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Risk Management Applications of Swap Strategies Swaps are contractual agreements that are used to exchange or swap a series of cash flows over a specific period of time e.g interest payments in floating-rate loans Characteristics: • In a swap transaction, at least one set of cash flows must be variable; the other set of cash flows can be fixed or variable • Swap is similar to a series of forward contracts • It has zero market value at initiation • However, few off-the-market swaps involve an exchange of money at the start Types of swaps: loan into a floating-rate loan or vice versa • Swaps can be used to create a synthetic security i.e investors can enter into a swap instead of investing in a security • Swaps can be used by banks to manage their interest rate risk Limitation: Swaps involve credit risk i.e risk that counterparty may default on the exchange of the interest payments Comparison: Financial Futures, FRAs, and Basic Swaps Position Objective Interest rate: It is an agreement to swap in which one party pays fixed interest rate payments and other party pays floating interest rate payments in exchange or when both parties pay floating-rate payments When both parties pay floating rates then floating rates are different • Interest rate swaps have less credit risk relative to ordinary loans because interest payments are netted and there is no exchange of notional principal • However, it is important to note that netting reduces the credit risk but it does not prevent the LIBOR component of the net swap payment from offsetting the floating loan interest payment Currency: It is an agreement to swap currencies of debt service obligation i.e one party make payments in one currency and the other party makes payments in another currency Equity: It is an agreement in which at least one set of payments is based on the return of a stock price or stock index Financial Futures FRAs& Basic Swaps Profit if Rates Rise Sell Futures Pay Fixed, Receive Floating Profit If Rates Fall Buy Futures Pay Floating Received Fixed Example: Company A has a commitment to borrow at a fixed rate of 5.2% and company B has a commitment to borrow at a floating rate of LIBOR + 0.8% Both companies enter into a swap contract i.e • Company B agrees to pay company ‘A’ a fixed rate of 5% per annum on a notional principal of $100 million • Company A agrees to pay company B the 6month LIBOR rate on $100 million notional principal • Thus, the swap effectively converts a fixed rate liability to a floating rate liability for A and viceversa for B Commodity swaps: It is an agreement in which at least one set of payments is based on the course of a commodity price i.e price of oil or gold Uses of swaps: • Swaps can be used to adjust the rate sensitivity of an asset or liability i.e by converting a fixed-rate STRATEGIES AND APPLICATIONS FOR MANAGING INTEREST RATE RISK Generally, swaps are not used to manage the risk associated with anticipated debt payments; rather, they are used to manage the risk on a series of debt obligations that either already exists or is in the process of being taken out 2.1 Using Interest Rate Swaps to Convert a FloatingRate Loan to a Fixed-Rate Loan (and Vice Versa) Borrowers prefer to use swaps to manage their interest rate exposure However, swaps involve taking a speculative position i.e when floating rate loan is –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading 30 Reading 30 Risk Management Applications of Swap Strategies converted to a fixed rate loan and if rates fall, borrower will not be able to take advantage of falling interest rates as he/she is locked in to a synthetic fixed-rate loan Structure of Swaps: A fixed rate on a swap is determined such that the PV of the two payment streams (fixed & floating)are equal The floating rates on the swap are set corresponding to the dates on which the loan interest rate is reset The notional principal on the swap is set equal to the face value of the loan NOTE: Payment at a rate of LIBOR is determined by using a rate that was established at the previous settlement date or the beginning of the swap if this is the first settlement period Duration of Swap: Floating rate bond’s duration ≈ Amount of time remaining until the next coupon payment E.g • Maximum Duration is 0.25 years • Minimum duration is Duration of fixed-rate bonds is between 0.6 and 1.0 and is assumed to equal 75% of its maturity for the purposes of this reading Example: One year (receive floating, pay fixed) swap with semiannual payments will have duration = ଵ ቀ ቁ - (0.75 × maturity of swap contract) ì ì ã Entering Into a pay-fixed receive floating swap is similar to issuing a fixed-rate bond and using the proceeds to buy a floating rate bond Thus, duration of a swap is: Duration of receive-floating and pay-fixed swap = duration of a long position in a floating rate bond – duration of a short position in a fixed rate bond < • Entering into a pay-floating receive fixed swap is similar to issuing a floating-rate bond and using the proceeds to buy a fixed rate bond Thus, duration of a swap is: Duration of receive-fixed and pay-floating swap = duration of a long position in a fixed rate bond – duration of a short position in a floating rate bond >0 Thus, Receive fixed rate swaps increases the duration of an existing position Pay fixed swaps decreases the duration of an existing position When floating rate loan is converted to fixed rate loan: • Cash flow risk falls because uncertainty associated with variable interest rate in case of floating payments decreases • Market risk rises* For a bond with quarterly payments: =ቀ FinQuiz.com ቁ - (0.75 × 1) = 0.25 – 0.75 = -0.50 One year (receive floating, pay fixed) swap with ଵ quarterly payments will have duration = ቀ ቁ - (0.75 × 1) ସ ×ଶ = 0.125 – 0.75 = –0.625 Two year swap (receive floating, pay fixed) with semiଵ annual payments will have duration = ቀ ቁ - (0.75 × 2) = ଶ×ଶ 0.25 – 1.50 = -1.25 Two year swap (receive floating, pay fixed) with ଵ quarterly payments will have duration = ቀ ቁ–(0.75 × 2) ସ ×ଶ = 0.125 – 1.50 = –1.375 NOTE: Issuer has negative duration and lender/investor has positive duration When fixed rate loan is converted to floating rate loan: • Cash flow risk increases because uncertainty associated with variable interest rate in case of floating payments rises • Market risk falls because receive fixed creates a positive duration position *Market value risk refers to uncertainty associated with the market value of an asset or liability, due to change in interest rates i.e when interest rates rise (fall), value of assets or liability decreases (increases) • When interest rates are expected to increase, floating rate assets and fixed-rate liabilities are preferred because when interest rate ↑, CFs on floating-rate assets ↑ whereas payments on fixedrate liabilities not change • When interest rates are expected to decrease, fixed rate assets and floating-rate liabilities are preferred Cash flow risk refers to the uncertainty associated with the size of the cash flows For example, floating-rate instruments have cash flow risk because their cash flows are adjusted according to changes in interest rates These securities are not subject to market value risk Reading 30 Risk Management Applications of Swap Strategies Example: Practice: Example 1, Volume 5, Reading 30 2.2 A firm XYZ issues a leveraged floating rate note or leveraged floater with following features to company ABC: Using Swaps to adjust the Duration of a FixedIncome Portfolio Duration is affected by the maturity and payment frequency of the swap When a swap maturity is different from the maturity of a bond e.g swap expires before the maturity of a bond, investor needs to initiate another swap Therefore, the most preferred approach is to use the swap with a maturity at least equal to the period during which the duration adjustment is applied The following formula is used to estimate the notional principal of a swap that is used to manage the duration (interest risk) of a portfolio: NP ൌ V ቆ MD୲ୟ୰ୣ୲ െ MD ቇ MDୱ୵ୟ୮ where, • Principal = FP • Coupon rate = 1.5 ìLIBOR ã Periodic interest/coupon payment = 1.5 ×LIBOR×FP Firm XYZ used those proceeds to buy a fixed-rate bond issued by Company A This bond will have: • Face value = 1.5 ìFP ã Coupon payment = ci (FP) (1.5) Firm XYZ enters into a swap contract as a fixed rate payer and floating rate receiver • Notional principal = 1.5 ìFP ã Fixed rate = FS ã Floating-rate = LIBOR Thus, net cash flows are as follows: NP= notional principal MDtarget= target or desired market duration MDB = current market duration of portfolio MDswap = market duration of a swap NOTE: Different durations affect the notional principal required Practice: Example 2, Volume 5, Reading 30 2.3 FinQuiz.com Using Swaps to Create and Manage the Risk of Structured Notes Structured notes are short-term or intermediate-term floating rate securities financial instruments that qualify as fixed income instruments, but they contain features similar to options, swaps, and margin transactions Firm XYZ will pay on the leveraged floater = –1.5 (LIBOR) (FP) Firm XYZ will receive