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Swaps

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Necessity is the Mother of all Invention

US-A(Parent)

UK-A(Subsidiary)

Loan

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US-A(Parent) US-B(Subsidiary)

UK-A(Subsidiary)

UK-B

(Parent)

Parent company A in US gives loan to Subsidiary Company of B in US

Parent of company B in UK gives loan to Subsidiary of company A in UK

Loan

Repayment

Repayment

Loan

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Where in my life I will use Swap???

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Interest rate.

Currency.

Commodity.

Equity.

Credit Risk.

Climatic (weather, temperature)

Where there is Risk let there be Swap

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First Leg

What is Borrower Existing Risk ?

What can Partially or CompletelyCover Borrower Risk ?

Borrower

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First Leg

Pay Fixed Rate loan installment in US$

Anyone who can partially or completelyPay borrower Fixed Rate loan installment in US$

Borrower

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Second Leg

What is Borrower Existing Risk ?

What can Partially or CompletelyCover Borrower Risk ?

Borrower

What Borrower will give in Return ?

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SecondLag

Pay Fixed Rate loan installment in US$

Pay Fixed Rate loan installment in US$

Borrower

Pay Floating Rate loan installment in US$

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Interest Rate Swap

Pay Fixed Rate loaninstallment in US$

Pay Fixed Rate loaninstallment in US$

Fixed Rate Borrower

Managed Interest Rate Risk

Pay Floating Rate loaninstallment in US$

Floating Rate

Borrower

Pay Floating Rate loanInstallment in US$

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Why this Interest Rate Swap came into existence?

Difference in opinion exists about Interest Rate Movement.

1. Fixed Rate Borrower feels: Interest Rate will Fall Why pay high fixed interest rate !

2. Floating Rate Borrower feels

Interest Rate will Rise Why pay high floating interest rate !

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Properties of Interest Rate Swap

An interest swap on a notional amount which act as if

it were the principal amount of bond.

There is no actual transfer of principal amount

An interest rate swap is transacted for a given time.

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Source of Various Fund

Floating Fixed

Commercial Paper Government Bond

Certificate of Deposits Bank Loans. T-bills

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What Profit I get from Swap

Company Fixed Floating

AAA 6.50 L+20

BBB 7.00 L+50

Consider two companies which have following credit rating and interest rate atwhich they can borrow money.

Each borrower borrows what it is relatively better at borrowing.

Hence AAA rated company will opt Fixed Rate loan (6.50) with advantage of 50basis points.

BBB rated company will opt Floating Rate loan (L+50) because it has pay 20basis points less on floating rate loan.

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What Profit I get from Swap

6.50 Fixed Rate

6.40

AAA

LIBOR

BBB

LIBOR+50

Here we are dealing between price of Bonds and Loan

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Cost of Swaps

Cost of floating-rate to AAA= 6.4-6.5-LIBOR= (LIBOR+ 10 basis points)

Cost of fixed rate debt to BBB=LIBOR-(LIBOR+50)-6.4= (6.9)

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Saving out of Swap

Company Fixed Floating

AAA 6.50 L+20

BBB 7.00 L+50

Saving of floating-rate to AAA = (LIBOR+20 basis points) - (LIBOR+ 10 basis points)= 10 basis point

Saving of fixed rate debt to BBB=7.00 (6.90)= 10 basis point

Total Saving on Interest Rate Swap to both the parties = L+50-(L+20)-[7.00-6.50]= 20 basis point

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Asset Swap

That means there is something like Liability Swap too ???

What is Asset Swap ???

Asset Swaps changes investment i.e. investment profit.

Why Asset Swap ???

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Skeleton of Asset Swap

Interest Swap

Market Maker

Fund Manager

Fixed Rate Revenue

Floating Rate Revenue

Fixed Rate Revenue

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Profit Above LIBOR in Asset Swap

Interest Swap

Market Maker

Fund Manager

LIBOR

8% p.a. 30/360

7.80% p.a.30/360

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Cost Above LIBOR in Liability Swap

6.50 Fixed Rate

6.40

AAA

LIBOR

BBB

LIBOR+50

Here we are dealing between price of Bonds and Loan

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Profit Below LIBOR in Asset Swap

Interest Swap

Market Maker

Fund Manager

LIBOR

8% p.a. 30/360

8.2% p.a. 30/360

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Cost Below LIBOR in Liability Swap

6.50 Fixed Rate

AAA

LIBOR

BBB

LIBOR+50

Here we are dealing between price of Bonds and Loan

6.70

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Banks & Swaps

What is Main Business of Bank??

If there is substantial Customer Demand for Fixed Longer Dated Maturities ???

How to satisfy their demand??

Launching Bond.

Encouraging Floating Rate Funding.

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Asset Liability Management

Balancing Assets(Loan to Customers) and Liabilities (Funding)

Examples:

Launching Bond.

Encouraging Floating Rate Funding.

Unbalancing Act

Give Long Term Loan using Short Term Source of Fund

Eg: Sanctioning 5 Year Loan (Asset) at Fixed Rate usingmoney market instrument at 3 month LIBOR (Liability)

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Advantage of Unbalancing Act

Yield Curve has Steep Slope: This shape of yield curve is foundwhen there is end of recession or beginning of economic expansion.

During this phase there is wider gap between yield of treasury bondAnd yield of Treasury Bill

That means it is cheaper to raise fund usingshort term instrument then using Long Term Instrument.

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Disadvantage of Unbalancing Act

Unbalancing is very tempting.

If short term interest rate doesn't remain low, then there can big mismatch Between Asset and Liabilities.

This problem can be solved using Swaps

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Customer

Bank

Interest Rate SwapMarket Maker

Fixed Rate

Fixed Rate

3-Month LIBOR

3-Month LIBOR

Bank & Swaps

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Benefits of Bank & Swap

Bank can no longer profit from fall in floating interest rate.

But it neither lose money with increase in rates.

Here Bank doesn't lose money because of bad prediction of interest rate.

It will lose money only if their badly price their credit riskor because of overall loan exposure.

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Currency Swap

Why Currency Swap ???

Any other method than swap to deal with this problem???

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Skeleton of Currency Swap

CompanyCurrency SwapMarket Maker

Yen interest & principal

US$ interest & principal

Yen debt

One Deal Transaction from Company point of view

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Steps in Currency Swaps

Objective: To convert fixed rate bond in Yen to US$

1. At the beginning of transaction company takes yen obtained from bond issue.

2. It then pays to swap dealer who pays the firm amount in US$.

3. Now company pays interest on bonds in Yen using interest received fromSwap dealer in Yen.

4. Company pays to swap dealer interest in US $.

5. At maturity company gets back its principal back, to give to bondholders

from Swap Dealer.

6. The company also pays agreed amount of Yen to Swap Dealer.

M l i l T i H d fi d b

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Multiple Transaction to Hedge fixed currency swap byMarket Maker

Transaction: 1. Interest rate Swap in Dollars.2. Interest rate Swap in Yen.3. A basis swap between floating yen & floating dollars.

6M US$ LIBOR Fixed Rate US$

6M US$ LIBOR

6M China LIBOR

6M China LIBORFixed Rate Yen

Fixed Rate Yen

Fixed Rate US$

Market Maker

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Equity derivatives: An application of Swap

Change of Risk from an exposure to Equity Markets to the Money Marketfor short term like 12 months.

Approach :- Selling stocks and investing in the money market (high cost).

Fund manager Equity index swapMarket Maker

Floating Interest Rate +S&P 500 Losses

S&P 500 Dividends + Gains

S&P 500 Dividends + Gains

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Profit with Zero Investment

InvestorEquity Index SwapMarket Maker

S&P 500 gains + dividends

Floating interest rate +S&P 500 losses

Here investor will earn as if he himself holds the portfolio of investment replicatingthe S&P 500.

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Commodity Derivative

They are way of creating an exposure to commodity risk withoutactually buying the commodity.

. They are same as Equity Index Swaps.

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Credit Default Swaps

Similar to Insurance.

One party fees to counter party in return for agreeing to pay its

counter party any credit loss resulting to its counter partybecause of borrower on agreed principal.

Simply saying that if he defaults I will repay you for some fee.

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Sukhriya