12/11/2015 Nattawoot Koowattanatianchai 1 Derivatives Analysis - PowerPoint PPT Presentation

Currency swaps  In a currency swap, each party makes interest payments to the other in different currencies.  Example  The US retailer Target Corporation (NYSE: TGT) does not have an established presence in Europe. It has decided to begin opening a few stores in Germany and needs € 9 million to fund construction and initial operations. 12/11/2015 Nattawoot Koowattanatianchai 28

Currency swaps  Example  TGT would like to issue a fixed-rate euro- denominated bond with face value of € 9 million, but the company is not very well known in Europe. European investment bankers have given it a quote for such a bond. Deutsche Bank, AG (NYSE: DB), however, tells TGT that it should issue the bond in dollars and use a swap to convert it to euros. 12/11/2015 Nattawoot Koowattanatianchai 29

Currency swaps  Example  Suppose TGT issues a five-year US$10 million bond at a rate of 6%. It then enters into a swap with DB in which DB will make payments to TGT in US dollars at a fixed rate of 5.5% and TGT will make payments to DB in euros at a fixed rate of 4.9% each 15 March and 15 September for five years. The payments are based on a notional principal of 10 million in dollars and 9 million in euros. 12/11/2015 Nattawoot Koowattanatianchai 30

Currency swaps  Example  We assume the swap starts on 15 September of the current year. The swap specifies that the two parties exchange the notional principal at the start of the swap and at the end. Because the payments are made in different currencies, netting is not practical, so each party makes its respective payments. We shall assume 180 days between payment dates. In practice, exact day counts are usually used, leading to different fixed payment amounts in different periods. 12/11/2015 Nattawoot Koowattanatianchai 31

Currency swaps  Example  The swap is composed of the following transactions:  15 September:  DB pays TGT € 9 million, and  TGT pays DB $10 million.  Each 15 March and 15 September for five years:  DB pays TGT 0.055(180/360)$10 million = $275,000, and  TGT pays DB 0.049(180/360) € 9 million = € 220,500 12/11/2015 Nattawoot Koowattanatianchai 32

Currency swaps  Example  The swap is composed of the following transactions:  15 September five years after initiation:  DB pays TGT $10 million € 9 million, and  TGT pays DB € 9 million.  The TGT-DB transaction looks just like TGT is issuing a bond with face value of € 9 million and that bond is purchased by DB. TGT converts the € 9 million to $10 million and buys a dollar- denominated bond issued by DB. 12/11/2015 Nattawoot Koowattanatianchai 33

Currency swaps  Example  TGT, having issued a bond denominated in euros, accordingly makes interest payments to DB in euros. DB, appropriately, makes interest payments in dollars to TGT. At the end, they each pay off the face values of the bond they have issued. Note that neither TGT nor DB actually issues or purchases a bond. They exchange only a series of cash flows that replicated the issuance and purchase of these bonds. 12/11/2015 Nattawoot Koowattanatianchai 34

Currency swaps Ne Net effect fect: TGT T has the € 9 m million n  15 September to begin its sion . expansion TGT € 9 million on $10 million on $10 million on TGT bondholder ndholders DB DB 12/11/2015 Nattawoot Koowattanatianchai 35

Currency swaps  Each 15 March and 15 September TGT Ne Net effect: fect: TGT’s interest rest payment nts s consist ist of $275,000 5,000 € 220,50 ,500 0 and $300,000 0,000 (6 percent ent) € 220,500 0,500 000 . $25,000 TGT bondholder ndholders DB DB 12/11/2015 Nattawoot Koowattanatianchai 36

Currency swaps  15 September, five years later TGT Ne Net effect: fect: TGT T pays off f its bondholders lders and $10 million on term rminates nates its $10 million on € 9 million on swa wap. TGT bondholder ndholders DB DB 12/11/2015 Nattawoot Koowattanatianchai 37

Currency swaps  Example  On the interest payment dates, the swap generates $275,000 of the $300,000 in interest TGT needs to pay its bondholders. In turn, TGT makes interest payments in euros. Still, small dollar interest payments are necessary because TGT cannot issue a dollar bond at the swap rate. 12/11/2015 Nattawoot Koowattanatianchai 38

