8Swaps

8Swaps - SWAPS Chapter 8 Slide 8-1 Introduction to swaps...

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Slide 8-1 SWAPS Chapter 8
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Slide 8-2 Introduction to swaps Section 8.1 Definition : A swap is a contract calling for an exchange of payments, on one or more dates, determined by the difference between two prices. A single-payment swap is a cash-settled forward contract. A swap is a portfolio of forward contracts. It can be used to hedge a stream of risky cash flows. Typical situation: Company Bank Fixed payments (F) Floating payments (S)
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Slide 8-3 Agenda Pricing of swaps – Pre-paid swaps – Swap pricing and implicit lending / borrowing – The market value of a swap Commodity swaps Interest rate swaps
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Slide 8-4 A commodity swap An industrial producer, IP Inc., needs to buy 100,000 barrels of oil 1 year from today and 2 years from today. The forward prices for delivery in year 1 and year 2 are $90 and $110 per barrel. The 1-year and 2-year zero- coupon bond yields are 3% and 4.5%. IP could guarantee the cost of buying oil for the next 2 years by entering into long forward contracts for 100,000 barrels in each of the next 2 years. The PV of the cost per barrel of oil (delivered periodically) would be: $ 90 1 . 03 + $ 110 1 . 045 2 = $ 188.11
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Slide 8-5 A prepaid commodity swap Alternatively, IP Inc. could pay an oil supplier $188.11, and receive one barrel in each of the next two years. A prepaid swap is a single payment today for multiple deliveries of oil in the future. A prepaid swap is a portfolio of prepaid forwards.
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Slide 8-6 The swap rate (or swap price) With a prepaid swap, the buyer might worry about the resulting credit risk. Therefore, a better solution is to defer payments until the oil is delivered, while still fixing the total price. Credit risk notwithstanding, any payment stream with a PV of $188.11 is acceptable. A swap contract will typically specify a sequence of equal periodic payments. For example, the payment per year per barrel, x , will have to be $99.71 to satisfy the following equation: We then say that $99.71 is the 2-year swap price. $188.11 = x 1 . 03 + x 1 . 045 2
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Slide 8-7 Swaps vs. forwards t 0 t 1 t 2 time Forward solution t 0 t 1 t 2 time Swap solution Difference S 1 -90 S 2 -110 S 1 -99.71 S 1 -99.71 +9.71 -10.29 The swap buyer makes a loan to the swap seller. The interest rate on this loan is 10.29 / 9.71 – 1 = 6%. If the deal is priced fairly, then this interest rate should be equal to the implied forward interest rate. This is indeed true: since the 1-year and 2-year zero-coupon bond yields are 3% and 4.5%, 6% is the 1-year implied forward yield from year 1 to year 2!
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Slide 8-8 Implicit lending and borrowing The swap price is a weighted average of future forward prices.
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8Swaps - SWAPS Chapter 8 Slide 8-1 Introduction to swaps...

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