Swaps and Other Derivatives

Richard R. Flavell

• Publisher: Wiley
• Year: 2012
• Print ISBN: 9780470721919
• eBook ISBN: 9780470661802
• Edition: 2
• Topic: Business
• Subtopic: Finance
• Index: Business

"Richard Flavell has a strong theoretical perspective on swaps with considerable practical experience in the actual trading of these instruments. This rare combination makes this welcome updated second edition a useful reference work for market practitioners."
—Satyajit Das, author of Swaps and Financial Derivatives Library and Traders and Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives

Fully revised and updated from the first edition, Swaps and Other Derivatives, Second Edition, provides a practical explanation of the pricing and evaluation of swaps and interest rate derivatives.

Based on the author's extensive experience in derivatives and risk management, working as a financial engineer, consultant and trainer for a wide range of institutions across the world this book discusses in detail how many of the wide range of swaps and other derivatives, such as yield curve, index amortisers, inflation-linked, cross-market, volatility, diff and quanto diffs, are priced and hedged. It also describes the modelling of interest rate curves, and the derivation of implied discount factors from both interest rate swap curves, and cross-currency adjusted curves.

There are detailed sections on the risk management of swap and option portfolios using both traditional approaches and also Value-at-Risk. Techniques are provided for the construction of dynamic and robust hedges, using ideas drawn from mathematical programming.

This second edition has expanded sections on the credit derivatives market – its mechanics, how credit default swaps may be priced and hedged, and how default probabilities may be derived from a market strip. It also prices complex swaps with embedded options, such as range accruals, Bermudan swaptions and target accrual redemption notes, by constructing detailed numerical models such as interest rate trees and LIBOR-based simulation. There is also increased discussion around the modelling of volatility smiles and surfaces.

The book is accompanied by a CD-ROM where all the models are replicated, enabling readers to implement the models in practice with the minimum of effort.

Chapter 1

Swaps and Other Derivatives

This is the second edition. Much has changed since the first was written in 2000. For the first seven years of the new century, the derivative market continued to grow at an exponential pace. From 2008, its growth reversed, albeit not by much, as the global economic recession bit. In terms of notional amount, it reduced by just over 13% in the second half of 2008, to just under USD600 trillion. Between the publication of the first edition and the writing of the second, there have been some major developments. Two in particular stand out: the growth in the credit transfer market, and the massive issuance of complex securities enabling investors to earn potentially higher returns by taking on more risks.1 Hence the requirement for a second edition, which addresses both of these topics in considerable detail.

1.1 INTRODUCTION

In the 1970s there was an active Parallel Loan market. This arose during a period of exchange controls in Europe. Imagine that there is a UK company that needs to provide its US subsidiary with $100 million. The subsidiary is not of sufficiently good credit standing to borrow the money from a US bank without paying a considerable margin. The parent however cannot borrow the dollars itself and then pass them on to its subsidiary, or provide a parent guarantee, without being subject to the exchange control regulations which may make the transaction impossible or merely extremely expensive.

The Parallel Loan market requires a friendly US company prepared to provide the dollars, and at the same time requiring sterling in the UK, perhaps for its own subsidiary. Two loans with identical maturities are created in the two countries as shown. Usually the two principals would be at the prevailing spot FX rate, and the interest levels at the market rates. Obviously credit is a major concern, which would be alleviated by a set-off clause. This clause allowed each party to off-set unpaid receipts against payments due. As the spot and interest rates moved, one party would find that their loan would be “cheap”, i.e. below the current market levels, whilst the other would find their loan “expensive”. If the parties marked the loans to market—in other words, valued the loans relative to the current market levels—then the former would have a positive value and the latter a negative one. A “topping-up” clause, similar in today’s market to a regular mark-to-market and settlement, would often be used to call for adjustments in the principals if the rates moved by more than a trigger amount.

As exchange controls were abolished, the Parallel Loan became replaced with the back-to-back Loan market whereby the two parent organisations would enter into the loans directly with each other. This simplified the transactions, and reduced the operational risks. Because these loans were deemed to be separate transactions, albeit with an off-setting clause, they appeared on both sides of the balance sheet, with a potential adverse effect on the debt/equity ratios.

The economic driving force behind back-to-back loans is an extremely important concept called “comparative advantage”. Suppose the UK company is little known in the US; it would be expensive to raise USD directly. Therefore borrowing sterling and doing a back-to-back loan with a US company (who may of course be in exactly the reverse position) is likely to be cheaper. In theory, comparative advantage cannot exist in efficient markets; in reality, markets are not efficient but are racked by varieties of distortions. Consider the simple corporate tax system: if a company is profitable, it has to pay tax; if a company is unprofitable, it doesn’t. The system is asymmetric; unprofitable companies do not receive “negative” tax (except possibly in the form of off-sets against future profits). Any asymmetry is a distortion, and it is frequently feasible to derive mechanisms to exploit it—such as the leasing industry.

Cross-currency swaps were rapidly developed from back-to-back loans in the late 1970s. In appearance they are very similar, and from an outside observer only able to see the cashflows, identical. But subtly different in that all cashflows are described as contingent sales or purchases, i.e. each sale is contingent upon the counter-sale. These transactions, being forward conditional commitments, are off-balance sheet. We have the beginning of the OTC swap market!

The structure of a generic (or vanilla) cross-currency swap is therefore:

• initial exchange of principal amounts;
• periodic exchanges of interest payments;2
• re-exchange of the principal amounts at maturity.

Notice that, if the first exchange is done at the current spot exchange rate, then it possesses no economic value and can be omitted.

Interest rate, or single-currency swaps, followed soon afterwards. Obviously exchange of principals in the same currency makes no economic sense, and hence an interest swap only consists of the single stage:

• periodic exchanges of interest payments;

where interest is calculated on different reference rates. The most common form is with one side using a variable (or floating) rate which is determined at regular intervals, and the other a fixed reference rate throughout the lifetime of the swap.

1.2 APPLICATIONS OF SWAPS

As suggested by its origins, the earliest applications of the swap market were to assist in the raising of cheap funds through the comparative advantage concept. The EIB-TVA transaction in 1996 was a classic example of this, and is described in the box below. The overall benefit to the two parties was about $3 million over a 10-year period, and therefore they were both willing to enter into the swap.

Comparative Advantage:

European Investment Bank-Tennessee Valley Authority swap

Date: September 1996

Both counterparties had the same objective: to raise cheap funds. The EIB, being an European lender, wanted deutschmarks. The TVA, all of whose revenues and costs were in USD, wanted to borrow dollars. Their funding costs (expressed as a spread over the appropriate government bond market) are shown in the matrix below:

	USD	DEM
EIB	T + 17	B + 13
TVA	T + 24	B + 17
Spread	7 bp	4 bp

Whilst both organisations were AAA, the EIB was deemed to be the slightly better credit.

If both organisations borrowed directly in their required currency, the total funding cost would be (approximately—because strictly the spreads in different currencies are not additive) 37 bp over the two bond curves.

However, the relative spread is much closer in DEM than it is in USD. This was for two reasons:

• the TVA had always borrowed USD, and hence was starting to pay the price of excess supply;
• it had never borrowed DEM, hence there was a considerable demand from European investors at a lower rate.

The total cost if the TVA borrowed DEM and the EIB borrowed USD would be only 34 bp, saving 3 bp pa.

The end result:

• EIB issued a 10-year $1 billion bond;
• TVA issued a 10-year DM1.5 billion bond; and
• they swapped the proceeds to raise cheaper funding, saving roughly $3 million over the 10 years.

This was a real exercise in Comparative Advantage; neither party wanted the currency of their bond issues, but it was cheaper to issue and the...

Table of contents

• Cover
• Half Title page
• Title page
• Copyright page
• Preface
• Worksheets
• Abbreviations
• Dedication
• Chapter 1: Swaps and Other Derivatives
• Chapter 2: Short-Term Interest Rate Swaps
• Chapter 3: Generic Interest Rate Swaps
• Chapter 4: The Pricing and Valuation of Non-Generic Swaps
• Chapter 5: Asset Packaging
• Chapter 6: Credit Derivatives
• Chapter 7: More Complex Swaps
• Chapter 8: Cross-Market and Other Market Swaps
• Chapter 9: Cross-Currency Swaps
• Chapter 10: OTC Options
• Chapter 11: Swapping Structured Products
• Chapter 12: Traditional Market Risk Management
• Chapter 13: Value-at-Risk
• Index