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7/27/2019 Interest Rate Swaps(Final)
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INTEREST RATE SWAPS
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AGENDA
Swaps and its evolution-
Evolution of IRS
IRS
Why IRS-
Types
Mechanism
Examples
Pros and cons IRS in India. Why failed
Future of IRS in India
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DEFINITION
A contract which involves two counter parties to exchange over an agreed
period, two streams of interest payments, each based on a different kind of
interest rate, for a particular notional amount.
Interest rate swaps are used to hedge interest rate risks .
If a treasurer s view is that the interest rates will be falling in the future, he
may convert his fixed interest liability into floating interest liability; and also
his floating rate assets into fixed rate assets. If he expects the interest rates to go
up in the future, he may do vice versa.
Since there are no movements of principal, these are off balance sheet
instruments and the capital requirements on these instruments are minimal.
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Characteristics
Contractual agreement
Over a period of time
Exchange a series of interest cash flows
Only net cash flows exchanged on the maturity date
The size of the swap is referred to as the notional amount and
is the basis for calculation
Actual principal of the swap NOT exchanged
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Types of Interest Rate Swaps
Coupon Swap
If an interest rate swap involves the swapping of a stream of payments
based on the fixed interest rate for a stream of floating interest rate, then it
is called a coupon swap.
Counter parties to the Coupon Swap:
Payer of the fixed interest stream is called the Payer in the swap.
Receiver of the fixed interest stream is called the Receiver in the Swap
Generic swapA plain vanilla swap is a generic swap. It contain the simple characteristics,
such as a constant notional principal amount, exchange of fixed against
floating interest (coupon swap), an immediate start (i.e., on the spot date).
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Asset Swap
If in an interest rate swap, one of the streams of payments being exchanged
is funded with interest received on an asset, the whole mechanism is called
the asset swap. i.e. it is an interest rate swap, which is attached to an asset.
Asset swaps are used by investors.
If an investor anticipates a change in interest rates, he can maximize
his interest inflow by swapping the fixed interest paid on the asset for
floating interest, in order to profit from an expected rise in interest
rates.
Term Swaps
A swap with an original tenor of more than two years is referred to as a
term swap.
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Basis Swap
Two streams of payments can be calculated using different floating rate
indices. These are also called as floating-against-floating swaps.
It is possible to enter into a swap with a 3-month Libor against a 6
months LIBORIt is also possible to enter into a swap with a 91-Day T-Bill Yield against a
6-Month Libor.
Counterparties to a basis swap:
In a basis swap, each counter party is described in terms of both the intereststream it pays and the interest stream it receives.
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Money Market Swaps
Swaps with an original maturity of up to two years are referred to as
Money Market swaps.
IMM swaps come under this category. The tenor of the swaps matches
exactly with the short-term interest futures in the IMM (InternationalMonetary Market- Traded in the Chicago Mercantile Exchange).
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Participants
5. Scheduled commercial banks (excluding Regional Rural Banks), primary dealers (PDs) and
all-India financial institutions (FIs) are free to undertake FRAs/IRS as a product for their own
balance sheet management or for market making. Banks/Fls/PDs can also offer these products to
corporates for hedging their (corporates) own balance sheet exposures. No specific permission
from Reserve Bank would be required to undertake FRAs/IRS. However, participants when they
start undertaking such transactions, will be required to inform Monetary Policy Department
(MPD), Reserve Bank of India and abide by such reporting requirements as prescribed by the
Reserve Bank from time to time.
6. Participants undertaking FRAs/IRS are, however, advised that before undertaking market
making activity in FRAs/IRS, they should ensure that appropriate infrastructure and risk
management systems such as ability to price the product and mark to market their positions,
monitor and limit exposures on an ongoing basis, etc., are put in place.
Types of FRAs/IRS
7. Banks/PDs/FIs can undertake different types of plain vanilla FRAs/IRS. Swaps having
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Mechanism of an Interest Rate Swap:
Example:"plain vanilla" or the "coupon swap
Counter parties:: A and B
Maturity:: 5 years
A pays to B : 6% fixed p.a.
B pays to A : 6-month LIBOR
Payment terms : semi-annualNotional Principal amount: USD 10 million
Diagram:
PARTY A PARTY B
6% Fixed
6 m LIBOR
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USES
Originally created to allow multi-national companies to evade exchange controls.
Hedging
To alter exposure to interest-rate fluctuations.
Swapping fixed-rate obligations for floating rate obligations, or vice versa.
Speculation
Used by hedge funds to change in interest rates or the relationship between them.
Arbitrage opportunities.
Insurers with long term assets and shorter term liabilities can enter a swap in whichthey pay a fixed rate and receive a floating rate
This swap provides cash inflows if interest rates rise
http://en.wikipedia.org/wiki/Exchange_controlshttp://en.wikipedia.org/wiki/Exchange_controlshttp://en.wikipedia.org/wiki/Exchange_controls7/27/2019 Interest Rate Swaps(Final)
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Risk Involved Interest Rate Risk
- Interest rates might move against the swap bank after it has only gottenhalf of a swap on the books, or if it has an unhedged position.
Basis Risk- If the floating rates of the two counterparties are not pegged to the same
index.
Tax Risk
-The risk created by potential tax events that could affect the relationshipof the swap index with the interest rate on our variable rate bonds.
Counterparty Risk-The failure of the counterparty to make required payments or otherwise
comply with the terms of the swap agreement.
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Termination Risk- The risk that there will be a mandatory termination of the swap. A termination
will almost always result in our either owing or being due to receive a terminationpayment.
Rollover Risk
- The mismatch of the maturity of the swap and the maturity of the underlyingbonds
Liquidity Risk
- The risk that liquidity is unavailable when needed for future renewals or that theprice for the liquidity is unattractive at that time.
Credit Risk
- The occurrence of an event modifying the credit quality or credit rating ofthe swap provider or its credit support provider.
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Dealing and Quotations
Trade date : The date on which the swap isentered
Effective date/ : The date on which the swapValue date becomes effective i.e. when theinterest obligations start to
accrue
Maturity date : The date on which the swap stopsaccruing interest and
terminates
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A quote of 9.75% - 10.25% against 3
month MIBOR means
One Party agrees to pay (bid) 9.75% fixed and
receives INR 3 month MIBOR.
Another Party agrees to receive (ask/offer)
10.25% fixed and pay the 3 month MIBOR
determined 3 months from today.
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Who can enter into IRS
For Rupee IRS
Banks, primary dealers and financial institutionsfor hedging & market making
Other corporate can enter only for hedging theinterest rate risk on an underlying asset/liability
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For Non-Rupee IRS
All participants are allowed to enter into thesetransactions only for the purposes of hedging
an underlying exposure.
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A Closer Look at Interest Rate Swaps
One party pays a fixed interest rate while
receiving a floating rate payment
Typical contract:
Floating rate is LIBOR (note, this has credit risk)
Settlement is quarterly
However, interest rate swaps are privately
negotiated so anything goes
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A Closer Look at Interest Rate Swaps (p.2)
Assume a quarterly settlement
At the first settlement date (in three months),the floating rate is (current) spot 3-month
LIBOR For future periods, the floating side is
determined by the future level of LIBOR
At settlement, the payment is based on thedifference of LIBOR and the fixed rate timesthe notional principal
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Interest Rate Swap
NP*Rfix NP*Rfix NP*Rfix NP*Rfix
NP*Rfloat NP*Rfloat NP*Rfloat NP*Rfloat
Cash flows for fixed rate receiver
Time
0 1 2 T-1 T
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Why Use Interest Rate Swaps?
Essentially translates a fixed cash flow into afloating cash flow (or vice versa)
Companies with interest rate exposure can
adjust their interest rate risk Insurers with long term assets and shorter
term liabilities can enter a swap in which theypay a fixed rate and receive a floating rate
This swap provides cash inflows if interest ratesrise
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Copyright Prof Kian-Guan Lim SMU 24
PRICING INTEREST RATE SWAPS
INTEREST RATE SWAPS
Trade Start (1R) 2nd Reset 3rd Reset 4th Reset Maturity
Date Date Date Date Date Date
Notional principal = amount on which interest is computedCash settlement = payment of loss by one counterparty to the other
Start Date = date on which the first floating rate is set (usually the Trade Date or Contract Date except for forward
start IRS)
Value (Effective) Date = date on which the interest rate payments start to accrue; could be start date
Reset Date = date on which the floating rate is reset (includes the first set date at start date)
Reset Frequency = number of times per year floating rate is reset e.g. quarterly or semi-annually
Reset period = 1/(reset frequency) year
Maturity Date = date when swap matures, the last day on which interest accrues for usual swap in-fine wheresettlement takes place at the end of the accruing period
Tenor* = total period in years from value date to maturity date
Front stub period = time from value date to first payment
Note:* For interest rate caps, tenor sometimes refer to the reset period, i.e. time length between two adjacent payments.
t3 #dayst2 #dayst1 #dayss #days
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Mechanism of Interest Rate SWAPS
In an interest rate swap, each counterparty
agrees to pay either a fixed or floating rate
denominated in a particular currency to the
other counterparty
The fixed or floating rate is multiplied by
a notional principle amount
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Mechanism of Interest Rate SWAPS
For example : one counterparty A pays a fixed
rate (the swap rate) to counterparty B, while
receiving a floating rate. So here
A pays fixed rate to B (A receives variable rate)
B pays variable rate to A (B receives fixed rate)
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Interest Rate SWAP between Alfa Corp.
and Strong Financial Corp.
Terms:
Fixed rate payer: Alfa Corp
Fixed rate: 5 percent, semiannualFloating rate payer: Strong Financial Corp
Floating rate: 3-month USD Libor
Notional amount: US$ 100 millionMaturity: 5 years
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Alfa Corp agrees to pay 5.0% of $100 million on a
semiannual basis to Strong Financial for the next
five years
That is, Alfa will pay 2.5% of $100 million, or $2.5
million, twice a year
Strong Financial agrees to pay 3-month Libor (as a
percent of the notional amount) on a quarterly
basis to Alfa Corp for the next five years
That is, Strong will pay the 3-month Libor rate,divided by four and multiplied by the notional
amount, four times per year
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Advantages
Asset-Liability Mismatch Correction
Opens up Diverse Avenues of Funding
Hedging Floating Rate Risks
Taking advantage of low floating rate borrowings Low Credit Risk
Decouple Funding and Duration Decisions
Can be CustomizedFlexibility in the Management of Interest
Rates Improve Funding Cost
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Interest Rate Swaps In The Indian Market According to RBIs, Mid-Term Review of Monetary and Credit Policy for
1998-99, it would facilitate introduction of Interest Rate Swaps as a step
towards liberalizing and deepening the Indian Money Markets.
Banks and Financial Institutions are permitted to make a market in IRS
without any restrictions on the size of the notional principal and the tenor
of the agreement.
Corporates are allowed to enter into IRS agreements only to hedge
underlying exposures.
Banks and financial institutions must observe capital adequacy for IRS, as
per the stipulations contained in Annexure 1. Primary dealers should follow
the norms as indicated in Annexure 2.
Benchmark rate for the floating side of the swap can be any domestic
money or debt market rate which is market determined, provided the
methodology of computing the rate was objective, transparent and mutually
acceptable to counterparties.
Majorly used Benchmarks used in the Indian MarketMIFOR, MIBOR
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Rupee Interest Rate Swaps
Swap market is now four years old
FY 03 has seen tremendous growth in volumesand outstanding contracts
Increasing volumes have led to lower bid-offerspreads for some of the price points
No of market players have increased More banks and PDs have joined the market
Corporate activity has also increased
Emerging consensus about benchmark rates OIS and MIFOR have emerged as two key swap curves
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Reasons for failure of IRS in India
Interest rate swaps Lack of credible term money benchmark
Lack of participation large players with interest rate risk - PSU Banks,
MFs and Insurance companies
Absence of cash market for floating rate products
Legality of OTC derivatives
Transparency availability of price and volume data
MTM and valuation framework
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Remedies
Measurement and management of credit risk inOTC derivative transactions
Robust mark-to-market and valuation framework
Accounting and disclosure guidelines (IAS 39)
Minimisation of taxation and regulatory arbitrageacross products and institutions
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Reasons of entering into IRS
To obtain lower cost funding
To hedge interest rate exposure
To obtain higher yielding investment assets
To create types of investment asset not otherwise obtainable To implement overall asset or liability management strategies
To take speculative positions in relation to future movements
in interest rates.