DCB = Dual Currency Bond CF= Cash Flow Types of Swaps One party pays fixed IR & other pays floating IR or both parties pay floating payments.. 2.3.1 Using Swaps to Create and Manage the
Trang 1“ RISK MANAGEMENT APPLICATIONS OF SWAP STRATEGIES ”
1 INTRODUCTION
SWAP ⇒ contractual agreements that are used to exchange a series of CF over a specific period of time
Swaps involve credit risk & have zero MV at initiation
Swaps can be used to adjust the rate sensitivity of an asset or liability
DCB = Dual Currency Bond
CF= Cash Flow
Types of Swaps
One party pays fixed IR & other pays floating IR or both parties pay floating payments
Less credit risk relative to ordinary loans (interest payments are netted)
One party makes payments in one currency
& other party makes payments in another currency
Agreement in which at least one set of payments is based on the return of a stock price or stock index
One set of payment is based on the course
of a commodity price
2 STRATEGIES AND APPLICATIONS FORMANAGING INTEREST RATE RISK
Borrower will not be able to take advantage of falling IR as he/she is locked in to a synthetic fixed rate loan through swap
The NP on the swap is set equal to the face value of the loan
Duration of floating rate bond ≈ amount of time remaining until the next coupon payment
Durations of fixed rate bonds ≈ 75% of its maturity for this reading
Receive (pay) fixed swaps () the duration of an existing position
MV risk ⇒ uncertainty associated with MV of an asset or liability due to ∆ in IR
CF risk ⇒ uncertainty associated with the size of the CFs
When floating rate loan is converted to fixed rate loan CF risk & MV risk
When fixed rate loan is converted to floating rate loan CF risk & MV risk
2.1 Using Interest Rate Swaps to Convert a Floating-Rate Loan to a Fixed-Rate Loan (and Vice Versa)
Trang 2Duration is affected by maturity & frequency of the swap
Most preferred approach ⇒ use the swap with a maturity at least equal to the period during which the duration adjustment is applied
=
Where
= target market duration
= current market duration of portfolio
= market duration of a swap
2.2 Using Swaps to Adjust the Duration of a Fixed-Income Portfolio
Leverage floater ⇒ type of leveraged structured note
Coupon is a multiple of a specific market rate of interest e.g
No capital is needed ⇒ cost of buying a fixed rate bond will be financed by the proceeds from issuing the structured note
2.3.1 Using Swaps to Create and Manage the Risk of Leveraged Floating Rate Notes 2.3 Using Swaps to Create and Manage the Risk of Structured Notes
Inverse floater is another type of structured note:
To manage -ve interest payment risk (LIBOR>b), inverse floater issuers should buy an
IR cap with followings features:
Exercise rate of b
NP = FV of loan
Caplet expires on the IR reset dates of the swap
Caplet payoff = (LIBOR-X) NP
Limitation ⇒the lender would have to accept a lower rate (b) to avoid –ve IR problem
2.3.2 Using Swaps to Create and Manage the Risk of Inverse Floaters
Currency swaps ⇒ swaps used to transform a loan denominated in one currency into
a loan denominated in another currency
Principal amounts are exchanged at the beginning & end of the life of the swap
Firms use currency swap to exploit their comparative advantage in foreign borrowings
If a firm wants to issue debt in FC at a floating rate:
It could issue a fixed rate bond in domestic currency & enter into a swap with the dealer in which the firm pays floating rate in FC against fixed rate domestic currency payment by dealer
Firm could issue a domestic currency floating rate bond & enter a floating for floating swap as FC floating rate payer
3.1 Converting a Loan in One Currency into a Loan in another Currency
3 STRATEGIES AND APPLICATIONS FORMANAGING EXCHANGE RATE RISK
Trang 3Currency swaps can be used to convert the FC cash flows into domestic CF (e.g foreign subsidiary’s CF)
Credit risk is inherent in such transactions
3.2 Converting Foreign Cash Receipts into Domestic Currency
Dual currency bond ⇒ interest is paid in one currency while the principal is paid in another
Synthetic dual-currency bond = ordinary bond in domestic currency +currency swap with no principal payments
Profitable if synthetic DCB is cheaper than the actual DCB
Take a long position in synthetic bond+ short positions in actual DCB
3.3 Using Currency Swaps to Create and Manage the Risk of a Dual-Currency Bond
4 STRATEGIES AND APPLICATIONSFOR MANAGING EQUITY MARKET RISK
Equity swap ⇒ swap where one party is obligated to pay an equity index or on an individual stock in exchange for a fixed rate, floating rate or the return on another index
Equity swaps can be used to:
Make necessary portfolio adjustments
Exploit restrictions of short selling
Lower transaction costs & to avoid losses
To avoid risk associated with a concentrated position
Limitation⇒ renewal required (limited swap life)
F.I Swap V/S Equity Swaps
Total return based payment
Total return is not known until the end of settlement period
When capital gain is –ve, the overall payment will also be-ve
FI swaps ⇒ interest payment represents major portion
of total return
Equities ⇒ dividend represents small amount of capital gains
Risk Inherent in Equity & F.I Swaps
Mismatch b/w performance of portfolio & indices that are used as proxy & on which swap payments are based
If FI payments > equity receipts, the investor faces the
CF problem
In case of swapping stock return for index return, net outflow may be required if stock outperforms the index
Trang 45 STRATEGIES AND APPLICATIONSUSING SWAPTIONS
Swaption ⇒ an option to enter into a swap
() exercise rate, the more expensive the receiver (payer) Swaption
Method used to exercise a Swaption is predetermined by the parties
Types of Swaption
Allows the holder to enter into a swap as fixed rate payer
Similar to put option on a bond
Allows the holder to enter into a swap as fixed rate receiver
Similar to call option on a bond
5.1 Using an Interest Rate Swaption in Anticipation of a Future Borrowing
Swaption gives the flexibility to the buyer to enter into
a swap at an attractive rate (option is in-the-money)
5.2 Using an Interest Rate Swaption to Terminate a Swap
Terminate an existing swap by entering into an offsetting swap with a different counterparty
Terminate an existing swap by entering into an offsetting swap with the original counterparty
If IR is expected to () a borrower should use receiver (payer) Swaption to convert its pay fixed (floating) position to a pay floating (fixed) position
5.3.1 Synthetically Removing the Call from Callable Debt
Receiver swaption is similar to call option on a bond
Call option can synthetically be removed by selling receiver swaption (also called monetizing a call)
Swaption will not cancel the bond’s call features & both options will remain in place
5.3 Synthetically Removing (Adding) a Call Feature in Callable (Non-callable) Debt
5.3.2 Synthetically Adding a Call to Non-callable Debt
Call option can synthetically be added to a non-callable bond by buying a receiver swaption
When rates, issuer starts receiving interest on receiver swaption & effectively cancel out its current fixed rate obligation on a non-callable bond
An investor can:
Synthetically add a call feature in a non-callable bond by selling a receiver swaption
Remove a call feature in a callable bond by buying a receiver swaption
Trang 5Payer Swaptions (Add or Remove Put Options)
Add a put to an otherwise non-putable bond by selling a payer Swaption
Synthetically remove a put option from a putable bond
by buying a payer Swaption
Synthetically add (remove) a put in (from) a non-putable (putable) bond by buying (selling) a payer Swaption
5.4 A Note on Forward Swaps
Forward Swaps V/S Swaptions
Commitment to enter into a swap
No upfront cash required at contract initiation
Option to enter into a swap
Upfront premium is paid by the buyer to the seller