Loans and financial matters

Pricing and valuation of swaps

admin — Fri, 11 Dec 2009 17:20:44 +0000

We took our first look at the concepts of pricing and valuation when we examined forward contracts on assets and FRAs, which are essentially forward contracts on interest rates. Recall that a forward contract requires no cash payment at the start and commits one party to buy and another to sell an asset at a later date. An FRA commits one party to make a single fixed-rate interest payment and the other to make a single floating- rate interest payment. A swap extends that concept by committing one party to making a series of floating payments. The other party commits to making a series of fixed or floating payments. For swaps containing any fixed terms, such as a fixed rate, pricing the swap means to determine those terms at the start of the swap. Some swaps do not contain any fixed terms; we explore examples of both types of swaps.
All swaps have a market value. Valuation of a swap means to determine the market value of the swap based on current market conditions. The fixed terms, such as the fixed rate, are established at the start to give the swap an initial market value of zero. As we have already discussed, a zero market value means that neither party pays anything to the other at the start. Later during the life of the swap, as market conditions change, the market value will change, moving from zero from both parties’ perspective to a positive value for one party and a negative value for the other. When a swap has zero value, it is neither an asset nor a liability to either party. When the swap has positive value to one party, it is an asset to that party; from the perspective of the other party, it thus has negative value and is a liability.
We begin the process of pricing and valuing swaps by learning how swaps are comparable to other instruments. If we know that one financial instrument is equivalent to another, we can price one instrument if we know or can determine the price of the other instrument.

Commodity and other types of swaps

admin — Sat, 05 Dec 2009 17:18:57 +0000

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. Commodity swaps are very commonly used. For example, 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. Gold mining companies use swaps to hedge future deliveries of gold. Other parties dealing in such commodities as natural gas and precious metals often use swaps to lock in prices for future purchases and sales. In addition, swaps can be based on non-storable commodities, like electricity and the weather. In the case of the weather, payments are made based on a measure of a particular
weather factor, such as amounts of rain, snowfall, or weather-related damage. We have now introduced and described the basic structure of swaps. We have made many references to the pricing and valuation of swaps, and we now move on to explore how this is done.

Country risk

admin — Tue, 01 Dec 2009 17:17:36 +0000

Country risk, also called political risk, is the uncertainty of returns caused by the possibility of a major change in the political or economic environment of a country. The United States is acknowledged to have the smallest country risk in the world because its political and economic systems are the most stable. Nations with high country risk include Russia, because of the several changes in the government hierarchy and its currency crises during 1998, and Indonesia, where there were student demonstrations, major riots, and fires prior to the resignation of President Suharto in May 1998. In both instances, the stock markets experienced significant declines surrounding these events. Individuals who invest in countries that have unstable political- economic systems must add a country risk premium when determining their required rates of return.
When investing globally, investors must consider these additional uncertainties. How liquid are the secondary markets for stocks and bonds in the country? Are any of the country’s securities traded on major stock exchanges in the United States, London, Tokyo, or Germany? What will happen to exchange rates during the investment period? What is the probability of a political or economic change that will adversely affect your rate of return? Exchange rate risk and country risk differ among countries. A good measure of exchange rate risk would be the absolute variability of the exchange rate relative to a composite exchange rate. The analysis of country risk is much more subjective and must be based on the history and current environment of the country.
This discussion of risk components can be considered a security’s fundamental risk because it deals with the intrinsic factors that should affect a security’s standard deviation of returns over time. In subsequent discussion, the standard deviation of returns is referred to as a measure of the security’s total risk, which considers the individual stock by itself—that is, it is not considered as part of a portfolio.

