4.B Types of Swaps

Types of Swaps 1. Currency Swaps 2. Interest Rate Swaps 3. Equity Swaps

1. Currency Swaps A swap in which each party makes interest payments to the other in different currencies. The U.S. retailer Target Corporation (TGT) does not have an established presence in Europe. It has decided to begin opening a few stores in Germany and needs 9 million to fund construction and initial operations. TGT would like to issue a fixed-rate euro-denominated bond with face value of 9 million, but the company is not very well known in Europe. European investment bankers have given TGT a quote for such a bond. (high interst)

Deutsche Bank (DB) tells TGT that it should issue the bond in dollars (US) and use a swap to convert it into euros.

Suppose TGT issues a 5-year US $10 million bond at a rate of 6%. It then enter into a swap with DB in which DB will make payments to TGT in US dollars at a fixed rate of 5.5% and TGT will make payments to DB in euros at a fixed rate of 4.9% each 15 March and 15 September for 5 years. The payments are based on notional principal of 10 million in dollars and 9 million in euros. We assume the swap starts on 15 Sept of the current year.

The swap specifies that the 2 parties exchange the notional principal at the start of the swap and at the end.

Because the payments are made in different currencies, netting is not practical, so each party makes its respective payments

This transaction looks like: TGT is issuing a bond with face value of 9 million and the bond is purchased by DB (DB pays TGT 9 million) TGT converts the 9 million to $10 million. (TGT has the $10 million) TGT use the $10 million to buy a dollar-denominated bond issued by DB. (TGT pays DB $10 million)

Note: TGT having issued a bond denomination in euros, accordingly makes interest payments to DB in euros. (TGT pays DB 220,500) DB, appropriately, makes interest payments in dollar to TGT. (DB pays TGT $275,000)

In fact, neither TGT or DB actually issues a bond to each other. They exchange only a series of cash flows that replicated the issuance and purchase of these bonds.

TGT has effectively issued a dollar-denominated bond and converted it to a euro-denominated bond. In all likelihood, it can save on interest expense by funding its need for euros in this way, because TGT is better know in the U.S. than in Europe. It can borrow cheaper in U.S.

The swap dealer, DB, knows TGT well and also obviously has a strong presence in Europe. Thus, DB can pass on its advantage in euro bond market to TGT.

Had TGT issued a euro-denominated bond, it would have assumed no credit risk.

By entering into the swap, TGT assumes a remote possibility of DB defaulting. Thus, TGT saves a little money by assuming some credit risk.

Some scenarios exist in which the notional principals are not exchanged.

Suppose many years later, TGT is generating 10 million in cash semi-annually and converting it back to dollars on 15 January and 15 July. It might then wish to lock in the conversion rate by entering into currency swap that would require it to pay a dealer 10 million and receive a fixed amount of dollar.

If the euro fixed rate is 5%, a notional principal of 400 million would generate a payment of 0.05(180/360)(400 million) = 10 million. If the exchange rate is $0.85, the equivalent dollar notional principal would be 400(0.85) = $340 million. If the dollar fixed rate is 6%, TGT would receive 0.06(180/360)(340 million) = $10.2 million.

TGT pays DB 10 million; TGT receives from DB $10.2 million. TGT locked the conversion rate by entering into a currency swap. There would be no reason to specify an exchange of notional principal.

2. Interest Rate Swap An interest rate swap can be created as a combination of currency swaps. Of course, no one would create as interest rate swap that way; it would require two transactions. Interest rate swaps evolved into their own market. Interest rate swap market is much bigger than the currency swap market.

A plain vanilla swap is simply an interest rate swap in which one party pays a fixed rate and the other pays a floating rate, with both sets of payments in the same currency. Plain vanilla swap is probably the most common derivative transaction in the global financial market. Note: There is no need to exchange notional principals at the beginning and at the end of an interest rate swap. Interest payments can be and nearly always are netted. This reduces the credit risk. Note: There is no reason to have both sides pay a fixed rate. The two streams of payments would be identical in this case.

So in an interest rate swap, either one side always pays fixed and the other side pays floating, or both sides pay floating, but never do both sides pay fixed. The case of both sides paying floating is called a basis swap. LIBOR and T-bill rate. Plain Vanilla Swap One fixed; the other floating. Same notional principal.

3. Equity Swaps A swap requires at least one variable rate or price underlying it. In an equity swap, that is the return on a stock or stock index. Party making the fixed-rate payment could also have to make a variable payment based on the equity returns. Suppose the end user pays the equity payment and receives the fixed payment, i.e., it pays the dealer the return on the S&P 500 index and the dealer pays the end user a fixed rate. If S&P 500 increases, the return of S&P is positive, end user pays that return to the dealer.

If S&P 500 decreases, the return is negative. In this case, the end user would pay the dealer the negative return on the S&P, which means that it would receive that return from the dealer. Example: If S&P decreases by 1%, the dealer would pay the end user 1%, in addition to the fixed payment the dealer makes in any case. So the dealer, or in general the party receiving the equity return, could end up making both a fixed-rate payment and an equity payment.

The variable payment is not know until the end of the settlement period, at which time the return on the stock is know. In an interest rate or currency swap, the floating interest rate is set at the beginning of the period. The rate of return is often structured to include both the dividends and capital gains. (In some kinds of interest rate swaps, the total return on a bond, which includes dividends and capital gains, is paid. This instrument is called a total return swap and is a common variety of a credit derivative.)

MWD Pays VAAPX Fixed

VAAPX pays MWD S&P 500 return

Net: VAAPX pays MWD 1,740,000 1,602,740 = $137,260

Total payment MWD to VAAPX: 3,530,000 + 1,620,548 = 5,150,548

References: Understanding Derivatives and Risk Management by Don M. Chance and Robert Brooks, 2011, 8th Edition. Derivatives and Alternative Investments by Don M. Chance, CFA Program Curriculum, Volume 6, 2013.