Derivatives: Valuation and Risk Management

By David A. Dubofsky; Thomas W. Miller Jr. | Go to book overview

CHAPTER 12

Using Swaps to Manage Risk
Swaps are an efficient vehicle for firms to manage the composition of many assets and liabilities. Because the value of an asset or liability is the present value of cash flows that are attributed to that asset or liability, it becomes apparent that swaps also let firms manage revenues and expenses. Swaps are preferred to forwards and futures under the following circumstances:
a. When the cash flow stream is periodic, or regularly occurring. A single risk exposure is better hedged using forwards or futures.
b. When the cash amounts are equal and occur at regular (e.g., quarterly) intervals.
c. When the user wishes to manage the entire stream of cash flows in the same way. In contrast, forwards and futures allow the risk manager to hedge a portion of some cash flows, leave others unhedged, and to hedge others completely.

In this chapter, the focus is on using swaps to manage the risk to the firm caused by an unexpected financial price change. However, swaps can be used to create value for a firm. Using interest rate swaps to reduce borrowing costs is one example of how a swap can create value for a firm.


12.1 USING INTEREST RATE SWAPS

12.1.1 Swapping to Lower Borrowing Costs

Frequently, the default risk premium on issued debt instruments is greater in the long-term, fixedrate bond market than it is in the floating-rate debt market. That is, there is a quality differential between fixed and floating borrowing. In the early days of swaps, market participants attributed the quality differential to the relatively risky, low-rated firm having a comparative advantage in the floating-rate market.1

Suppose a quality differential exists between fixed and floating borrowing. Consider the following example. The BBB Company, rated BBB by Standard & Poor's, has the opportunity to borrow either at a fixed rate of 8% or at a floating rate of LIBOR+75 basis points.2 AA Corporation, which is rated AA by Standard & Poor's, can borrow either in the long-term fixed-coupon debt market at 7% or at a floating interest rate of LIBOR+25 basis points.

The AA Corp. has an absolute advantage in both markets because it faces lower interest rates in both markets. But AA has a comparative, or relative, advantage in the fixed-rate market because it can borrow there at 100 basis points below BBB Co. In contrast, BBB has a comparative advantage in the floating-rate market because it must pay only 50 basis points more than AA in the floatingrate market. In the fixed-rate market, BBB must pay 100 basis points more than AA. The term

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