Equity swaps

admin — Fri, 27 Nov 2009 17:14:36 +0000

By now, it should be apparent that a swap requires at least one variable rate or price underlying it. So far, that rate has been an interest rate.8 In an equity swap, the rate is the return on a stock or stock index. This characteristic gives the equity swap two features that distinguish it from interest rate and currency swaps.
First, the party making the fixed-rate payment could also have to make a variable payment based on the equity return. 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, however, 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. For example, if the S&P 500 falls by 1 percent, the dealer would pay the end user 1 percent, in addition to the fixed payment the dealer makes in any case. So the dealer, or in general the party receiving the equity return, could end up making both a fixed-rate payment and an equity payment.
The second distinguishing feature of an equity swap is that 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.
Another important feature of some equity swaps is that the rate of return is often structured to include both dividends and capital gains. In interest rate and currency swaps, capital gains are not paid. Finally, we note that in some equity swaps, the notional principal is indexed to change with the level of the stock, although we will not explore such swaps in this series of posts.
Equity swaps are commonly used by asset managers. Let us consider a situation in which an asset manager might use such a swap. 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 U.S. 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 to be made on the last day of March, June, September, and December. It enters into such a swap with Morgan Stanley (NYSE: MWD).
Specifically, the swap covers a notional principal of $100 million and calls for VAAPX to pay MWD the return on the S&P 500 Total Return Index and for MWD to pay V AAPX 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 percent. The fixed payments will be made using an actual day countJ365 days convention. There are 90 days between 31 December and 31 March, 91 days between 31 March and 30 June, 92 days between 30 June and 30 September, and 92 days between 30 September and 31December.

Liquidity Risk

admin — Mon, 23 Nov 2009 17:11:07 +0000

When an investor wants to sell an asset, he or she is concerned whether the price that can be obtained from dealers is close to the true value of the asset. For example, if recent trades in the market for a particular asset have been between $40 and $40.50 and market conditions have not changed, an investor would expect to sell the asset in that range.
Liquidity risk is the risk that the investor will have to sell an asset below its true value where the true value is indicated by a recent transaction. The primary measure of liquidity is the size of the spread between the bid price (the price at which a dealer is willing to buy an asset) and the ask price (the price at which a dealer is willing to sell an asset). The wider the bid-ask spread, the greater the liquidity risk.
Liquidity risk is also important for portfolio managers that must mark to market positions periodically. For example, the manager of a mutual fund is required to report the market value of each holding at the end of each business day. This means accurate price information must be available. Some assets do not trade frequently and are therefore difficult to price.

Interest rate swaps

admin — Thu, 19 Nov 2009 17:00:00 +0000

As we discovered in the earlier posts, an interest rate swap can be created as a combination of currency swaps. Of course, no one would create an interest rate swap that way; doing so would require two transactions when only one would suffice. Interest rate swaps evolved into their own market. In fact, the interest rate swap market is much bigger than the currency swap market, as we have seen in the notional principal statistics.
As previously noted, one way to look at an interest rate swap is that it is a currency swap in which both currencies are the same. Consider a swap to pay Currency A fixed and Currency B floating. Currency A could be dollars, and B could be euros. But what if A and B are both dollars, or A and B are both euros? The first case is a dollar-denominated plain vanilla swap; the second is a euro-denominated plain vanilla swap. A plain vanilla swap is simply an interest rate swap in which one party pays a fixed rate and the other pays a pouting rate, with both sets of payments in the same currency. In fact, the plain vanilla swap is probably the most common derivative transaction in the global financial system.
Note that 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. In addition, 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. Finally, we note that there is no reason to have both sides pay a fixed rate. 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.
Thus, in a plain vanilla interest rate swap, one party makes interest payments at a fixed rate and the other makes interest payments at a floating rate. Both sets of payments are on the same notional principal and occur on regularly scheduled dates. For each payment, the interest rate is multiplied by a fraction representing the number of days in the settlement period over the number of days in a year. In some cases, the settlement period is computed assuming 30 days in each month; in others, an exact day count is used. Some cases assume a 360-day year; others use 365 days.
Let us now illustrate an interest rate swap. 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 15th 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. On the 15th of December, March, June, and September, LIBOR is observed and sets the rate for that quarter. The interest is then paid at the end of the quarter.
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. The bank prices the swap and quotes a fixed rate of 6.2 percent. The fixed payments will be made based on a day count of 901365, and the floating payments will be made based on 901360. Current LlBOR is 5.9 percent. 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 payment.
The first floating payment, which JPM makes to GE, is $25,000,000(0.059)(901360)= $368,750. Of course, the remaining floating payments will not be known until later.

Currency swaps – 2

admin — Tue, 17 Nov 2009 17:08:13 +0000

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 United States 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. In addition, had TGT issued a euro-denominated bond, it would have assumed no credit risk. By entering into the swap, TGT assumes a remote possibility of DB defaulting. Thus, TGT saves a little money by assuming some credit risk.
Returning to the Target swap, recall that Target effectively converted a fixed-rate loan in dollars to a fixed-rate loan in euros. 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 pay it dollars at a floating rate.
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 annually and converting it back to dollars twice a year 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. If the euro fixed rate were 5 percent, 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 percent, 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. 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.
As we previously described, there are four types of currency swaps. Using the original Target-Deutsche Bank swap as an example, the semiannual payments would be
A.   TGT pays euros at a fixed rate; DB pays dollars at a fixed rate.
B.   TGT pays euros at a fixed rate; DB pays dollars at a floating rate.
C. TGT pays euros at a floating rate; DB pays dollars at a floating rate.
D.   TGT pays euros at a floating rate; DB pays dollars at a fixed rate.
Or, reversing the flow, TGT could be the payer of dollars and DB could be the payer of euros:
E.   TGT pays dollars at a fixed rate; DB pays euros at a fixed rate.
F.   TGT pays dollars at a fixed rate; DB pays euros at a floating rate.
G . TGT pays dollars at a floating rate; DB pays euros at a floating rate.
H. TGT pays dollars at a floating rate; DB pays euros at a fixed rate.
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
I. TGT pays dollars at a floating rate; DB pays dollars at a fixed rate. Suppose we combine Swap B with Swap E. Similarly, the euro payments again wash out, and the net effect is
J. TGT pays dollars at a fixed rate; DB pays dollars at a floating rate.
Suppose we combine Swap C with Swap F. Likewise, the euro floating payments wash out, and the net effect is
K.   TGT pays dollars at a fixed rate; DB pays dollars at a floating rate. Lastly, suppose we combine Swap D with Swap G. Again, the euro floating payments wash out, and the net effect is 1. TGT pays dollars at a floating rate; DB pays dollars at a fixed rate.
Of course, the net results of I and L are equivalent, and the net results of J and K are equivalent. What we have shown here, however, is that 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.

Currency swaps – 1

admin — Sun, 15 Nov 2009 17:06:37 +0000

In a currency swap, each party makes interest payments to the other in different currencies. Consider this example. The U.S. retailer Target Corporation (NYSE: TGT) does not have an established presence in Europe. Let us say that it has decided to begin opening a few stores in Germany and needs €9 million to fund construction and initial operations. 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 into euros.
Suppose TGT issues a five-year US$10 million bond at a rate of 6 percent. It then enters into a swap with DB in which DB will make payments to TGT in U.S. dollars at a fixed rate of 5.5 percent and TGT will make payments to DB in euros at a fixed rate of 4.9 percent 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. 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.
Thus, the swap is composed of the following transactions: 15 September:
DB pays TGT €9 million TGT pays DB $10 million
Each 15 March and 15 September for five years: DB pays TGT O.O55(180/36O)$lO million = $275,000
TGT pays DB 0.049(180/360) €9 million = €220,500 15 September five years after initiation:
DB pays TGT $10 million TGT pays DB €9 million
Note that we have simplified the interest calculations a little. In this example, we calculated semiannual interest using the fraction 1801360. Some parties might choose to use the exact day count in the six-month period divided by 365 days. LIBOR and Euribor transactions, the predominant rates used in interest rate swaps, nearly always use 360 days.
Note that the Target-Deutsche Bank 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. Note that 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 bonds they have issued. We emphasize that the Target-Deutsche Bank transaction looks like what we have just described. In fact, 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.
It takes the dollars and passes them through to DB, which gives TGT the €9 million it needs. On the interest payment dates, the swap generates $275,000 of the $300,000 in interest TGT needs to pay its bondholders (Panel B). 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. At the end of the transaction, TGT receives $10 million back from DB and passes it through to its bondholders (Panel C ) .TGT pays DB f9 million, thus effectively paying off a euro-denominated bond.

