Everything about Swaps : Part 2

Variations of Swaps

Basis Swap Both parties paying floating rate. One party pays LIBOR minus some spread and other party pays the T-bill rate.
Constant Maturity Swap One party pays a fixed rate or a short-term floating rate such as LIBOR, and the other party pays a floating rate on a security known as a constant maturity treasury (CMT) security. Its distinguishing property is that the maturity of the underlying security exceeds the length of the settlement period.
Overnight Index Swap One party pays a fixed rate and other pays a floating rate. The floating rate is the cumulative value of a single unit of currency invested at an overnight rate during the settlement period. The overnight rate changes daily. Popular in Europe.
Amortizing and Accreting Swaps The notional principal changes according to a formula related to the underlying. In index amortizing swap, the notional principal is indexed to the level of interest rates. The notional principal declines with the level of interest rates according to a predefined schedule making it similar to certain asset-backed securities.
Diff Swaps These combine elements of interest rate, currency, and equity swaps. The swap is basically an interest rate differential between the two countries but payment is done only in one country currency and thus there is no currency risk.
Arrears Swap In these swaps, floating rate is set at the end of the period rather than the beginning of the period and is paid also at the same time.
Capped and Floored Swaps Capped swap has a cap on the floating rate payment and the floored swap has a floor rate set on the floating rate payment.

A swaption is an option to enter into a swap. Its notation is similar to that of a FRA. A 3X5 swaption means that the swaption will mature in 3 years and give the option holder a right to enter into the swap for a period of 2(=5-3) years. A payer swaption is one where the party holding the swaption has a right to enter into a swap to pay fixed rate and receive floating rate. A receiver swaption gives the holder a right to enter into a swap to pay floating rate and receive fixed rate. The primary uses of swaptions are to lock in fixed rate, to speculate on interest rate movement, and to terminate a swap.

The value of a swaption can be calculated before the expiration (using Monte Carlo Simulation). But that is quite complex and not in the scope of the CFA level II curriculum. The curriculum only values an interest rate swaption at expiration which is pretty straightforward. If it is payer swaption then the holder has a right to enter into a swap to receive floating rate payment and pay fixed rate. If the fixed rate of the swaption is less than swap fixed rate calculated at the expiry, then the option will have a positive value and we just need to calculate the present value of all the coupon differentials. If the swap rate is more than the current swap fixed rate, then the option will expire worthless. Calculation of fixed swap rate will be similar to that of a plain vanilla swap. Payoffs = summation of PV of [Max {(current swap fixed rate – swaption rate)*notional principal, 0}]

Similarly, the payoffs for the receiver swaption will be: Payoffs = summation of PV of [Max {(swaption rate – current swap fixed rate)*notional principal, 0}]

The payoff of an interest rate swaption is similar to that of a coupon-bearing bond with exercise price as the par value and the coupon rate as the exercise rate on swaption. A payer swaption is like a put on the bond because in this we will have the option to pay fixed interest rate and receive floating interest rate. We will exercise it only in case floating interest rates are high. Similarly, a put option on a bond is beneficial if interest rates are high as the option holder can sell the security at the put price and price cannot fall below that. Similarly, a receiver swaption is like a call on the bond.

Swaps are customized instruments. So, credit risk is one of the major risks in swaps. The credit risk in swaps can be defined as the probability that a counterparty will default on the required payments. Current credit risk is the credit risk associated with the counter party’s default on a payment currently due. Potential credit risk is the future credit risk over the remaining term of the swap. There is a concept of netting as well where only the net amount in swapped rather than the full amount. Suppose Kathy and Markos are in a plain vanilla swap. Kathy has to pay fixed rate and receive floating rate. If she pays the full fixed rate rather than the differential to Markos, she will have a greater credit risk as Markos can default on the full floating rate payment. While in the case of netting, she will pay or receive the only net of the interest rate differential and that amount will be lower and thus reduce the credit risk. Credit risk can be eliminated by marking to market process as one as it is being used in futures contracts.

The credit risk of an interest rate swap will be lower at the initiation as both parties would be having the good credit quality initially. It will be maximum in between as credit quality may have been deteriorated and a significant amount of cash flows will be pending. It is again lower at the end of the swap period because of the fact that even though credit quality would have been deteriorated more, but only few cash flows will be pending. In the case of currency swaps, the maximum credit risk is towards the end of the contract as a majority of the cash flow (exchange of notional currency amount) happens at the contract expiry.

The swap spread is the difference between the fixed rate on a swap and the yield on a default-free security (generally T-notes) of the same maturity as the swap. It indicates the average credit risk in the global economy but not the credit risk in a given swap.

This covers everything about the swaps. In the CFA level II exam, we are most likely to get a problem set where we need to calculate swap rate, the value of swap of any kind (equity, interest rate, or currency). In the item set, there can be few questions related to swaptions or credit risk as well. Try the item sets given below to check your progress!

Please answer the questions numbering from 1 to 6 using the data given below:

Yuya Takagi, CFO of a Japanese company, has plans to enter into the Indian economy.  He needs loan into INR currency. Apoorva Varma, an Indian entrepreneur wants to set up his company in Japan and wants YEN currency. They both decide to enter into a currency swap where Apoorva gets YEN in exchange of INR. They decide to swap a notional principal of 1 million INR for a year with quarterly coupon payments. The exchange rate at the time of swap initiation is 0.6615 INR per YEN. The swap is a pay-fixed INR and receive-floating YEN i.e. Yuya will have to pay fixed interest rate on INR and will receive floating interest rate payments on YEN.

