CHAPTER 5

INTRODUCTION TO SWAPS

5.1 INTEREST RATE SWAPS

5.1.1 Generic structure
Below is a typical term sheet for an interest rate swap deal.
Swap Confirmation
Date: 1 July 1998

To: Party B Inc.

From: Party A Bank

Our Ref: IRS 9871-1

We are pleased to confirm our mutually binding agreement to enter into a Rate Swap
Transaction with you in accordance to our telephone agreement with [ Mr Swapper ] on [ 1 July
1998 ], pursuant to the ISDA Master Agreement between us dated [ 10 November 1996 ].
Effective date: 3 June 1998

Termination date: 3 June 2003

Notional Amount: USD 50,000,000

Fixed Rate Payor: Party B Inc.

Floating Rate Payor: Party A Bank

Fixed Rate: 8.50% percent per annum

Day Count: 30/360

Floating Rate Index: LIBOR

Designated Maturity: six months

First Rate: 5.53% percent per annum

Day Count: Actual/360

Reset Dates: Two London business days prior to the First day of each
Party A Calculation Period, based on the rate published
by the British Bankers Association ("BBAIRS").
 Payment Dates: Each party pays on its own Period End Dates

Settlement Instructions: Normal

Party A Calculation Periods for Payments

First Period: Effective Date to but excluding 3 December 1998
(the "Period End")

Later period dates: Each 3 June and 3 December after the First Period End
Date, subject to the Modified Following Banking Day convention,
and finally the Termination Date.

Party B Calculation Period for Payments

First Period: Effective Date to but excluding 3 December 1998
(the "Period End")

Later period dates: Each 3 June and 3 December after the First Period End
Date, subject to the Modified Following Banking Day convention,
and finally the Termination Date.

Please confirm to us that the terms set forth herein accurately reflect our Transaction.

For Party A Bank,

John Smith
Settlements Manager

Definitions:

ISDA Master Agreement - most swap contracts are now drawn using the standard terms and
conditions set by ISDA, the International Swaps and Derivatives Association. The Master
Agreement is a bulky umbrella document which specifies additional terms and conditions: rights of
assignment, representations and warranties, events of late payment or default, and so on.

Effective date - the start date of the swap, when the interest on each side begins to accrue.
Generic swaps typically become effective on the spot date, so the LIBOR is fixed on the trade date,
as in a Eurocurrency deposit.

Fixed rate payor / receiver - buying or selling a swap is ambiguous because a swap is an
exchange of two cash flows. Good practice is to state who is the
fixed rate payor or receiver, which automatically implies who is the payor or receiver of the floating
rate. However, traders do use buy and sell. In this market:

- Buy means to receive the floating rate, the price of which is the fixed rate
- Sell means to pay the floating rate

The swap rate - the fixed rate of interest to be exchanged for the series of floating rates (in
this case 8.50%)
 Notional Amount - this is not an amount payable by either party. Its function is just to
convert interest rates into interest payments (see example below)
Calculation Period - the number of days between the date interest begins to accrue and the
date it becomes payable. Notice that here the day-count conventions applied to the fixed and the
floating legs of the swap are different.
Moreover, the fixed and the floating legs need not have the same Calculation Period. It is
quite common for a contract to specify that the fixed rate is payable annually, while the floating rate
is payable semi-annually. Each swap market sector uses its own distinct Calculation Periods (see
Market Quotation).
Designated Maturity Dates - the dates when the LIBOR legs of the swap become payable.
In this example these are also the Payment Dates, which is when the net settlement amounts are
payable. In this 5 year swap there are a total of ten Payment Dates.
Generic Swap
The most common type of interest rate swap (also known as: Vanilla Swap):
One party pays a fixed rate of interest
The other party pays LIBOR.
The swap starts on the spot date and matures on a single specified date
The notional is constant
The figure below illustrates the cash flows involved in this swap.

At each Designated Maturity Date the counterparties settle the net difference in amounts payable
and a new LIBOR is reset for the new Calculation Period.
5.1.2 Applications
Interest rate swaps may be used for speculation, but corporates and institutional
investors commonly use them to manage interest rate exposures.

) Example - Credit Arbitrage

Credit spreads paid by different quality of borrowers tend to be wider in the fixed rate bond
markets, which is traditionally dominated by institutional and retail investors, than that in the
floating rate market which is the domain of the commercial banks.
Differences in credit risk perceptions among investor groups open up windows of opportunity
for bond issuers, as the following example illustrates.
 Two companies need to borrow USD 50 million for 5 years. The borrowing terms available to
each company are as follows:

Can Borrow: Company A Company B Cost Difference

Fixed Rate 8.50% 10.00% 1.50%

(US Treasury +0.50%) (US Treasury+ 2.00%)

Floating Rates LIBOR + 0.25% LIBOR + 1.00% 0.75%

Required basis Floating Fixed

Without a swap, A would borrow on a floating floating basis and pay LIBOR + 0.25%, while B
would issue a bond with a 10% coupon. Instead, the two companies proceed as follows:

Company A issues a straight bond with an 8.50% coupon

Company B issues floating rate debt paying LIBOR + 1.00%
The two parties then agree to enter into a swap, for a notional of USD 50 million, on the
following terms:
- B makes fixed rate payments to A of 9.75%
- A makes floating rate payments to B of LIBOR + 1.00%

The figure below identifies all the cash flows associated with each party:

Provided all rates are calculated on the same notional amount and interest rate basis,
we can add up these rates directly. Thanks to the swap both sides have saved money:

A saves a net 0.50% per annum, paying LIBOR - 0.25% instead of LIBOR +
0.25% through a floating rate issue
 B saves 0.25%, paying 9.75% all-in instead of 10% through a fixed bond issue

The swap enables two parties to borrow in the most cost-effective way, by separating:

The interest rate basis of a loan

From the instrument in which the principal is raised

The swap allows each party to exploit its comparative advantage in a specific funding market.
Company A has an absolute funding advantage over B in both the fixed and the floating rate
markets. However, A has a comparative advantage in the fixed rate market, being able to pay 150
basis points below B, whereas in the floating market As advantage is only 75 basis points. To
exploit this opportunity:

Each party first borrows in the market and on terms in which it has a
comparative advantage

The two parties then exchange the interest rate basis of their borrowing through a swap

Nowadays it is rare for two commercial companies to enter into such a swap directly: typically
each company will deal separately with a market maker

5.1.3 Market quotation

Banks make active two-way markets in swaps. The figure below illustrates a typical
swap rates screen from a market maker or broker.

A swap quotation 5.42/47 means the market maker is willing to:

Pay 5.42% per annum fixed, against receiving LIBOR flat

Receive 5.47% per annum fixed, against payment of LIBOR flat

The swap curve: a graphical representation of swap rates for various maturities, similar to a
bond yield curve.
Market makers typically quote swap rates for fixed periods, ranging from 1 to 10 years or longer. In
the major currencies bid/offer spreads are very tight, amounting to only 3 - 5 basis points. Such
tight spreads reflect the very high liquidity of these markets.

In the US dollar sector swap rates are quoted as a spread over the yield on a Treasury bond
bond with comparable maturity. Thus, if the yield on the 3 year Treasury is 5.25% then a price
17/22 means an all-in rate of 5.42 / 5.47.

Swap spread = Swap rate - Underlying benchmark bond yield

This convention is designed to show the credit risk element in the swap rate separately from the
general cost of funding in the current market, in the same way as corporate bonds are often priced
on a yield spread over Treasuries. However, not all currencies have well-developed government
bond markets, with plenty of benchmark bonds right across the yield curve, and in most other
countries swap rates are quoted all-in, as a total rate.

The figure below illustrates how a market maker might interact with two counterparties.

Counterparty B is the same corporate as in the example in the earlier section Applications, except
they are now paying 8.75% fixed against LIBOR flat on the swap, instead of 9.75% against LIBOR
+ 1.00%. The net cost of finance to B still comes out at 9.75%, as before. For the duration of the
swap the corporate has effectively converted its borrowing into a synthetic straight bond, an
example of a liability swap.

Counterparty A is now a money market fund. This fund is invested in floating rate assets yielding
on average LIBOR + 20 basis points. The manager of the fund fears LIBOR rates might fall and has
contracted with the market maker to receive 8.70% fixed against paying LIBOR. For the duration of
the swap the fund has converted its floating rate assets into synthetic straight bonds yielding 8.90%,
all-in, an example of an asset swap.

EXERCISE

Market Conditions
Four year swap: 7.50 - 7.60%
Basis: Semi-annual, Actual/actual against 6 month LIBOR

Situation
Hybex Electrics is a highly rated company with a considerable amount of fixed rate liabilities. The
Treasurer would like to increase the percentage of floating rate debt in the companys liabilities.
There is currently a 7 5/8% USD 100 million Eurobond (annual, 30/360) outstanding with four
years to maturity.

Gartside Trust is a medium-sized fixed income fund. The manager of this fund feels strongly that
interest rates will rise and would like to take advantage of this perceived trend. The fund currently
has USD 100 million invested in fixed rate corporate US bonds yielding 8.00% (semi-annual,
30/360). The manager would like to convert this onto a LIBOR basis for a period of four years.

a. How could Hybex achieve its objectives using swaps and what swap rate would apply to them?

b. How could Gartside achieve its objectives using swaps and what swap rate would apply to
them?

ANSWER

a. Hybex should become a receiver of 7.50% fixed on a swap, against payment of LIBOR

b. Gartside should become a payer of 7.60% fixed on a swap, against receiving LIBOR.

5.2 CURRENCY SWAPS

5.2.1 Structure and applications

The currency swap is contractually similar to an interest rate swap. The only differences are:

Each interest rate is in a different currency

The notional amount is now replaced by two principal amounts - one in each currency

These principal amounts are exchanged at the start of the swap and then re-exchanged at
maturity

The currency swap is contractually similar to an interest rate swap (see Interest Rate
Swaps - Generic Structure). The only differences are:

Each interest rate is in a different currency

 The notional amount is now replaced by two principal amounts - one in each currency

These principal amounts are exchanged at the start of the swap and then re-exchanged at
maturity

Example

Situation
A German bank requires 5 year USD floating rate finance to fund its growing US loan
portfolio. It is considering two alternatives:

Continue funding in the interbank market at USD LIBOR flat

Issue a 5 year DEM Eurobond with a coupon of 5.85%

Strategy: Issue DEM bond and swap it into a floating USD basis.

Notice:
Unlike the interest rate swap, where there is no exchange of principal, in a currency swap
there is an exchange of principal amounts at the start and at the end of the contract period.

Details of the strategy are as follows:

The bond issuer receives a total of DEM 170 from the bond issue

On the Effective Date of the swap the two parties exchange principal amounts:
bond issuer hands over DEM 170 million against receipt of USD 100 million.
This is based on the spot rate of exchange of 1.7000 at the time

Every year the bond issuer receives a payment of 5.96% of DEM 170 million on the swap
and pays USD LIBOR flat on USD 100 million. At the same time the issuer pays the coupon of
5.85% on the underlying bond.

Net cash flows = - DEM 5.85 + (DEM 5.96 - USD LIBOR)

= - USD LIBOR + DEM 0.11

Through the swapped bond the issuer is able to fund at USD LIBOR minus DEM
18,700,000 (11 basis points on DEM 170 million). These D-marks may be sold forward in the fx
market, resulting in a series of fixed USD payments. Depending on the forward rates of exchange,
these will amount to a little more or a little less than 11 basis points in USD, so this alternative is
certainly cheaper than funding directly in the interbank market

At the Maturity Date of the swap the two parties re-exchange the principal amounts on the
swap: issuer receives DEM 170 against payment of USD 100.
At the same time the issuer repays the principal on its maturing DEM bond.

Sructurally, the currency swap is very similar to a parallell loan. If you are familiar with the forward
fx markets you will notice that the currency swap is also similar to a series of rolling fx swaps,
except that in the currency swap the interest rate differences are explicit, whereas in the fx swap
they are implicit in the forward rate of exchange (the "forward points").
5.2.2 Basis swaps

A basis swap involves a regular exchange of cash flows, both of which are based on floating interest
rates.

Most swaps are based on payment of a fixed rate against LIBOR. In the basis swap both legs
are calculated on floating rates. Popular basis swaps include:

USD LIBOR against US Commercial Paper rate

6 months USD LIBOR against 3 months USD LIBOR
6 month DEM LIBOR against 6 month USD LIBOR
DEM LIBOR against US Commercial Paper rate

The last two are examples of cross currency basis swaps.

Market Quotation - DEM LIBOR / USD LIBOR

... ...
4 years -3/+1
5 years -4/+1
10 years -4/+2
...

A quotation -4/+1 means that for 4 years the market maker is prepared to:

Pay DEM LIBOR - 0.04% against USD LIBOR flat

Or receive DEM LIBOR + 0.01% against USD LIBOR flat

This variety of basis swap is especially significant because it acts as a bridge between currency
swaps and the various interest rate swap markets.

5.3 EQUITY SWAPS

5.3.1 Contract Structure

The equity swap is contractually similar to an interest rate swap. The only differences are:

At least one of the legs is linked to an equity market

The notional amount may be fixed, or it may be reset in line with the equity index (floating
notional, see below)

Below are the key elements of a typical equity swap term sheet.

Equity Swap Confirmation

Date: 1 July 1998

To: XYZ Inc.

From: Big Bank N.A.

Our Ref: Equity Swap 9871-2

We are pleased to confirm our mutually binding agreement to enter into an Equity Swap
Transaction with you in accordance to our telephone agreement with [ Mr Swapper ] on [ 1 July
1998 ], pursuant to the ISDA Master Agreement between us dated [ 10 November 1996 ].

Effective date: 3 June 1998

Termination date: 3 June 2000

Notional Amount: GBP 100,000,000.00 (fixed notional)

Equity Payor: Big Bank N.A.

Floating Rate Payor: XYZ Inc.

Equity Index: FT-SE 100 plus 85% of dividends

Designated Maturity: Three months

First Index Level: 5,510.50

Reset Dates: One business days prior to the First day of each
Big Bank Calculation Period, based on the London Stock
Exchange official closing price for that day.

Floating Rate Index: LIBOR

Spread over Rate: 0.20% per annum

Designated Maturity: Three months

First Rate: 5.53% percent per annum

Day Count: Actual/365

Reset Dates: One London business days prior to the First day of Big Bank
Calculation Period, based on the rate published by the British
Bankers Association ("BBAIRS").

Payment Dates: Each party pays on its own Period End Dates

Settlement Instructions: Normal

Big Bank Calculation Periods for Payments:

First Period:
Effective Date to but excluding 3 September 1998
(the "Period End")
 Later period dates:
Each 3rd day of March, June, September and December after the First Period End
Date, subject to the Modified Following Banking Day convention, and finally the
Termination Date.

XYZ Calculation Period for Payments:

First Period:
Effective Date to but excluding 3 December 1998
(the "Period End")
Later period dates:
Each 3rd day of March, June, September and December after the First Period End
Date, subject to the Modified Following Banking Day convention, and finally the
Termination Date.

Please confirm to us that the terms set forth herein accurately reflect our
Transaction.

For Big Bank N.A.,

John Smith
Settlements Manager

Definitions:

ISDA Master Agreement - like interest rate and currency swaps, most equity swap contracts
are now drawn up under the umbrella of standard ISDA terms and conditions

Effective date - the start date, when the First Index Level is established and interest begins
to accrue

Equity payor / receiver - buying or selling a swap is very ambiguous in this context.
Standard good practice is to state which party is the equity payor or equity receiver.

Notional Amount - this is not an amount of cash payable by either party, or an amount of
equity. The notional is just used to convert interest rates and equity returns into actual cash
flows.

Some contracts specify a floating notional, where the notional amount is adjusted
periodically in line with the change in the reference equity index.

Calculation Period - the number of days between the date interest begins to accrue
and the date it becomes payable.

Designated Maturity Dates - the dates when the difference between the LIBOR leg and the
equity leg becomes payable. In this 2 year swap there are a total of 8 Designated Maturity
Dates.

Settlement Calculation - ) Example

Date: 2 September 1998 (the day before the First Designated Maturity Date)
Closing FT-SE Index level: 5,890.67
Dividends paid on GBP 100 million FT-SE
 portfolio during the First Calculation Period: GBP 650,000.00

Number of days in First Calculation Period (3 June - 3 September 1998) = 92

Big Bank is liable for total return on the FT-SE:

(5,890.67 5,510.50)
Capital gain: 100 million = GBP 6,899,010.98
5,510.50

Dividends: 0.85 x 650,000 = GBP 552,500.00

Total GBP 7,451,510.98
5.53 92
XYZ Inc. is liable for x x 100 million = GBP 1,393,863.01
100 365

Net Settlement Amount GBP 6,057,647.97

(in favour of XYZ Inc.)

On this date a new 3 month LIBOR is fixed and the closing FT-SE 100 index level of 5,890.67
becomes the starting level for the Second Calculation Period.

Outperformance does not imply a positive return: if the return on the equity index over any
Calculation Period is negative then the equity receiver loses out - just as if it had invested in cash
equities.

5.3.2 Market Quotation

The most common equity swaps exchange:

The total return on an equity price, basket or index (including dividends)

Against LIBOR plus (or minus) a fixed spread.

) Example

Equity Index Swaps

FT-SE 100 DAX 30
1 year ... ...
2 years -15/+20 -50/-40
3 years ... ...
...

A quote -15/+20 means the market maker is prepared to:

Receive Total return on FT-SE

Pay GBP LIBOR -0.15%

Pay Total return on FT-SE

Receive GBP LIBOR +0.20%

A quote of -50/-40 on the DAX means the market maker is prepared to:

Receive Total return on DAX

Pay DEM LIBOR -0.50%
 Pay Total return on DAX
Receive DEM LIBOR -0.40%

The spreads over or under LIBOR in the quotations are a reflection of the costs of hedging the
market risks on the resulting positions. They are, in effect, the prices of these swaps.
Buying or selling are ambiguous terms in this context, so market practice is to
specify which party is the equity receiver and which the equity payer.

5.3.3 Application

Equity swaps are typically used in situations where:

There are legal restrictions on foreign ownership of cash equities

There are tax disadvantages to holding/disposing of cash equities
Market liquidity in the underlying equities is limited

) Example - Synthetic Asset Allocation

Situation
A US fund manager requires exposure of GBP 100 million to UK equities for a period of one
year.
Alternatives
Purchase a portfolio of cash equities

Buy index futures (see Introduction to Futures - Index Futures - Applications)

Purchase a portfolio of money market securities yielding LIBOR + 0.30%

and overlay this with an equity index swap on the following terms:

Receive:
Total return on FT-SE 100 index,
including dividends
Pay:
3 month GBP LIBOR + 0.15%

Net cash flows to the fund:

Yield on money market portfolio
+ LIBOR + 0.30%
Equity leg of swap
+ Total return on FT-SE 100
Interest leg of swap
- LIBOR - 0.15%
Net
+ Total return on FT-SE 100 + 0.15%

With the equity swap the fund is able to outperform the return on the index by a guaranteed 15
basis points per annum - significantly better than could be achieved, net of transaction costs, by
moving into cash equities.

The equity swap may also perform better than an equivalent index futures position because the
swap does not have:
 Roll risk - the risk that the futures contract may not trade at fair value when the position is
rolled over every three months

Basis risk - the risk that the futures price may not track the cash index perfectly if interest
rates change

Daily margining requirements

EXERCISE

A client currently holds a portfolio of USD Eurobonds yielding 7.00% but wishes to swap its
exposure to German equities for two years instead. Market rates are as follows:

Interest Rate Swaps Basis Swaps Index Swaps

USD DEM USD/DEM DAX 30
...
2 years 6.77/80 6.00/05 -4/+1 -60/-50
...

What swap transactions should the client enter into, and what would be the net position for the
fund after the swaps?

ANSWER

Strategy Cash Flow

Underlying bonds + USD 7.00%

Interest rate swap - USD 6.80%

+ USD LIBOR

Basis swap + DEM LIBOR - 0.04%

- USD LIBOR

Index swap + Return on DAX

- DEM LIBOR + 0.50%

Net cash flow + Return on DAX + DEM 0.46%

+ USD 0.20%

The 20 basis points per annum left in USD may be sold for DEM in the forward fx markets.
Depending on the fx rates, this could be worth a little more or a little less than DEM 20 basis points
per annum.

The net result for the fund would be close to + Return on DAX + DEM 0.66%.