4.

B Types of Swaps
Types of Swaps

1. Currency Swaps
2. Interest Rate Swaps
3. Equity Swaps
1. Currency Swaps

A swap in which each party makes interest payments to
the other in different currencies.

The U.S. retailer Target Corporation (TGT) does not have an
established presence in Europe. It has decided to begin
opening a few stores in Germany and needs 9 million to
fund construction and initial operations.

TGT would like to issue a fixed-rate euro-denominated
bond with face value of 9 million, but the company is not
very well known in Europe. European investment bankers
have given TGT a quote for such a bond. (high interst)
Deutsche Bank (DB) tells TGT that it should issue the bond in
dollars (US) and use a swap to convert it into euros.

Suppose TGT issues a 5-year US $10 million bond at a rate of 6%.
It then enter into a swap with DB in which DB will make
payments to TGT in US dollars at a fixed rate of 5.5% and TGT will
make payments to DB in euros at a fixed rate of 4.9% each 15
March and 15 September for 5 years. The payments are based on
notional principal of 10 million in dollars and 9 million in euros.
We assume the swap starts on 15 Sept of the current year.

The swap specifies that the 2 parties exchange the notional
principal at the start of the swap and at the end.

Because the payments are made in different currencies, netting is
not practical, so each party makes its respective payments
This transaction looks like:
TGT is issuing a bond with face value of 9 million and the
bond is purchased by DB (DB pays TGT 9 million)
TGT converts the 9 million to $10 million. (TGT has the
$10 million)
TGT use the $10 million to buy a dollar-denominated bond
issued by DB. (TGT pays DB $10 million)

Note: TGT having issued a bond denomination in euros,
accordingly makes interest payments to DB in euros. (TGT
pays DB 220,500)
DB, appropriately, makes interest payments in dollar
to TGT. (DB pays TGT $275,000)

In fact, neither TGT or DB actually issues a bond to each
other. They exchange only a series of cash flows that
replicated the issuance and purchase of these bonds.
TGT has effectively issued a dollar-denominated bond and
converted it to a euro-denominated bond. In all likelihood, it
can save on interest expense by funding its need for euros in
this way, because TGT is better know in the U.S. than in
Europe. It can borrow cheaper in U.S.

The swap dealer, DB, knows TGT well and also obviously has
a strong presence in Europe. Thus, DB can pass on its
advantage in euro bond market to TGT.

Had TGT issued a euro-denominated bond, it would have
assumed no credit risk.

By entering into the swap, TGT assumes a remote possibility
of DB defaulting. Thus, TGT saves a little money by assuming
some credit risk.
Some scenarios exist in which the notional principals are not
exchanged.

Suppose many years later, TGT is generating 10 million in cash
semi-annually and converting it back to dollars on 15 January and
15 July. It might then wish to lock in the conversion rate by
entering into currency swap that would require it to pay a dealer
10 million and receive a fixed amount of dollar.

If the euro fixed rate is 5%, a notional principal of 400 million
would generate a payment of 0.05(180/360)(400 million) = 10
million.

If the exchange rate is $0.85, the equivalent dollar notional
principal would be 400(0.85) = $340 million. If the dollar fixed
rate is 6%, TGT would receive 0.06(180/360)(340 million) = $10.2
million.
TGT pays DB 10 million;
TGT receives from DB $10.2 million.

TGT locked the conversion rate by entering into a
currency swap. There would be no reason to specify an
exchange of notional principal.
2. Interest Rate Swap

An interest rate swap can be created as a combination of
currency swaps. Of course, no one would create as
interest rate swap that way; it would require two
transactions.

Interest rate swaps evolved into their own market.

Interest rate swap market is much bigger than the
currency swap market.

A plain vanilla swap is simply an interest rate swap in which
one party pays a fixed rate and the other pays a floating
rate, with both sets of payments in the same currency.

Plain vanilla swap is probably the most common derivative
transaction in the global financial market.

Note: There is no need to exchange notional principals at
the beginning and at the end of an interest rate swap.

Interest payments can be and nearly always are netted. This
reduces the credit risk.

Note: There is no reason to have both sides pay a fixed rate.
The two streams of payments would be identical in this
case.
So in an interest rate swap, either one side always pays
fixed and the other side pays floating, or both sides pay
floating, but never do both sides pay fixed.

The case of both sides paying floating is called a basis swap.
LIBOR and T-bill rate.

Plain Vanilla Swap
One fixed; the other floating.
Same notional principal.

3. Equity Swaps

A swap requires at least one variable rate or price underlying
it. In an equity swap, that is the return on a stock or stock
index.

Party making the fixed-rate payment could also have to make
a variable payment based on the equity returns.

Suppose the end user pays the equity payment and receives
the fixed payment, i.e., it pays the dealer the return on the
S&P 500 index and the dealer pays the end user a fixed rate.

If S&P 500 increases, the return of S&P is positive, end user
pays that return to the dealer.
If S&P 500 decreases, the return is negative. In this case, the
end user would pay the dealer the negative return on the
S&P, which means that it would receive that return from the
dealer.

Example: If S&P decreases by 1%, the dealer would pay the
end user 1%, in addition to the fixed payment the dealer
makes in any case.

So the dealer, or in general the party receiving the equity
return, could end up making both a fixed-rate payment and
an equity payment.
The variable payment is not know until the end of the
settlement period, at which time the return on the stock
is know. In an interest rate or currency swap, the floating
interest rate is set at the beginning of the period.

The rate of return is often structured to include both the
dividends and capital gains.

(In some kinds of interest rate swaps, the total return on
a bond, which includes dividends and capital gains, is
paid. This instrument is called a total return swap and is
a common variety of a credit derivative.)
MWD Pays VAAPX
Fixed
VAAPX pays MWD
S&P 500 return
Net: VAAPX pays MWD
1,740,000 1,602,740 = $137,260
Total payment MWD to VAAPX:
3,530,000 + 1,620,548 = 5,150,548
References:

Understanding Derivatives and Risk
Management by Don M. Chance and Robert
Brooks, 2011, 8th Edition.

Derivatives and Alternative Investments by
Don M. Chance, CFA Program Curriculum,
Volume 6, 2013.