2.2c Swaps

Swaps

A swap is an OTC derivative in which two parties agree to exchange a stream of cash flows over multiple future dates. It can be interpreted as a series of forward contracts for each cash flow leg that are calculated differently and netted, so that only the difference changes hands on each settlement date.

There are many types of swaps, including uncommon (exotic) swaps. Popular swaps include:

• Interest-Rate Swaps, in which two parties exchange a series of fixed‑rate and floating‑rate interest payments on a notional principal over a specified term.
• Credit Default Swaps, where one party pays a periodic fee in exchange for protection (“insurance”) against the default of a specified borrower or bond.
• Currency Swaps, where parties exchange principal and interest payments in different currencies over a set period.
• Commodity swaps, where parties exchange cash flows based on the price of a specified commodity over a set period.

In all swaps, one party typically pays the spot (floating) rate, whereas another pays a rate fixed by the swap contract. However, total floating swaps or fixed swaps are common currency swaps.

Examples

I. Interest Rate Swaps and Comparative Advantage

Suppose AAACorp and BBBCorp are able to obtain the following borrowing rates for 5-year $100M loans from their respective bankers:

| | Fixed Rate | Floating Rate |
| :—: | :--------: | :----------------------: |
| AAA | $4.00\%$ | $\text{Floating}-0.1\%$ |
| BBBB | $5.20\%$ | $\text{Floating}+0.6\%$ |

The table above shows that AAA has a comparative advantage in fixed rate borrowing, whereas BBB has a comparative advantage in floating rate borrowing.

Suppose further that AAACorp would prefer to pay a floating rate, whereas BBBCorp would prefer to pay a fixed rate. A banker with relationships with both companies notices this, and contemplates the flowing Interest Rate Swap:
$\stackrel{4\%}{\leftarrow }{\boxed{\text{AAA}}}_{\stackrel{\text{Floating}}{\to }}^{\stackrel{4.35\%}{\leftarrow }}\boxed{\text{BBB}}\stackrel{\text{Floating + 0.6\%}}{\to }$

A) What would the net effect of the cash flows be for AAACorp, and how does this compare to its direct marketplace opportunity for floating-rate borrowing?

A) Solution. $4\%$ and is paid at $4.35\%$, AAA's net gain is $0.35\%$. It pays BBB the floating rate, which means that it net pays $\text{Floating}-0.35\%$, which is 25 basis points better than the direct-market price.

Since AAA borrows at

B) What would the net effect of the cash flows be for BBBCorp, and how does this compare to its direct marketplace opportunity for fixed-rate borrowing?

B) Solution. $\text{Floating}+0.6\%$ and is paid the floating rate by AAA, its net interest is $0.6\%$. Since BBB also pays AAA $4.35\%$, this means that it pays $4.35\%+0.6\%=4.95\%$ in total fixed rate, which is 25bp less than the market fixed rate.

Since BBB directly borrows at

Suppose the banker instead envisions this arrangement:
$\stackrel{4\%}{\leftarrow }{\boxed{\text{AAA}}}_{\stackrel{\text{Floating}}{\to }}^{\stackrel{4.33\%}{\leftarrow }}{\boxed{\text{Financial Inst.}}}_{\stackrel{\text{Floating}}{\to }}^{\stackrel{4.37\%}{\leftarrow }}\boxed{BBB}\stackrel{\text{Floating + 0.6\%}}{\to }$

C) What is the new net effect of the cash flows for AAACorp, and how does this compare to its direct marketplace opportunity for floating-rate borrowing?

C) Solution. $\text{Floating}+4\%$, whereas its inflow is $4.33\%$. This equates to a net outflow of $\text{Floating}+4\%-4.33\%=\text{Floating}-0.33\%,$ which is $23$bp better than their market floating rate.

AAA’s outflow is

D) What is the new net effect of the cash flows for BBBCorp, and how does this compare to its direct marketplace opportunity for floating-rate borrowing?

D) Solution. $\text{Floating}+4.97\%$, whereas its inflow is the floating rate. Therefore, its net outflow is $4.97\%$, which is $5.20\%-4.97\%=0.23\%$ (or 23bp) better than their fixed market rate.

BBB’s outflow under this scheme is

E) What is the annual fee (in dollars) effectively earned by the banker under this arrangement?

E) Solution $\text{Floating}+4.33\%$, and their inflow is $\text{Floating}+4.37\%$, which means that their net inflow is $(\text{Floating}+4.37\%)-(\text{Floating}+4.33\%)=0.04\%$ or 4bp.

The banker’s outflow is

Since the loans are both for \100\text{M}$,thismeansthatthebankerearns$$40,000$ per year for 5 years with this scheme.

CDS something

Cash Swap something