Chapter 7 Swaps 2007 Thomson Delmar Learning a

Chapter 7 Swaps © 2007 Thomson Delmar Learning, a part of the Thomson Corporation

Swaps n n Swaps are used as risk management tools by banks, financial institutions, international companies, and manufacturers. Three major types of swaps: – – – n 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 n n n 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) © 2007 Thomson Delmar Learning, a part of the Thomson Corporation

Swap Basics (continued) n n 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 n n n 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. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation

Agricultural Swaps n n 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 n n 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) © 2007 Thomson Delmar Learning, a part of the Thomson Corporation

Corn Marketing Swap (continued) n n n 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 n n 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) © 2007 Thomson Delmar Learning, a part of the Thomson Corporation

Corn Production Swap (continued) n n 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 n n n 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 n n 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: – – – n 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 n n n 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 n n 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