Finance - Interest Rate Swaps presentation.pptx

Interest rate swaps - Finance

1. INTEREST RATE SWAP SHALAKA PHATAK - 170 SHIVANI LOKARE - 172 SHREYA RAO - 175 SURBHI GUJARANI - 177 SUSHMITA KARMAKAR - 178 TEJASHREE DESHMUKH - 179 Presented to : Dr. Pradip Mitra

2. What are Swaps? A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate , or index price. The most common kind of swap is an interest rate swap . Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter (OTC) contracts primarily between businesses or financial institutions that are customized to the needs of both parties.

3. Examples of Swaps EDU Inc. enters into a financial contract with CBA Inc. in which they have agreed to exchange cash flows making LIBOR as its benchmark wherein EDU Inc. will pay a fixed rate of 5% and receive a floating rate of LIBOR +2% from CBA Inc. Now, if we see, in this financial contract, there are two legs of the transaction for both parties. EDU Inc. is paying the fixed rate of 5% and receiving a floating rate (Annual LIBOR+2%), whereas CBA Inc. is producing a floating rate (Annual LIBOR+2%) and receiving a fixed percentage (5%). In the above example, let’s assume that both the parties have entered into a swaps contract for one year with a notional principal of Rs.1,00,000/-(since this is an Interest rate swap, hence the principal will not be exchanged). And after one year, the one year LIBOR in the prevailing market is 2.75%.

4. Looking at the above exchange of cash flows, an obvious question comes to our mind that why financial institutions enter into swaps agreement. It is clearly seen in scenario one that a fixed paying party is benefitted from the swaps. However, when the one year LIBOR increased by 50 bps to 5.25%, it was in loss from the same swap agreement.

5. What is Interest Rate Swap? An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap .

6. Example of Interest Rate Swap In a nutshell, interest rate swap can be said to be a contractual agreement between two parties to exchange interest payments. The most common type of interest rate swap arrangement is one in which Party A agrees to make payments to Party B based on the fixed interest rate, and Party B agrees to pay party A based on the floating interest rate. In almost all cases, the floating rate is tied to some kind of reference rate.

7. How Interest Rate Swaps work? Basically, interest rate swaps occur when two parties: One of which is receiving fixed-rate interest payments. The other of which is receiving floating-rate payments mutually agree that they would prefer the other party’s loan arrangement over their own. They do not exchange debt assets, nor pay the full amount of interest due on each interest payment date – only the difference due as a result of the swap contract. A good interest rate swap contract clearly states the terms of the agreement, including the respective interest rates each party is to be paid by the other party, and the payment schedule for e.g., monthly, quarterly, or annually. If interest rates rise during the term of the swap agreement, then the party receiving the floating rate will profit and the party receiving the fixed rate will incur a loss. Conversely, if interest rates decline, then the party getting paid the guaranteed fixed rate return will benefit, while the party receiving payments based on a floating rate will see the amount of the interest payments it receives go down.

8. Types of Interest Rate Swap Interest rate swaps are the exchange of one set of cash flows for another. Because they trade over-the-counter (OTC), the contracts are between two or more parties according to their desired specifications and can be customized in many different ways. Swaps are often utilized if a company can borrow money easily at one type of interest rate but prefers a different type. There are three different types of interest rate swaps: Fixed-to-floating, floating-to-fixed, and float-to-float. Fixed-to-Floating The swap is structured to match the maturity and cash flow of the fixed-rate bond and the two fixed-rate payment streams are netted. TSI and the bank choose the preferred floating-rate index, which is usually LIBOR for a one-, three-, or six-month maturity. TSI then receives LIBOR plus or minus a spread that reflects both interest rate conditions in the market and its credit rating.

9. Floating-to-Fixe d A company that does not have access to a fixed-rate loan may borrow at a floating rate and enter into a swap to achieve a fixed rate. The floating-rate tenor, reset, and payment dates on the loan are mirrored on the swap and netted. The fixed-rate leg of the swap becomes the company's borrowing rate. Float-to-Float Companies sometimes enter into a swap to change the type or tenor of the floating rate index that they pay; this is known as a basis swap. A company can swap from three-month LIBOR to six-month LIBOR For eg : either because the rate is more attractive or it matches other payment flows. A company can also switch to a different index, such as the federal funds rate , commercial paper, or the Treasury bill rate .

10. Pros and Cons of Interest Rate Swap Commercial motivations: Some companies are in businesses with specific financing requirements, and interest rate swaps can help managers meet their goals.Two common types of businesses that benefit from interest rate swaps are: Banks : which need to have their revenue streams match their liabilities. Hedge funds : which rely on speculation and can cut some risk without losing too much potential reward. Comparative advantages: the swap lets banks, investment funds, and companies capitalize on a wide range of loan types without breaking rules and requirements about their assets and liabilities. PROS

11. CONS OF INTEREST RATE SWAP Floating interest rates are very unpredictable and create significant risk for both parties : One party is almost always going to come out ahead in a swap, and the other will lose money. Counterparty risk adds an additional level of complication to the equation : Usually this risk is fairly low, since institutions making these trades are usually in strong financial positions, and parties are unlikely to agree to a contract with an unreliable company.

12. Plain Vanilla Interest Rate Swap Introduction: A plain vanilla swap is one of the simplest financial instruments contracted in the over-the-counter market between two private parties, both of which are usually firms or financial institutions. A plain vanilla interest rate swap is often done to hedge a floating rate exposure, although it can also be done to take advantage of a declining rate environment by moving from a fixed to a floating rate. