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Swaps and their Applications
Overview of Swaps

Swaps – Obligates two parties to exchange some
specified cash flows at specified intervals over a
specified time period. Like futures contracts, swaps
can be viewed as a portfolio of forward contracts.
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Key Features:
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Credit risk is two-sided but a swap is less risky than a
forward (and more risky than futures) because a swap
reduces the “performance period” (the time interval between
cash payments) but does not require posting a margin.
Swaps can be tailored exactly to customer needs and can be
arranged for longer time periods than futures and forwards
(e.g., 1-5 years vs. 1-2 years for forwards/futures).
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Basic Components of a Swap
Contract
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Swaps can be created for all types of financial assets
and commodities.
Swaps have experienced explosive growth since the
early 1980s due to the ability to custom-tailor payoffs
over relatively long time periods.
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Notional Principal is used to define the magnitude of
cash flows but this principal is never exchanged.
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Payments are netted at pre-specified settlement
dates over the life of the swap.
A difference check is sent to one of the two parties at
each settlement date (reduces credit risk).
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Types of Swaps
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Interest Rate Swaps: The most common swap is based on
swapping fixed versus floating interest payments. Also,
can create basis swaps and cross-currency swaps.
Currency Swaps: Enables two parties to exchange
currencies at pre-specified dates over the life of the swap.
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Commodity Swaps: Can receive or pay floating or fixed
prices for commodities such as oil and natural gas.
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Equity Swaps: Can exchange the return on a stock (or
stock index) for the return on another asset (e.g., LIBOR).
Credit Default Swaps: Enables to exchange cash flows
depending on changes in a borrower’s credit rating.
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Example of Motivation for Swaps
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Swaps can allow both parties to achieve lower
financing costs.
Example:
Borrower:
AAA
BBB
Fixed Rate
10.8%
12.0%
Floating Rate
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LIBOR + 0.25% LIBOR + 0.75%
AAA can borrow at fixed rate (10.8%) and swap with
BBB in order to pay floating rate (L-0.1%). Both parties
can then split the 70 bps savings (120-50 bps).
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Alternative Swap Example
(‘Hi’ / AAA swaps floating for fixed rate):
Reduce borrowing costs by using interest rate
swaps.
 Example: Two firms with different credit
ratings, Hi and Lo:
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Hi can borrow fixed at 11.0% and floating
at LIBOR + 1.0%.
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Lo can borrow fixed at 11.4% and floating
at LIBOR + 1.5%.
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Hi wants fixed rate, but it will issue floating and “swap”
with Lo. Lo wants floating rate, but it will issue fixed
and swap with Hi. Lo also makes “side payment” of
0.45% to Hi.
Hi
CF to lender
Lo
-(LIBOR+1%)
-11.40%
CF Hi to Lo
-11.40%
+11.40%
CF Lo to Hi
+(LIBOR+1%)
-(LIBOR+1%)
CF Lo to Hi
+0.45%
-0.45%
Net CF
-10.95%
-(LIBOR+1.45%)
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Rationales for why Swap “Savings”
Exist

Comparative Advantage – predicts savings should
disappear (but they don’t!).
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Under-priced Credit Risk – again, predicts savings
disappear as market corrects under-pricing.

Different Cash Flows – interest rate swaps don’t
have call provisions, so “savings” are really the cost
of the issuer’s option to call fixed rate debt (most
plausible reason).
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Different Information Sets – insiders can signal their
beliefs about the true value of the firm.
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Rationales for why Swap “Savings”
Exist (cont.)
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Different Taxation and Regulation – can explain certain
transactions but should disappear as governments close
loopholes.
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Exposure Management – more firms are actively managing
their financial price risks and therefore swaps have grown
in line with this trend.
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Synthetic Instruments – as more issuers create synthetic
instruments (or hybrids), more swaps are needed.
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Liquidity – lower B-A spreads attract more investors and
improves the liquidity of the market.
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Pricing and Valuing a Swap
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A Swap can be decomposed into a portfolio of
forward contracts (or short term loans).
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At origination, both types of loans/forwards (fixed
and floating rate) have an E(NPV) = 0.
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A swap is a combination of long position in one type
of loan (e.g., long a fixed rate) and a short position
in the other type (short a floating rate).
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Three yield curves (spot zero-coupon, forward zerocoupon, and spot par bond) are used to price the
expected cash flows from a swap.
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Applications of Swaps
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Types of Users:
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Non-financial Corporations
Financial Companies (CB’s, IB’s, Brokers, Insurance)
Institutional Investors (Pension funds, Mutual funds)
Governments (Federal and Municipal)
Usually used to Modify Debt Obligations:
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Match Interest Sensitivity of Assets
Reduce Funding Costs
Enhance Yield on Investments
Increase Debt Capacity
Protect Value of Investments from Interest Rate Risk
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Applications of Swaps (cont.)
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Also used to Modify Cash Flows:
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Reduce Volatility of CF’s to IR, FX, Commodity, Equity Price
Movements
Hedge on Inflows (Income, Receivables)
Hedge on Outflows (Cost of Goods Sold, Operating Expenses)
“Macro Hedge” of Both Inflows and Outflows (e.g., A/L Mgmt.)
Can also be used to Create Synthetic Instruments:
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Inverse Floating Rate Notes
Adjustable-rate Preferred Stock
Synthesize Long-Dated Forward Contracts (can be cheaper)
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FX Rate Risk and Swaps
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Typical Usage:
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Firm borrows in one currency where interest rates are
lower and then swaps cash flows into home/base
currency.
Hedge transaction exposures rather than “macro
hedges”.
Common Examples:
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Company managing Foreign Inflows or Outflows (e.g.,
Import/Export business).
Governments borrowing in international capital markets.
To access long-term fixed rate capital in “exotic”
currencies (e.g., McDonalds borrowing in New Zealand).
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Credit Default Swaps – Infinite Leverage
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Like an insurance contract that pays in the event of default.
FASB requires mark-to-market valuation.
Collateral Call - Protection Buyers can call for partial payment if default event is likely.
Determined by mark-to-market value.
Protection Buyer
Tends to own
reference asset
Protection Seller
Premium Payments
 Hedging or going
“short”
 Benefits when
reference asset price
DECREASES
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 Does not usually
own reference asset
Going “long”
Payment upon Default of
Reference Asset
Reference Asset can be a MBS,
CDO, Bond, or Loan
Benefits when
reference asset price
INCREASES, max at
Par