from the bond = + ci (1.5) (FP) Firm XYZ will receive from the swap as Floating rate receiver = + 1.5 (LIBOR) (FP) Firm XYZ will pay as a Fixed rate payer in a swap = –1.5 (FS) (FP) Net effect: XYZ earns = 1.5 (ci – FS) (FP) fixed if the interest rate received on the fixed rate exceeds the swap rate Advantage: No capital is needed to engage in this sort of transaction because cost of buying a fixed rate bond will be financed by the proceeds from issuing the structured note Risks involve: Firm XYZ has to assume some credit risk i.e risk of default by Company A as well as the risk of default by the swap counterparty Uses of Structured notes: Structured notes are used by investors (e.g insurance companies and pension funds) to add exposure in their portfolios to those asset classes or markets in which they are prohibited to invest directly due to investment mandates and regulatory constraints 2.3.1) Using Swaps to create and manage the risk of Leveraged Floating-Rate Notes A leveraged floating rate note or leveraged floater is a type of leveraged structured note In a leveraged floater, the coupon is a multiple of a specific market rate of interest (i.e LIBOR) e.g Coupon rate = 1.5 × LIBOR Practice: Example 3, Volume 5, Reading 30 2.3.2) Using Swaps to Create and Manage the risk of Inverse Floaters Inverse Floater is another type of structured note In inverse floater, Coupon rate = b – LIBOR Reading 30 Risk Management Applications of Swap Strategies Example: Company A issues an inverse floater that pays rate = b – LIBOR and has a notional principal = FP • When LIBOR = b, rate = • When LIBOR > b, rate = -ve Company A uses proceeds from issuing an inverse floater to buy a fixed-rate note with a notional principal of FP and coupon rate of ci × (FP) Company A then enters into a swap contract as receive-fixed, pay-floating to match the structured note i.e • It receives fixed rate = + FS ì (FP) ã It pays floating rate = - LIBOR × (FP) Thus, net cash flows are as follows: Company A pays on the inverse floater = –(b – LIBOR)× (FP) Company A receives from the fixed-rate bond = + ci × (FP) Company A receives fixed rate = + FS (FP) Company A pays floating rate = - LIBOR × (FP) Overall cash flow to Company A will be positive when b < (FS + ci) i.e • The lower the value of “b” set by Company A, the larger its cash flows from the overall transactions • However, the lower the “b”, the less attractive the note will be for potential investors • In order to avoid negative interest payments in inverse floater, company A should set value of “b” at a reasonably high level but below FS + ci • It is important to note that Company A is only able to set “b” It cannot set FS and ci because ci is based on both the level of market interest rates and the credit risk of the issuer of the fixed-rate bond Negative cash flow risk faced by Lenders: To manage negative interest payment risk i.e when LIBOR > b, inverse floater investor should buy an interest rate cap with the following features: • An exercise rate of b • Notional Principal = FV of loan/Swap • Each caplet expires on the interest rate reset date of the swap/loan Whenever L>b, Caplet pay-off = (L – exercise rate) × NP Limitation: To avoid negative interest rate problem, the lender would have to accept a lower rate i.e “b” would be set a little lower by the borrower/issuer of the inverse floater Practice: Example 4, Volume 5, Reading 30 STRATEGIES AND APPLICATIONS FOR MANAGING EXCHANGE RATE RISK Currency swaps can be used by investors to manage exchange rate risk They are also useful to manage interest rate risk but only in situations when exchange rate risk exists 3.1 FinQuiz.com Converting a Loan in One Currency Into a Loan in another Currency Example: Company B is a U.S based firm and it borrows yen and engages in a swap with the company A that borrows dollars with parallel interest and principal repayment schedules: Currency Swaps can be used to transform a loan denominated in one currency into a loan denominated in another currency • In a currency swap, a principal must be specified in each currency and the principal amounts are exchanged at the beginning and end of the life of the swap • Two firms can enter into a currency swap to exploit their comparative advantages regarding borrowing in different countries i.e each firm borrows in the market in which it has a comparative advantage in terms of lower borrowing rate When a firm needs to borrow in foreign currency it can use currency swap to so instead of directly borrowing foreign currency from the foreign market due to the following advantages: Reading 30 Risk Management Applications of Swap Strategies Advantages: A firm can borrow from a domestic bank at a lower rate (because there it may be better known as creditor) and then swap domestic currency for foreign currency that it needs for foreign expansion In addition, a firm can borrow at a lower cost by assuming some credit risk i.e by entering into a swap contract, credit risk faced by a firm is that swap counterparty will default on its swap payments Note that when a firm issues debt directly in foreign currency where the lender is of high credit quality, it faces no credit risk; only lenders will face credit risk in this case Example: A firm ABC needs ₤30 million expand into Europe To implement this expansion plan, a firm needs to borrow Euros Suppose current exchange rate is €1.62/₤ Thus, a firm needs to borrow €48.60 million Instead of directly borrowing Euros, a firm can use currency swap e.g if a firm issues fixed rate pound denominated bond for 30 million pounds with interest rate of 5% (annual interest payments) FinQuiz.com • The 150,000 additional interest paid by the firm represents a credit risk premium which a firm is required to pay it regardless of whether it borrowed directly in the foreign market or indirectly through a swap At swap and bond maturity: • Firm ABC will receive ₤30 million from currency swap dealer and uses that amount to discharge its liabilities • Firm ABC will pay €48.60 million to currency swap dealer NOTE: If a firm wants to issue debt in foreign currency at a floating rate: • It could issue bond at a fixed rate in domestic currency and • Enter into a currency swap where the dealer pays its domestic currency at a fixed rate and it pays the dealer foreign currency at a floating rate Or A firm enters into a currency swap contract in which it will pay 30 million pounds to dealer and receives 48.60 Euros The terms of a swap are i.e • Firm will pay 3.25% in Euros to a dealer • Firm will receive 4.50% in pounds from a dealer Exchange of principals at contract initiation: • Firm ABC will receive €48.60 million from currency swap dealer • Currency swap dealer will receive ₤30 million from Firm ABC Cash flows at each settlement: ã Interest payments on pound-denominated bond = 30,000,000 ì 0.05 = ₤1,500,000 • Interest payments due to Firm ABC from swap dealer = 30,000,000 ì 0.045 = 1,350,000 ã Interest payments that Firm ABC owes swap dealer = €48,600,000 × 0.0325 = €1,579,500 It should be considered that the interest received from the dealer does not completely offset the interest that a firm owes on its bond • It could issue a floating rate bond denominated in domestic currency • Enter into a currency swap where the dealer pays its domestic currency at a floating rate and firm pays foreign currency at a floating rate The choice to pay a fixed or floating rate in a swap contract depends on expectations regarding the direction of interest rate movements i.e if a firm believes that interest rates will fall (rise) in the future, it will prefer to be a floating (fixed) rate payer in a swap contract Difference between currency swaps and interest rate swaps: • Currency swaps involve the payment of notional principal However, it is important to note that not all currency swaps involve the payment of notional principal • Unlike interest rate swaps, interest payments in currency swaps are not netted as they are in different currencies Practice: Example 5, Volume 5, Reading 30 Reason: A firm ABC cannot borrow in pounds at the swap market fixed rate because its credit rating is not as good as the rating that is implied in the LIBOR market term structure Therefore, a firm will need to pay an additional interest of (0.05 – 0.045) × ₤30,000,000 = ₤150,000 3.2 Converting Foreign Cash Receipts into Domestic Currency A currency swap can be used to convert the foreign currency cash flows to domestic cash flows when an investor has investment in foreign currency e.g for a Reading 30 Risk Management Applications of Swap Strategies foreign currency bond, foreign subsidiaries generate cash in foreign currency FinQuiz.com Practice: Example 6, Volume 5, Reading 30 Example: A U.S firm receives quarterly cash flows of €10 million The exchange rate is €0.90/$ The swap fixed rates are 8% in U.S and 7.5% in Europe Step 1: To determine the implied notional principal in FC i.e Euros, Foreign cash flows are divided by foreign interest rate NP × (0.075 / 4) = €10,000,000 NP = 10,000,000 / (0.075/4) = €533,333,333 Step 2: To Calculate the corresponding principal in Dollars, foreign NP is converted into corresponding domestic NP (i.e $) using the current exchange rate: €5,333,333,333 / €0.90/$ = $592,592,593 NOTE: A swap is entered with the above calculated NP Step 3: To Calculate the $ interest payment, the domestic NP is multiplied by the domestic interest rate $592,592,593 ì(0.08/4) = $11,851,852 ã Thus, the currency swap effectively locks in the conversion of quarterly cash flows in Euros for one year NOTE: In this case, the swap parties are not required to exchange notional principals (neither initially nor at maturity) Risks inherent in such transactions: Credit Risk: A firm faces credit risk that the swap counterparty may default on its obligations Risk associated with uncertainty of cash flows generated by foreign subsidiary i.e • When a firm generates > €10m, some of the cash flows will not be converted at locked-in rate • When a firm generates < €10m, a firm is still obligated to pay €10m to the swap counterparty 3.3 Using Currency Swaps to Create and Manage the Risk of a Dual-Currency Bond Dual currency bond is a bond in which the interest is paid in one currency and the principal is paid in another It can be used by a multinational company that generates cash in foreign currency which is sufficient to pay interest only and principal is paid in domestic currency Synthetic Dual-currency Bond = Ordinary bond issued in one currency (domestic currency)+ Currency swap (with no principal payments) To offset dual-currency bond, investor can synthetically short the dual-currency bond by taking opposite position i.e Synthetic dual-currency bond = buy domestic bond + currency swap When synthetic dual-currency bond is cheaper than the actual dual-currency bond → profit can be earned by: Taking long position in the synthetic bond + short position in the actual dual-currency bond Example: Synthetic dual currency bond • A firm issues a bond in $ that will make interest payments in $ • Engage in a currency swap (with no principal payments) to pay interest in Foreign Currency and receive interest in $ This will offset the interest payments made in dollar-denominated bond Thus, effectively a firm will make interest payments in foreign currency • At maturity date of bond & swap: The firm will pay off the $-denominated bond and there will be no payments on the swap Practice: Example 7, Volume 5, Reading 30 STRATEGIES AND APPLICATIONS FOR MANAGING EQUITY MARKET RISK In an equity swap: • One party is obligated to make payments based on the total return of some equity index e.g S&P 500 or an individual stock • The other party pays a fixed rate, a floating rate, or Reading 30 Risk Management Applications of Swap Strategies the return on another index Strategies: A When investor has bearish outlook towards stock market and interest rates are falling → Swap equity return for fixed rate B When investor has bearish outlook towards stock market and interest rates are increasing→ Swap equity return for floating rate Uses of Equity swaps: • It can be used by equity managers to make necessary adjustments to portfolios by synthetically buying and selling stock without actually trading the stock • It can be used to exploit restrictions of short selling stocks or other legal limits i.e margins, capital controls etc • It involves lower transaction costs relative to cash transactions • It can be used to avoid taxes • It can be used to keep equity positions and voting shares (to retain voting rights) without bearing equity risk • It can be used to avoid risk associated with a concentrated portfolio • It can be used to achieve international diversification without actually investing in foreign securities • It can be used to alter the asset allocation of the portfolio Limitation: Equity swaps have a pre-defined expiration date; thus, in order to manage equity risk continuously, a manager needs to periodically renew equity swaps with terms determined by the new market conditions on the renewal date A Strategy for diversifying a concentrated Portfolio: By using an equity swap, the concentrated portfolio return can be swapped for diversified portfolio return e.g swapping return on 30 stocks for return on index i.e S&P 500 B Strategy for achieving international Diversification: By using an equity swap, domestic return can be swapped for international portfolio return e.g swapping return on S&P for return on EAFE index Risks: Tracking error: It refers to the difference in return generated by Domestic stock holdings and return on the Index which is used as a proxy It poses a cash flow problem for an investor when domestic stock generates negative return whereas