Derivatives: Hedging against risk
DERIVATIVE
A product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index or reference rate ), in a contractual manner. The underlying asset can be equity , forex commodity or any other asset.
In the Indian context the securities contracts (Regulation)Act, 1956(SC(R)A) defines “Derivative” to include :
•A security derived from a debt instrument ,share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.
•A contract which derives its value from the prices, or index of prices, of underlying securities.
Introduction (I)
In the financial marketplace some instruments are regarded as fundamentals, while others are regarded as derivatives.
Financial Marketplace
Derivatives Fundamentals
Simply another way to catagorize the diversity in the FM*.
*Financial Market
Financial Marketplace
Derivatives Fundamentals
• Stocks
• Bonds
• Futures
• Forwards
Introduction (II)
What is a Derivative? (I)
Options
Swaps
Forwards Futures
The value of the derivative instrument is
DERIVED from the underlying security
Underlying instrument such as a commodity, a stock, a stock index, an exchange rate, a bond, another derivative etc..
Options
Swaps Forwards
Futures
The owner of an options has the OPTION to buy or sell something at a predetermined price and is therefore more costly than a futures contract.
The owner of a forward has the OBLIGATION to sell or buy something in the future at a predetermined price. The difference to a future contract is that forwards are not standardized.
The owner of a future has the OBLIGATION to sell or buy something in the future at a predetermined price.
What is a Derivative? (II)
A swap is an agreement between two parties to exchange a sequence of cash flows.
Reasons to use derivatives (I)
Hedging:
Speculation:
• Interest rate volatility
• Stock price volatility
• Exchage rate volatility
• Commodity prices volatility
VOLATILITY
• High portion of leverage
• Huge returns
EXTREMELY RISKY
Derivative markets have attained an overwhelming popularity for a variety of reasons...
Reasons to use Derivatives (II)
Also derivatives create...
• a complete market, defined as a market in which all identifiable payoffs can be obtained by trading the securities available in the market*.
• and market efficiency, characterized by low transaction costs and greater liquidity.
Milestones in the development of Indian derivative market
• November 18, 1996 L.C. Gupta Committee set up to draft a policy framework for introducing derivatives
• May 11, 1998 L.C. Gupta committee submits its report on the policy framework
• May 25, 2000 SEBI allows exchanges to trade in index futures
• June 12, 2000 Trading on Nifty futures commences on the NSE
• June 4, 2001 Trading for Nifty options commences on the NSE
• July 2, 2001 Trading on Stock options commences on the NSE
• November 9, 2001 Trading on Stock futures commences on the NSE
• August 29, 2008 Currency derivatives trading commences on the NSE
• August 31, 2009 Interest rate derivatives trading commences on the NSE
• February 2010 Launch of Currency Futures on additional currency pairs
•
Difference between forwards and futures
Forwards Futures
Two parties Three Parties
Autonomous Regulated
Privately negotiated contracts Traded on an exchange Not standardized Standardized contracts Settlement dates can be Fixed settlement dates as set by the parties declared by the exchange High counter party risk Almost no counter party risk
Derivatives in India (1)
• Sodhani Committee (expert group on
foreign exchange) was formed in 1992 to look into the issues in and development of the foreign exchange market in India
• Some recommendations
– Corporates should be allowed to hedge upon declaration of underlying assets
– Banks may be permitted to initiate overseas
Sodhani Committee..
• Banks should be allowed to borrow and lend in the overseas markets
• More participants be allowed in the foreign exchange market
• Corporates must be allowed to cancel and re- book option contracts
• Banks be permitted to use hedging instruments for their own ALM
• Banks to be allowed to fix interest rates on
FCNR (B) deposits subject to caps fixed by RBI
Derivatives in India (2)
• The use of financial derivatives started in India is the nineties’ in the foreign exchange and stock market
• In 1992 RBI had permitted banks to offer cross currency options to their clients
• In 1996 banks were allowed to offer their
corporate clients interest rate swaps, currency swaps, interest rate options and forward rate agreements
• The derivatives market in India is still in an
Milestones in the development of Indian derivative market
◼ November 18, 1996 L.C. Gupta Committee set up to draft a policy
framework for introducing derivatives
◼ May 11, 1998 L.C. Gupta committee submits its report on the policy
framework
◼ May 25, 2000 SEBI allows exchanges to trade in index futures
◼ June 12, 2000 Trading on Nifty futures commences on the NSE
◼ June 4, 2001 Trading for Nifty options commences on the NSE
◼ July 2, 2001 Trading on Stock options commences on the NSE
◼ November 9, 2001 Trading on Stock futures commences on the NSE
Conti…
◼ August 29, 2008 Currency derivatives trading commences on the NSE
◼ August 31, 2009 Interest rate derivatives trading commences on the NSE
◼ February 2010 Launch of Currency Futures on additional currency pairs
◼ October 28, 2010 Introduction of European style Stock Options
Options (I)
Options The owner of an options has the OPTION to buy or sell something at a predetermined price and is therefore more costly than a futures.
Some terms to understand:
• Call option
• Put option
• Excersice price / strike price
• Option premium
• Moneyness (in-the-money, at-the-money, out-of-money)
• European vs. American Options
Factors impacting option prices
Options (II)
Call Option
Write Purchase
Write The four basic positions:
Payoff (at time of expiration) for a Call option
0
Break-even Exercise price (X)
Spot Price
Premium paid Payoff of
option
Payoff (at time of expiration) for a Put option
0
Exercise price (X)
Spot Price Payoff of
option
An investor buys one European Call option on one share of Neyveli Lignite at a premium of Rs.2 per share on 31 July.
The strike price is Rs.60 and the contract matures on 30 September. It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits
opportunity.
On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.
Illustration on Call Option
Options (VI)
Write & Purchase Call Option:
Profit and Loss
Stock Price at Expiration
Long Put
Premium Earned
An investor buys one European Put Option on one share of Neyveli Lignite at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The adjoining graph shows the fluctuations of net profit with a
Illustration on Put Options
The Black-Scholes-Merton Option Pricing Model
• The Black-Scholes-Merton option pricing model says the value of a stock option is determined by six factors:
S, the current price of the underlying stock
y, the dividend yield of the underlying stock
K, the strike price specified in the option contract
r, the risk-free interest rate over the life of the option contract
T, the time remaining until the option contract expires
, (sigma) which is the price volatility of the underlying stock
15-42
The Black-Scholes-Merton Option Pricing Formula
• The price of a call option on a single share of common stock is: C = Se–yTN(d1) – Ke–rTN(d2)
• The price of a put option on a single share of common stock is: P = Ke–rTN(–d2) – Se–yTN(–d1)
( ) ( )
σ T d
d
σ T
T σ 2
y r
K S d ln
1 2
2 1
−
=
+
−
=
d1 and d2 are calculated using these two formulas:
Formula Details
• In the Black-Scholes-Merton formula, three common fuctions are used to price call and put option prices:
– e-rt, or exp(-rt), is the natural exponent of the value of –rt (in common terms, it is a discount factor)
– ln(S/K) is the natural log of the "moneyness" term, S/K.
– N(d1) and N(d2) denotes the standard normal probability for the values of d1 and d2.
• In addition, the formula makes use of the fact that:
N(-d1) = 1 - N(d1)
15-44
Example: Computing Prices for Call and Put Options
• Suppose you are given the following inputs:
S = $50 y = 2%
K = $45
T = 3 months (or 0.25 years)
= 25% (stock volatility) r = 6%
• What is the price of a call option and a put option, using the Black-Scholes-Merton option pricing formula?
We Begin by Calculating d
1and d
2( ) ( ) ( ) ( )
0.86038 0.25
0.25 0.98538
σ T d d
0.98538
0.125
0.25 0.07125
0.10536
0.25 0.25
0.25 2
0.25 0.02
0.06 45
50 ln σ T
T σ 2
y r K S d ln
1 2
2 2
1
=
−
=
−
=
=
= +
+
−
= +
−
=
Now, we must compute N(d1) and N(d2). That is, the standard normal probabilities.
15-46
Calculating Delta
• Delta measures the dollar impact of a change in the underlying stock price on the value of a stock option.
Call option delta = e–yTN(d1) > 0 Put option delta = –e–yTN(–d1) < 0
• A $1 change in the stock price causes an option price to change by approximately delta dollars.
Example: Calculating Delta
Stock Price: 50.00 Discounted Stock: 49.75 Strike Price: 45.00 Discounted Strike: 44.33 Volatility (%): 25.00
Time (in years): 0.2500 Riskless Rate (%): 6.00 Dividend Yield (%): 2.00
d(1): 0.98538
N(d1): 0.83778 N(-d1): 0.16222
Call Delta: 0.83360
d(2): 0.86038
N(d2): 0.80521 N(-d2): 0.19479
Put Delta: -0.16141
Call Price: $ 5.985 Put Price: $ 0.565
15-48
Calculating Vega
• Vega measures the impact of a change in stock price volatility on the value of stock options.
• Vega is the same for both call and put options.
Vega = Se–yTn(d1)T > 0
n(d) represents a standard normal density, e-d/2/ 2p
• If the stock price volatility changes by 100% (i.e., from 25% to 125%), option prices increase by about vega.
Example: Calculating Vega
Stock Price: 50.00 Discounted Stock: 49.75 Strike Price: 45.00 Discounted Strike: 44.33 Volatility (%): 25.00
Time (in years): 0.2500 Riskless Rate (%): 6.00 Dividend Yield (%): 2.00
d(1): 0.98538
N(d1): 0.83778 N(-d1): 0.16222
Call Delta: 0.83360 n(d1): 0.24375
d(2): 0.86038
N(d2): 0.80521 N(-d2): 0.19479
Put Delta: -0.19382
Call Price: $ 5.985
Vega: 6.06325
Put Price: $ 0.565
15-50
The "Vega" Prediction:
• The vega value of 6.063 predicts that if the stock price volatility increases by 100% (i.e., from 25% to 125%), call and put option prices will increase by $6.063.
• Generally, traders divide vega by 100—that way the prediction is: if the stock price volatility increases by 1% (25% to 26%), call and put option prices will both increase by about $0.063.
• If stock price volatility increases from 25% to 26%, you can use the spreadsheet to see that the
– Call option price is now $6.047, an increase of $0.062.
– Put option price is now $0.627, an increase of $0.062.
Other Impacts on Option Prices from Input Changes
• Gamma measures delta sensitivity to a stock price change.
– A $1 stock price change causes delta to change by approximately the amount gamma.
• Theta measures option price sensitivity to a change in time remaining until option expiration.
– A one-day change causes the option price to change by approximately the amount theta.
• Rho measures option price sensitivity to a change in the interest rate.
– A 1% interest rate change causes the option price to change by approximately the amount rho.
15-52
Chapter Review, I.
• The Black-Scholes-Merton Option Pricing Model
• Valuing Employee Stock Options
• Varying the Option Price Input Values
– Varying the Underlying Stock Price – Varying the Option’s Strike Price
– Varying the Time Remaining until Option Expiration – Varying the Volatility of the Stock Price
– Varying the Interest Rate – Varying the Dividend Yield
Chapter Review, II.
• Measuring the Impact of Input Changes on Option Prices
– Interpreting Option Deltas – Interpreting Option Etas – Interpreting Option Vegas
– Interpreting an Option’s Gamma, Theta, and Rho
• Implied Standard Deviations
• Hedging a Stock Portfolio with Stock Index Options
• Implied Volatility Skews
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special
types of forward contracts in the sense that the former are standardized
exchange-traded contracts, such as futures of the Nifty index.
Economic Importance of the Futures Market
• Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrow's estimated amount of supply
Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This helps reduce the ultimate cost to the retail buyer because with less risk there is less of a chance that manufacturers will jack up prices to make up for profit losses in the cash market.
Background
◦ 1972: Chicago Mercantile Exchange opens International Monetary Market. (IMM)
◦ IMM provides an outlet for hedging currency risk with futures contracts
Futures Contracts: contracts written requiring a
Advantages of Futures
Smaller contract size
Easy liquidation
Well-organized and stable market.
Little default risk.
Disadvantages of Futures
Currencies available limited
Limited dates of delivery
Rigid contract sizes.
Future mechanism
Differences between futures and options
Future Options
Both the buyer and the seller are under an obligation to fulfill the contract.
The buyer of the option has the right and not an obligation whereas the seller is under obligation to fulfill the contract if and when the buyer exercises his right.
The buyer and the seller are subject to unlimited risk of loss.
The seller is subjected to unlimited risk of losing whereas the buyer has limited potential to lose (which is the option premium).
The buyer and the seller have
potential to make unlimited gain or loss.
The buyer has potential to make unlimited gain while the seller has a
potential to make unlimited gain. On the other hand the buyer has a limited loss
Payoff for futures
Futures contracts have linear payoffs. In
Simple words, it means that the losses as
well as profits for the buyer and the seller
of a futures contract are unlimited. These
linear Payoffs are fascinating as they can
be combined with options and the
underlying to generate various complex
A payoff is the likely profit/loss that would accrue to a market participant with change in the
price of the underlying asset. This is generally depicted in the form of payoff diagrams which
show the price of the underlying asset on the X–axis and the profits/losses on the Y–axis.
In this
section we shall take a look at the payoffs for buyers and sellers of futures and options.
1.
The stock of the an investor has gone downfrom Rs.450 to Rs. 400 and further it is likely to go down.
2.
He should take a short futures position.3.
2 months future cost him Rs. 415 for that he has to keep the margin money.4.
If price goes down to Rs. 360, he is looser by Rs. 40 per share.5.
But his short position will start making profit.Hedging: Long security, sell futures
Payoff for a buyer of Nifty futures
The figure shows the profits/losses for a long futures
position. The investor bought futures when the index was at 6200.
Profit
0 6200 Nifty
Loss
Payoff for a seller of Nifty futures
The figure shows the profits/losses for a short futures position. The investor sold futures when the index was at
4000
.
Profit
0 4000
Loss
If the index goes down, his futures position starts making
ACCOUNTING AND TAX
▪ Accounting Consider a trader who in September 2002 takes a long position in a March 2003 corn futures contract and closes out the position at the end of February 2003.
▪ Suppose that the futures prices are 150 cents
per bushel when the contract is entered into,
170 cents per bushel at the end of 2002, and
180 cents per bushel when the contract is
closed out. One contract is for the delivery of
5,000 bushels. If the trader is a speculator, the
gains for accounting purposes are
Currency and Interest Rate Swaps
Chapter Objective:
This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging long- term interest rate risk and foreign exchange risk.
Chapter Outline:
• Types of Swaps
• Size of the Swap Market
• The Swap Bank
• Interest Rate Swaps
Swaps A swap is an agreement between two parties to exchange a sequence of cash flows.
Swaps (I)
• Counterparties
• Interest rate swaps
• Currency swaps
• Phenomenal growth of the swap market
• Future and Option markets only provide for short term investment horizon
• Traded in OTC markets with little regulations
• No secondary market
• Market limited to institutional investors
6.75
Swaps
• Contracts that can be constructed with multiple forward contracts
• An agreement to exchange cash flows at specified future times according to certain specified rules
• Types of swaps
– Interest Rate Swaps – Currency Swaps
– Commodity Swaps
Swap Market
In a swap, two counterparties agree to a contractual
arrangement wherein they agree to exchange cash flows at periodic intervals.
There are two basic types of swaps:
◼ Single Currency Interest rate swap
⚫ “Plain vanilla” fixed-for-floating swaps in one currency.
◼ Cross Currency Interest Rate Swap (Currency swap)
⚫ Fixed for fixed rate debt service in two (or more) currencies.
