in a futures contract in government bonds)position in a futures contract in government bonds)«the losses in the portfolio will be offset by gains on«the losses in the portfolio will be offset by gains onthe short hedge.the short hedge.

This third alternative is often the best one,This third alternative is often the best one,because buying and selling bonds will incurbecause buying and selling bonds will incurtransactions costs and upset the structure of transactions costs and upset the structure of the portfolio.the portfolio.

If the hedge cannot be perfectly constructedIf the hedge cannot be perfectly constructedthe portfolio will be exposed tothe portfolio will be exposed to basis riskbasis riskbecause losses on the long portfolio may not because losses on the long portfolio may not be exactly offset by the short future position.be exactly offset by the short future position.




Basis RiskBasis Risk

Is the residual risk resulting from an incompleteIs the residual risk resulting from an incompletehedge.hedge.

As futures contracts are standardized, it isAs futures contracts are standardized, it ispossible that a particular risk exposure may not possible that a particular risk exposure may not be completely hedgeable.be completely hedgeable.

Consider trying to hedge an $85,690 USConsider trying to hedge an $85,690 USpayable using futures contracts in incrementspayable using futures contracts in incrementsof $10,000of $10,000

± ± This is one of the advantages of forwards.This is one of the advantages of forwards.





Futures Contracts and MarketsFutures Contracts and MarketsSummary of Forward and Future ContractsSummary of Forward and Future Contracts

Forward and Future Contracts serve the sameForward and Future Contracts serve the samepurpose.purpose.

Forward contracts offer more flexibilityForward contracts offer more flexibility

because they are customized OTC contracts.because they are customized OTC contracts. Forward contracts, however, face additionalForward contracts, however, face additional

risks:risks:

± ± Not actively traded (created by a bank for customers)Not actively traded (created by a bank for customers)

± ± Possess credit riskPossess credit risk



SwapsSwapsDefinedDefined

An agreement between counterparties, to exchangeAn agreement between counterparties, to exchangecash flows in the future.cash flows in the future.

± ± No for mal exchange to guarantee perfor mance, so theNo for mal exchange to guarantee perfor mance, so thearrangement involves a dealer or OTC market and there is creditarrangement involves a dealer or OTC market and there is creditriskrisk

± ± They have evolved into a bank instrument, with banks or swapThey have evolved into a bank instrument, with banks or swapdealers serving as inter mediaries.dealers serving as inter mediaries.

An interest rate swap is:An interest rate swap is: ± ± An exchange of interest payments on a principal amount in which An exchange of interest payments on a principal amount in which

borrowers switch loan rates.borrowers switch loan rates. ± ± Often this involves one counterparty trading fixed loan paymentsOften this involves one counterparty trading fixed loan payments

(the swap rate) for variable rate loan payments (usually LIBOR or (the swap rate) for variable rate loan payments (usually LIBOR or CDOR (BA rates in Canada)CDOR (BA rates in Canada)

A plain vanilla interest rate swap isA plain vanilla interest rate swap is denominated indenominated in oneonecurrency.currency.



SwapsSwapsComparative AdvantageComparative Advantage

The benefits of swapping are not only basedThe benefits of swapping are not only basedon hedgingon hedging ² ² there can be cost savings asthere can be cost savings aswell.well. ± ± Based on the comparative advantage of one party inBased on the comparative advantage of one party in

fixed vs. floating rate debt markets or from onefixed vs. floating rate debt markets or from onecountry¶s debt market to another¶s.country¶s debt market to another¶s.

± ± Any fir m offered a good deal in floating rate funds but Any fir m offered a good deal in floating rate funds but

doesn¶t need them should borrow them anyway anddoesn¶t need them should borrow them anyway anduse a swap to exchange it for what is needed anduse a swap to exchange it for what is needed andlock in the financing advantage.lock in the financing advantage.



