SWAPS

Definition of SWAP

A swap is a derivative in which two

counterparties agree to exchange one

stream of cash flows against another

stream. These streams are called the legs

of the swap.

The cash flows are calculated over a

notional principal amount, which is usually

not exchanged between counterparties.

Swaps can be used to hedge certain risks

such as interest rate risk, or to speculate

on changes in the underlying prices.

BACKGROUNDSwaps first evolved in 1981, in the form

of currency swaps, (IBM and the World

Bank for$210 million dollars and a term of

over ten years)

Interest rate swaps emerged, which offered

an alternative method to overcome asset-

liability mismatches and to lower the cost

of borrowing.

Swaps provide a level playing field for risk

management but still struggle to find a

future, especially in developing countries

TYPES OF SWAP

Interest Rate Swaps

Currency Swaps

Commodity Swaps

Equity Swaps

INTEREST RATE SWAPS

An interest rate swap is defined as a

mutual agreement among different

parties, to exchange interest payments

over a predetermined period.

 The primary motives behind the

interest rate swaps are to lower the

costs of borrowing and to overcome the

asset liability mismatch.

INTEREST RATE SWAPS – Eg

Take the case of a plain vanilla fixed-to-

floating interest rate swap. Here party A

makes periodic interest payments to party B

based on a variable interest rate of LIBOR

+50 basis points.

Party B in turn makes periodic interest

payments based on a fixed rate of 3%. The

payments are calculated over the notional

amount. The first rate is called variable,

because it is reset at the beginning of each

interest calculation period to the then

current reference rate, such as LIBOR.

TYPES OF INTEREST RATE SWAPS

Fixed for Floating

Also known as Plain Vanilla swap

Customer receives cash flows at a fixed rate of interest

and simultaneously pays cash flows at a floating rate of

interest or vice versa.

The cash flows are calculated on a Notional Principal

amount.

The floating rate of interest is usually determined by

reference to a transparent benchmark

Fixed for Floating – CONT.

Investors call the parts of interest swap

agreements “legs.”

In a fixed-for-floating swap agreement, one

party agrees to pay the fixed leg of the swap,

with the other party agreeing to pay the

floating leg of the swap.

The fixed rate is the interest charged over the

life of a loan and does not change.

The floating rate is an interest rate pegged to

an international reference rate index and is

subject to change. The most commonly used

reference rate is London Interbank Offered

Rate or LIBOR.

An Example of a Plain Vanilla Fixed-for-Floating Interest

Party A- (Receives Floating Rate)Party B- (Pays the

Floating Rate)

Notional Principal- $40 million.

Fixed rate day count method is 30/360 day basis.

Floating rate is Six- Month LIBOR, determined on a

30/360 day basis.

Swaps origination: July 20, 1999.

Swaps termination: July 20, 2000.

First payment: January 20, 2000

Semiannual payments will be made on each July 20

and January 20.

TYPES OF INTEREST RATE SWAPS

Floating for Floating

In this kind of a swap, both the counter-

parties exchange interest amounts based on

two different floating reference rates,

through the life of the swap.

In a floating-for-floating interest rate swap

agreement, both parties agree to pay a

floating rate on their respective legs of the

swap.

Floating for Floating - CONTThe floating rates for each leg of the swap

generally come from different reference rate

indexes, but can also come from the same

index.

If both parties choose the same index,

generally they then choose different

payment dates.

The two main indexes investors use in a

floating for floating interest rate swap are

the LIBOR and the Tokyo Interbank

Offered Rate or TIBOR

TYPES OF INTEREST RATE SWAPS

Fixed for Fixed

In fixed-for-fixed interest rate swaps, both

parties agree to a fixed interest for their

respective legs of the swap.

The interest rate does not change over the life

of the loan for both parties.

Investors most commonly use fixed-for-fixed

interest rate swaps when they are dealing with

different currencies.

Companies often use fixed-for-fixed interest

rate swaps when they are building or expanding

their business in a foreign country.

TYPES OF INTEREST RATE SWAPS

Index Amortization Swap

A swap whereby the notional principal

amount of the agreement is amortized

according to the movement of an underlying

rate.

Forward Swaps

A swap agreement created through the

synthesis of two swaps differing in duration

for the purpose of fulfilling the specific time-

frame needs of an investor. Also referred to

as a "forward start swap," "delayed start

swap," and a "deferred start swap."

TYPES OF INTEREST RATE SWAPS

Off market Swap

An interest rate or other swap contract with

a fixed rate payment materially different

from current coupon rates on bonds or notes

of similar term. Ordinarily, this swap will

have a net present value that requires the

counterparties to exchange an extra

payment at the beginning or end of the

swap tenor. Also called Adjustment Swap

TYPES OF INTEREST RATE SWAPS

Callable Swaps & Putable Swaps

Fixed rate receiver has the right, but not the

obligation to terminate the swap at one or

more pre-determined times during the life

of the swap.

A Swap where the fixed rate payer has the

right to terminate is known as a Callable

Swap. Both the Putable and Callable Swaps

are also known as Cancellable Swaps.

  The foreign exchange version of a

Cancellable Swap is called the Break

Forward or Cancellable Forward

LIMITATIONS OF SWAP DEALS

Counter Party Risk

Fund Requirement

Cordial Relationships

Information Network

CURRENCY SWAPS

DEFINITION

A currency swaps (or cross currency

swap) is a foreign exchange agreement

between two parties to exchange a given

amount of one currency for another and,

after a specified period of time, to give back

the original amounts swapped.

Currency swaps were originally done to get

around exchange controls.

EXAMPLE

For example, suppose a U.S.-based company needs to

acquire Swiss francs and a Swiss-based company needs

to acquire U.S. dollars. These two companies could

arrange to swap currencies by establishing an interest

rate, an agreed upon amount and a common maturity

date for the exchange. Currency swap maturities are

negotiable for at least 10 years, making them a very

flexible method of foreign exchange.

Types of currency swaps

Fixed for fixed

Fixed for floating

Floating for fixed

Floating for floating

RISKS OF INTEREST RATE AND CURRENCY SWAPS

Sovereign Risk

Mismatch Risk

Credit Risk

Exchange rate Risk

Basis Risk

Interest Rate Risk

RISKS OF INTEREST RATE AND CURRENCY SWAPS

Interest Rate Risk

Interest rates might move against

the swap bank after it has only gotten half

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 to the same index.

RISKS OF INTEREST RATE AND CURRENCY SWAPS

Exchange rate Risk

In the example of a currency swap

given earlier, the swap bank would be

worse off if the pound appreciated.

Credit Risk

This is the major risk faced by a

swap dealer—the risk that a counter party

will default on its end of the swap.

RISKS OF INTEREST RATE AND CURRENCY SWAPS

Mismatch Risk

It’s hard to find a counterparty that

wants to borrow the right amount of

money for the right amount of time.

Sovereign Risk

The risk that a country will impose

exchange rate restrictions that will

interfere with performance on the swap.

ROLE OF FINANCIAL

INTERMEDIARY

MEANING

In the financial markets, a

company with the need for

swapping a fixed rate liability

may not easily find another

company with a matching need

in the reverse direction (same

notional principal, maturity

period, fixed rate and floating

rate)

MEANING

In such cases, the company

needing an interest rate swap may

approach a financial intermediary

such as a bank which is prepared

to enter into swap agreement with

the company.

The intermediary would then find

out a party or a combination od

parties with the matching need in

the reverse direction

ROLE OF FIs IN INTEREST RATE SWAP

Two limitations,

There is a cost of time and resources associated

with searching for a suitable swap candidate

and negotiating the swap terms

Each swap participant faces the risk that the

counter participant could default on payments

ROLE OF FIs IN INTEREST RATE SWAP- eg

Company A has borrowed Rs.5 lac from the

lender X on fixed interest rate at 12%. The

company wishes to convert the fixed rate

liability into floating rate liability and

approaches a bank(FI) for a swap deal. The bank

agrees to receive interest at floating rate from

company A in exchange for interest payment at

fixed rate to company A.

ROLE OF FIs IN INTEREST RATE SWAP- eg

Meanwhile company B has borrowed Rs.5 lac

from lender Y at floating interest rate specified

as LIBOR+0.50%. It wants to exchange this

floating rate liability into fixed rate liability. The

financial intermediary would enter into a swap

deal with company B agreeing to pay interest at

floating rate to company A and receive interest at

fixed rate from company A

ROLE OF FIs IN CURRENCY RATE SWAP

A currency swap can be used to transform a

loan in one currency into a loan in another

currency.

A typical situation that necessitates currency

swap is when a firm has liability

denominated in one currency and an income

stream denominated in another currency

ROLE OF FIs IN CURRENCY RATE SWAP- eg

An Indian firm may have borrowed Japanese yen

to finance the acquisition of equipment from

Japan. This firm engaged in exporting goods to

the U.S and would therefore be receiving its

income in U.S dollars. Thus, the firm has to

make payments in Japanese yen to meet its loan

commitment when it receives its income in U.S

dollars.

ROLE OF FIs IN CURRENCY RATE SWAP- eg

The U.S dollars would have to be converted to

Japanese yen whenever interest payments and

principal repayments have to be made. This firm is

exposed to forex risk as there is a possibility that the

U.S dollar may weaken against the Japanese yen in the

future. The firm would then suffer a loss in conversion

of U.S dollar into yen as more dollars would have to

be converted into yen to meet its loan commitment

WAREHOUSING

MEANING

One of the problems with swaps is

the difficulty of finding a potential

counterparty with matching needs.

This problem is resolved by swap

dealers, working for invt banks,

commercial bans and merchant

banks, who take one side of the

transaction themselves, this is called

positioning the swap or booking

the swap.

MEANING

Positioning of swaps is also

called warehousing swaps.

Swap dealers becomes

counterparty to the swap. For its

services, the dealer earns a pay-

receive spreads.

It is also known as bid-ask

spreads

MEANING

The problem of finding a suitable

counterparty can also be solved

by employing a swap broker.

Brokers match counterparties

without themselves becoming

counterparties to swap.

They do this exchange for

commission

MEANING

Two types of facilitators,

BROKERS: financial institutions

first became involved in the role

of swap brokers to find

counterparties with matched

needs.

Its role is limited to that of

agent.

MEANING

Two types of facilitators,

SWAP DEALERS: he plays a role

similar to that of dealers in other

financial markets.

He helps counterparties to

complete swap transaction

He may serves a broker or

dealer