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<!doctype html>
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<title>Study Session 13 | Reading 32 | Swaps</title>
<meta name="description" content="Chartered Financial Analyst Level 3 study materials">
<meta name="author" content="MacLane Wilkison">
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<section>
<h1>Reading 32</h1>
<h3>Swaps</h3>
<p>
<small>Created for <a href="http://alchemistsacademy.com">Alchemists Academy</a> by <a href="http://alchemistsacademy.com/about">MacLaneWilkison</a></small>
</p>
</section>
<section>
<h2>Introduction</h2>
<p><em>Definition: A contract calling for an exchange of payments over time</em></p>
<ul>
<li>Hedges stream of risk payments</li>
<li>Prepaid vs. postpaid</li>
<li>Physical vs. financial settlement</li>
</ul>
<aside class="notes">
In simple terms, a swap is designed so that one party makes a payment to, or receives a payment from, the other depending upon a specified reference variable. As a hedge against a stream of risky pyaments, swaps act as an efficient alternative to a series of forward contracts. Prepaid and postpaid swaps expose one of the parties to significant credit risk. Thus, a preferred solution might be to defer payments until delivery is made. Physical settlement requires delivery of the physical commodity upon which the contract is based. Financial settlement provides for delivery of the difference between the swap price and spot price.
</aside>
</section>
<section>
<h2>Illustrative Swap Mechanics</h2>
<ul>
<li>Mad Cow Co. plans to purchase 10,000 heads of cattle 1 year from now and 2 years from now</li>
<li>F<sub>0,1</sub> = $100/head; F<sub>0,2</sub> = $105/head</li>
<li>1- and 2-year zero-coupon bond yields are 7% and 7.5%, respectively</li>
<li>PV = $100/1.07 + $105/1.075<sup>2</sup> = $184.318</li>
</ul>
<aside class="notes">
The present value is what it would cost to "lock in" the purchase of a head of cattle at the end of each of the next two years. Obviously, you can extend this calculation out as long as necessary depending on the terms of the swap. Paying $184 upfront in a "prepaid" swap would expose Mad Cow Co. to credit risk in the event the counterparty is unable to make delivery. Alternatively, if Mad Cow Co. entered into a "postpaid" swap the counterparty would be exposed to credit risk in the event Mad Cow Co. is unable to make full payment in two years time. To mitigate this risk, both parties might prefer to make payment and delivery concurrently.
</aside>
</section>
<section>
<h2>Illustrative Swap Mechanics (cont'd)</h2>
<ul>
<li>$184.318 = <em>x</em>/1.07 + <em>x</em>/1.075<sup>2</sup></li>
<ul>
<li><em>x</em> = $102.404</li>
</ul>
</ul>
<img src="images/32/swap-illustration-a.png" alt="swap illustration A">
<img src="images/32/swap-illustration-b.png" alt="swap illustration B">
<aside class="notes">
For simplicity's sake, let's assume that we make EQUAL payments each period
</aside>
</section>
<section>
<h2>Other Considerations</h2>
<ul>
<li>Implicit loan build into swap</li>
<li>Back-to-back/"matched book" transaction</li>
</ul>
<img src="images/32/matched-book-transaction.png" alt="matched book transaction">
<aside class="notes">
Why isn't the swap payment simply the average of the two forward prices? The reason is that there's an implicit loan built into the swap (so you're actually overpaying the first year--$102.404 vs. a forward price of $100--and underpaying the second year--$102.404 vs $105). If you just paid the average of $102.50, you'd effectively be making an interest-free loan to the counterparty. But with payment set to $102.404, you're charging them the implied forward interest rate. Typically, the counterparty is a broker or financial institution and they're going to hedge the contract, essentially acting as just a middleman and charging the bid-ask spread.
</aside>
</section>
<section>
<h2>Other Considerations</h2>
<ul>
<li>In practice, dealers will hedge position:</li>
</ul>
<img src="images/32/hedge-illustration.png" alt="hedge illustration">
<ul>
<li>PV = 2.404/1.07 + 2.596/1.075<sup>2</sup> = 0</li>
<li>Dealer will also hedge interest rate risk</li>
</ul>
<aside class="notes">
At initiation, market value of the swap is set to zero but as time passes and forward prices and interest rates change, the market value will changes as well. Additionally, as swap payments are made and received, the market value will change. Finally, dealers will also hedge interest rate risk using Eurodollar contracts or FRAs
</aside>
</section>
<section>
<h1>THE END</h1>
<h3><a href="http://alchemistsacademy.com">AlchemistsAcademy.com</a></h3>
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