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					     Swap Derivatives:
Forward Swaps and Swaptions




                              1
                 Swap Derivatives
 Today, there are a number of nonstandard or non-generic
  swaps used by financial and non-financial corporations to
  manage their varied cash flow and asset and liability
  positions.

 Two of the most widely used non-generic swaps are the
  forward swap and options on swaps or swaptions.

 A forward swap is an agreement to enter into a swap that
  starts at a future date at an interest rate agreed upon today.

 A swaption, in turn, is a right, but not an obligation, to take
  a position on a swap at a specific swap rate.


                                                                   2
              Forward Swaps
 Like futures and farward contracts on debt
  securities, forward swaps provide borrowers and
  investors with a tool for locking in a future
  interest rate.

 As such, they can be used to manage interest rate
  risk for fixed-income positions.




                                                    3
            Hedging a Future Loan
            with a Forward Swap
Financial and non-financial institutions that
 have future borrowing obligations can lock
 in a future rate by obtaining forward
 contracts on fixed-payer swap positions.




                                                 4
              Hedging a Future Loan
    Example:
   A company wishing to lock in a rate on a 5-year, fixed-
    rate $100,000,000 loan to start two years from today,
    could enter a 2-year forward swap agreement to pay
    the fixed rate on a five-year 9%/LIBOR swap.

   At the expiration date on the forward swap, the
    company could issue $100,000,000 floating-rate debt
    at LIBOR that, when combined with the fixed position
    on the swap, would provide the company with a
    synthetic fixed rate loan paying 9% on the floating
    debt.




                                                              5
                  Hedging a Future Loan

               Instrument                Action

Issue Flexible Rate Note            Pay LIBOR        −LIBOR
Swap: Fixed-Rate Payer’s Position   Pay Fixed Rate   −9%
Swap: Fixed-Rate Payer’s Position   Receive LIBOR    +LIBOR

Synthetic Fixed Rate                Net Payment            9%




                                                                6
             Hedging a Future Loan
   Alternatively, at the forward swap’s expiration date,
    the company could sell the 5-year 9%/LIBOR swap
    underlying the forward swap contract and issue a 5-
    year fixed-rate bond.

   If the rate on 5-year fixed rate bond were higher than
    9%, for example at 10%, then the company would be
    able offset the higher interest by selling its fixed
    position on the 9%/LIBOR swap to a swap dealer for
    an amount equal to the present value of a 5-year
    annuity equal to 1% (difference in rates: 10% − 9%)
    times the NP.

                                                             7
             Hedging a Future Loan
 For example, at 10% the value of the underlying
  9%/LIBOR swap would be $3.8609 million
  using the YTM swap valuation approach:




                                                    8
              Hedging a Future Loan
   With the proceeds of $3.8609 million from closing its
    swap, the company would only need to raise $96.1391
    million (= $100 million − $3.8609 million).

   The company, though, would have to issue $96.1391
    million worth of 5-year fixed-rate bonds at the higher
    10% rate.

   This would result in semiannual interest payments of
    $4.8070 million (= (.10/2)($96.1391 million), and the
    total return based on the $100 million funds needed
    would be approximately 9%.


                                                             9
                Hedging a Future Loan
   If the rate on 5-year fixed rate loans were lower than 9%, say 8%,
    then the company would benefit from the lower fixed rate loan, but
    would lose an amount equal to the present value of a 5-year annuity
    equal to 1% (difference in rates: 8% − 9%) times the NP when it
    closed the fixed position.

   Specifically, at 8%, the value of the underlying 9%/LIBOR swap is
    −$4.055 million using the YTM approach:




                                                                     10
               Hedging a Future Loan
   The company would therefore have to pay the swap bank $4.055
    million for assuming its fixed-payer’s position.

   With a payment of $4.055 million, the company would need to raise a
    total of $104.055 million from its bond issue.

   The company, though, would be able to issue $104.055 million worth
    of 5-year fixed-rate bonds at the lower rate of 8% rate.

   Its semiannual interest payments would be $4.1622 million (=
    .08/2)($104.055 million), and its total return based on the $100
    million funds needed would be approximately 9%.




                                                                       11
           Hedging a Future Investment
   Forward swaps can also be used on the asset side to fix
    the rate on a future investment.

   Consider the case of an institutional investor planning to
    invest an expected $10 million cash inflow one year from
    now in a 3-year, high quality fixed-rate bond.

   The investor could lock in the future rate by entering a 1-
    year forward swap agreement to receive the fixed rate and
    pay the floating rate on a 3-year, 9%/LIBOR swap with a
    NP of $10 million.




                                                              12
      Hedging a Future Investment
   At the expiration date on the forward swap, the
    investor could invest the $10 million cash inflow in
    a 3-year FRN at LIBOR that, which when combined
    with the floating position on the swap, would
    provide the investor with a synthetic fixed rate-loan
    paying 9%.




                                                            13
                Hedging a Future Investment

              Instrument                    Action
Buy Flexible Rate Note                  Receive LIBOR       LIBOR
Swap: Floating-Rate Payer’s Position     Pay LIBOR          −LIBOR
Swap: Floating-Rate Payer’s Position   Receive Fixed Rate    +9%
Synthetic Fixed Rate Investment           Net Receipt        9%




                                                               14
        Hedging a Future Investment
   Instead of forming a synthetic fixed investment
    position, the investor alternatively could sell the 3-year
    9%/LIBOR swap underlying the forward swap
    contract and invest in a 3-year fixed-rate note.

   If the rate on the 3-year fixed rate note were lower than
    the 9% swap rate, then the investor would be able to
    sell his floating position at a value equal to the present
    value of an annuity equal to the $10 million NP times
    the difference between 9% and the rate on 3-year fixed
    rate bonds; this gain would offset the lower return on
    the fixed-rate bond.




                                                                 15
         Hedging a Future Investment
    Example:
   If at the forward swaps’ expiration date, the rate on 3-year,
    fixed rate bonds were at 8%, and the fixed rate on a 3-year
    par value swap were at 8%, then the investment firm
    would be able to sell its floating-payer’s position on the 3-
    year 9%/LIBOR swap underlying the forward swap
    contract to a swap bank for $262,107 (using the YTM
    approach with a discount rate of 8%):




                                                               16
       Hedging a Future Investment
   The investment firm would therefore invest $10
    million plus the $262,107 proceeds from closing its
    swap position.

   The total return based on an investment of $10
    million, though, would be approximately equal to
    9%.




                                                          17
         Hedging a Future Investment
   On the other hand, if the rate on 3-year fixed-rate
    securities were higher than 9%, the investment company
    would benefit from the higher investment rate, but
    would lose on closing its swap position.

   Example: If at the forward swap’s expiration date, the
    rate on 3-year, fixed rate bonds were at 10% and the
    fixed rate on a 3-year par value swap were at 10%, then
    the investment firm would have to pay the swap bank
    $253,785 for assuming its floating-payer’s position on
    the 3-year 9%/LIBOR swap underlying the forward
    swap contract:




                                                              18
        Hedging a Future Investment
   The investment firm would therefore invest
    $9,746,215 ($10,000,000 minus the $253,785 costs
    incurred in closing its swap) in 3-year, fixed rate
    bonds yielding 10%.

   The total return based on an investment of $10
    million funds, though, would be approximately
    equal to 9%.




                                                          19
           Other Uses of Forward Swaps
   The examples illustrate that forward swaps are like
    futures on debt securities.

   As such, they are used in many of the same ways as
    futures:
      1.   Locking in future interest rates
      2.   Speculating on future interest rate changes
      3.   Altering a balance sheet’s exposure to interest rate changes

   Different from futures, though, forward swaps can be
    customized to fit a particular investment or borrowing
    need and with the starting dates on forward swaps
    ranging anywhere from one month to several years, they
    can be applied to not only short-run but also long-run
    positions.

                                                                     20
                        Swaptions
   One of the most innovative non-generic swaps is the
    swap option or simply swaption.

   As the name suggests, a swaption is an option on a swap.

   The purchaser of a swaption buys the right to start an
    interest rate swap with a specific fixed rate or exercise
    rate, and with a maturity at or during a specific time
    period in the future.

   If the holder exercises, she takes the swap position, with
    the swap seller obligated to take the opposite
    counterparty position.

   For swaptions, the underlying instrument is a forward
    swap and the option premium is the up-front fee.
                                                                 21
                        Swaptions
   The swaption can be either a receiver swaption or a
    payer swaption:

   A receiver swaption gives the holder the right to
    receive a specific fixed rate and pay the floating rate
       The right to take a floating payer’s position

   A payer swaption gives the holder the right to pay a
    specific fixed rate and receive the floating rate
       The right to take a fixed payer’s position




                                                              22
                Swaptions
 Swaptions can be either European or
 American:
 A European swaption can be exercised only at a
  specific point in time, usually just before the
  starting date on the swap.

