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Derivative Markets: An Introduction Derivative markets: swaps 4 Derivative markets: swaps 4.1 Learning outcomes After studying this text the learner should / should be able to: 1. Define a swap. 2. Describe the different types of swaps. 3. Elucidate the motivations underlying interest rate swaps. 4. Illustrate how swaps are utilised in risk management. 5. Appreciate the variations on the main themes of swaps. 4.2 Introduction Figure 1 presentsFigure the derivatives 1: derivatives and their relationshipand relationship with the spotwith markets. spot markets forwards / futures on swaps FORWARDS SWAPS FUTURES OTHER OPTIONS (weather, credit, etc) options options on on swaps = futures swaptions money market debt equity forex commodity market market market markets bond market SPOT FINANCIAL INSTRUMENTS / MARKETS Figure 1: derivatives and relationship with spot markets Download free eBooks at bookboon.com 116 Derivative Markets: An Introduction Derivative markets: swaps Swaps emerged internationally in the early eighties, and the market has grown significantly. An attempt was made in the early eighties in some smaller to kick-start the interest rate swap market, but few money market benchmarks were available at that stage to underpin this new market. It was only in the middle nineties that the swap market emerged in some of these smaller countries, and this was made possible by the creation and development of acceptable benchmark money market rates. The latter are critical for the development of the derivative markets. We cover swaps before options because of the existence of options on swaps. This illustration shows that we find swaps in all the spot financial markets. A swap may be defined as an agreement between counterparties (usually two but there can be more 360° parties involved in some swaps) to exchange specific periodic cash flows in the future based on specified prices / interest rates. The cash flow calculations are made with reference to an agreed notional amount (i.e. an amount that is not exchanged). Swaps allow financial market participants to better manage risk thinking in their relevant preferred habitat markets. 360° . thinking. 360° thinking . 360° thinking. Discover the truth at www.deloitte.ca/careers Discover the truth at www.deloitte.ca/careers © Deloitte & Touche LLP and affiliated entities. Discover the truth at www.deloitte.ca/careers © Deloitte & Touche LLP and affiliated entities. Download free eBooks at bookboon.com © Deloitte & Touche LLP and affiliated entities. Discover the truth117 at www.deloitte.ca/careersClick on the ad to read more © Deloitte & Touche LLP and affiliated entities. Derivative Markets: An Introduction Derivative markets: swaps Swaps are a significant part of the financial markets and, as noted, are found in all the markets. The interest rate swap has a leg in the money market and a leg in the bond market. Equity / share swaps have a leg in the share market and the other in the bond market (and sometimes the money market). Currency swaps (not to be confused with foreign exchange swaps) have two legs in the foreign exchange market, but in different geographic markets. Commodity swaps involve the exchange of a fixed price on a commodity for the spot price (usually an average), and sometimes the transaction does not include the same commodity. The swap marketFigure may be 2:depicted swaps as in Figure 2. FINANCIAL AND COMMODITY SWAPS INTEREST RATE EQUITY CURRENCY COMMODITY SWAPS SWAPS SWAPS SWAPS money market debt equity forex commodities market market market market bond market FINANCIAL MARKETS Figure 2: swaps To this list may be added the credit risk swap, but as the compensation for the “protection buyer” is contingent upon a “credit event”, it is more akin to an insurance policy, and will be discussed in the “other derivatives” section. The various swaps undertaken in the five markets are covered briefly below. Interest rate swaps dominate and are given pole position, and we conclude with brief sections on the listed swaps in South Africa and the organisation of the swap market. The following are the headings: • Interest rate swaps. • Currency swaps. • Equity / share swaps. • Commodity swaps. • Listed swaps. • Organisation of the swap market. Download free eBooks at bookboon.com 118 Derivative Markets: An Introduction Derivative markets: swaps 4.3 Interest rate swaps 4.3.1 Introduction An interest rate swap entails the swapping of differing interest obligations between two parties via a facilitator, usually a bank that focuses on this market (and makes a market in this market). It is 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. These interest amounts are calculated with reference to a mutually agreed notional amount. The notional amount is not exchanged between the parties. 