Loans and financial matters

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.

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.

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.