 An American swaption is exercisable at any point
  in time during a specified period of time.




                                                     23
                      Swaptions
    Swaptions are similar to interest rate options or
     options on debt securities. They are, however, more
     varied:

    1.   They can range from options to begin a 1-year
         swap in 3 months to a 10-year option on a 8-year
         swap (sometimes referred to as a 10 x 8 swaption).

    2.   The exercise periods can vary for American
         swaptions.

    3.   Swaptions can be written on generic swaps or non-
         generic swaps.

                                                           24
                     Swaptions
 Like interest rate and debt options, swaptions
  can be used for:
      1. Speculating on interest rates

      2. Hedging debt and asset positions against market
         risk

      3. Combined with other securities to create
         synthetic positions




                                                           25
           Swaptions: Speculation
 Suppose a speculator expects the rate on high
  quality, 5-year fixed rate bonds to increase from
  their current 8% level.

 As an alternative to a short T-note futures
  position or an interest rate call, the speculator
  could buy a payer swaption.




                                                      26
            Swaptions: Speculation
   Suppose the speculator elects to buy a 1-year European
    payer swaption on a 5-year, 8%/LIBOR swap with a
    NP of $10,000,00 for 50 bp times the NP:
      1. 1 x 5 payer swaption
      2. Exercise date = 1 year
      3. Exercise rate = 8%
      4. Underlying swap = 5-year, 8%/LIBOR with NP
          = $10,000,000
      5. Swap position = fixed payer
      6. Option premium = 50 bp times NP



                                                             27
           Swaptions: Speculation
   On the exercise date, if the fixed rate on a 5-year
    swap were greater than the exercise rate of 8%, then
    the speculator would exercise her right to pay the
    fixed rate below the market rate.

   To realize the gain, she could take her 8% fixed-rate
    payer’s swap position obtained from exercising and
    sell it to another counterparty.




                                                            28
              Swaptions: Speculation
   For example, if the 5-year par value swap were trading at
    9% and swaps were valued by the YTM approach, then
    she would be able to sell her 8% swap for $395,636:




   If the swap rate at the expiration date were less than 8%,
    then the payer swaption would have no value and the
    speculator would simple let it expire, losing the premium
    she paid.


                                                             29
                 Swaptions: Speculation
   Formally, the value of the payer swaption at expiration is:




       For rates, R, on par value 5-year swaps exceeding the exercise rate of
        8%, the value of the payer swaption will be equal to the present value
        of the interest differential times the notional principal on the swap.

       For rates less than or equal to 8%, the swap is worthless.


   The next slide shows graphically and in a table the values and
    profits at expiration obtained from closing the payer swaption
    on the 5-year 8%/LIBOR swap given different rates at
    expiration.
                                                                         30
  Value and Profit at Expiration
from 8%/LIBOR Payer Swaption




                                   31
               Swaptions: Speculation
   Instead of higher rates, suppose the speculator expects
    rates on 5-year high quality bonds to be lower one year
    from now.

   In this case, her strategy would be to buy a receiver
    swaption.




                                                              32
             Swaptions: Speculation
   If she bought a receiver swaption similar in terms to
    the above payer swaption (1-year receiver option on
    a 5-year, 8%/LIBOR swap), and the swap rate on a
    5-year swap were less than 8% on the exercise date,
    then she would realize a gain from exercising and
    then either selling the floating-payer’s position or
    combining it with a fixed-payer’s position on a
    replacement swap.




                                                            33
               Swaptions: Speculation
   For example, if the fixed rate on a 5-year par value swap
    were 7%, the investor would exercise her receiver
    swaption by taking the 8% floating-rate payer’s swap and
    then sell the position to another counterparty.

   With the current swap rate at 7% she would be able to sell
    the 8% fixed-payer’s position for $415,830:




   If the swap rate were higher than 8% on the exercise date,
    then the investor would allow the receiver swaption to
    expire, losing, in turn, her premium.

                                                          34
                  Swaptions: Speculation
    Formally, the value of the 8%/LIBOR receiver swaption at expiration
    is




   For rates, R, on par value 5-year swaps less than the exercise rate of
    8%, the value of the receiver swaption will be equal to the present
    value of the interest differential times the notional principal on the
    swap.