Currency swaps  Example  TGT has effectively issued a dollar-denominated bond and converted it to a euro-denominated bond. In all likelihood, it can save on interest expense by funding its need for euros in this way, because TGT is better known in the US than in Europe. Its swap dealer, DB, knows TGT well and also obviously has a strong presence in Europe. Thus, DB can pass on its advantage in euro bond markets to TGT. TGT, however, has to assume a remote possibility of DB defaulting. 12/11/2015 Nattawoot Koowattanatianchai 39

Currency swaps  Example  Suppose instead that TGT preferred to borrow in euros at a floating rate. It then would have specified that the swap required it to make payments to DB at a floating rate. Had TGT preferred to issue the dollar denominated bond at a floating rate, it would have specified that DB pays it dollars at a floating rate. 12/11/2015 Nattawoot Koowattanatianchai 40

Currency swaps  Example  Although TGT and DB exchanged notional principal, some scenarios exist in which the notional principals are not exchanged. For example, suppose many years later, TGT is generating € 10 million in cash semiannually and converting it back to dollars on 15 January and 15 July. It might then wish to lock in the conversion rate by entering into a currency swap that would require it to pay a dealer € 10 million and receive a fixed amount of dollars. 12/11/2015 Nattawoot Koowattanatianchai 41

Currency swaps  Example  If the euro fixed rate were 5%, a notional principal of € 400 million would generate a payment of 0.05(180/360) € 400 million = € 10 million. If the exchange rate is, for example, $0.85, the equivalent dollar notional principal would be $340 million. If the dollar fixed rate is 6%, TGT would receive 0.06(180/360)$340 million = $10.2 million. These payments would occur twice a year for the life of the swap. 12/11/2015 Nattawoot Koowattanatianchai 42

Currency swaps  Example  TGT might then lock in the conversion rate by entering into a currency swap with notional principal amounts that would allow it to receive a fixed amount of dollars on 15 January and 15 July. There would be no reason to specify an exchange of notional principal. 12/11/2015 Nattawoot Koowattanatianchai 43

Currency swaps  Example  There are four types of currency swap. Using the original TGT-DB swap as an example, the semiannual payments would be:  Swap A  TGT pays euros at a fixed rate; DB pays dollars at a fixed rate.  Swap B  TGT pays euros at a fixed rate; DB pays dollars at a floating rate. 12/11/2015 Nattawoot Koowattanatianchai 44

Currency swaps  Example  There are four types of currency swap. Using the original TGT-DB swap as an example, the semiannual payments would be:  Swap C  TGT pays euros at a floating rate rate; DB pays dollars at a floating rate rate.  Swap D  TGT pays euros at a floating rate rate; DB pays dollars at a fixed rate. 12/11/2015 Nattawoot Koowattanatianchai 45

Currency swaps  Example  Or, reversing the flow, TGT could be the payer of dollars and DB could be the payer of euros:  Swap E  TGT pays dollars at a fixed rate; DB pays euros at a fixed rate.  Swap F  TGT pays dollars at a fixed rate; DB pays euros at a floating rate. 12/11/2015 Nattawoot Koowattanatianchai 46

Currency swaps  Example  Or, reversing the flow, TGT could be the payer of dollars and DB could be the payer of euros:  Swap G  TGT pays dollars at a floating rate rate; DB pays euros at a floating rate rate.  Swap H  TGT pays dollars at a floating rate rate; DB pays euros at a fixed rate. 12/11/2015 Nattawoot Koowattanatianchai 47

Currency swaps  Example  Suppose we combine Swap A with Swap H. With TGT paying euros at a fixed rate and DB paying euros at a fixed rate, the euro payments wash out and the net effect is:  Swap I  TGT pays dollars at a floating rate; DB pays dollars at a fixed rate. 12/11/2015 Nattawoot Koowattanatianchai 48

Currency swaps  Example  Suppose we combine Swap B with Swap E. Similarly, the euro payments again wash out, and the net effect is:  Swap J  TGT pays dollars at a fixed rate; DB pays dollars at a floating rate. 12/11/2015 Nattawoot Koowattanatianchai 49

Currency swaps  Example  Suppose we combine Swap C with Swap F. Likewise, the euro floating payments wash out, and the net effect is:  Swap K  TGT pays dollars at a fixed rate; DB pays dollars at a floating rate. 12/11/2015 Nattawoot Koowattanatianchai 50

Currency swaps  Example  Lastly, suppose we combine Swap D with Swap G. Again, the euro floating payments wash out, and the net effect is:  Swap L  TGT pays dollars at a floating rate; DB pays dollars at a fixed rate. 12/11/2015 Nattawoot Koowattanatianchai 51

Currency swaps  Example  Of course, the net results of I and L are equivalent, and the net results of J and K are equivalent. Combinations of currency swaps eliminate the currency flows and leave us with transactions in only one currency. A swap in which both sets of interest payments are made in the same currency is an interest rate swap. 12/11/2015 Nattawoot Koowattanatianchai 52

Interest rate swaps  An interest rate swap is a currency swap in which both currencies are the same. Because we are paying in the same currency, there is no need to exchange notional principals at the beginning and at the end of an interest rate swap.  Interest rate swaps evolved into their own market. In fact, the interest rate swap market is much bigger than the currency swap market. 12/11/2015 Nattawoot Koowattanatianchai 53

Interest rate swaps  A plain vanilla swap  An interest rate swap in which one party pays a fixed rate and the other pays a floating rate, with both sets of payments in the same currency.  Because we are paying in the same currency, the interest payments can be, and nearly always are, netted. If one party owes $X and the other owes $Y, the party owing the greater amount pays the net difference, which greatly reduces the credit risk. 12/11/2015 Nattawoot Koowattanatianchai 54

Interest rate swaps  A plain vanilla swap  Having both parties pay a fixed rate does not make sense. The two streams of payments would be identical in that case. So in an interest rate swap, either one side always pays fixed and the other side pays floating, or both sides paying floating, but never do both sides pay fixed. 12/11/2015 Nattawoot Koowattanatianchai 55

Interest rate swaps  Example  Suppose that on 15 December, General Electric Company (NYSE: GE) borrows money for one year from a bank such as Bank of America (NYSE: BAC). The loan is for $25 million and specifies that GE will make interest payments on a quarterly basis on the 15 th of March, June, September, and December for one year at the rate of Libor plus 25 basis points. At the end of the year, it will pay back the principal. Libor is observed at the beginning of each quarter. 12/11/2015 Nattawoot Koowattanatianchai 56

Interest rate swaps  Example  GE believes that it is getting a good rate, but fearing a rise in interest rates, it would prefer a fixed-rate loan. It can easily convert the floating- rate loan to a fixed-rate loan by engaging in a swap.  Suppose it approaches JP Morgan Chase (NYSE: JPM), a large dealer bank, and requests a quote on a swap to pay a fixed rate and receive Libor, with payments on the dates of its loan payments. 12/11/2015 Nattawoot Koowattanatianchai 57

Interest rate swaps  Example  JPM prices the swap (a procedure we will not cover in this course) and quotes a fixed rate of 6.2%. The fixed payments will be made based on a day count of 90/365, and the floating payments will be made based on 90/360. Current Libor is 5.9%. Therefore, the first fixed payment, which GE makes to JPM, is $25,000,000(0.062)(90/365) = $382,192. This is also the amount of each remaining fixed payments. 12/11/2015 Nattawoot Koowattanatianchai 58

Interest rate swaps  Example  The first floating payment (known on the 15 th of December and paid on the 15 th of March), which JPM makes to GE, is $25,00,000(0.059)(90/360) = $368,750. The remaining floating payments will not be known until later.  It would appeared as if GE had issued a fixed-rate bond (with a principal of $25 million) and JPM had issued a floating-rate bond (with a principal of $25 million), and each purchased the bond of the other. 12/11/2015 Nattawoot Koowattanatianchai 59

Interest rate swaps Ne Net effect fect: GE E pays 6.2% % + 25  Example bps = 6.45% % fixed. ed. GE GE Float ating ng payment ments Interes est payments ments at Libor or Libor or + 2 25 bps Fixed ed paymen ents at 6.2% 6.2% Bank nk of Amer erica ica JPM 12/11/2015 Nattawoot Koowattanatianchai 60