Swap DealersSwap DealersSwap RateSwap Rate

A swap dealer is a financial intermediary who helps toA swap dealer is a financial intermediary who helps toreduce search costs for firms looking to swap rates, asreduce search costs for firms looking to swap rates, aswell as diversifying counterwell as diversifying counter--party riskparty risk

± ± They enter into numerous swaps with parties looking for bothThey enter into numerous swaps with parties looking for both

exposures to reduce the risk of default.exposures to reduce the risk of default.

To account for these services, such intermediaries takeTo account for these services, such intermediaries takea bit of the total savings for themselves.a bit of the total savings for themselves.

± ± There is a bidThere is a bid--ask spread on swap rates so dealers can offsetask spread on swap rates so dealers can offsetlosses and earn profits.losses and earn profits.

Instead of the parties negotiating the swap rate (moreInstead of the parties negotiating the swap rate (morelater), it is set by the supply and demand of funds in thelater), it is set by the supply and demand of funds in theswap market.swap market.



SwapsSwaps

The interest rate benchmark is theThe interest rate benchmark is the Swap RateSwap RateYield CurveYield Curve which identifies the relationshipwhich identifies the relationshipbetween swap rate for different maturitiesbetween swap rate for different maturities

swap rate = fixed reference rateswap rate = fixed reference rate (gov bond, same maturity)(gov bond, same maturity)

+ swap spread+ swap spread

This yield curve plots just above the correspondingThis yield curve plots just above the corresponding

gov bond yield curve with the spread beinggov bond yield curve with the spread beingdetermined by the perceived counterdetermined by the perceived counter--party riskparty risk

± ± Like LIBOR, the Swap Rate is NOT riskLike LIBOR, the Swap Rate is NOT risk--freefree




Swap rate is the rate that is paid in exchange for receiving CDOR/LIBOR or Swap rate is the rate that is paid in exchange for receiving CDOR/LIBOR or prepared to receive in exchange for paying CDOR/LIBORprepared to receive in exchange for paying CDOR/LIBOR

± ± the 2 year swap rate tells the company that it needs to pay 2.31% to receive 3the 2 year swap rate tells the company that it needs to pay 2.31% to receive 3--month CDORmonth CDORwith the rate resetting every 3 months for 2 yearswith the rate resetting every 3 months for 2 years

Swap rates provided by CIBC World MarketsSwap rates provided by CIBC World Markets

Canada U.S.

BA/CDOR Rate% LIBOR Rate%

1mo BA/CDOR 1.20 1mo LIBOR 0.27

3mo BA/CDOR 1.30 3mo LIBOR 0.31

SWAP RATE

2 year 2.31 2 year 1.34

3 year 2.67 3 year 1.93

4 year 2.99 4 year 2.44

5 year 3.24 5 year 2.87

8 year 3.77 8 year 3.72

9 year 3.90 9 year 3.90

10 year 4.03 10 year 4.04

CAD vs USD Swap CurvesCAD vs USD Swap Curves



± ± The dollar amount of the interest paymentsThe dollar amount of the interest paymentsexchanged is based on a predeter mined dollar exchanged is based on a predeter mined dollar amount called theamount called the notional principal amountnotional principal amount..

This amount, multiplied by the appropriate net interest rate,This amount, multiplied by the appropriate net interest rate,

deter mines the size of payments between the counterpartiesdeter mines the size of payments between the counterparties

± ± TheThe Bank for International SettlementsBank for International Settlements reports thatreports thatinterest rate swaps are the largest component of theinterest rate swaps are the largest component of theglobalglobal OTCOTC derivativederivative market. Themarket. The notional amountnotional amount

outstanding as of June 2009 in OTC interest rateoutstanding as of June 2009 in OTC interest rateswaps was $342 trillion, up from $310 trillion in Decswaps was $342 trillion, up from $310 trillion in Dec2007. The gross market value was $13.9 trillion in2007. The gross market value was $13.9 trillion inJune 2009, up from $6.2 trillion in Dec 2007.June 2009, up from $6.2 trillion in Dec 2007.

Interest Rate SwapsInterest Rate Swaps



There are two ways that a swap position can beThere are two ways that a swap position can beinterpreted:interpreted:

1.1. as a package of forward/futures contracts, andas a package of forward/futures contracts, and

2.2. as a package of cash flows from buying and selling market instrumentsas a package of cash flows from buying and selling market instruments

1.1. Package of Forward ContractsPackage of Forward Contracts

± ± Investor to pay a swap rate of 10% and in turn receive 6 mo LIBORInvestor to pay a swap rate of 10% and in turn receive 6 mo LIBOR

If the principal amount is $50 million, then Investor A has agreed toIf the principal amount is $50 million, then Investor A has agreed tobuy 6 month LIBOR for $2.5 million (10%/2 x $50 million)buy 6 month LIBOR for $2.5 million (10%/2 x $50 million)

This is effectively a 6 month forward contract where the investor This is effectively a 6 month forward contract where the investor agrees to pay $2.5 million to receive 6 month LIBOR (every 6 monthsagrees to pay $2.5 million to receive 6 month LIBOR (every 6 monthsfor the ter m of the swap)for the ter m of the swap)

± ± There is therefore an implicit forward contract corresponding to eachThere is therefore an implicit forward contract corresponding to eachexchange dateexchange date

Interpreting a Swap PositionInterpreting a Swap Position



2.2. Package of Cash Market InstrumentsPackage of Cash Market Instruments

Buy $50 million par of a 5 year floatingBuy $50 million par of a 5 year floating--rate note (FRN) that pays 6rate note (FRN) that pays 6month LIBOR every 6 monthsmonth LIBOR every 6 months

Finance the purchase by borrowing $50 million for five years on ter msFinance the purchase by borrowing $50 million for five years on ter ms

requiring 10% annual interest rate paid every six monthsrequiring 10% annual interest rate paid every six months The net cash inflows versus outflows (fixed rate interest payment minusThe net cash inflows versus outflows (fixed rate interest payment minus

the cash inflow of LIBOR (all multiplied by the notional amount) isthe cash inflow of LIBOR (all multiplied by the notional amount) isidentical to the position of a fixedidentical to the position of a fixed--rate payer/floatingrate payer/floating--rate receiver rate receiver

Interpreting a Swap PositionInterpreting a Swap Position

TimeT1 T2 T3 T4

0 1 year 1.5 years 2 years etc«6 months

Pay fixed couponof $2.5 MM




Receive 6 monthLIBOR from FRN






Assume:Assume:

± ± Ter m of the Swap: 5 yearsTer m of the Swap: 5 years

± ± 5 year US gov bond rate is 5.50% at the time the swap is entered into5 year US gov bond rate is 5.50% at the time the swap is entered into

± ± swap spread: 50 bpsswap spread: 50 bps

± ± reference rate: 3reference rate: 3--month LIBORmonth LIBOR

± ± notional amount: $50 millionnotional amount: $50 million

± ± frequency of payments: quarterly (every 3 months)frequency of payments: quarterly (every 3 months)

Therefore:Therefore:

Swap Rate = 5.50%+ 50 bps = 6.00%Swap Rate = 5.50%+ 50 bps = 6.00% This means that the fixedThis means that the fixed--rate payer agrees to pay a 6% annual raterate payer agrees to pay a 6% annual rate

for the next 5 years with payments made quarterly and receive (from for the next 5 years with payments made quarterly and receive (fromthe fixed ratethe fixed rate--receiver) 3receiver) 3--month LIBOR also made quarterly onmonth LIBOR also made quarterly on$50MM notional amount $50MM notional amount

Schedule of Payments ExchangeSchedule of Payments Exchange



Payments by Fixed Rate Payer

Assuming a Notional principal amount: $50,000,000

Swap Rate Annual Dollar Amount Quarterly6% $3,000,000 $750,0006% $3,000,000 $750,000

