swaps
swaps are a primary element in the derivatives markets, and one of the most active financial sector (represents 61% of the OTC market in 2001).
swaps are OTC instruments which means they traded in context other than a formal exchanges so it's falls under the forward contracts, in fact we can consider swaps as a series of forward contracts due to the substantial similarity between their characteristics as we will below.
Before we cross to the characteristics, let's take a look to the definition of swaps: swaps are contract between two parties to exchange a series of cash flows based on notional principles at a specified dates.
Characteristics:
1- as mentioned the swaps are an OTC instruments.
2- at initiation neither party pays any amount to other, so swap has a zero value at the start. except currency swap which the parties exchange amounts denominated in two different currencies but equal in value.
3- with different titles but same concept, swaps has a two important dates as all derivatives instruments, the first one is a settlement date which refer to each date the parties exchange the payments, the time between two settlement dates call as a settlement period, the second date is the termination period and it's refer to the date of final payment between the parties.
4- the payment between the parties is based on net owed amount, for example if I owes you $10 and you owes me $8, simply I will pay you $2, also this point is excluded from currency swap.
of course as all OTC instruments, swaps subject to the default risk, the risk of the counterparty fault to pay the his obligation, that's why before entering to any contract swap, one must to make a enough analysis to assess the credit quality of the counterparty.
Types of Swap:
there are various types of swap, but the most important are
1-currency swap
2-interest rates swap
3-equity swap
Currency Swap:
remember the two swap characteristics which are excluded from the currency swap 1- no notional principle exchange at initiation, 2- the payment make based on netting.
the general definition of the swap currency is: exchange of interest payments between two parties in different currencies.
for example if Apple corporation seeks to expands it's operations in Europe and need a € 1 million, Apple has a three choices as follows:
1- issue a fixed-rate euro denominated bond: which is required a well knowledge in a European bonds market (suppose Apple lacks this feature)
2-borrowing a €1 million from a bank at floating rate which subject apple to the risk of interest rates increases. for sure Apple will not prefer this type of finance.
3- is to issue a fixed-rate dollar denominated bond and swap it with a fixed-rate euro denominated bond, which represents a perfect solution for Apple in this scenario, please remember that even the both bonds denominated in the different currencies, but the bonds value are equal
to progress in the third solution, simply apple send to the best credit quality European financial brokers or investment banks, ask them to quote such bond, suppose that Apple chose ABC investment bank for their good offer to make the transaction with.
suppose Apple issues a 3 years $1.5 million bond at rate of 5.5% semiannually, then enters into a swap with ABC which issues a €1 million at a rate of 4.9% semiannually (note that the $1.5 million and €1 million are equal in value if the exchange rate $1=€0.667).
now Apple will exchanges it's dollar denominated bond at rate 5.5% with the ABC's euro denominated bond at rate of 4.9%, so apple will pay the principle amount of it's bond to the ABC, and receive the principle amount of the ABC's bond, practically this operation equal to Apple has issued euro denominated bond at 4.9% interest rate and this bond purchased by ABC which will receive semiannually interest payments in euro, and the same for ABC prospective.
now lets continue our example to discover how this transaction will running during the life of transaction and how it will be terminated.
suppose the settlements dates (the dates of payments occurrence) are 1st of June and 1st of December of each 3 years.
at the initiation (1st June 2012), Apple will pay $1.5 million to the ABC, and ABC will pay €1 million to the Apple.
at the 2nd settlement date (1st Dec 2012), apple will pay interest payment =
€1 million *0.049*0.49315068= €24,164.68
and ABC will pay interest payment =
$1.5 million * 0.055*0.9315068= $40,684.931
this interest payments will be the same, until the 5th settlement date
(1st June 2014), in the final interest payments (termination date 1st Dec 2014) both parties are pays the interest payment plus the bond's amount, that means the final payment of Apple = €24,164.68 + €1 million= €1,024,164.68 and for ABC= 40,684.931+ $1.5 million= $1,50,684.931.
I used the bonds here for simplicity, but actually neither Apple or ABC issued any bond, simply they exchange the amounts they need at a different denominated currencies and the interest payments at a rates and dates they agreed in advanced.
Interest Rate Swaps:
the definition of interest rate swaps are: the exchange a series of cash flows in the same currency between two parties based on a notional principle amount, one party pay at a fixed interest rate, and the other at a floating interest rate (most often LIBOR), this called as plain vanilla swap.
Characteristics:
1- as mentioned in the swaps characteristics the interest rate swaps no exchange of any payment between the parties at initiation(except the fools), because the both side will pay the same amounts in the same currency.
2- the interest payments always netted ( I owes you $10 you owes me $8, I pay you only $2).
3- interest rate swaps one party pay fixed rate, while the other party pay floating, or both pay floating (different rates)m but never both pays fixed rates.
4-the floating rate always determined at the beginning of the settlement period, which means the floating payer know the amount will pay only if the new settlement period has started.
note: always remember that the floating interest rates will be made based on 30 days in month and 360 days in year, and for the fixed interest rates 30 days in month 365 days in year.
let's take an example on interest rate swaps
suppose that on 1st Jan 2012 Apple borrowed $1 million from ABC bank, at a LIBOR + 25 points on a quarterly basis on the 1st March, 1st June, 1st September and 1st December at the end of the year Apple will return the principle amount they borrowed.
Apple fears from the increasing in LIBOR rate, and prefer to pay a fixed rate, so the management call for their broker XYZ ask him to make an interest rate swap, the broker quote the transaction and give Apple a fixed rate of 5.8% on the same settlement dates of the loan payment.
suppose the current LIBOR is 6.1% , so the first payment which apple make to the XYZ = $1 million * 0.058* 0.24657s= $14,301.35 and this amount is constant during the swap's life, and the amount will pay to the Apple = $1 million*0.061*0.25= $15,250 and this amount is flactuates in respones to the LIBOR, we can note that XYZ is owes the greater amount, and the difference between the two amounts = $948.65 this amount will pay by the XYZ to the Apple.
we cant determine the next payments of the XYZ before we reach to the end of the next settlement period.
now apple is pay a fixed rate of 5.8% and receive the LIBOR rate, also Apple pay a 0.25 of LIBOR to the ABC bank, so the total interest rate Apple pays = 5.8% + 0.25%= 6.5%.
Equity Swaps
equity swaps are same the other types there's a party pay at a fixed rate while the other party pays at floating rate, but instead of a interest rates, the floating payer pays based on the return on stock or stock index (S&P500, NASDAQ indices).
There's a two points distinguishes equity swap than the currency and interest rate swaps.
First one is the fixed payer could also pay a variable amount, when the equity return of the index declined, suppose Apple enters into equity swap with XYZ broker, Apple promised to pay the return on the NASDAQ while XYZ promised to pay a fixed rate of 8% and the specified notional principle amount is $1 million, if the current return on the NASDAQ is 1287.23, after few days it became 1280.00, payments make on a quarterly basis.
It's obvious that the return is negative by 3197/3287.23-1= -0.02744, now the XYZ must to pay the fixed payment which = $1 million*0.08*0.24657= $19,725.6 + $1 million (-0.02744)= $47,165.6.
If the current return on NASDAQ is 3237 and became 3350, the return is positive and apple must to pay 3350.23/3237-1* $1 million = $34,908.86 (this payment will be paid by Apple to XYZ).
XYZ will pay $1 million *0.08*0.24657= $19,724.6, so Apple owes the great amount, so apple must pay $34,908.86 - $19,724.6.
Yasser Almansoor
https://www.linkedin.com/pulse/swaps-definition-types-characteristics-calculations-yasser-almansoor
No comments:
Post a Comment