   For rates equal to or greater than 8%, the swap is worthless.

   The next slide shows graphically and in a table the values and profits at
    expiration obtained from closing the receiver swaption on the 5-year
    8%/LIBOR swap given different rates at expiration.


                                                                        35
   Value and Profit at Expiration
from 8%/LBOR Receiver Swaption




                                    36
            Swaptions: Hedging
 Like other option hedging tools, swaptions
  give investors or borrowers protection
  against adverse interest rate movements, but
  still allow them to benefit if rates move in
  their favor.




                                                 37
              Swaptions: Hedging
 As a hedging tool, swaptions serve as a rate-
  protection tool:
    As rates increase, the value of the payer swaptions
     increases in value, making the payer swaption act as
     a cap on the rates paid on debt positions.

    As rates decrease, receiver swaptions increase in
     value, making them act as a floor on the rates earned
     from asset positions.




                                                         38
                 Swaptions: Floor
   To illustrate how receiver swaptions are used for
    establishing a floor, consider the case of a fixed-
    income investment fund that has a Treasury bond
    portfolio worth $30,000,000 in par value that is
    scheduled to mature in 2 years.

   Suppose the fund plans to reinvest the $30,000,000
    in principal for another 3 years in Treasury notes that
    are currently trading to yield 6%, but is worried that
    interest rate could be lower in two years.




                                                              39
              Swaptions: Floor

   To establish a floor on its investment, suppose the
    fund purchased a 2-year receiver swaption on a 3-
    year, 6%/LIBOR generic swap with a notional
    principal of $30,000,000 from First Bank for
    $100,000.




                                                          40
                  Swaptions: Floor
    The next slide shows:
    1. The values that the fund would obtain from closing its
       receiver swaption given different rates at the swaption’s
       expiration.

    2. The hedged total return it would obtain from reinvesting for
       3 years the $30,000,000 plus the proceeds from the swaption
       based on $30,000,000 investment and the assumption of a
       flat yield curve.




                                                                   41
Swaptions: Floor




                   42
              Swaptions: Floor
   As shown in the exhibit slide, for rates less than 6%
    the swaption values increase as rates fall, in turn,
    offsetting the lower investment rates and yielding a
    rate on the investment of approximately 6%.

   On the other hand, for rates equal or greater than 6%,
    the swaption are worthless, whereas the investment’s
    total return increases as rates increase.

   Thus, for the cost of $100,000, the receiver swaption
    provides the fund a floor with a rate of 6%.



                                                            43
                  Swaptions: Cap
   In contrast to the use of swaptions to establish a floor
    on an investment, suppose a firm had a future debt
    obligation whose rate it wanted to cap. In this case,
    the firm could purchase a payer swaption.

   To illustrate, suppose a company has a $60,000,000,
    9% fixed-rate bond obligation maturing in 3 years that
    it plans to finance by issuing new 5-year fixed-rate
    bonds.

   Suppose the company is worried that interest rates
    could increase in 3 years and as a result wants to
    establish a cap on the rate it would pay on its future 5-
    year bond issue.
                                                               44
                   Swaptions: Cap
   To cap the rate, suppose the company purchases a 3-
    year payer swaption on a 5-year, 9%/LIBOR generic
    swap with notional principal of $60,000,000 from First
    Bank for $200,000.

   The next slide shows for different rates at expiration,
    the values the company would obtain from closing its
    payer swaption and the hedged rate (based on
    $60,000,000 debt and the assumption of a flat yield
    curve) it would obtain from borrowing for five years
    the $60,000,000 minus the proceeds from the
    swaption.



                                                              45
Swaptions: Cap




                 46
               Swaptions: Cap
   As shown in the exhibit slide, for rates greater than
    9% the swaption values increase as rates increase, in
    turn, offsetting the higher borrowing rates and
    yielding a total return on the hedged bond issue of
    approximately 9%.

   On the other hand, for rates less than 9%, the
    swaption are worthless whereas the debt’s rate
    decreases as rates decrease.

   Thus, for the cost of $200,000, the payer swaption
    provides the fund a cap on it future debt with a cap
    rate of 9%.



                                                            47
                  Hedging the Risk of
                 Embedded Call Option
   Swaptions can also be used to hedge against the
    impacts that adverse interest rate changes have on
    investment and debt positions with embedded options.

   Consider a fixed-income manager holding
    $10,000,000 worth of 10-year, high quality, 8% fixed-
    rate bonds that are callable in two years at a call price
    equal to par.




                                                                48
                  Hedging the Risk of
                 Embedded Call Option
   Suppose the manager expects a decrease in rates over
    the next two years, increasing the likelihood that his
    bonds will be called and he will be forced to reinvest
    in a market with lower rates.

   To minimize his exposure to this call risk, suppose the
    manager buys a 2-year receiver swaption on an 8-year,
    8%/LIBOR swap with a NP of $10,000,000.




                                                             49
                  Hedging the Risk of
                 Embedded Call Option
   If two years later, rates were to increase, then the
    bonds would not be called and the swaption would
    have no value.

   In this case, the fixed income manager would lose the
    premium he paid for the receiver swaption.




                                                            50
                 Hedging the Risk of
                Embedded Call Option
   However, if two years later, rates on 8-year bonds were
    lower at say 6%, and the bonds were called at a call
    price equal to par, then the manager would be able to
    offset the loss from reinvesting the call proceed at
    lower interest rate by the profits from exercising the
    receiver swaption.




                                                          51
                   Hedging the Risk of
                  Embedded Put Option
   The contrasting case of a fixed-income manager
    hedging callable bonds would be the case of a financial
    manager who issued putable bonds some time ago and
    was now concerned that rates might increase in the
    future.

   If rates did increase and bondholders exercised their
    option to sell the bonds back to the issuer at a specified
    price, the issuer would have to finance the purchase by
    issuing new bonds paying higher rates.

   To hedge against this scenario, the financial manager
    could buy a payer swaption with a strike rate equal to
    the coupon rate on the putable bonds.


                                                                 52
                   Hedging the Risk of
                  Embedded Put Option
   If the current swap rate exceeded the strike rate and the
    bonds were put back to the issuer, the manager could
    exercise his payer swaption to take the fixed payer
    position at the strike rate and then sell the swap and use
    the proceeds to defray part of higher financing cost of
    buying the bonds on the put.

   On the other hand, if rates were to decrease, then the
    put option on the bond would not be exercised and the
    payer swaptions would have no value. In this case, the
    manager would lose the swaption premium.



                                                             53
                  Synthetic Positions

   With swaptions, generic swaps, and non-generic
    swaps, there are a number of synthetic asset and
    liability permutations: Callable and putable debt,
    callable and putable bonds, flexible rate securities, and
    flexible-rate debt.

   Example: A company that wants to finance a
    $50,000,000 capital expenditure with 7-year, option-
    free, 9% fixed-rate debt could issue 7-year, option-
    free, fixed-rate bonds or create a synthetic 7-year bond
    by issuing 7-year FRNs and taking a fixed-payer’s
    position on a 7-year swap.

                                                                54
                    Synthetic Positions

   With swaptions, as well as other non-generic swaps,
    there are actually several other ways in which this
    synthetic fixed-rate bond could be created.

   For example, to obtain an option-free, fixed-rate bond,
    the company could issue a callable bond and then sell a
    receiver swaption with terms similar to the bond.

   This synthetic debt position will provide a lower rate
    than the rate on a direct loan if investors underprice the
    call option on callable debt.


                                                             55
     Cancelable and Extendable Swaps

   Swaps can have clauses giving the counterparty the
    right to extend the option or to cancel the option.

   These swaps are known as cancelable and extendable
    swaps.

   Analogous to bonds with embedded call and put
    options, these swaps are equivalent to swaps with
    embedded payer swaptions and receiver swaption.




                                                          56
                Cancelable Swap
   A cancelable swap is a swap in which one of the
    counterparties has the option to terminate one or more
    payments.

   Cancelable swaps can be callable or putable.




                                                         57
                     Cancelable Swap
       A callable swap is one in which the fixed payer has
        the right to early termination.
          Thus, if rates decrease, the fixed-rate payer on the swap with
           this embedded call option to early termination can exercise
           her right to cancel the swap.


       A putable swap is one in which the floating payer has
        the right to early cancellation.
          A floating-rate payer with this option may find it
           advantageous to exercise his early-termination right when
           rates increase.




                                                                            58
               Cancelable Swap
    Note:
   If there is only one termination date, then a cancelable
    swap is equivalent to a standard swap plus a position in
    a European swaption.




                                                           59
                           Cancelable Swap
      A 5-year putable swap to receive 6% and pay LIBOR that is cancelable after
       two years is equivalent to a floating position in a 5-year 6%/LIBOR generic
       swap and a long position in a 2-year payer swaption on a 3-year 6%/LIBOR
       swap.

