Prof. Ian Giddy New York University Swap Financing Techniques SIM/NYU The Job of the CFO.

Prof. Ian GiddyNew York University

Swap FinancingTechniques

SIM/NYUThe Job of the CFO

Copyright ©2001 Ian H. Giddy Swap Financing 2giddy.org

Interest Rate and Currency Swaps

Mechanics of swaps Valuation of swaps Credit risk of swaps Pricing swaps Hedging swaps The all-in cost of swap financing Currency swaps vs forwards


Swaps: Mechanics and Valuation

IC&TelIC&Tel CIBCCIBC

Fixed ECU 7%

Floating

ECU Libor

Periodic exchanges of interest payments are made during the life of the swap. Remember that the principal amount is not exchanged


Interest-Rate Swap Example

CIBC

AA

IC&Tel

BBB Fixed 5.00%Floating 6-MonthLIBOR + 25

Payments to CapitalMarkets



Interest-Rate Swap Example

Exchange of Interest Payments Every 6 Mo

Fixed 5.50%

Floating 6-Month

LIBOR Flat

Fixed 5.00%Floating 6-MonthLIBOR + 25

Cost of Funds After Swap:

- Pay fixed 5.50%- Receive LIBOR Flat- Pay LIBOR + 25- Net Cost: 5.75% Fixed

Cost of Funds After Swap:

- Pay 5.00% fixed - Receive 5.50% fixed - Pay 6-month LIBOR Flat- Net Cost: 6-month LIBOR - 50



AABBB

CIBCIC&Tel


Swap Quotation Screen

GovPX/GGB SwapPX US Medium Term Swaps vs 3M LIBOR 8/6/96 Page 261Term Cpn Mty TrPrice TrYld-SB SwapSpd-SB SwapRate-SB CBA-TED

2Y 6.250 07/98 100.214 /216 5.952 /948 19.50 21.00 6.143 /162 20.233Y 6.375 05/99 100.174 /176 6.103 /100 22.80 23.00 6.327 /333 22.924Y 6.202 /200 26.00 26.50 6.460 /468 25.665Y 6.625 07/01 100.114 /120 6.302 /299 27.00 27.80 6.569 /580 26.316Y 6.351 /348 30.00 31.00 6.648 /661 29.467Y 6.400 /397 33.00 34.00 6.726 /740 32.478Y 6.449 /446 33.50 34.50 6.781 /794 33.109Y 6.498 /494 34.50 35.50 6.839 /853 34.1610Y 7.000 07/06 103.084 /094 6.547 /543 35.00 36.00 6.893 /907 34.7311Y 6.558 /554 38.00 40.00 6.923 /94712Y 6.569 /565 41.00 43.00 6.953 /97713Y 6.581 /577 44.00 45.00 6.983 /99714Y 6.592 /588 48.00 49.00 7.023 /03715Y 6.603 /599 51.00 52.00 7.053 /06720Y 6.659 /654 53.00 55.00 7.113 /12725Y 6.715 /710 54.00 55.00 7.108 /12230Y 6.000 2/26 90.065 /085 6.771 /766 35.50 37.50 7.121 /146


A Currency Swap

FMCFMC BANKBANK

GBP 100

USD 150

Company issues dollar debt, but wants sterling financing

so exchanges its dollars for sterling equivalent

at today’s spot exchange rate

USD 150


Three Parts of a Currency Swap

FMCFMC BANKBANK

GBP 100

USD 150

FMCFMC BANKBANK

Fixed GBP 12%

Floating USD

Libor s.a.

FMCFMC BANKBANK

GBP 100

USD 150


Valuation Off-market swaps Cancellation Counterparty exposure Hedging swap positions

Swaps: Applications of Valuation

B

O

N

D

FRN

ABBABB BVBBVB

Fixed ECU 7%

Floating

ECU Libor


Valuation of an Interest Rate Swap

Valuation of the swap is based on discounting the cash flows over its life.

VALUE OF

INTEREST RATE

SWAP

PRICE OF

BOND WITH

N YEARS

TO RUN

PRICE OF

MONEY MARKET

INSTRUMENT

WITH

M DAYS TO RUN

= -

A RECEIVE-FIXED, PAY-FLOATING SWAP:


Labatt’sLabatt’s BankBank

Fixed USD 9%

Floating USD

Libor s.a.

Swap Valuation

The value of a swap equals the "net worth" of the swap cash flows expressed as a balance sheet

Labatt’s swap:Receive floating, pay fixed

“ASSETS”

Receiving floating6-mo US$ LiborSemi-annual for 5 yearsPrincipal US$100mLike a 5-year US$ FRN

“LIABILITIES”

Paying fixed 9%Annual for 5 yearsPrincipal US$100mLike a 5-year bond


At Inception, Standard Swap is Worth Zero


“ASSETS”


Value=$100m

”LIABILITIES”


Value=$100m


Two Years Later, Rates Have Fallen...


“ASSETS”


Value still $100m

”LIABILITIES”


Swap rate = 6%Value=$108m


Interest Rate Swap Calculator value date: 22-Sep-96

swap structure 1 effective date 27-Sep-96

interpolation method 2 maturity date 27-Sep-00

date generation 1 margin (+ -) floating index 0.00%

holidays 6 current reset rate

Pay Leg fixed coupon rate 8.00%

date convention 2 notional principal 1,000,000

cash flow frequency 3

accrual method 2 statistic 1

Receive Leg

date convention 2 Result 10269.29782

cash flow frequency 2 last update 9/22/96 17:07

accrual method 3

next good business day

forward from effective date

quarterly

actual/ 360

pay floating and receive fixed

cubic spline

actual/ 365 (actual)

next good business day

semi-annual

New York

fair value

Calculate

Swap Valuation Spreadsheet(This Uses the Zero-Coupon Approach)


Termination of Swaps

Basic principle: cancel or neutralize all future swap cash flows

What are the alternative ways in which this can be done?Offsetting swap with same counterpartyOffsetting swap with new counterpartyCancel swapReassign swap.


Default Risk in Swaps

In-the-money swaps entail credit risk—the value of the swap is the amount owed

At initiation, credit risk exposure is based on the potential value of the swap, which depends on potential changes in interest rates and currencies

Credit risk can be mitigated by collateralization and by netting of bilateral exposure.


How Swaps are Quoted

US$ INTEREST RATE SWAPS CURRENCY SWAPSYears Treasury Curve

BenchmarkSemi-Annual

Yields

Spread [b.p.]to AA

Counterparties

DEM/USDAnnual

JPY/USDAnnual

23457

10

8.028.018.018.028.138.14

62-6670-7572-7678-8177-8178-81

7.00-7.107.00-7.107.00-7.107.00-7.107.02-7.127.02-7.12

5.35-5.455.35-5.455.35-5.455.35-5.455.40-5.505.45-5.53

CURRENCY SWAPSYears CHF/USD

AnnualGBP/USD

AnnualECU/USD

AnnualAUD/USD

Annual23457

10

6.60-6.706.20-6.306.05-6.106.00-6.105.95-6.055.95-6.05

12.80-12.9012.35-12.4511.90-12.0011.75-11.8511.50-11.6011.26-11.36

9.20-9.309.15-9.259.10-9.209.05-9.159.05-9.159.05-9.15

15.65-15.8015.25-15.4015.1515.3014.78-15.13

NANA


Swap Spreads are Tied to TED Spreads

Treasury

bonds

Treasury

bills

TED

spread

Swap

spreadInterest rate

swaps

Corporate

bonds

FRAs and

futures

Libor:

E$ market

+

+

=

=

LONG TERM

SHORT TERM


FRAs and Friends

FRA: A contract to lock in a rate for a future period

Futures: A daily recontracted FRA Swap: A strip of FRAs at a blended rate


Estimating the Cost of Funds in a Swap

Problem: Convert existing 4 year floating rate dollar sub-LIBOR funds into fixed rate sterling funds. Pay sterling fixed annually; receive dollar floating semi-annually.

What is the all-in sterling cost? Swap Quote Indication Sheet

Swap Quote: Standard four year sterling/dollar swap quote would be sterling 11.90-12.00 against 6 month $ LIBOR flat. If client wants a non-standard swap such as sterling fixed against 6-month $ LIBOR-25, bank might quote: “You pay sterling 11.73% annual, we pay 6-mo LIBOR less 25."