The structure of global swap markets

admin — Fri, 13 Nov 2009 17:05:17 +0000

The global swaps market is much like the global forward and over-the-counter options markets. It is made up of dealers, which are banks and investment banking firms. These dealers make markets in swaps, quoting bid and ask prices and rates, thereby offering to take either side of a swap transaction. Upon taking a position in a swap, the dealer generally offsets the risk by making transactions in other markets. The counterparties to swaps are either end users or other dealers. The end users are often corporations with risk management problems that can be solved by engaging in a swap-a corporation or other end user is usually exposed to or needs an exposure to some type of risk that arises from interest rates, exchange rates, stock prices, or commodity prices. The end user contacts a dealer that makes a market in swaps. The two engage in a transaction, at which point the dealer assumes some risk from the end user. The dealer then usually lays off the risk by engaging in a transaction with another party. That transaction could be something as simple as a futures contract, or it could be an over-the-counter transaction with another dealer.
Risk magazine conducts annual surveys of participants in various derivative products. One survey provides opinions of banks and investment banks that are swaps dealers. In the other survey, the respondents are end users. The results give a good idea of the major players in this market. It is interesting to note the disagreement between how dealers view themselves and how end users view them. Also, note that the rankings change, sometimes drastically, from year to year.

Termination of a swap

admin — Wed, 11 Nov 2009 16:16:17 +0000

As we noted earlier, a swap has a termination or expiration date. Sometimes, however, a party could want to terminate a swap before its formal expiration. This scenario is much like a party selling a bond before it matures or selling an exchange-traded option or futures contract before its expiration. With swaps, early termination can take place in several ways. As we mentioned briefly and will cover in more detail later, a swap has a market value that can be calculated during its life. If a party holds a swap with a market value of $125,000, for example, it can settle the swap with the counterparty by having the counter- party pay it $125,000 in cash. This payment terminates the transaction for both parties. From the opposite perspective, a party holding a swap with a negative market value can terminate the swap by paying the market value to the counterparty. Terminating a swap in this manner is possible only if the counterparties specify in advance that such a transaction can be made, or if they reach an agreement to do so without having specified in advance. In other words, this feature is not automatically available and must be agreed to by both parties.
Many swaps are terminated early by entering into a separate and offsetting swap. For example, suppose a corporation is engaged in a swap to make fixed payments of 5 percent and receive floating payments based on LIBOR, with the payments made each 15 January and 15 July. Three years remain on the swap. That corporation can offset the swap by entering into an entirely new swap in which it makes payments based on LIBOR and receives a fixed rate with the payments made each 15 January and 15 July for three years. The swap fixed rate is determined by market conditions at the time the swap is initiated. Thus, the fixed rate on the new swap is not likely to match the fixed rate on the old swap, but the effect of this transaction is simply to have the floating payments offset; the fixed payments will net out to a known amount. Hence, the risk associated with the floating rate is eliminated. The default risk, however, is not eliminated because both swaps remain in effect.
Another way to terminate a swap early is sell the swap to another counterparty. Suppose a corporation holds a swap worth $75,000. If it can obtain the counterparty’s permission, it can find another party to take over its payments. In effect, it sells the swap for $75,000 to that party. This procedure, however, is not commonly used.
A final way to terminate a swap early is by using a swaption. This instrument is an option to enter into a swap at terms that are established in advance. Thus, a party could use a swaption to enter into an offsetting swap, as described above.