Chapter 7
Swaps
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Swaps
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Swaps are used as risk management tools by banks,
financial institutions, international companies, and
manufacturers.
Three major types of swaps:
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commodity
interest rates
currency
This chapter focuses on commodity and interest rate
swaps.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Swap Basics
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Swaps are the exchange between two or more parties of certain
types of cash flows.
The notional is the principal or core value.
The notional’s value is used to calculate the service payments that
will be exchanged between the two parties.
The contracting parties are called counterparties.
Bid-ask spread or pay-receive spread is what the swap dealers
receive for their services. It is the difference between the cash flow
one counterparty pays to the dealer and what dealer pays out to the
other counterparty.
(continued)
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Swap Basics (continued)
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Plain vanilla swap—basic swap
(See Figure 7-1, next slide)
Effective date—the starting date for the swap
Termination date—ending date
Maturity or tenor—the length of time between the
effective and the termination date
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Commodity Swaps
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Commodity swaps are commonly used in the energy and metals
markets for price risk management.
A plain vanilla commodity swap is based on a reference price.
Two counterparties buy and sell the actual cash commodity in the
normal market channel. The cash flow they agree to swap is based
on a reference price so that they are both swapping values based on
a common price.
The reference price is usually based on a well-known location or
index.
Figures 7-2 and 7-3 show a swap between a natural gas producer
and a large natural gas buyer.
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Agricultural Swaps
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Agriculture has not embraced swaps, therefore there are no swap
markets for the industry.
However, there are many opportunities. For example, grain elevators
have potential swapping opportunities with continuous grain users
such as feed mills or feedlots.
Tier or ladder maturity is a strategy by the swap dealer to fix
discrete production.
Two potential agricultural swaps are discussed in the text: corn
marketing operations and corn production operations.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Corn Marketing Swap
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Elevators buy grain from producers, dry it, store it, then sell it.
They constantly sell the grain into the market receiving spot
prices (Figure 7-4). They have the risk of prices dropping. The
also have the risk of prices rising, as they are constantly buying
grains.
This provides the opportunity for a swap. A swap dealer could
enter the following deal: pay the current spot price and in return
receive $2.70/bushel. The dealer would say to the feed mill: pay
$2.80/bushel and receive the current spot price.
(continued)
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Corn Marketing Swap (continued)
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The elevator has mitigated the risk of declining
prices by passing on the spot price to the dealer and
receiving $2.70 per bushel.
The swap dealer receives $2.80/bushel and pays
$2.70, thereby earning $.10 per bushel margin.
The swap would have a reference price the
counterparties would use to determine the price to
pay and receive.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Corn Production Swap
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This swap is more complicated since corn production
is a discrete operation.
The swap dealer would have to create tier or ladder
maturities for producers. This requires numerous
participants on one side of the swap. The dealer has to
build a tier or ladder of maturities that would be
attractive to a feed mill or food processor. The ladder
of maturities would mimic a large grain elevator. The
swap would then be identical to the corn marketing
swap except there is more than one participant on the
left leg.
(continued)
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Corn Production Swap (continued)
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See Figure 7-5.
This is very complex for the swap dealer, but simple
for the individual corn producer.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Final Notes on
Agricultural Swaps
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The two examples presented are representative of potential
opportunities that exist. Other swaps are possible as well.
The lack of swaps in the agricultural industry could be due
to the availability of other risk management choices.
The potential for agricultural commodity swaps is
enormous.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Interest Rate Swaps
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By far the most popular form of swaps, interest rate swaps
involve swapping the cash flows from fixed rate loans with
variable rate loans.
Fixed versus Variable Loan Swap Example:
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Two counterparties want loans, one fixed and one variable at different
rates. The dealer offers a compromise between the two counterparties
to come up with benefits for both parties.
See Figure 7-6.
This type of a deal is said to be Pareto optimal.
If counterparty A decides to hedge against the risk of the
LIBOR rate changes, they will have created a complex
derivative.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Currency Swaps
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Currency swaps generally involve the swapping of fixed rate loans
denominated in one foreign currency with another fixed rate loan in another
currency.
They almost always involve notional swaps.
The example in Table 7-1 shows a swap between a Canadian firm and a
U.S. firm.
Each firm is subject to currency rate risk for each year’s interest payment,
which could also be hedged.
One counterparty could have a fixed rate loan and the other a variable, they
could both be variable, or they could both be fixed as in Table 7-1.
The only certain gain from this example was a known currency exchange
rate for the initial and final swap of the notional principals.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
A Final Word on Swaps
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The swap market is very large and has no major
governmental oversight. Swap markets have none of
the provisions as the futures and options markets do,
thus resulting in a default risk and the need to assess
the creditworthiness of each counterparty. Traders
must carefully assess their trade partners.
On the other side of this, swaps have a measure of
privacy and can be negotiated for unique quantities,
qualities, and contract provisions.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation