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Swaps

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SWAPS

 A SWAP is an agreement between two parties to exchange a series of future cash


flows.
 Mostly one party makes payments that are determined by a random outcome such
as interest rate, currency, equity return or a commodity price (variable or floating
payments).
 In some swaps both sides are floating or variable
 When a swap is initiated, neither party pays any amount to the other; therefore a
swap has zero value at the start of the contract.
 Only currency swaps do exchange equal notional amounts at the beginning of the
contract though these will be denoted in different currencies.

INTEREST RATE SWAPS

Hedging Interest Rate Risk


Example

Fixed rate- 5%

PAYS RECIEVES

MSB FFC

RECEIVES PAYS
T-Bill + 1%

Midwest Savings Bank which tends to borrow short term and lend long term in the
mortgages market has $1 million less of rate sensitive assets than it has of rate sensitive
liabilities. As interest rates rises, the increase in cost of funds (liabilities) is greater than the
interest it receives on its assets, many of which are fixed rate. This scenario results in MSB’s
net interest margin shrinking, hence its profitability. To avoid this scenario MSB will have to
convert $1 million of its fixed assets into rate sensitive, in effect making rate sensitive assets
equal to rate sensitive liabilities, thereby eliminating the gap.

A 10 year interest rate swap with $1 million notional value in which RSB pays a fixed rate of
5% to Friendly Finance Company and receives the T-Bill rate + 1% effectively converts the
1 million fixed interest asset into a variable interest asset. Now when interest rates rise, the
increase on rate sensitive income on its assets exactly matches the increase in the cost of
funds on its rate sensitive liabilities, leaving the net interest margin and profitability
unchanged.
Advantages of the RSB Interest Rate Swap
 Cost effective rearrangement of the balance Sheet
 Banks keep information advantages on its customers whom they known for a longer
period (KYC)
 Swaps can be arranged for a very long horizon compared to other instruments like
futures and options
Disadvantages
 Lack of liquidity
 Default risk
To avoid the problem of default risk and limited information on the counterparties, swaps
usually involve investment banks and commercial banks who match the parties willing to
trade.

CURRENCY SWAPS
 In a currency swap, each party makes interest payments to the other in different
currencies
 This involves exchanging of the notional amount at the beginning of the currency
 Netting off is not practical because parties are paying each other in different
currencies
Example
A US retailer Target Corporation does not have an established presence in Europe. It has
decided to begin opening a few stores in Germany and need €9 million to fund construction
and initial operations. Target would like to issue a fixed rate euro denominated bond with a
face value €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 however tells TGT
that it should issue the bond in dollars and use a swap to convert it into euros. Suppose
Target issues a five year US$10 million bond at a rate of 6%.It then enters into a swap with
Deutsche Bank in which DB will make payments to TGT in U.S. dollars at a fixed rate of 5.5%
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 principle of 10
million in dollars and 9 million in euros .Assume the swap start on 15 September of the
current year. The swap specifies that the two parties exchange the notional principle at the
start of the contract.
Cash flows
15 September
 DB will pay TGT €9 million
 TGT pays DB $10 million
Each 15 March and 15 September for five years
 DB pays TGT 0.055(180/360)10 000 000 = $275,000
 TGT pays DB pays DB 0.049 (180/360)9 000 000 = €220 500
After 5 years, 15 September
 DB pays TGT $10 million
 TGT pays DB €9 million
N/B Interest calculations have been simplified by calculating semiannual interest payments
using a fraction of 180/360.In some instances actual days can be used then divided by 365

This transaction looks like TGT issued a €9 million bond then it was bought by DB ,then TGT
converts the €9 million to $10 million and buys a dollar denominated bond issued by DB.As
such TGT will pay interest in euros to DB while DB make dollar denominated interest to TGT
$10 million
DB
TGT
€9 million
10 million

Target has €9 million to start expansion

TGT Bondholders

€220.500 DB
TGT
$275 000

$300 000 Net effect: Target’s interest payments consists of €220 500 and $25 000
6%
TGT Bondholders
After 5 years

$10 million
TGT DB

€9 million
$10 million

Target pays off its bond holders and terminates its swap

TGT Bondholders

Termination of a SWAP
 By entering into a directly opposite swap
 Selling to another counterparty
 Use a swaption to enter into an offsetting swap
Option Trading Strategies

Long Call
This is utilized when the investor is bullish about the market. It mainly involves buying a call
option on a particular security. The investor benefits when security prices are going up in the
market

Risk limited to the Premium. (Maximum loss if market expires at or below the option strike price).

Reward is unlimited

Breakeven Point = Strike Price + Premium

Example

Mr. XYZ is bullish on Nifty on 24th June, when the Nifty is at 4191.10. He buys a call option with
a strike price of Rs. 4600 at a premium of Rs. 36.35, expiring on 31st July. If the Nifty goes above
4636.35, Mr. XYZ will make a net profit (after deducting the premium) on exercising the option.
In case the Nifty stays at or falls below 4600, he can forego the option (it will expire worthless)
with a maximum loss of the premium.

On expiry, Nifty closes at Net payoff

4100.00 -36.35
4300.00 -36.35
4500.00 -36.35
4636.35 0
4700.00 63.65
4900.00 263.65
5100.00 463.65
5300.00 663.65

The option increases in value as the price of the underlying increase. As long as the price is below
the strike price plus the premium, the investor will not exercise the option hence loosing the
premium paid. Payoff is equal to ST –(K+P) = 4700 – (4600 +36.35) = 63.65.

Long Put

When an investor is bearish, he can buy a Put option. A put option gives the buyer of the put the
right to sell the stock at a pre specified price there by limiting his risk.

Risk is limited to the premium paid

Reward is limited

Breaking-even: K –Premium

A trader is bearish about on ZSE when it is trading at 2694.He buys a put option with strike price
$2600 at premium of $52.If the ZSE goes below 2548, the trader will make a profit on exercising
the option. If it rises above 2600, he can forgo the option.

On expiry Net Payoff

2300 248

2400 148

2500 48

2548 0

2600 -52

2700 -52

Short Call (Naked Call)


This strategy involves selling a call option with the view that security prices will fall in the future.
Selling a call gives the buyer the right to come and buy a security from you the seller of the call
option. If prices go down, the buyer of the call option will not exercise the option since it will be
profitable to buy in the market at low prices hence you pocket the premium.

Risk: Unlimited
Reward: Limited to the amount of premium
Break-even Point: Strike Price+ Premium (From the buyer’s point of view)

Example

Mr. XYZ is bearish about Nifty and expects it to fall. He sells a Call option with a strike price of
Rs. 2600 at a premium of Rs. 154, when the current Nifty is at 2694. If the Nifty stays at 2600 or
below, the Call option will not be exercised by the buyer of the Call and Mr. XYZ can retain the
entire premium of Rs.154.
Nifty closes at Net Payoff
2400 154
2500 154
2600 154
2700 54
2754 0
2800 -46
2900 -146
3000 -246

This strategy is executed by an investor who is bearish about the market. If prices continue to fall,
the buyer will not exercise the option but rather will buy the asset in the market at low price hence
the seller pockets the premium. Pay off is (K + premium -ST) = (2600+154) -2700= 54.This
strategy is very risky since the investor is selling a call option on an asset that he does not hold. If
prices continue to rise, the option buyer will exercise the option hence the option seller will be
forced to buy the asset in the market at higher prices.
Short Put

This is executed when the investor is bullish about the market. The investor is hoping to earn a
premium from the transaction if the option expires unexercised. When prices are rising the option
buyer will not exercise the option hence the seller of the option will pocket the premium.

Long Straddle

This is a volatility strategy that is used when the stock price /index is expected to show large
movement in either direction. This strategy involves buying a call as well as put on the same
stock or index for the same maturity and strike price. If the price of the stock or index
increases, the call is exercised while the put expires worthless and if the price decreases, the
put is exercised and the call expires worthless. The investor is direction neutral.

Risk: Limited to the initial premium

Reward: Unlimited

Breakeven

Upper Breakeven Point is Strike Price of Long Call +net premium paid

Lower breakeven Point is Strike Price of Long Put –Net Premium paid

Assume the JSE is now 4450.An investor enters a long straddle buy buying a May R4500 JSE
put for R85 and a May R4500 JSE call for 122.The net debit taken to enter the trade is
R207,which is also the maximum possible loss.

On expiry Net Payoff for Put Net Payoff for Call Net Payoff

3800 615 -122 493

3900 515 -122 393


4000 415 -122 293

4100 315 -122 193

4200 215 -122 93

4234 181 -122 59

4293 122 -122 0

4300 115 -122 -7

4400 15 -122 -107

4500 -85 -122 -207

4600 -85 -22 -107

4700 -85 78 -7

4707 -85 85 0

4766 -85 144 59

4800 -85 178

Covered Call

This is when an investor sells a call on an asset he owns. The investor can also buy the asset and
sell the option simultaneously. This leads to a inflow of premium to the investor. This is often
employed when an investor has short term neutral and to moderately bullish. The profit increases
as the underlying rises but gets caped when it reaches the strike price.

Risk is limited to the entire price of the underlying if it falls to zero but retains the premium
since prices the option will not be exercised against him.

Rewards are capped at the strike price plus premium received i.e (Call Strike Price-Stock
price paid) + premium received.

Breakeven point Stock price paid –premium received


Example

John bought Delta for $3850 and simultaneously sells a call option at a strike price of
$4000.John does not expect the price to go beyond $4000.John’s net outflow becomes $3850-
$80 =3770 hence reducing the cost of buying the asset. If the stock stays at or below $4000,
the call option will not get exercised and John pockets $80.

Delta closing price Net payoff

3600 -170

3700 -70

3740 -30

3770 0

3800 30

3900 130

4000 230

4100 230

4200 230

4300 230

Synthetic Long Call (Buy Stock and Buy Put)

This strategy is used by an investor who is conservatively bullish about the market. The
investor purchases a stock anticipating that the price of the stock will rise in the future.
However the investor is also worried about the downside risk of the stock hence he buy a put
option on the stock. In case the price of the stock rises you get the full benefit of the price
rise. In case the price of the stock falls, exercise the Put Option (remember Put is a right to
sell). You have capped your loss in this manner because the Put option stops your further
losses. The strategy has limited losses (put premium when prices go up) and unlimited profits
(after subtracting put premium). It’s called a synthetic call because the result looks like a Call
Buy Strategy although they are not similar.

This is used when ownership of the stock is desired while at the same time the investor about
near term downside risk.

Risk: Losses are limited to the stock price +put premium – put strike price

Breakeven point: Put Strike price +put premium +stock price –put strike price (The investor
will have to recover the cost of the put option purchase price + the stock price to break even)

Mr K is bullish about the Econet share .He buys Econet at the current price of $4000.To protect
against fall in the price of Econet he bought a put option with strike price $3900 at a premium
of $143

Hint: Net pay off = Payoff from the stock and net payoff from the put option

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