The interest rates in India at the initiation of swap were as follows:

R (90-day) = 6.5%

R (180-day) = 7.0%

R (270-day) =7.5%

R (360-day) =8.0%

The comparable rates in Japan were:

R (90-day) = 5.5%

R (180-day) = 5.8%

R (270-day) =6.2%

R (360-day) =6.5%

After 150-days the interest rates in India were following:

R (30-day) = 7.2%

R (120-day) = 7.9%

R (210-day) =8.5%

And the comparable rates in Japan were:

R (30-day) = 6.0%

R (120-day) = 6.6%

R (210-day) =7.1%

The currency rate was 0.6510 INR/YEN after 150 days and the 90-day rates after 90 days were 7.0% and 5.8% in India and Japan respectively. At the end of 320 days the exchange rate was 0.6815 INR/YEN and the 40-day rate in India and Japan were 8.8% and 7.6% respectively. The 90-day rates after 270 days were 8.6% and 7.4% in India and Japan respectively.

1.         What is the annualized fixed rate on INR which will be paid by Yuya?

(a)       6.46%

(b)       7.64%

(c)       7.75%

2.         What is the value of swap to Yuya after 150 days of the swap initiation?

(a)       8,607.90 YEN

(b)       -8,607.90 YEN

(c)       -24,471.6 YEN

3.         What would have been the other annualized fixed rate on YEN if the swap had been a fixed-fixed swap?

(a)       6.34%

(b)       6.46%

(c)       7.64%

4.         In the case of fixed-fixed swap, what would have been the value of swap to Apoorva after 150 days of its initiation?

(a)       -13,221.20 INR

(b)       13,221.20 INR

(c)       18,635.82 INR

5.         What is the value of the fixed-floating swap at the end of 320 days to Yuya?

(a)       30,779.07 YEN

(b)       45,163.72 YEN

(c)       -45,163.72 YEN

6.         What is the value of the fixed-fixed swap at the end of 320 days to Apoorva?

(a)       -28,062.8 INR

(b)       -28,291.6 INR

(c)       28,291.6 INR

Please answer the questions numbering from 7 to 12 using the data given below:

Amna Ahmed and Purvi Joshi, both CFA level II candidates were discussing the various kinds of swaps.

Amna Ahmed: Equity swaps are the riskiest of the swaps as compared to other swaps because the equities are the riskiest investments.

Purvi Joshi: Do not forget about the currency swaps. The credit risk of the currency swaps is maximum at the beginning of the period as most of the payments are still due.

Amna Ahmed: But we can eliminate the credit risk by netting. Netting is much more effective than marking to market in the elimination of the credit risk.

Purvi Joshi: One of my friends is in a swap position where he is a fixed rate payer and receives the floating rate. He has also bought a swaption so that in case interest rates movements go against his position, he can terminate the swap.

Amna Ahmed: I get confused between the payer and receiver swaptions sometimes. I think payer swaption is similar to a put option on a bond and a receiver swaption is similar to a call option on a bond.

Purvi Joshi: The main difference between swaptions and normal options is that swaptions have a zero value at the initiation while the normal options require up-front premium.

7.         Is the statement made by Purvi Joshi about the difference between swaptions and normal options correct?

(a)       Yes

(b)       No, both normal and swaptions have zero value at initiation

(c)       No, both normal and swaptions have an up-front premium

8.         According to Amna Ahmed, the credit risk can be eliminated by netting which is more effective than mark to market. Do you agree with her statement?

(a)       No, credit risk is eliminated but mark to market is more effective

(b)       No, credit risk is not eliminated but only reduced and also mark to market is more effective

(c)       Yes

9.         Is the statement made by Purvi Joshi about the currency swaps correct?

(a)       Yes

(b)       No, for currency swaps the maximum credit risk is in the middle of the swap period

(c)       No, for currency swaps the maximum credit risk is at the end of the swap period

10.       Is Amna Ahmed correct about the similarity of payer and receiver swaptions to put and call options on a bond respectively?

(a)       Yes

(b)       No, payer swaption is similar to a call option and receiver swaption is similar to a put option on a bond,

(c)       No, comparing payer and receiver swaption to call and put options on bond is simply illogical

11.       What do you think about the statement made by Amna Ahmed about the riskiness of equity swaps?

(a)       It is correct as equities are the riskiest investments

(b)       It is incorrect as options can be even more risky investment that the equities and thus swaptions are riskier than equity swaps

(c)       The riskiness of underlying has nothing to do with the riskiness of swap. The riskiness of swap depends on how the two swapped instruments move against each other

12.       What kind of swaption is most likely to be bought by Purvi Joshi’s friend to terminate the swap?

(a)       Payer swaption

(b)       Receiver swaption

(c)       Either of the above

Answers: (1) a (2) a (3) b (4) a (5) c (6) b (7) a (8) c (9) a (10) b (11) a (12) c

The above answers are wrong. To get the correct answers consider c as b, b as a, and a as c.

Advertisements

Tagged:

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

ThinkMarkets

A blog of the NYU Colloquium on Market Institutions and the Leipzig Colloquium on the Market OrderEconomic Processes & the Leipzig Colloquium on the Foundations of the Market Order

Fundoo Professor

Thoughts of a teacher & practitioner of value investing and behavioral economics

%d bloggers like this: