Chapter 7

Swaps
Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014 1
Nature of Swaps
A swap is an agreement to exchange
cash flows at specified future times
according to certain specified rules
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An Example of a Plain Vanilla Interest
Rate Swap
An agreement by Microsoft to receive 6-
month LIBOR & pay a fixed rate of 5% per
annum every 6 months for 3 years on a
notional principal of $100 million
Next slide illustrates cash flows that could
occur (Day count conventions are not
considered)
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One Possible Outcome for Cash
Flows to Microsoft (Table 7.1, page 155)
Date LIBOR Floating Cash
Flow
Fixed Cash
Flow
Net Cash
Flow
Mar 5, 2014 4.20%
Sep 5, 2014 4.80% +2.10 2.50 0.40
Mar 5, 2015 5.30% +2.40 2.50 0.10
Sep 5, 2015 5.50% +2.65 2.50 + 0.15
Mar 5, 2016 5.60% +2.75 2.50 +0.25
Sep 5, 2016 5.90% +2.80 2.50 +0.30
Mar 5, 2017 +2.95 2.50 +0.45
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Typical Uses of an I nterest 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

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I ntel and Microsoft (MS)
Transform a Liability (Figure 7.2, page 155)

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Intel MS
LIBOR
5%
LIBOR+0.1%
5.2%
Financial I nstitution is I nvolved
(Figure 7.4, page 157)

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F.I.
LIBOR
LIBOR
LIBOR+0.1
%
4.985%
5.015%
5.2%
Intel MS
Financial Institution has two offsetting
swaps
I ntel and Microsoft (MS) Transform an
Asset (Figure 7.3, page 156)


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Intel
MS
LIBOR
5%
LIBOR-0.2%
4.7%
Financial I nstitution is I nvolved
(See Figure 7.5, page 157)

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Intel
F.I. MS
LIBOR LIBOR
4.7%
5.015% 4.985%
LIBOR-0.2%
Quotes By a Swap Market Maker
(Table 7.3, page 158)
Maturity Bid (%) Offer (%) Swap Rate (%)
2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850
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Day Count
A day count convention is specified for for
fixed and floating payment
For example, LIBOR is likely to be actual/360
in the US because LIBOR is a money market
rate
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Confirmations
Confirmations specify the terms of a
transaction
The International Swaps and Derivatives has
developed Master Agreements that can be
used to cover all agreements between two
counterparties
Many interest rate swaps are now cleared
through a CCP such as LCH Clearnet or the
CME Group
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The Comparative Advantage Argument
(Table 7.4, page 160)

AAACorp wants to borrow floating
BBBCorp wants to borrow fixed
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Fixed Floating
AAACorp 4.0% 6 month LIBOR 0.1%
BBBCorp 5.2% 6 month LIBOR + 0.6%
The Swap (Figure 7.6, page 161)

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AAACorp
BBBCorp
LIBOR
LIBOR+0.6%
4.35%
4%
The Swap when a Financial
I nstitution is I nvolved (Figure 7.7, page 162)

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AAACorp
F.I
.
BBBCorp
4%
LIBOR LIBOR
LIBOR+0.6%
4.33%
4.37%
Criticism of the Comparative
Advantage Argument
The 4.0% and 5.2% rates available to AAACorp
and BBBCorp in fixed rate markets are 5-year
rates
The LIBOR0.1% and LIBOR+0.6% rates
available in the floating rate market are six-
month rates
BBBCorps fixed rate depends on the spread
above LIBOR it borrows at in the future
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The Nature of Swap Rates
Six-month LIBOR is a short-term AA borrowing
rate
The 5-year swap rate has a risk corresponding to
the situation where 10 six-month loans are made
to AA borrowers at LIBOR
This is because the lender can enter into a swap
where income from the LIBOR loans is
exchanged for the 5-year swap rate
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The Discount Rate
Pre-crisis derivatives cash flows were
discounted at LIBOR
As Chapter 9 explains, this has changed
Here we illustrate the valuation methodology
by assuming that LIBOR is the discount rate

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Using Swap Rates to Bootstrap the
LI BOR/Swap Zero Curve
Consider a new swap where the fixed rate is the
swap rate
When principals are added to both sides on the final
payment date the swap is the exchange of a fixed
rate bond for a floating rate bond
The floating-rate rate bond is worth par assuming
LIBOR discounting is used. The swap is worth zero.
The fixed-rate bond must therefore also be worth par
This shows that swap rates define par yield bonds
that can be used to bootstrap the LIBOR (or
LIBOR/swap) zero curve
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Example of Bootstrapping the
LI BOR/Swap Curve (Example 7.1, page 164)
6-month, 12-month, and 18-month
LIBOR/swap rates are 4%, 4.5%, and 4.8%
with continuous compounding.
Two-year swap rate is 5% (semiannual)



The 2-year LIBOR/swap rate, R, is 4.953%


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100 5 102
5 2 5 2 5 2
2
5 1 048 0 0 1 045 0 5 0 04 0

R
e
e e e
.
. . .
. . . . . .
Valuation of an I nterest Rate Swap
Initially interest rate swaps are worth close
to zero
At later times they 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 (FRAs)
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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
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Valution of Floating-Rate Bond
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0 t
*

Valuation
Date
First Pmt
Date
Floating
Pmt =k
*

Second
Pmt Date
Maturity
Date
Value = L
Value =
L+k
*

Value = PV
of L+k
*
at t
*

Example
Receive six-month LIBOR, pay 3% (s.a.
compounding) on a principal of $100 million
Remaining life 1.25 years
LIBOR zero rates for 3-months, 9-months and
15-months are 2.8%, 3%, and 3.2% (cont
comp)
6-month LIBOR on last payment date was
12.9% (s.a. compounding)
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Valuation Using Bonds (page 166)
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Time B
fix
cash
flow
B
fl
cash
flow
Disc
factor
PV
B
fix

PV
B
fl

0.25 1.5 101.450 0.9930 1.4895 100.7423
0.75 1.5 0.9763 1.4644
1.25 101.5 0.9584 97.2766
Total 100.2306 100.7423
Swap value = 100.7423 100.2306 = 0.5117
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 that todays forward rates are
realized
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Valuation of Example Using FRAs
(page 167)
Time Fixed cash
flow
Floating
cash flow
Net Cash
Flow
Disc factor PV
B
fl

0.25 1.5000 +1.4500 0.0050 0.9930 0.0497
0.75 1.5000 +1.7145 +0.2145 0.9763 +0.2094
1.25 1.5000 +1.8672 +0.3672 0.9584 +0.3519
Total +0.5117
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An Example of a Currency Swap
An agreement to pay 5% on a sterling
principal of 10,000,000 & receive 6% on
a US$ principal of $15,000,000 every year
for 5 years
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Exchange of Principal
In an interest rate swap the principal is not
exchanged
In a currency swap the principal is usually
exchanged at the beginning and the end of
the swaps life
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The Cash Flows (Table 7.7, page 170)
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Date Dollar Cash Flows
(millions)
Sterling cash flow
(millions)
Feb 1, 2014 15.00 +10.0
Feb 1, 2015 +0.90 0.50
Feb 1, 2016 +0.90 0.50
Feb 1, 2017 +0.90 0.50
Feb 1, 2018 +0.90 0.50
Feb 1, 2019 +15.90 10.50

Typical Uses of a
Currency Swap
Convert a liability in one currency to a
liability in another currency
Convert an investment in one currency to
an investment in another currency

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Comparative Advantage May Be
Real Because of Taxes
General Electric wants to borrow AUD
Quantas wants to borrow USD
Costs after adjusting for the differential
impact of taxes:
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USD AUD
General Electric 5.0% 7.6%
Quantas 7.0% 8.0%
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
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Example
All Japanese LIBOR/swap rates are 4%
All USD LIBOR/swap rates are 9%
5% is received in yen; 8% is paid in dollars.
Payments are made annually
Principals are $10 million and 1,200 million
yen
Swap will last for 3 more years
Current exchange rate is 110 yen per dollar

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Valuation in Terms of Bonds (Table 7.9,
page 173)
Time Cash Flows ($) PV ($) Cash flows (yen) PV (yen)
1 0.8 0.7311 60 57.65
2 0.8 0.6682 60 55.39
3 0.8 0.6107 60 53.22
3 10.0 7.6338 1,200 1,064.30
Total 9.6439 1,230.55
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Value of Swap = 1230.55/110 9.6439 = 1.5430
Valuation in Terms of Forwards
(Table 7.10, page 174)
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Time $ cash
flow
Yen cash
flow
Forward
Exch rate
Yen cash
flow in $
Net
Cash
Flow
Present
value
1 -0.8 60 0.009557 0.5734 -0.2266 -0.2071
2 -0.8 60 0.010047 0.6028 -0.1972 -0.1647
3 -0.8 60 0.010562 0.6337 -0.1663 -0.1269
3 -10.0 1200 0.010562 12.6746 +2.6746 2.0417
Total 1.5430
Swaps & Forwards
A swap can be regarded as a convenient
way of packaging forward contracts
Although the swap contract is usually
worth close to zero at the outset, each of
the underlying forward contracts are not
worth zero
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Credit Risk: Single Uncollateralized
Transaction with Counterparty
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 ithe value is
positive
Some swaps are more likely to lead to credit risk exposure than
others
What is the situation if early forward rates have a positive value?
What is the situation when the early forward rates have a negative
value?

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Other Types of Swaps
Floating-for-floating interest rate swaps
amortizing swaps
step up swaps
forward swaps
constant maturity swaps
compounding swaps
LIBOR-in-arrears swaps
accrual swaps
diff swaps
cross currency interest rate swaps
equity swaps
extendable swaps
puttable swaps
swaptions
commodity swaps
volatility swaps
etc etc
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