index (used as a proxy) generates positive return Higher cost: In addition, due to currency risk and market risk faced by counterparty, a firm needs to compensate counterparty (swap dealer)by paying higher costs in the form of a spread C Strategy for changing asset allocation: By using an equity swap, small-cap equity can be swapped for large-cap equity or equity can be swapped for debt Example: The following table shows the current allocation and new allocation for both equity and bonds Stock Current ($150 million, 75%) New ($180 million, 90%) Required Transaction Large cap $90 million (60%) $117 million (65%) Buy $27 million Mid cap $45 million (30%) $45 million (25%) None Small cap $15 million (10%) $18 million (10%) Buy $3 million Example: On April 1, Hedge Fund A enters into a 3-year equity swap Hedge Fund A pays the average S&P 500 return in exchange of 90-day LIBOR (count 30/360) on a quarterly basis 4.1, 4.2 & 4.3 Diversifying a Concentrated Portfolio, Achieving International Diversification and Changing an Asset Allocation between Stocks and Bonds FinQuiz.com Bonds Current ($50 million, 25%) New ($20million, 10%) Required Transaction Government $40 million (80%) $15 million (75%) Sell $25 million Corporate $10 million (20%) $5 million (25%) Sell $5 million Source: Volume 5, Reading 30, Section 4.3 Strategy: The swaps can be initially structured as follows: Reading 30 Risk Management Applications of Swap Strategies Consider the following: Similarities SP500 represents the large-cap equity sector SPSC represents the small-cap equity sector LLTB represents the government bond sector MLCB represents the corporate bond sector Difference for the overall payment to be negative Risks inherent in Equity and Fixed income swaps: a) Equity swaps: • Receive return on SP500 on $27 million o Pay LIBOR on $27 million • Receive return on SPSC on $3 million o Pay LIBOR on $3 million Tracking error: It refers to a problem of mismatch between the performance of the various sectors of equity and fixed-income portfolios and the performance of the indices which are used as proxy and on which swap payments are based Cash flow problem: b) Fixed income swaps: • Receive LIBOR on $25 million o Pay return on LLTB on $25 million • Receive LIBOR on $5 million o Pay return on MLCB on $5 million Alternative ways: • • • • FinQuiz.com Receive return on SP500 on $27 million Receive return on SPSC on $3 million Pay return on LLTB on $25 million Pay return on MLCB on $5 million Fixed income swaps v/s Equity Swaps: Similarities Difference • It involves payment of the total return on a bond or bond index against some other index i.e LIBOR • In Fixed-income swaps, fixed payment of interest represents a major portion of total return; whereas in equities, dividends represent a small amount of capital gains • The total return is not known until the end of the settlement period • When capital gain is negative, it is possible i In case of swapping fixed-income return for equity return, if fixed-income payments > equity receipts, the investor faces cash flow problem to meet his swap obligations Investor can generate cash from his actual stock and bond portfolios in the form of dividends and interest payments In order to receive capital gains on stock or bond portfolio, investor needs to liquidate a portion of his portfolio However, it is not reasonable to so because the basic reason behind using swaps was to offset negative performance of portfolio without actually liquidating it ii In case of swapping stock return for index return, cash flow problem could also arise when the stocks outperform index and consequently a firm is required to make net outflow Or when a stock generates positive return whereas index generates negative return, then the firm owes payments on both legs of the swap Practice: Example 8, 9, 10 & 11, Volume 5, Reading 30 NOTE: Equity swaps are used by executives, to offset negative return associated with stock options Such actions can result in significant agency cost problems for the company STRATEGIES AND APPLICATIONS USING SWAPTIONS A SWAPTION is an option to enter into a swap Swaptions can be used to enter into interest rate, equity, currency, and commodity swaps Interest rate swaptions represent the largest swaptions market and are highly liquid • A swaption can be either European style i.e can be exercised only at expiration or American style i.e can be exercised at any time prior to expiration • A swaption is based on an underlying swap which has a specific set of terms i.e o Notional principal o Underlying interest rate o Time to expiration o Specific payment dates o Method to calculate interest o Exercise rate i.e a fixed rate at which the swaption holder can enter into the swap as either a fixed-rate payer or fixed-rate receiver It is always specified at the initiation of the swaption • The buyer of the swaption pays premium to the Reading 30 Risk Management Applications of Swap Strategies seller which represents cost of the option • The higher (lower) the exercise rate, the more expensive the receiver (payer) swaption Ways to exercise Swaption: a) Holder of a swaption can exercise swaption by actually entering into the swap or b) Holder of a swaption can exercise swaption by receiving an equivalent amount of cash from the seller FinQuiz.com example, if a firm plans to borrow in the future at floating rate, it can offset its risk of rising interest rates by buying a payer swaption i.e • When fixed rate in the market at swaption expiration > exercise rate of swaption, a firm can exercise the payer swaption • When fixed rate in the market at swaption expiration < exercise rate of swaption, a firm will not exercise the payer swaption; rather, it can enter into a swap at the market rate NOTE: The method used to exercise a swaption is predetermined by the parties when the contract is created Types of swaptions: Payer swaption: It is an option that allows the holder to enter into a swap as a fixed-rate payer, floatingrate receiver It is similar to a put option on a bond Receiver swaption: It is an option that allows the holder to enter into a swap as fixed-rate receiver, floating-rate payer It is similar to a call option on a bond A swaption is similar to an option on a Coupon Bond Practice: Example 12, Volume 5, Reading 30 5.2 Using an Interest Rate Swaption to Terminate a Swap There are two ways to terminate an existing swap: i By entering into an offsetting swap: a) When a firm terminates an existing swap by entering into an offsetting swap with a different counterparty: • Both of the swaps (new & original) would remain in place • Floating payments on both swaps would be equivalent and would offset each other • Net effect: Firm would make a stream of fixed payments at one rate and receive a stream of fixed payments at another rate b) When a firm terminates an existing swap by entering into an offsetting swap with original counterparty: 5.1 Using an Interest Rate Swaption in Anticipation of a Future Borrowing A swaption can be used: • To create a swap • To terminate an existing swap Using swaption to create a swap: A swaption gives the flexibility to the buyer of the swaption to enter into the swap at an attractive rate For • The two parties may offset and eliminate both swaps • Payments would be netted i.e the party who owes net cash outflow to other party would pay a lump sum of the PV of the difference between the two streams of fixed payments ii By buying a swaption a) When interest rates are expected to fall, a borrower should use receiver swaption to convert its pay-fixed position to a pay-floating position Reading 30 Risk Management Applications of Swap Strategies b) When interest rates are expected to rise, a borrower should use payer swaption to convert its pay-floating position to a pay-fixed position FinQuiz.com NOTE: Exercise rate of swaption does not include credit spread because the swaption can be used to manage the risk associated with changes in interest rates only 5.3.2) Strategy used by an Issuer to synthetically add call feature in a non-Callable bond by using a swaption We know that receiver swaption is similar to a call option on a bond Therefore, a call option can be synthetically added to a non-callable bond by Buying a Receiver Swaption Practice: Example 13, Volume 5, Reading 30 5.3 Synthetically Removing (Adding) a Call Feature in callable (Noncallable) Debt In a callable bond, the issuer has a right to retire the bond early This right is referred to as the call option and the issuer receives this right by paying a higher coupon rate on the bond For Issuers: 5.3.1) Strategy used by an Issuer to synthetically remove call feature from a Callable bond by using a swaption We know that receiver swaption is similar to a call option on a bond Therefore, a call option can be synthetically removed from a callable bond by Selling a Receiver Swaption • When interest rates fall, call option becomes valuable and becomes more likely to be exercised • On the other hand, receiver swaption also becomes valuable • It should be noted that the swaption will not cancel the bond’s call feature Both options will remain in place; however, both