6% $3,000,000 $750,0006% $3,000,000 $750,0006% $3,000,000 $750,000

Payments by Fixed Rate Receiver

Assuming a Notional principal amount: $50,000,000

If LIBOR is Annual Dollar Amount Quarterly

2% $1,000,000 $250,000

3% $1,500,000 $375,0004% $2,000,000 $500,0005% $2,500,000 $625,0006% $3,000,000 $750,000

Schedule of Payments ExchangeSchedule of Payments Exchange



Net PaymentsNet Payments

In swap arrangements, counterparties are oftenIn swap arrangements, counterparties are often¶unequal· partners to the contract.¶unequal· partners to the contract.

± ± One counterparty may be AAA rated«the other BBB for exampleOne counterparty may be AAA rated«the other BBB for example

The net credit risk is borne by the higher ratedThe net credit risk is borne by the higher ratedcounterparty (generally the swap dealer).counterparty (generally the swap dealer).

± ± AAA¶s counter party (rated BBB) has a higher probability of default AAA¶s counter party (rated BBB) has a higher probability of default

Strategies to control credit risk include:Strategies to control credit risk include: ± ± SetSet--off rights in the swap agreement allowing the other party to stopoff rights in the swap agreement allowing the other party to stop

m

aking paym

ents if the other party defaultsm

aking paym

ents if the other party defaults ± ± Net paymentsNet payments ± ± instead of exchanging total interest amounts, only theinstead of exchanging total interest amounts, only thedifference between the two streams are exchanged and structuring thedifference between the two streams are exchanged and structuring thepayments into subpayments into sub--periods (every six months)periods (every six months)



Assuming the standard Canadian market convention of a 365Assuming the standard Canadian market convention of a 365day count, the formula to calculate the periodic settlement in aday count, the formula to calculate the periodic settlement in arate swap would be:rate swap would be:

Net Payment = (Swap rateNet Payment = (Swap rate -- BA rate) x (notional amount) x (# of BA rate) x (notional amount) x (# of days/365)days/365)

For example:For example: Fixed swap rate = 4.50%Fixed swap rate = 4.50%

BA rate = 5.00%BA rate = 5.00%

Notional Amount = $50 millionNotional Amount = $50 million

Quarterly resetsQuarterly resets

Net Payment = (4.50%Net Payment = (4.50%-- 5.00%)x ($50 million) x (91/365) = 5.00%)x ($50 million) x (91/365) = --$62,328.76$62,328.76

± ± This negative amount implies a SAVINGS for the fir m which bought the swapThis negative amount implies a SAVINGS for the fir m which bought the swap

Net Payments



A fir m has 3 years remaining on a $50 MM fixed rate bond of 7.00% A fir m has 3 years remaining on a $50 MM fixed rate bond of 7.00%but can swap the fixed rate coupon for a floating obligation at a ratebut can swap the fixed rate coupon for a floating obligation at a rateof (3of (3--month BA's plus 315 bps)month BA's plus 315 bps)

Assume 3 month BA rates are at 2.10% Assume 3 month BA rates are at 2.10%

By refinancing in this way, the fir m¶s interest cost (for the next threeBy refinancing in this way, the fir m¶s interest cost (for the next threemonths) is equal to (3.15% + 2.10% = 5.25%) versus the fixedmonths) is equal to (3.15% + 2.10% = 5.25%) versus the fixed7.00%7.00%

Breakeven BA rate = Existing debt coupon rateBreakeven BA rate = Existing debt coupon rate ± ± BA SpreadBA Spread

= 7%= 7% -- 3.15% = 3.85%3.15% = 3.85%

If BA rates are below this level (3.85%), the fir m¶s (net)If BA rates are below this level (3.85%), the fir m¶s (net)funding costs would be reduced.funding costs would be reduced.

