12.3 Swaps

Swaps are powerful financial tools that let parties exchange cash flows or liabilities. They're key for managing risk and optimizing costs in finance. Interest rate swaps trade fixed for floating payments, while currency swaps involve different currencies.

Companies use swaps to hedge against market changes and access better rates. Swaps start at zero value but fluctuate over time with market conditions. Pricing involves complex calculations to ensure fairness for both parties involved.

Swaps and their characteristics

Definition and structure of swaps

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• A swap is a derivative contract where two parties agree to exchange cash flows or liabilities from two different financial instruments
  • Most often involves exchanging a fixed cash flow for a floating cash flow
  • Allows parties to hedge against or speculate on changes in interest rates, exchange rates, commodity prices, or other financial variables
• Swaps are customized contracts traded over-the-counter (OTC)
  • Can be structured to meet the specific needs of both parties involved in the transaction
  • Example: A company with floating-rate debt can swap it for fixed-rate debt to lock in borrowing costs

Key components of swap contracts

• Notional principal
  • The predetermined dollar amounts used to calculate the cash flows that are exchanged
  • Not actually exchanged itself, only used as a reference for calculations
• Tenor
  • The length or duration of the swap contract
  • Can range from a few months to several decades (30-year interest rate swap)
• Floating rate
  • The variable interest rate tied to a reference rate (LIBOR, federal funds rate)
  • Subject to change over the life of the swap based on market conditions
• Fixed rate
  • The predetermined, unchanging interest rate
  • Remains constant throughout the life of the swap contract

Mechanics of interest rate and currency swaps

Interest rate swaps

• Involve the exchange of fixed interest rate payments for floating interest rate payments, or vice versa
  • Based on a notional principal amount
• Plain vanilla interest rate swap
  • One party agrees to pay a fixed interest rate on the notional principal
  • The other party pays a floating rate based on a reference rate (LIBOR)
  • The net difference between the fixed and floating payments is exchanged between the parties on each payment date, typically every six months
• Basis swaps
  • Exchange two floating rate payments
  • Typically based on different reference rates or with different tenors (1-month LIBOR for 3-month LIBOR)

Currency and cross-currency swaps

• Currency swaps
  • Involve the exchange of principal and interest payments in one currency for principal and interest payments in another currency
  • Principal amounts are exchanged at the beginning and end of the swap at a predetermined exchange rate
  • Interest payments are exchanged periodically throughout the life of the swap
  • Can be fixed-for-fixed, floating-for-floating, or fixed-for-floating (depending on the type of interest rates)
• Cross-currency interest rate swaps
  • Combine elements of interest rate and currency swaps
  • Involve the exchange of both interest and principal payments in different currencies
  • Example: A U.S. company borrows in euros and swaps the euro payments for U.S. dollar payments

Pricing and valuation of swaps

Swap pricing at initiation

• The value of a swap at initiation is typically zero
  • Terms are set such that the present value of the expected cash flows for both parties is equal
• Swap pricing involves determining the fixed rate that makes the present value of the fixed and floating legs equal
  • Given the agreed-upon notional principal, tenor, and floating rate reference

Fixed rate calculation

• Project the expected future cash flows for the floating leg
  • Based on forward rates derived from the yield curve for the relevant reference rate
• Discount the expected floating cash flows to their present value
  • Using the appropriate discount rates from the yield curve
• Solve for the fixed rate that equates the present value of the fixed leg cash flows to the present value of the floating leg cash flows
  • Fixed rate = $\frac{PV(floating\ leg)}{PV(notional\ principal)}$

Valuation over the life of the swap

• As market conditions change, the value of the swap will fluctuate for each party
  • Based on changes in interest rates, exchange rates, or other relevant variables
• The value of a swap at any given point in time can be calculated as the net present value (NPV) of the expected future cash flows for each leg of the swap
  • Discounted at the appropriate market rates
• Example: If interest rates rise, the value of a pay-fixed, receive-floating swap will increase for the fixed-rate payer

Applications of swaps in risk management

Interest rate risk management

• Corporations, financial institutions, and governments use interest rate swaps to manage interest rate risk exposure and optimize borrowing costs
• Hedging floating-rate debt
  • A company with floating-rate debt can enter into a pay-fixed, receive-floating swap
  • Hedges against rising interest rates and locks in a fixed borrowing cost
• Benefiting from declining rates
  • A company with fixed-rate debt can use a pay-floating, receive-fixed swap
  • Allows the company to benefit from potential declines in interest rates

Currency risk management

• Currency swaps enable companies and investors to access foreign capital markets, hedge foreign currency exposure, and manage the risk associated with cross-border investments
• Hedging foreign currency revenue
  • A U.S. company with euro-denominated revenue can use a currency swap to convert its euro cash flows into U.S. dollars
  • Mitigates the impact of exchange rate fluctuations
• Financial institutions use swaps to manage the interest rate and currency risk associated with their assets and liabilities
  • Also create customized solutions for clients

Advanced applications and strategies

• Swaps can be used with other derivatives (options, futures) to create more complex financial instruments and risk management strategies
• Swaptions
  • An option that grants the holder the right, but not the obligation, to enter into a swap contract at a specified future date and under predetermined terms
  • Allows for added flexibility and customization in risk management
• Swaps play a crucial role in the global financial system
  • Provide a flexible and efficient means of transferring risk, accessing capital, and optimizing investment strategies across different markets and currencies