The most popular currencies are: US$, Yen, Euro, SF, BP
6.77
Plain Vanilla Interest Rate Swap
Firm A pays 5% fixed and receives LIBOR
Firm A Swap
Dealer
Pay 5%
Receive 6 mo. LIBOR
If the swap is being used by Firm A as a hedge, what
6.78
Typical Uses of an Interest Rate Swap
• Converting a liability from
– fixed rate to floating rate – floating rate to
fixed rate
• Converting an investment from
– fixed rate to floating rate
– floating rate to fixed
rate
6.79
Valuation of an Interest Rate Swap
• Interest rate swaps can be valued as the difference between the value of a fixed- rate bond and the value of a floating-rate bond
• Alternatively, they can be valued as a
portfolio of forward rate agreements
6.80
Valuation in Terms of Bonds
• The fixed rate bond is valued in the usual way
• The floating rate bond is valued by noting
that it is worth par immediately after the
next payment date
6.81
Valuation in Terms of FRAs
• Each exchange of payments in an interest rate swap is an FRA
• The FRAs can be valued on the assumption
6.82
Valuation of an Interest Rate Swap: an Example
• Suppose that, under the terms of a swap, a
financial institution has agreed to pay six-month LIBOR and receive 8% per annum (with
semiannual compounding) on a notional principal of $100 million. The swap has a remaining life of 1.25 years. The LIBOR rates with continuous
compounding for 3-month, 9-month and 15-month maturities are 10%, 10.5%, and 11%, respectively.
The 6-month LIBOR at the last payment date was 10.2% (with semiannual compounding).
6.83
Currency Swap
• Example : A bilateral agreement to
- Receive 8% on a US$ principal of 15,000,000 - and Pay 11% on a sterling principal of
$10,000,000
- cash flows are exchanged every year for 5 years
• Principal is exchanged at the beginning and
6.84
Fixed-for-fixed Currency Swap
Years
Dollars Pounds
$
---millions--- 0 –15.00 +10.00 1 +1.20 –1.10
2 +1.20 –1.10 3 +1.20 –1.10 4 +1.20 –1.10 5 +16.20 -11.10
£
6.85
Typical Uses of a Currency Swap
• Conversion from a liability in one
currency to a
liability in another
• Conversion from
an investment in
one currency to an
investment in
6.86
Valuation of Currency Swaps
Like interest rate swaps, currency
swaps can be valued either as the
difference between 2 bonds or as
a portfolio of forward contracts
6.87
Valuation of a Currency Swap: an Example
• Suppose that the term structure of interest rates is flat in both Japan and the US. The Japanese
interest rate is 4% per annum and the US rate is 9% per annum (both with continuous
compounding). A financial institution has entered into a currency swap in which it receives 5% per annum in yen and pays 8% per annum in dollars once a year. The principals in the two currencies are $10 million and 1,200 million yen. The swap will last for another three years, and the current
6.88
Commodity Swaps: Oil Swap
• In 1986, the first oil swap was intermediated by Chase Manhattan Bank
• The parties agree on a notional amount that is expressed in barrels of oil (rather than in dollars)
• Similar to a fixed-for-floating interest rate swap,
payments are made on the basis of fixed and floating oil prices.
– Example: One party receives a cash flow based on an oil price that is fixed at the origination of the contract and pays a cash flow based on the average spot price over a period.
• Oil prices increase, this party makes a net payment
• Oil prices decrease, this party receives a net payment
• No physical quantities of oil are exchanged.
Swaps & Forwards
6.89• A swap can be regarded as a convenient way of packaging forward contracts
• The “plain vanilla” interest rate swap in our example consisted of 6 FRAs
• The “fixed for fixed” currency swap in our example consisted of a cash transaction & 5 forward contracts
• The value of the swap is the sum of the values of the forward contracts underlying the swap
• Swaps are normally “at the money” initially
– This means that it costs nothing to enter into a swap
– It does not mean that each forward contract underlying
6.90
Credit Risk
• A swap is worth zero to a company initially
• At a future time its value is liable to be either positive or negative
• The company has credit risk exposure only
when its value is positive
The Swap Bank
A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.
The swap bank can serve as either a broker or a dealer.
◼ As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap.
◼ As a dealer, the swap bank stands ready to accept either
Interest Rate Swap
Used by companies and banks that require either fixed or floating-rate debt.
Interest rate swaps allow the companies (or banks) and the swap bank to benefit by swapping fixed-for-floating interest payments.
Since principal is in the same currency and the same amount, only interest payments are exchanged (net).
Interest Rate Swap
Each party will issue the less advantageous form of debt.
Swap Bank Company A
prefers floating
Company B prefers fixed
Pay fixed Pay floating
Receive Floating Receive
fixed
An Example of an Interest Rate Swap
Bank A is a AAA-rated international bank located in the UK and wishes to raise $10M to finance floating-rate Eurodollar loans.
◼ It would make more sense for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.
◼ Bank A can issue 5-year fixed-rate Eurodollar bonds at 10 %
Firm B is a BBB-rated U.S. company. It needs $10 M to finance an investment with a five-year economic life.
◼ Firm B can issue 5-year fixed-rate Eurodollar bonds at 11.75 %
◼ Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR + 0.50 percent.
◼ Firm B would prefer to borrow at a fixed rate because it locks in a financing cost.
The borrowing opportunities
of the two firms are: COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
The Quality Spread Differential
QSD represents the potential gains from the swap that can be shared between the counterparties and the swap bank.
QSD arises because of a difference in default risk premiums for fixed (usually larger) and floating rate (usually smaller) instruments for parties with different credit ratings
There is no reason to presume that the gains will be shared
equally, usually the company with the higher credit rating will take more of the QSD.
In the above example, company B is less credit-worthy than
An Example of an Interest Rate Swap
The swap bank makes this offer to Bank A: You pay LIBOR per year on $10 million for 5 years and we will pay you 10.50% on $10
million for 5 years
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
Swap Bank
LIBOR 10.50%
Bank A
Issue $10M debt at 10% fixed-rate
COMPANY B BANK A
Fixed rate 11.75% 10%
An Example of an Interest Rate Swap
Here’s what’s in it for Bank A:
Bank A can borrow externally at 10% fixed and have a net borrowing position of
-10.50% + 10% + LIBOR = LIBOR – 0.50% which is 0.50
% better than they can borrow floating without a swap.
10%
0.50% of $10,000,000
= $50,000. That’s quite a cost savings per year for 5 years.
Swap Bank
LIBOR 10.50%
Bank A
An Example of an Interest Rate Swap
Company B
The swap bank makes this offer to company B:
You pay us 10.75% per year on $10 million for 5 years and we will pay you LIBOR per year on
$10 million for 5 years.
Swap Bank
10.75%
LIBOR
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
Issue $10M debt at
LIBOR+0.50% floating-rate
COMPANY B BANK A
Fixed rate 11.75% 10%
An Example of an Interest Rate Swap
Firm B can borrow externally at LIBOR + .50 % and have a net borrowing position of
10.75 + (LIBOR + .50 ) - LIBOR = 11.25% which is 0.50 % better than they can borrow floating
(11.75%).
LIBOR + .50%
Here’s what’s in it for Firm B:
0.5 % of $10,000,000 =
$50,000 that’s quite a cost savings per year for 5 years.
Swap Bank
Company B
10.75%
LIBOR
An Example of an Interest Rate Swap
The swap bank makes money too.
.25% of $10 million =
$25,000 per year for 5 years.
LIBOR+10.75%– LIBOR-10.50%=0.25%
Swap Bank
Company B
10.75%
LIBOR LIBOR
10.50%
Bank A
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
An Example of an Interest Rate Swap
Swap Bank
Company B
10.75%
LIBOR LIBOR
10.50%
Bank A
B saves .50%
A saves .50%
The swap bank makes .25%
COMPANY B BANK A
Fixed rate 11.75% 10%
Example: Interest Rate Swap
◼ Company A can borrow at 8% fixed or LIBOR + 1% floating (borrows fixed)
◼ Company B can borrow at 9.5% fixed or LIBOR + .5% (borrows floating)
◼ Company A prefers floating and Company B prefers fixed
◼ By entering into the swap agreements, both A and B are better off then they would be borrowing from the bank and the swap dealer makes .5%
Pay Receive Net
Company A LIBOR 8% -
(LIBOR+.25)
Swap Dealer w/A 7.75% LIBOR
Company B 8.25% LIBOR -8.75%
Swap Dealer w/B LIBOR 8.5%
Swap Dealer Net LIBOR+7.75
%
LIBOR+8.25% +0.50%
Currency Swaps
Most often used when companies make cross- border capital investments or projects.