    5-year Putable Swap                    • A floating position in a 5-year, 6%/LIBOR
    • Pay LIBOR and receive 6%       ≡     generic swap
    fixed rate                             and
    • Cancelable after 2 years             • A long position in a 2-year payer swaption
                                           on a 3-year, 6%/LIBOR swap.


      After two years, the payer swaption gives the holder the right to take a fixed-
       payer’s position on a 3-year swap at 6% that offsets the floating position on
       the 6% generic swap.



                                                                                  60
                                 Cancelable Swap
     A 5-year callable swap to pay 6% and receive LIBOR that is cancelable after
      two years would be equivalent to a fixed position in a 5-year 6%/LIBOR generic
      swap and a long position in a 2-year receiver swaption on a 3-year 6%/LIBOR
      swap.


    5-year Callable Swap                  • A fixed position in a 5-year, 6%/LIBOR
    • Pay 6% fixed Rate and                 generic swap
    receive LIBOR                    ≡    and
    • Cancelable after 2 years            • A long position in a 2-year receiver swaption
                                            on a 3-year, 6%/LIBOR swap.

     After two years, the receiver swaption gives the holder the right to take a
      floating-payer’s position on a 3-year swap at 6% that offsets the fixed-payer’s
      position on the 6% generic swap.




                                                                                  61
                Extendable Swap
   An extendable swap is just the opposite of a
    cancelable swap.

   It is a swap that has an option to lengthen the terms of
    the original swap.

   The swap allows the holder to take advantage of
    current rates and extend the maturity of the swap.




                                                           62
               Extendable Swap
   Like cancelable swaps, extendable swaps can be
    replicated with a generic swap and a swaption.

   The floating payer with an extendable option has the
    equivalent of a floating position on a generic swap
    and a receiver swaption.

   The fixed payer with an extendable option has the
    equivalent of a fixed position on a generic swap and a
    payer swaption.



                                                           63
                           Extendable Swap
     Floating Payer Extendable Swap
    A 3-year floating payer swap to pay LIBOR and receive a 6% fixed rate that
     is extendable at maturity to two more years would be equivalent to a floating
     position in a 3-year 6%/LIBOR generic swap and a long position in a 3-year
     receiver swaption on a 2-year 6%/LIBOR.

3-Year Floating Payer Extendable Swap         • A floating payer position on a 3-year
•3-year floating-payer swap to pay            6%/LIBOR generic swap
                                         ≡    and
LIBOR and receive 6%
• Extendable after 2 years                    • A long position in a 3-year receiver
                                              swaption on a 2-year, 6%/LIBOR swap

    At the end of 3 years, the receiver swaption gives the holder the right to take
     a floating-payer’s position on a 2-year swap at 6% which in effect extends
     the maturity of the expiring floating position on the 6% generic swap.



                                                                                64
                            Extendable Swap
      Fixed Payer Extendable Swap
     A 3-year fixed payer swap to pay 6% fixed rate and receive LIBOR that is
      extendable at maturity to two more years would be equivalent to a fixed
      position in a 3-year 6%/LIBOR generic swap and a long position in a 3-year
      payer swaption on a 2-year 6%/LIBOR.
                                               • A fixed payer position on a 3-year
3-Year Fixed Payer Extendable Swap             6%/LIBOR generic swap
•3-year fixed-payer swap to pay 6% and
receive LIBOR
                                          ≡    and
                                               • A long position in a 3-year payer
• Extendable after 2 years                     swaption on a 2-year, 6%/LIBOR swap.


     At the end of 3 years, the payer swaption gives the holder the right to take a
      fixed-rate payer’s position on a 2-year swap at 6% which in effect extends
      the maturity of the expiring fixed-payer’s position on the 6% generic swap.



                                                                               65
          Cancelable and Extendable Swaps:
                 Synthetic Positions
   Because cancelable and extendable swaps are equivalent
    to generic swaps with a swaption, they can be used like
    swaptions to create synthetic positions.

   For example, the synthetic fixed-rate debt position
    formed by issuing FRNs and taking a fixed-payer’s
    position on a generic swap could also be created by:
       1. Issuing callable bonds
       2. Taking a fixed payer’s position on a generic swap
       3. Taking a floating payer’s position on a callable
           swap



                                                              66
         Cancelable and Extendable Swaps:
                Synthetic Positions
 The synthetic fixed-rate debt position also
  could be formed by:
      1. Issuing putable bonds
      2. Taking a fixed-payer’s position on a generic
         swap
      3. Taking a floating position on a putable swap




                                                        67
                 Non-Generic Swaps
   Today, there are a number of non-generic swaps used
    by financial and non-financial corporations to manage
    their varied cash flow and return-risk problems.

   non-generic swaps usually differ in terms of their rates,
    principal, or effective dates.

   For example, instead of defining swaps in terms of the
    LIBOR, some swaps use the T-bill rate or the prime
    lending rate.




                                                             68
               Non-Generic Swap
   In a total return swap, the return from one asset or
    portfolio of assets is swapped for the return on another
    asset or portfolio.

   These swaps can be used to pass credit risk onto another
    party or to achieve a more diversified portfolio.

   For example, a California bank with a relatively heavy
    proportion of loans to technology companies could enter
    into a swap with a Michigan bank with a relatively large
    proportion of loans to auto-related companies.




                                                               69
                Non-Generic Swap
   In an equity swap, one party agrees to pay the return
    on an equity index, such as the S&P 500, and the
    other party agrees to pay a floating rate (LIBOR) or
    fixed rate.

   For example, on an S&P 500/LIBOR swap, the
    equity-payer would agree to pay the 6-month rate of
    change on the S&P 500 (e.g., proportional change in
    the index between effective dates) times a NP in
    return for LIBOR times NP, and the debt payer would
    agree to pay the LIBOR in return for the S&P 500
    return.

   Equity swaps are useful to fund managers who want
    to increase or decrease the equity exposure of their
    portfolios.
                                                            70
                Non-Generic Swap
   An amortizing swap is one in which the NP decreases
    over time based on a set schedule. Amortizing swaps
    can be used by companies that have fixed-rate
    borrowing obligations with a certain prepayment
    schedule, but would like to swap them for floating
    rates.

   An accreting swap (also called set-up swap) is one in
    which the NP increases over time based on a set
    schedule. An accreting swap is useful to companies that
    plan to borrow increasing amounts at floating rates and
    want to swap them for fixed-rate funds; accreting
    swaps are particularly popular in construction
    financing.



                                                          71
               Non-Generic Swap
   Basis Swap: Both rates are floating; each party
    exchanges different floating payments: One party
    might exchange payments based on LIBOR and the
    other based on the T-bill yield.

   Delayed-Rate Set Swap allows the fixed payer to wait
    before locking in a fixed swap rate – the opposite of a
    forward swap.

   Delayed-Reset Swap: The effective date and payment
    date are the same. The cash flows at time t are
    determined by the floating rate at time t rather than
    the rate at time t −1.


                                                              72
                    Non-Generic Swaps: Summary

1.   Non-LIBOR Swap: Swaps with floating rates different than LIBOR. Example: T-
     bill rate, CP rate, or Prime Lending Rate.

2.   Delayed-Rate Set Swap allows the fixed payer to wait before locking in a fixed
     swap rate – the opposite of a forward swap.

3.   Zero-Coupon Swap: Swap in which one or both parties do not exchange
     payments until maturity on the swap.

4.   Prepaid Swap: Swap in which the future payments due are discounted to the
     present and paid at the start.

5.   Delayed-Reset Swap: The effective date and payment date are the same. The
     cash flows at time t are determined by the floating rate at time t rather than the
     rate at time t − 1.

6.   Amortizing Swaps: Swaps in which the NP decreases over time based on a set
     schedule.

                                                                                      73
                   Non-Generic Swaps: Summary


7.   Set-Up Swap or Accreting Swap: Swaps in which the NP increases over time
     based on a set schedule

8.   Index Amortizing Swap: Swap in which the NP is dependent on interest rates.

9.   Equity Swap: Swap in which one party pays the return on a stock index and the
     other pays a fixed or floating rate.

10. Basis Swap: Swaps in which both rates are floating; each party exchanges
    different floating payments: One party might exchange payments based on
    LIBOR and the other based on the T-bill yield.

11. Total Return Swap: Returns from one asset are swapped for the returns on
    another asset.

12. Non-U.S. Dollar Interest Rate Swap: interest-rate swap in a currency different
    than U.S. dollar with a floating rate often different than the LIBOR: Frankfort
    rate (FIBOR), Vienna (VIBOR), and the like.

                                                                                74

				
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