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Exotic Swaps

There is greater competition in the global derivatives market and increased demand for tools to help investors tailor their risk profiles. And this means financial engineers are coming up with more creative options, including products like exotic swaps.

Just as the financial engineers at banks all over the world have developed exotic options that have specifically tailored payoff profiles that differ from the payoff profile of plain vanilla options, these same groups have come up with new products in the swap market. Whether the evolution of these new financial products has been driven by the demand of the end-user for tools that help them tailor their risk profiles more individually or it has been guided by the incessant need for banks to create new markets, it is important to have a general overview of these instruments and how they can be used. This article will introduce some of the more common non-vanilla swaps, termed ‘exotic swaps’: the delayed start swap, collapsible swap, and the indexed principal swap. Recall that there are often many names for the same product when it is issued by different and competing financial institutions.

The Delayed Start Swap

Just as its name suggests, these exotic swaps are a regular plain vanilla swap exchanging cash flows in one index against cash flows in another index with the exception that the start date of the swap is not immediate.

Why would anyone want to use a delayed start swap? To match the swap’s cash flows with their existing cash flows.

Suppose that you are the CFO of a company that has outstanding corporate bonds with semi-annual coupon payments, payable June 30 and December 31 of every calendar year over the life of the bond. It is now April 1 and you are worried about the prospect of rates going lower. You would like to pay floating rates and receive fixed rates.

In order to keep your balance sheet as “clean” as possible, it is worthwhile to you to enter into a swap where you will receive fixed rate coupon payments on the same day that you have to make such payments on your company’s outstanding bond. Therefore, you enter into a delayed start swap.

The delayed start swap is priced using the forward swap curve.

Recall that the swap curve is the yield curve used to price interest rate swaps, reflecting both the general level of risk-free interest rates and the credit spread or swap spread in the interbank market attributable to the credit risk of default over the life of the swap.

We can determine the forward yield curve for the risk-free curve using simple arbitrage. Consider two cases of borrowing for one year. In Case A, I borrow for six months at a known rate and then I roll over my loan for another six months at the prevailing rate for six months in six months. In Case B, I borrow for one year at a fixed, known rate.

I can simulate a loan lasting six months, starting in six months by borrowing for one year and simultaneously lending for six months. The forward rate is the rate I would effectively pay for the six months loan starting in six months if I were to simulate this loan.

This is the forward rate. It is the rate at which the current yield curve tells me I can lock in borrowing or lending starting in the future for some pre-determined period of time.

The Collapsible Swap

There will be times when interest rates are uncertain. Let’s say that I want to enter into a swap but I want to have the right to back out of that swap if the trend in interest rates changes.

Again, let us say that we believe we are entering into a period of declining interest rates in which it is preferable to receive fixed rates and pay floating rates. However, let’s say that we are the CFO of a company that is highly leveraged. We cannot afford to be too wrong about this shift in trend. Therefore, we enter into a collapsible swap. If interest rates start rising, we can collapse the swap.

The collapsible swap is simply a combination of a plain vanilla swap with a swaption on that swap. A swaption is an option on the swap. In this case, the swaption gives us the right but not the obligation to enter into a swap with the same terms except that we will be paying fixed rates and receiving floating rates. The cash flows will offset and the swap will be deemed to be closed out since the swaption is with the same financial institution with whom we have contracted the swap.

The Indexed Principal Swap

Up until now, we have been focusing on interest rate swaps (and currency swaps, etc.) with a fixed notional amount. These exotic swaps, indexed principal swaps, are a variant in which the principal is not fixed for the life of the option but tied to the level of interest rates.

Consider an indexed principal swap in which we are obligated to pay fixed rates and receive floating rates and in which the size of the principal increases as interest rates decline.

This kind of indexing means that the higher principal pares our risk of lower interest rates.

Embedding options in the swap accomplishes this payoff structure for us.

By adding an option to the swap that pays us if interest rates fall below a pre-set level, we can benefit from the decline in interest rates, offsetting the swap’s reduced value should interest rates fall. This can be shown as a reduced principal on the swap.

These are just a few examples of the kinds of variations on the plain vanilla swap that financial engineers can construct by adding different products together. If you can imagine a cash flow, someone can design a product that mimics that cash flow, albeit with a price attached to it. The question is, does the value of taking on such a cash flow exceed the price that banks are willing to charge for designing these exotic swaps?

Increasingly, with transactional costs continuing to diminish in the global derivatives markets and a greater diffusion of information about such products comes greater competition and higher volumes.