◼ Ex., U.S. parent company wants to finance a project undertaken by its subsidiary in Germany. Project proceeds would be used to pay interest and principal.
◼ Options:
1. Borrow US$ and convert to Euro – exposes company to exchange rate risk.
2. Borrow in Germany – rate available may not be as good as that in
Currency Swaps
Typically, a company should have a comparative advantage in borrowing locally
issue local issue local
Swap Bank Company
A
Company B
Pay foreign pay foreign
Receive local
Receive local
Issue local Issue local
An Example of a Currency Swap
Suppose a U.S. MNC wants to finance a €40,000,000 expansion of a German plant.
They could borrow dollars in the U.S. where they are well known and exchange for dollars for euros.
◼ This will give them exchange rate risk: financing a euro project with dollars.
They could borrow euro in the international bond market, but pay a premium since they are not as well known abroad.
If they can find a German MNC with a mirror-image financing need they may both benefit from a swap.
If the spot exchange rate is S0($/ €) = $1.30/ €, the U.S. firm
An Example of a Currency Swap
Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a Germany–based multinational.
Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.
$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%
$8%
An Example of a Currency Swap
Firm B
$8% € 6%
Swap Bank
Firm A
€ 6%
$8%
€ 6%
$ €
Company A 8.0% 7.0%
Borrow
$52M Borrow
€ 40M Annual
Interest
$4.16M
Annual Interest
€2.4 M
Annual Interest
$4.16M
Annual Interest
€2.4 M
$8%
An Example of a Currency Swap
Firm B
$8% € 6%
Swap Bank
Firm A
€ 6%
$8%
€ 6%
$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%
$52M € 40M
A’s net position is to borrow at € 6%
B’s net position is to borrow at $8%
Swap Market Quotations
Swap banks will tailor the terms of interest rate and currency swaps to
customers’ needs. They also make a market in “plain vanilla” and currency swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.
Interest Rate Swap Example:
Swap bank terms: USD: 2.50 – 2.65
Means that the bank is willing to pay fixed-rate 2.50% interest against receiving LIBOR OR bank is willing to receive fixed-rate 2.65% against paying LIBOR.
Currency Swap Example:
Swap bank terms: USD 2.50 – 2.65
Euro 3.25 – 3.50
Means that bank is willing to make fixed rate USD payments at 2.5% in return for receiving fixed rate Euro at 3.5% OR the bank is willing to
Risks of Interest Rate and Currency Swaps
Interest Rate Risk
Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position.
Basis Risk
Floating rates of the two counterparties being pegged to two different indices Exchange rate Risk
Exchange rates might move against the swap bank after it has only gotten half of a swap set up.
Credit Risk
This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap.
Mismatch Risk
It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.
Sovereign Risk
The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.
INTERNATIONAL FINANCIAL MANAGEMENT
EUN / RESNICK Fifth Edition
Chapter Objective:
This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging long-term interest rate risk and foreign exchange risk.
14
Chapter Fourteen
Interest Rate and Currency Swaps
14-112
Chapter Outline
⚫ Types of Swaps
⚫ Size of the Swap Market
⚫ The Swap Bank
⚫ Swap Market Quotations
⚫ Interest Rate Swaps
⚫ Currency Swaps
⚫ Variations of Basic Interest Rate and Currency Swaps
⚫ Risks of Interest Rate and Currency Swaps
⚫ Is the Swap Market Efficient?
⚫ Types of Swaps
⚫ Size of the Swap Market
⚫ The Swap Bank
⚫ Swap Market Quotations
⚫ Interest Rate Swaps
⚫ Currency Swaps
⚫ Variations of Basic Interest Rate and Currency Swaps
⚫ Risks of Interest Rate and Currency Swaps
⚫ Is the Swap Market Efficient?
⚫ Types of Swaps
⚫ Size of the Swap Market
⚫ The Swap Bank
⚫ Swap Market Quotations
⚫ Interest Rate Swaps
⚫ Currency Swaps
⚫ Variations of Basic Interest Rate and Currency Swaps
⚫ Risks of Interest Rate and Currency Swaps
⚫ Is the Swap Market Efficient?
⚫ Types of Swaps
⚫ Size of the Swap Market
⚫ The Swap Bank
⚫ Swap Market Quotations
⚫ Interest Rate Swaps
⚫ Currency Swaps
⚫ Variations of Basic Interest Rate and Currency Swaps
⚫ Risks of Interest Rate and Currency Swaps
⚫ Is the Swap Market Efficient?
⚫ Types of Swaps
⚫ Size of the Swap Market
⚫ The Swap Bank
⚫ Swap Market Quotations
⚫ Interest Rate Swaps
⚫ Currency Swaps
⚫ Variations of Basic Interest Rate and Currency Swaps
⚫ Risks of Interest Rate and Currency Swaps
⚫ Is the Swap Market Efficient?
⚫ Types of Swaps
⚫ Size of the Swap Market
⚫ The Swap Bank
⚫ Swap Market Quotations
⚫ Interest Rate Swaps
⚫ Currency Swaps
⚫ Variations of Basic Interest Rate and Currency Swaps
⚫ Risks of Interest Rate and Currency Swaps
⚫ Is the Swap Market Efficient?
⚫ Types of Swaps
⚫ Size of the Swap Market
⚫ The Swap Bank
⚫ Swap Market Quotations
⚫ Interest Rate Swaps
⚫ Currency Swaps
⚫ Variations of Basic Interest Rate and Currency Swaps
⚫ Risks of Interest Rate and Currency Swaps
⚫ Is the Swap Market Efficient?
⚫ Types of Swaps
⚫ Size of the Swap Market
⚫ The Swap Bank
⚫ Swap Market Quotations
⚫ Interest Rate Swaps
⚫ Currency Swaps
⚫ Variations of Basic Interest Rate and Currency Swaps
⚫ Risks of Interest Rate and Currency Swaps
⚫ Is the Swap Market Efficient?
⚫ Types of Swaps
⚫ Size of the Swap Market
⚫ The Swap Bank
⚫ Swap Market Quotations
⚫ Interest Rate Swaps
⚫ Currency Swaps
⚫ Variations of Basic Interest Rate and Currency Swaps
⚫ Risks of Interest Rate and Currency Swaps
⚫ Is the Swap Market Efficient?
⚫ Types of Swaps
⚫ Size of the Swap Market
⚫ The Swap Bank
⚫ Swap Market Quotations
⚫ Interest Rate Swaps
⚫ Currency Swaps
⚫ Variations of Basic Interest Rate and Currency Swaps
⚫ Risks of Interest Rate and Currency Swaps
⚫ Is the Swap Market Efficient?
⚫ Types of Swaps
⚫ Size of the Swap Market
⚫ The Swap Bank
⚫ Swap Market Quotations
⚫ Interest Rate Swaps
⚫ Currency Swaps
⚫ Variations of Basic Interest Rate and Currency Swaps
⚫ Risks of Interest Rate and Currency Swaps
⚫ Is the Swap Market Efficient?
Definitions
⚫
In a swap, two counterparties agree to a
contractual arrangement wherein they agree to exchange cash flows at periodic intervals.
⚫
There are two types of interest rate swaps:
⚫ Single currency interest rate swap
⚫ “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps.
⚫ Cross-Currency interest rate swap
⚫ This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.
14-114
Size of the Swap Market
⚫
In 2007 the notational principal of:
Interest rate swaps was $271.9 trillion USD.
Currency swaps was $12 trillion USD
⚫
The most popular currencies are:
⚫ U.S. dollar
⚫ Japanese yen
⚫ Euro
⚫ Swiss franc
⚫ British pound sterling
The Swap Bank
⚫
A swap bank is a generic term to describe a financial institution that facilitates swaps
between counterparties.
⚫
The swap bank can serve as either a broker or a dealer.
⚫ As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap.
⚫ As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.
14-116
Swap Market Quotations
⚫
Swap banks will tailor the terms of interest rate and currency swaps to customers’ needs
⚫