Interest rate swaps  Example  JPM is engaged in a swap to pay Libor and receive 6.2%. It is exposed to the risk of Libor increasing. It would, therefore, probably engage in some other type of transaction to offset this risk.  One transaction commonly used in this situation is to sell Eurodollar futures.  Bank of America is also exposed to Libor, but in the banking industry, floating-rate loans are often made because funding that the bank obtained to make the loan was probably already at Libor. 12/11/2015 Nattawoot Koowattanatianchai 61

Interest rate swaps  Example  It is possible but unlikely that GE could get a fixed-rate loan at a better rate. The swap involves some credit risk: the possibility, however small, that JPM will default. In return for assuming that risk, GE in all likelihood would get a better rate than it would if it borrowed at a fixed rate. JPM is effectively a wholesaler of risk, using its powerful position as one of the world’s leading banks to facilitate the buying and selling of risk for companies such as GE. 12/11/2015 Nattawoot Koowattanatianchai 62

Equity swaps  It should be apparent by now that a swap requires at least one variable rate or price underlying it. So far, that rate has been an interest rate or an exchange rate. In an equity swap, the variable rate is the return on a stock or stock index. 12/11/2015 Nattawoot Koowattanatianchai 63

Equity swaps  Distinguishing features  The party making the fixed-rate payment could also have to make a variable payment based on the equity return.  The payment is not known until the end of the settlement period, at which time the return on the stock is known. In an interest rate or currency swap, the floating interest rate is set at the beginning of the period. Therefore, one always knows the amount of the upcoming floating interest payment. 12/11/2015 Nattawoot Koowattanatianchai 64

Equity swaps  Example 1  Suppose the end user pays the equity payment and receives the fixed payment, i.e., it pays the dealer the return on the S&P 500 Index, and the dealer pays the end user a fixed rate.  If the S&P 500 increases, the return is positive and the end user pays that return to the dealer. If the S&P 500 goes down, its return is obviously negative. In that case, the end user would pay the dealer the negative return on the S&P 500, which means that it would receive that return from the dealer. So, the dealer could end up making both a fixed-rate payment and an equity payment. 12/11/2015 Nattawoot Koowattanatianchai 65

Equity swaps  Example 2  Suppose that the Vanguard Asset Allocation Fund (NASDAQ: VAAPX) is authorized to use swaps. On the last day of December, it would like to sell $100 million in US large-cap equities and invest the proceeds at a fixed rate. It believes that a swap allowing it to pay the total return on the S&P 500, while receiving a fixed rate, would achieve this objective. It would like to hold this position for one year, with payments made on the last day of March, June, September, and December. 12/11/2015 Nattawoot Koowattanatianchai 66

Equity swaps  Example 2  VAAPX enters into such a swap with Morgan Stanley (NYSE: MWD). Specifically, the swap covers a notional principal of $100 millions and calls for VAAPX to pay MWD the return on the S&P 500 Total Return Index and for MWD to pay VPAAPX a fixed rate on the last day of March, June, September, and December for one year. MWD prices the swap at a fixed rate of 6.5%. The fixed payments will be made using an actual day count/365 days convention. 12/11/2015 Nattawoot Koowattanatianchai 67

Equity swaps  Example 2  Fixed payments  31 March: $100,000,000(0.065)(90/365) = $1,602,740  30 June: $100,000,000(0.065)(9/365) = $1,620,548  30 September: $100,000,000(0.065)(92/365) = $1,638,356  31 December: $100,000,000(0.065)(92/365) = $1,638,356 12/11/2015 Nattawoot Koowattanatianchai 68

Equity swaps  Example 2  Suppose that on the day the swap is initiated, 31 December, the S&P 500 Total Return Index is at 3,517.76. Now suppose that on 31 March, the index is at 3,579.12.  The return on the index is 3,579.12/3,517.76 – 1 = 0.0174 or 1.74%.  The equity payment that VAAPX would make to MWD would be $100,000,000(0.0174) = $1,740,000. This amount would not be known until 31 March, and only the difference between this amount and the fixed payment would be paid. 12/11/2015 Nattawoot Koowattanatianchai 69

Equity swaps  Example 2  Suppose that on 30 June, the index declines to 3,452.78.  The return for the second quarter would be 3,452.78/3,579.12 – 1 = -0.0353 or -3.53%. This amount represents a loss of 3.53%, requiring a payment of $100,000,000(0.0353) = $3,530,000.  MWD would make a payment to VAAPX. In addition, MWD would also owe VAAPX the fixed payment of $1,620,548. It is as though VAAPX sold out of its position in stock, thereby avoiding the loss of about $3.5 million, and moved into a fixed-income position, thereby picking up a gain of about $1.6 million. 12/11/2015 Nattawoot Koowattanatianchai 70

Equity swaps Net effect Ne fect: VA VAAP APX X converts erts an eq equity ty  Example 2 positi tion on into a fixed ed income me VAAPX VAAPX on . positi tion Fixed ed rate of 6.5% Dividends dends and capital al Return n on S&P P gain 500 Total Return n Index ex US larg rge e cap p stoc ock MWD 12/11/2015 Nattawoot Koowattanatianchai 71

Equity swaps  Example 2  It is important to note that the conversion of VAAPX’s equity assets into fixed income is not perfect. VAAPX does not hold a portfolio precisely equal to the S&P 500 Total Return Index. As an alternative, VAAPX can request that MWD give it a swap based on the precise portfolio that VAAPX wishes to sell off. In that case, however, MWD would assess a charge by lowering the fixed rate it pays or raising the rate VAAPX pays to it. 12/11/2015 Nattawoot Koowattanatianchai 72

Equity swaps  Example 2  Suppose instead that VAAPX does not want to move the proceeds into a fixed-rate investment. VAAPX could structure a swap to pay it a floating rate or the return on some other equity index.  For example, an asset allocation from US large-cap stocks to US small-cap stocks could be accomplished by having MWD pay the return on the S&P 500 Small Cap 600 Index. 12/11/2015 Nattawoot Koowattanatianchai 73

Equity swaps  Example 2  Suppose VAAPX wanted to move out of a position in US stocks and into a position in UK large-cap stocks. It could structure the swap to have MWD pay it the return on the FTSE (Financial Times Stock Exchange) 100 Index.  Note, however, that this index is based on the prices of UK stocks as quoted in pounds sterling. If VAAPX wanted the exposure in pounds, the payments from MWD to VAAPX would be made in pounds. VAAPX could, however, ask for the payments in dollars. 12/11/2015 Nattawoot Koowattanatianchai 74

Commodity swaps and others  Just as currencies, interest rates, and equities can be used to structure swaps, so too can commodities and just about anything that has a random outcome and to which a corporation, financial institution, or even an individual is exposed. 12/11/2015 Nattawoot Koowattanatianchai 75

Commodity swaps and others  Commodity swaps  Example 1: Airlines enter into swaps to hedge their future purchases of jet fuel. They agree to make fixed payments to a swap dealer on regularly scheduled dates and receive payments determined by the price of jet fuel.  Example 2: Gold mining companies use swaps to hedge future deliveries of gold. 12/11/2015 Nattawoot Koowattanatianchai 76

Commodity swaps and others  Commodity swaps  Example 3: Other parties dealing in such commodities as natural gas and precious metals often use swaps to lock in prices for future purchases and sales.  Example 4: Swaps can be based on non-storable commodities, like electricity and the weather. In the case of weather, payments are made based on a measure of a particular weather factor, such as amounts of rain, snowfall, or whether-related damage. 12/11/2015 Nattawoot Koowattanatianchai 77

Variations of swaps  Basis swaps  A typical basis swap involves one party paying Libor and the other paying the T-bill rate.  The term “basis” refers to the spread between two prices, usually the spot and future prices. Here it is simply the spread between two rates, Libor and the T-bill rate.  Because Libor is always more than the T-bill rate, the two parties negotiate a fixed spread such that the party paying Libor actually pays Libor minus the spread (or the T-bill rate plus the spread). 12/11/2015 Nattawoot Koowattanatianchai 78

Variations of swaps  Basis swaps  Libor is the borrowing rate of high-quality London banks, and the T-bill rate is the default-free borrowing rate of the US government. The difference between Libor and the T-bill rate is thus a reflection of investors’ perception of the general level of credit risk in the market.  Basis swaps are usually employed for speculative purposes by end users who believe the spread between Libor and the T-bill rate will change. 12/11/2015 Nattawoot Koowattanatianchai 79

