Coupon swap: transforming an asset

Figure 4: interest rate swap: transforming an asset

In the example presented in Figure 4, Company A transforms its investment in 91-day commercial paper, which is reprised every 91-days, into an 11.9% fixed rate investment. Company B does the reverse. In this example the motivation for the deal was a change in interest rate views. It will be noted that there is a mismatch in the timing of the interest payments. This does not have to be the case.

Coupon swap: comparative advantage

Table 2: Example of comparative advantage IRS

Figure 5: interest rate swap: comparative advantage

The comparative advantage motivation for a swap deal rests on the existence of a differential in borrowing rates in different markets. An example is presented in Table 2.

Company A has an absolute advantage in both markets (as a result of the credit rating difference), i.e. borrows at a lower rate in both markets. However, it will be evident that while Company B pays a higher rate than Company A in both markets, it is "penalized" to a lesser extent in the money market than in the bond market (which could be because of the lower probability of default in the short-term). On the other hand, Company A pays less in the bond market than in the money market when compared with Company B.

Thus, Company A has a comparative advantage in the bond market, while Company B has a comparative advantage in the money market.

Important assumptions have to be made in this example:

• Company A wants to borrow floating.

• Company B wants to borrow fixed.

An astute banker sees the opportunity and proposes the following deal:

• Company A borrows in the market where it has a comparative advantage in relation to Company B (bond market).

• Company B borrows in the market where it has a comparative advantage in relation to Company A (money market).

The deal is accepted and the IRS then takes place as illustrated in Figure 5.

The details of the transaction supplied in Table 3 should be apparent.

Table 3: Example of comparative advantage irs: interest payments

Company A borrows out of its preferred habitat (floating rate), but the swap synthesizes the preferred habitat, and the company benefits by 0.2%. Company B wants to borrow fixed, but borrows floating every 6 months for 3 years at 6-month JIBAR + 0.5%. It receives 6-month JIBAR, and therefore makes a loss on this leg of 0.5%. It however pays 11.3% fixed to the bank, making its total cost 11.8%, which is 0.2% lower than the fixed rate it would have paid in the bond market for its 3-year paper. The banker pockets 0.1% pa on LCC100 million for 3 years (LCC100 000 per year).

Variations on the theme

There are many variations on the main IRS theme. A few examples are:

• Basis swap: A swap where two floating rates are swapped.

• Amortizing swap: A swap with a notional value that reduces over the life of the swap in a predetermined way.

• Accreting swap (also called step-up swap): A swap in terms of which the notional amount increases in a predetermined manner during the term of the swap.

• Roller-coaster swap: A swap in terms of which the notional amount increases and decreases during the term of the swap.

• Deferred swap (also called forward start swap): A swap where the counterparties do not start exchanging interest payments until a future date.

• Extendable swap: A swap where one party has the option to extend the life of the swap beyond the term of the swap, according to predetermined conditions.

• Puttable swap: A swap where one party has the option to terminate the swap prior to maturity date, according to predetermined conditions.

• Constant maturity swap: A swap where a floating rate (for example LIBOR) is exchanged for a specific rate (for example the 10-year rate on government bonds).

• Index amortizing rate swap (also called indexed principal swap): A swap where the notional amount reduces in a way that is dependent on the level of interest rates.

• Timing-mismatched swap: A swap with a timing mismatch.