Swapping to Reduce Fixed Funding Costs



Plain vanilla interest rate swap (cont¶d)Plain vanilla interest rate swap (cont¶d) Break Even BA Rate is 3.85%Break Even BA Rate is 3.85%

When rates begin to rise, the benefit to the client wouldWhen rates begin to rise, the benefit to the client woulddecline, reaching breakeven at a BA rate of 3.85%decline, reaching breakeven at a BA rate of 3.85%

If BA rates rise beyond 3.85%, the result would be an increaseIf BA rates rise beyond 3.85%, the result would be an increasein the clients overall interest ratein the clients overall interest rate

Bond Investors or

Lender

Swap DeskThe Company

Fixed Swap Rate

7% in example

Fixed Rate Obligation

(loan or corporate bond)

Floating rate index (3 month BA s + 315 bps)

Swapping to Reduce Fixed Funding Costs



In the absence of a swap dealer (less developed capitalIn the absence of a swap dealer (less developed capitalmarkets), firms can negotiate their own swap agreement.markets), firms can negotiate their own swap agreement.

± ± For this to be useful to both fir ms, one must have a comparativeFor this to be useful to both fir ms, one must have a comparativeadvantage over the other in borrowing either fixed or floating debt.advantage over the other in borrowing either fixed or floating debt.

In these situations, the difference in fixed vs floating spreadsIn these situations, the difference in fixed vs floating spreadsis the total amount of savings available to the two firms.is the total amount of savings available to the two firms.

± ± How those savings are divided depends entirely on the swap rate theyHow those savings are divided depends entirely on the swap rate theynegotiate (as in example 11negotiate (as in example 11--4 where the 10.9% swap rate was chosen4 where the 10.9% swap rate was chosenby the fir ms so that each would save exactly the same amount)by the fir ms so that each would save exactly the same amount)

In general, the more credit worthy firm captures a great In general, the more credit worthy firm captures a great percentage of the savings as they have more negotiatingpercentage of the savings as they have more negotiatingpower (better rating).power (better rating).

Swaps without DealersSwaps without Dealers



Table 11Table 11 ² ² 4 illustrates an OTC plain vanilla interest rate4 illustrates an OTC plain vanilla interest rateswap between counterparties A and B and is structuredswap between counterparties A and B and is structuredto benefit both parties equally. This is rarely the case.to benefit both parties equally. This is rarely the case.

In this example, the total savings were 0.7% and the twoIn this example, the total savings were 0.7% and the two

parties agreed to split it equallyparties agreed to split it equally ± ± The swap rate was chosen to make this happen.The swap rate was chosen to make this happen.

To determine the swap rate, consider the rates theTo determine the swap rate, consider the rates the

parties would have had to borrow on their own at,parties would have had to borrow on their own at,remove the savings, and this is amount must be the sumremove the savings, and this is amount must be the sumof the three transactions (one initial and two others fromof the three transactions (one initial and two others fromthe swap)the swap)

± ± The 10.9% swap rate here was backThe 10.9% swap rate here was back--engineered in this fashionengineered in this fashion

Swaps without DealersSwaps without Dealers



Swaps without DealersSwaps without DealersFir ms choose to split savings equallyFir ms choose to split savings equally

A BQuotes (AAA) (BBB)

Floating LIBOR + 0.25 LIBOR + 0.75

Fixed 10.8 12.0

Initial

Floating - (LIBOR + 0.75)

Fixed -10.8

Swap B pays A fixed and A pays B floating

+10.9 - 10.9

- LIBOR + LIBOR

Net - (LIBOR - 0.10) - 11.65

Saving 0.35% 0.35%

Table 11- 4 An Interest Rate Swap



Interest Rate SwapsInterest Rate Swaps(note that payments are being made semi(note that payments are being made semi--annually)annually)

Period LIBOR (%)Floating Pay

(%)

Fixed Pay

(%)Net Pay (%)

1 8.0 -4.00 +5.45 + 1.45

2 9.0 -4.50 +5.45 + 0.95

3 9.80 -4.90 +5.45 + 0.55

4 11.00 -5.50 +5.45 - 0.05

5 12.00 -6.00 +5.45 - 0.55

Table 11- 5 Interest Rate Swap Net Payments



Currency SwapsCurrency Swaps

Currency swaps permit the firms to adjust theirCurrency swaps permit the firms to adjust their foreign exchange exposure. foreign exchange exposure.