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. These swaps are also called coupon swaps. When two floating rates are exchanged they are called basis swaps. In fact, there are a variety of interest rate swaps, and these are mentioned at the close of this section. The following sections are covered here: • Motivation for interest rate swaps. • Coupon swap: transforming a liability. • Coupon swap: transforming an asset. • Coupon swap: comparative advantage. • Organisation of the swap market. • Variations on the theme. 4.3.2 Motivation for interest rate swaps The circumstances that give rise to interest rate swaps (IRSs) usually involve interest rate risk or comparative advantage. The following main IRSs may be identified: • Transforming a liability. • Transforming an asset. • Comparative advantage. 4.3.3 Coupon swap: transforming a liability An example of an IRS that Figuretransforms 3: interest a liability rate swap:is shown transforming in Figure a 3. liability Pays 12.1% pa fixed Pays 12.0% pa fixed rate every 6 months rate every 6 months COMPANY A SWAP BROKER- COMPANY B DEALER (BANK) borrows LCC 100 million borrows LCC 100 million by by issuing 91-day CP Pays CP Pays CP issuing 3-year corporate (at floating rate) floating rate floating rate bonds (at 12% pa fixed rate) every 91 days every 91 days Pays CP Pays 12% floating rate fixed rate LCC 100 LCC 100 every 91 days every 6 million million months INVESTORS INVESTORS NOTIONAL in LCC 100 million Co A 91-day AMOUNT = LCC in LCC 100 million Co B CP (at floating rate) (CP rolled 100 MILLION 3-year corporate bonds over every 91 days at market rate) (at 12% pa fixed rate) Figure 3: interest rate swap: transforming a liability Download free eBooks at bookboon.com 119 Derivative Markets: An Introduction Derivative markets: swaps In this example Company A has borrowed LCC100 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 LCC100 million by the issuing of corporate bonds at a fixed rate of 12% pa for a 3-year period. These borrowing habitats could reflect the following: • Company A believes interest rates are going to move down or sideways. It therefore does not want to “lock in” a rate for a long period, and wants to take advantage of rates declining if this does come about. • Company B is of the view that rates are about to rise and wishes to lock in a rate now for the next three years. Time passes and the two parties change their views. A sharp banker spots the changed views of the two companies and puts the following deals to them: Company A • Company A and the bank enter into an interest rate swap agreement. • Company A agrees to pay to the bank a fixed rate of 12.1% for the next three years, interest payable six-monthly. • The bank agrees to pay Company A the floating commercial paper rate every 91-days. • The notional amount of the swap is LCC100 million. We will turn your CV into an opportunity of a lifetime Do you like cars? Would you like to be a part of a successful brand? Send us your CV on We will appreciate and reward both your enthusiasm and talent. www.employerforlife.com Send us your CV. You will be surprised where it can take you. Download free eBooks at bookboon.com 120 Click on the ad to read more Derivative Markets: An Introduction Derivative markets: swaps Company B • Company B and the bank enter into an interest rate swap agreement. • Company B agrees to pay to the bank the commercial paper floating rate every 91 days. • The bank agrees to pay to Company B paying a fixed rate of 12.0%, interest payable six-monthly. • The notional amount of the swap is LCC100 million. Because of their changed views, the deals are accepted by both companies. Company A’s obligation to pay the 91-day commercial paper rate to the holders (which may be different in each rollover period) is matched by the bank’s payment of the 91-day commercial paper rate to it. It is then left only with the obligation to pay the fixed rate of 12.1% pa to the bank. Conversely, Company B’s obligation to pay the fixed 12% pa to the investors in its paper is matched by the bank’s obligation to pay the fixed 12% pa rate to it. Company B is thus left with the obligation to pay the 91-day commercial paper rate to the bank. The interest obligations of the bank match, with the exception that the bank earns 0.1% on the fixed interest leg of the transaction (LCC100 000 per annum excluding compounding and present value calculations).
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