©david dubofsky and 12-1 thomas w. miller, jr. chapter 12 using swaps to manage risk swaps can be...

©David Dubofsky and 12-1 Thomas W. Miller, Jr.

Chapter 12Using Swaps to Manage Risk

• Swaps can be used to lower borrowing costs and generate higher investment returns.

• Swaps can be used to transform floating rate assets into fixed rate assets, and vice versa.

• Swaps can transform floating rate liabilities into fixed rate liabilities, and vice versa.

• Swaps can transform the currency behind any asset or liability into a different currency.

©David Dubofsky and 12-2 Thomas W. Miller, Jr.

Swapping to Lower Borrowing Costs, I.

• Two firms can enter into a plain vanilla swap to exploit their comparative advantages regarding quality spread differentials.

• For example:– Firm B is a low-rated, risky, firm. It can borrow at a fixed rate of

8%, or at a floating rate of LIBOR + 75bp. – Potential counter-party, Firm A, can borrow at a fixed rate of 7%,

or at a floating rate of LIBOR +25bp.

©David Dubofsky and 12-3 Thomas W. Miller, Jr.

Swapping to Lower Borrowing Costs, II.

• Suppose Firm B wishes to borrow at a fixed rate, and Firm A wishes to borrow at a variable rate.

• Although B faces higher rates in both markets, it has a comparative advantage in the floating rate market.– It is paying only 50bp more in the floating rate market, but it

must pay 100bp more in the fixed rate market.

• Firm A has a comparative advantage in the fixed rate market because– Firm A is paying 100 bp less there, compared to 50 bp less

in the floating rate market.

©David Dubofsky and 12-4 Thomas W. Miller, Jr.

Swapping to Lower Borrowing Costs, III.

Capital Market

pays floatingLIBOR + 75bp

Firm B Firm A

Fixed at 7.1%

Floating at LIBOR

THE SWAP

borrowsNP at afixed rate

pays fixedrate of 7%

borrowsNP at a variablerate

Net result: Firm B has borrowed at a fixed rate of 7.85%, and Firm A has borrowed at a floating rate equal to LIBOR - 10bp. Both counter-parties to this swap have lowered their interest expense by swapping.

©David Dubofsky and 12-5 Thomas W. Miller, Jr.

Swapping to Lower Borrowing Costs, IV.

• The gains to these types of swaps (that lower borrowing costs) have diminished in recent years, but judging from surveys on derivatives usage, the gains still exist.

• These swaps are done with swap dealers (intermediaries); firms don’t do them between themselves.

Firm

B

Swap Dealer

Firm

A

7.12% fixed 7.08% fixed

Floating LIBOR

Floating LIBOR

©David Dubofsky and 12-6 Thomas W. Miller, Jr.

Using a Swap to Transform Liabilities:Party A is hedging against rising interest rates;

Party B will then benefit from falling interest rates

BLIBOR

5%

6%

LIBOR

A

‘B’ has an existing fixed rate loan

‘A’ has an existing floating rate loan

The Swap

The result (with the swap) is that A will be paying 5% fixed. B will be paying LIBOR + 100 bp.

©David Dubofsky and 12-7 Thomas W. Miller, Jr.

Using a Swap to Transform Assets:Party A is locking in a fixed rate of return;

Party B will benefit from rising interest rates

BLIBOR

5%

6%

LIBOR

A

‘B’ owns an existing fixed coupon bond

‘A’ owns an existing floating rate bond

The Swap

The result (with the swap) is that A will be receiving 5% fixed. B will be receiving LIBOR + 100 bp.

©David Dubofsky and 12-8 Thomas W. Miller, Jr.

Using a Currency Swap to Hedge Against an increase in the Price of a Foreign Currency

• Transform a liability in one currency into a liability in another currency.

• Transform an expense (cost) in one currency into a another currency.

¥

¥

$

Before the swap, this U.S. firm loses if the $/ ¥ exchange rate rises.

©David Dubofsky and 12-9 Thomas W. Miller, Jr.

Using a Currency Swap to Hedge Against a Decrease in the Price of a Foreign Currency

• Transform an investment in one currency into an asset in another currency.

• Transform a revenue in one currency into a another currency.

€

$

€ Before the swap, this U.S. firm loses if the $/€ exchange rate falls.

©David Dubofsky and 12-10 Thomas W. Miller, Jr.

Comparative Advantage for Currency Swaps

• Two firms can enter into a currency swap to exploit their comparative advantages regarding borrowing in different countries.

• That is, suppose:– Firm B can borrow in $ at 8.0%, or in € at 6.0%. – Firm A can borrow in $ at 6.5% or in € at 5.2%.

• If A wants to borrow €, and B wants to borrow $, then they may be able to save on their borrowing costs if each borrows in the market in which they have a comparative advantage, and then swapping into their preferred currencies for their liabilities.

©David Dubofsky and 12-11 Thomas W. Miller, Jr.

Using Commodity Swaps: Examples

• An airline wants to lock in the price it pays for ‘x’ gallons of jet fuel per quarter.– In each of the next N years, the airline will agree to pay a

fixed price and receive the floating price.

• A gold producer wants to lock in the price it receives for ‘z’ oz. of gold each month.– In each of the next M years, the gold producer will agree to

pay a floating price and receive a fixed price.

©David Dubofsky and 12-12 Thomas W. Miller, Jr.

Using Equity Swaps: Examples

• A bearish portfolio manager might agree to pay, each month, the monthly rate of return on a portfolio of stocks, and receive a floating rate of return linked to LIBOR (divided by 12), receive a fixed payment.

• Note if the portfolio of stocks declines in value, the portfolio manager actually receives two cash flows!