± ± This means that there is increased credit risk«but it presentsThis means that there is increased credit risk«but it presentsopportunities.opportunities.

The first swap was a currency swap between IBMThe first swap was a currency swap between IBMand the World Bank.and the World Bank. ± ± This swap was motivated by comparative advantageThis swap was motivated by comparative advantage ± ± It was a primary market transactionIt was a primary market transaction ± ± both IBM and the Worldboth IBM and the World

Bank used it to raise new capital cheaply.Bank used it to raise new capital cheaply. ± ± Once swaps became standardized, it became possible toOnce swaps became standardized, it became possible to

constantly change the nature of the institution¶s liability stream.constantly change the nature of the institution¶s liability stream.

Currency swaps require exchange of all cash flows.Currency swaps require exchange of all cash flows. ± ± Not just net cash flows as in an interest rate swapNot just net cash flows as in an interest rate swap



± ± Cross currency swaps are done when a client hasCross currency swaps are done when a client hasrevenue for his products in a currency that does notrevenue for his products in a currency that does notmatch his liabilities (or borrowings)match his liabilities (or borrowings)

± ± A cross currency swap can be used to hedged forex A cross currency swap can be used to hedged forex

risk, allowing a fir m to emulate a CAD issuance for therisk, allowing a fir m to emulate a CAD issuance for theentire life of the ter m loan (a synthetic position)entire life of the ter m loan (a synthetic position)

± ± The reThe re--exchange of the principal under the crossexchange of the principal under the cross--currency swap is donecurrency swap is done at the same exchange rateat the same exchange rate asas

established at the inception of the transaction becauseestablished at the inception of the transaction becausethe interest rate differential is already taken into accountthe interest rate differential is already taken into accountin the fixed or floating rates payable on the swapin the fixed or floating rates payable on the swap

Currency Swaps



Telus borrowed in USD to take advantage of cheaper rates but Telus borrowed in USD to take advantage of cheaper rates but now has regular USD liabilities (paying a fixed rate coupon innow has regular USD liabilities (paying a fixed rate coupon inUSD) and it must repay USD principal at the end of the termUSD) and it must repay USD principal at the end of the term

Company does not want this risk, but instead wants CAD FixedCompany does not want this risk, but instead wants CAD Fixed

Currency Swaps



Step #1: The USD proceeds are sold to the bank at the current F/X spot rate and the CADStep #1: The USD proceeds are sold to the bank at the current F/X spot rate and the CADequivalent is paid by the bank to the client equivalent is paid by the bank to the client

Step#2 : The USD interest on the term loan is paid by the bank to the client to satisfy theStep#2 : The USD interest on the term loan is paid by the bank to the client to satisfy thepayment the client is required to make to the bond holders. In return a coupon in CAD ispayment the client is required to make to the bond holders. In return a coupon in CAD ispaid by the client to the bankpaid by the client to the bank

Step #3: On the maturity of the term loan the notional amountsStep #3: On the maturity of the term loan the notional amounts are reare re--exchanged at theexchanged at thehistorical F/X ratehistorical F/X rate ² ² this provides the client with the USD proceeds to retire the term loanthis provides the client with the USD proceeds to retire the term loanin exchange for payment to the bank of the CAD equivalent in exchange for payment to the bank of the CAD equivalent

Client

Client

Client

Swap Desk

Swap Desk

Swap Desk

USD proceeds from bond issue i.e. USD 3.3 Billion sold to SwapDesk

CAD equivalent @ current spot F/X

CAD Interest

USD Interest

Residual CAD @ original F/X rate

Residual USD amount

Currency Swaps

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11 - Forwards, Futures, And Swaps(1)

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