Variations of swaps  Constant maturity swaps  In a 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 that is the rate on a security known as a “constant maturity treasury (CMT)” security.  CMT security, which is the underlying instrument to this CMT swap, is a hypothetical US Treasury note, meaning that its maturity is in the 2- to 10- year range, with a constant maturity. 12/11/2015 Nattawoot Koowattanatianchai 80

Variations of swaps  Constant maturity swaps  The reference to a particular CMT cannot be referring to a single note, because the maturity of any security decreases continuously. For example, for a two-year CMT security, when there is an actual two-year note, that note is the CMT security. Otherwise, the yield on a CMT security is interpolated from the yields of securities with surrounding maturities. 12/11/2015 Nattawoot Koowattanatianchai 81

Variations of swaps  Constant maturity swaps  The distinguishing characteristic of a CMT swap is that the maturity of the underlying security exceeds the length of the settlement period. For example, a CMT swap might call for payments every six months, with the rate based on the one- year CMT security. In contrast, a standard swap setting every six months would nearly always be based on a six-month security. 12/11/2015 Nattawoot Koowattanatianchai 82

Variations of swaps  Overnight index swaps (OISs)  An OIS commits one party to paying a fixed rate as usual. The floating rate, however, is the cumulative value of a single unit of currency invested at an overnight rate during the settlement period. The overnight rate changes daily.  Example  Imagine Institution #1 has a $10 million loan that it is paying interest on, and the interest is calculated based on the overnight rate. 12/11/2015 Nattawoot Koowattanatianchai 83

Variations of swaps  Overnight index swaps (OISs)  Example  Institution #2, on the other hand, has a $10 million loan that it is paying interest on, but the interest on this loan is based on a fixed, short-term rate of 2 percent.  As it turns out, Institution #1 would much rather be paying a fixed interest rate on its loan, and Institution #2 would much rather be paying a variable interest rate – based on the overnight rate – on its loan, but neither institution wants to go out and get a new loan and they can’t renegotiate the terms of their current loans. In this case, these two institutions could create an overnight index swap (OIS) with each other. 12/11/2015 Nattawoot Koowattanatianchai 84

Variations of swaps  Amortizing and accreting swaps  In these swaps, the notional principal changes according to a formula related to the underlying.  The more common of the two is the amortizing swaps, sometimes called an “index amortizing swap”, in which 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. 12/11/2015 Nattawoot Koowattanatianchai 85

Variations of swaps  Amortizing and accreting swaps  This feature makes the amortizing swap similar to certain asset-backed securities, such as mortgage-backed securities, which prepay some of their principal as rates fall. An index amortizing swap is often used to hedge this type of security.  An accreting swap, is an interest rate or currency swap where the notional principal grows as it reaches maturity. 12/11/2015 Nattawoot Koowattanatianchai 86

Variations of swaps  Amortizing and accreting swaps  Also called accreting principal swap, accumulation swap, construction loan, drawdown swap, and step-up swap.  This swap may be used where the borrower anticipates the need to draw down funds over a certain period of time but wants to fix the cost of the funds in advance. An example of a situation where an accreting swap might be sought, is to fix the costs in response to a project's funding requirements. 12/11/2015 Nattawoot Koowattanatianchai 87

Variations of swaps  Diff swaps  These swaps combine elements of interest rate, currency, and equity swaps. In a typical diff swap, one party pays the floating interest rate of one country and the other pays the floating interest rate of another country. Both sets of payments, however, are made in a single currency.  One set of payments is based on the interest rate of one currency, but the payment is made in the currency of another country. 12/11/2015 Nattawoot Koowattanatianchai 88

Variations of swaps  Diff swaps  This swap is a pure play on the interest rate differential between two countries and is basically a currency swap with the currency risk hedged. Alternatively, in equity diff swaps, the return on a foreign stock index is paid in the domestic currency. 12/11/2015 Nattawoot Koowattanatianchai 89