Years Treasury Yields Spread [s.a.] GBP/USD [ann]2345

8.028.018.018.02

62-6670-7572-7678-81

12.80-12.9012.35-12.4511.90-12.0011.75-11.85


A Standard Currency Swap

FMCFMC BANKBANK

GBP 100

USD 150

FMCFMC BANKBANK

Fixed GBP 12%

Floating USD

Libor s.a.

FMCFMC BANKBANK

GBP 100

USD 150


FMCFMC BANKBANK

Fixed GBP 12%

Floating USD

Libor s.a.


Fixed GBP 11.73%

Floating USD

Libor s.a.

-0.25%

Floating USD

Libor -0.25%


Basis Point Conversion:The quote of Sterling 11.73% annual fixed payments

against LIBOR - 25 required conversion from dollar basis points to sterling basis points.

How to do this:1. Find present value of 25 U.S. dollar basis points paid

semi-annually at 8.77% interest.

2. Find the sterling annuity equivalent of 82.84 at the sterling swap rate of 12.00% paid annually.

Annuity value of 82.84 @ 12% [annual] = 27.27bpGBP


PV bp bpUS tt[ ]

.

( ..$25

12 5

1 4 385%)82 84

1

8


Kalamazoo needs $60 million. Receiving Euro, the European Currency unit.

Whose Zoo?

K’zoo could borrow five-year money at semi-annual LIBOR + 3/4%, and Dresdner agreed to enter into a currency swap with the company. Diagram the swap with little boxes. What would K’zoo's cost of capital be if it

did the swap? (US 5-yr swap rate = 10%) Effect of a rise in ST & LT rate? How would a 0.75% up front commitment

fee affect K’zoo's cost of capital?

DRESDNERSWAP

QUOTATIONS

Years

Euro Fixedvs USD Libor

sa23457

10

8.00 - 8.108.00 - 8.108.20 - 8.308.20 - 8.358.25 - 8.358.40 - 8.50


Kalamazoo

K’ZOOK’ZOO DRESDNERDRESDNER

Fixed ECU 8.35%

Floating USD

Libor s.a.

Fixed EURO 8.35+0.73%=9.08%

Floating USD Libor +0.75%

Floating USD

Libor +0.75%

75bpUSD=73bpEuro; swapped cost is 9.08% ST rate: no effect. LT rate rise: value of swap will

change by duration. K’zoo gains, Dresdner loses. Amortize the up-front fee of 0.75% over the period of the

financing, and add it to swapped cost..

Euro revenues


BP Conversion: Excel Spreadsheet

Basis Point ConversionEnter the blue numbers

First currencyNUMBER OF BASIS POINTS (US$) 75US$ INTEREST RATE 10.00%NUMBER OF PAYMENT PERIODS PER YEAR 2NUMBER OF YEARS 5

PRESENT VALUE OF BASIS POINTS (US$) 290

Second currencyEuro INTEREST RATE 8.35%NUMBER OF PAYMENT PERIODS PER YEAR 1NUMBER OF YEARS 5

NUMBER OF BASIS POINTS (Euro) (ANNUITY EQUIV) 73.2

Basis Point ConversionEnter the blue numbers

First currencyNUMBER OF BASIS POINTS (US$) 75US$ INTEREST RATE 10.00%NUMBER OF PAYMENT PERIODS PER YEAR 2NUMBER OF YEARS 5

PRESENT VALUE OF BASIS POINTS (US$) 290

Second currencyEuro INTEREST RATE 8.35%NUMBER OF PAYMENT PERIODS PER YEAR 1NUMBER OF YEARS 5

NUMBER OF BASIS POINTS (Euro) (ANNUITY EQUIV) 73.2


INVESTORINVESTOR

Asset Swaps: The Same Idea

Fixed GBP 12.73%

Investor buys cheap fixed-rate bond But wants a floating-rate note.


INVESTORINVESTOR BANKBANK

Fixed GBP 12%

Floating USD

Libor s.a.

Asset Swaps: The Same Idea

Fixed GBP 12.73%

Floating USD

Libor s.a.

+0.75%

Fixed GBP 12.73%


Currency Swaps vs Long-dated Forwards

SF

SFSF

£

£

LONG-DATED FORWARD

SPOTRATE

End-period exchange occurs atforward rate, which representsthe spot rate plus thecumulative interest tatedifferential.

FORWARDRATE


Currency Swaps vs Long-dated Forwards

SF SF

SFSFSF

£ £

££

LONG-DATED FORWARD CURRENCY SWAP

SPOTRATE

SPOTRATE

PERIODICINTERESTRATEDIFFERENTIAL

End-period exchange occurs atforward rate, which representsthe spot rate plus thecumulative interest tatedifferential.

End-period exchange occurs atspot rate , since thecumulative interest tatedifferential is paid duringinterim periods.

FORWARDRATE

SPOTRATE


A Basis Swap

Fuji

Bank

Fuji

Bank CitiCiti

Fuji makes a loan at Prime + Spread, but gets funding in the Eurodollar interbank market

Prime + Spread

Floating

Libor


A Basis Swap

Fuji

Bank

Fuji

Bank CitiCiti

Prime

Floating

Libor

Fuji makes a loan at Prime + Spread, but gets funding in the Eurodollar interbank market

Fuji wants to lock in its spread, so does a basis swap with Citibank

Prime + Spread

Floating

Libor


Basis Swap Quotations

GovPX/GGB GovPX Index Basis Swaps vs 3M LIBOR 8/6/96 Page 262 Prime vs LIBOR Fix LIBOR Fed Funds vs LIBOR

Term Pay Prime Rec Prime 1M 5 7/16 Term Pay FF Rec FF1Y P- 271 P- 267 3M 5 1/2 1Y FF+ 21 1/2 FF+ 23 1/22Y P- 268 P- 264 6M 5 11/16 2Y FF+ 23 FF+ 253Y P- 267 P- 263 Mkt LIBOR 3Y FF+ 23 1/2 FF+ 25 1/24Y P- 265 P- 261 1M 5 7/16 4Y FF+ 24 1/2 FF+ 26 1/25Y P- 263 P- 259 3M 5 1/2 5Y FF+ 25 FF+ 277Y P- 260 P- 255 6M 5 11/16 7Y FF+ 26 FF+ 2810Y P- 259 P- 254 10Y FF+ 26 FF+ 28 3M T-Bill vs LIBOR Prime 8.25 CP vs LIBOR

Term Pay T-Bill Rec T-Bill Term Pay CP Rec CP1Y B+ 37 B+ 40 Fed Funds 1Y CP+ 4 3/4 CP+ 6 3/42Y B+ 39 B+ 42 5 1/16-1/8 2Y CP+ 5 CP+ 63Y B+ 40 1/2 B+ 43 1/2 3Y CP+ 5 1/4 CP+ 6 1/24Y B+ 43 B+ 47 3M T-Bill Yld 4Y CP+ 5 1/2 CP+ 6 3/45Y B+ 44 B+ 48 5.171-166 5Y CP+ 6 CP+ 77Y B+ 45 B+ 49 7Y CP+ 6 1/2 CP+ 810Y B+ 46 B+ 50 30D CP 5.32 10Y CP+ 7 CP+ 9

Alert Line


A Basis Swap

Fuji

Bank

Fuji

Bank CitiCiti

Prime-263

Floating

3-mo Libor

Fuji makes a 3-year loan at Prime + 1%, and swaps at P-2.63%

Fuji thus locks in a spread of 3.63%

Prime + 1%

Floating

Libor flat


Commodity Swap Example: Qantas

QANTASQANTAS

US$ LIBOR +1/4%

SEMIIANNUAL

PASSENGER

REVENUES

FUEL

COSTS


Example: Qantas

QANTASQANTAS PARIBASPARIBAS

US$ LIBOR +1/4%

SEMIIANNUAL

PASSENGER

REVENUES

FUEL

COSTS


Example: Qantas

QANTASQANTAS PARIBASPARIBAS

US$ LIBOR +1/4%

SEMIIANNUAL

US$ FIXED 10%

+/- $30 M X (1-%CH AW INDEX)

US$ LIBOR +1/4%

SEMIIANNUAL


Summary

Mechanics of swaps Valuation of swaps Credit risk of swaps Pricing swaps Hedging swaps The all-in cost of swap financing Swap around the clock


Ian H. Giddy

Stern School of Business

New York University

44 West 4th Street, New York, NY 10012, USA

Tel 212-998-0332

Fax 917-463-7629

[email protected]

http://giddy.org

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Prof. Ian Giddy New York University Swap Financing Techniques SIM/NYU The Job of the CFO.

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