options should behave in a similar manner • Thus, when rates decline, issuer stops paying interest on a callable bond as bond is called back However, it starts paying interest on a receiver swaption which he sold for a premium • Premium received up front by selling a receiver swaption effectively leads to decrease in issuer’s cost i.e it reduces the coupon rate on a callable bond • However, in this case swaption is held by another party and thus, the seller (i.e issuer in this case) has no guarantee that exercise will occur at the optimal time Synthetically removing a call feature from a Callable bond is also known as “monetizing a call” • When interest rates fall, receiver swaption also becomes valuable • Thus, when rates decline, issuer starts receiving interest on receiver swaption and effectively cancels out its current fixed rate obligation on a non-callable bond • Premium is paid up front by the issuer when he buys receiver swaption which effectively leads to increase in issuer’s cost i.e increases coupon rate on a bond For Investors: Strategy used by an Investor to synthetically add call feature in a non-Callable bond by using a swaption:→Selling a receiver swaption i.e by selling a receiver swaption, an investor effectively sells a call option on a bond similar to a callable bond • The premium received by the investor will effectively increase the coupon rate on the bond Strategy used by an Investor to synthetically remove call feature in a Callable bond by using a swaption:→Buying a receiver swaption i.e by buying a receiver swaption, an investor effectively receives the right to receive fixed rate when interest rates fall and thus cancels out the call feature of a callable bond Practice: Example 14, Volume 5, Reading 30 To synthetically add or remove put options, payer swaptions can be used For Issuers: Strategy used by an Issuer to synthetically add a put option in a non-Putable bond by using a swaption: We know that payer swaption is similar to a put option on a bond • Therefore, the issuer of the bond can synthetically add a put to an otherwise non-putable bond by selling a payer swaption The premium received by the issuer will effectively reduce the coupon rate Reading 30 Risk Management Applications of Swap Strategies on the bond Strategy used by an Issuer to synthetically remove a put option from a Putable bond by using a swaption: We know that payer swaption is similar to a put option on a bond • Therefore, the issuer of the bond can synthetically remove a put option from a putable bond by buying a payer swaption The premium paid will effectively increase the coupon rate on the bond →Selling a payer swaption i.e by selling a payer swaption, an investor effectively cancels out a put option on a bond 5.4 • The premium paid by the investor will effectively reduce the coupon rate on the bond Forwards Swaps V/S Swaptions Forwards swaps Swaptions • Forward swap represents a commitment to enter into a swap • No cash payment is required at contract initiation • Swaption represents an option to enter into a swap • Buyer of the option pays cash up front in the form of premium to the seller of the option Strategy used by an Investor to synthetically remove a put option from a Putable bond by using a swaption: • Forwards, futures, options and swaps can be used by investors/managers to manage risk However, to properly use these derivatives, they must be monitored and controlled periodically Practice: End of Chapter Practice Problems for Reading 30 & FinQuiz Item-set ID# 9280 A Note on Forward Swaps Forward swaps refer to forward contracts in which the underlying instruments are swaps For Investors: Strategy used by an Investor to synthetically add a put option in a non-Putable bond by using a swaption: →Buying a payer swaption i.e by buying a payer swaption, an investor effectively purchases a put option similar to a putable bond FinQuiz.com CONCLUSIONS ... (0.075/4) = € 533 ,33 3 ,33 3 Step 2: To Calculate the corresponding principal in Dollars, foreign NP is converted into corresponding domestic NP (i.e $) using the current exchange rate: €5 ,33 3 ,33 3 ,33 3 / €0.90/$... a Reading 30 Risk Management Applications of Swap Strategies foreign currency bond, foreign subsidiaries generate cash in foreign currency FinQuiz. com Practice: Example 6, Volume 5, Reading 30 ... $5 million (25%) Sell $5 million Source: Volume 5, Reading 30 , Section 4 .3 Strategy: The swaps can be initially structured as follows: Reading 30 Risk Management Applications of Swap Strategies
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