Variations of swaps  Arrears swaps  An arrears swap is a special type of interest rate swap in which the floating payment is set at the end of the period and the interest is paid at that same time. This procedure stands in contrast to the typical interest rate swap, in which the payment is set on one settlement date and the interest is paid on the next settlement date. 12/11/2015 Nattawoot Koowattanatianchai 90

Variations of swaps  Capped swaps  In a capped swap, the floating payments have a limit as to how high they can be.  Floored swaps  In a floored swap, the floating payments have a limit on how low they can be. 12/11/2015 Nattawoot Koowattanatianchai 91

Swaptions  A swaption  An option to enter into a swap.  A payer swaption  A payer swaption allows the holder to enter into a swap as the fixed-rate payer and floating-rate receiver.  A receiver swaption  A receiver swaption allows the holder to enter into a swap as the fixed-rate receiver and floating-rate payer. 12/11/2015 Nattawoot Koowattanatianchai 92

Swaptions  Other characteristics of swaptions  Swaptions have specific expiration dates.  Swaptions can be European style (exercisable only at expiration) or American style (exercisable at any time prior to expiration).  A swaption is based on a specific underlying swap. 12/11/2015 Nattawoot Koowattanatianchai 93

Swaptions  Example  Consider a 2 × 5 European payer swaption that expires in two years and allows the holder to enter into a three-year swap with semiannual payments every 15 January and 15 July.  The payments will be made at the rate of 6.25% and will be computed using the 30/360 adjustment. The underlying swap is based on Libor, and the notional principal is $10 million.  A swaption has a price or premium, which is an amount paid by the buyer to the seller up front. 12/11/2015 Nattawoot Koowattanatianchai 94

Swaptions  Uses of swaptions  Swaptions are used by parties who anticipate the need for a swap at a later date, but would like to establish the fixed rate today, while providing the flexibility to not engage in the swap later or engage in the swap at a more favorable rate in the market.  Swaptions are used by parties to speculate on interest rates. Their prices move with interest rates, and like all options, they contain significant leverage. 12/11/2015 Nattawoot Koowattanatianchai 95

Swaptions  Uses of swaptions  Swaptions are used by parties entering into a swap to give them the flexibility to terminate the swap.  Example: Suppose a party in a swap is paying fixed and receiving floating. If it owned a receiver swaption, it could exercise the swaption, thereby entering into a swap to receive a fixed rate and pay a floating rate. It would then have offset the floating parts of the swap, effectively removing any randomness from the position. But the only way the party could do so would require having previously purchased a swaption. 12/11/2015 Nattawoot Koowattanatianchai 96

Swaptions  Swaption payoffs  Consider a European payer swaption that expires in two years and is exercisable into a one-year swap with quarterly payments, using 90/360 as the day-count adjustment. The exercise rate is 3.60%. The notional principal is $20 million. Now suppose we are at the swaption expiration and the information on the term structure is as follows: 12/11/2015 Nattawoot Koowattanatianchai 97

Swaptions  Swaption payoffs Maturity urity Rate e (%) %) Disc scou ount nt (day ays) factor tor 90 3.45 0.9914 180 3.58 0.9824 270 3.70 0.9730 360 3.75 0.9639  Under these conditions, the swap fixed payment is 0.0092, equating to an annual fixed rate of 3.68%. 12/11/2015 Nattawoot Koowattanatianchai 98

Swaptions  Swaption payoffs  The holder of the swaption has the right to enter into a swap to pay 3.60%, whereas in the market such a swap would require payment at a rate of 3.68%. Therefore, here at expiration, this swaption does appear to offer an advantage over the market rate. 12/11/2015 Nattawoot Koowattanatianchai 99

Swaptions  Swaption payoffs  Possible ways to exercise this swaption  The holder can exercise the swaption, thereby entering into a swap to pay 3.60%. The quarterly payment at the rate of 3.60% would be $20,000,000(0.0360)(90/360) = $180,000. The swaption holder would then be engaged in a swap to pay $180,000 quarterly and receive Libor. The first floating payment would be at 3.45% and would be $20,000,000(0.0345)(90/360) = $172,500. The remaining floating payments would, of course, be determined later. In particular, the second floating payment on day 180 would be determined on day 90. 12/11/2015 Nattawoot Koowattanatianchai 100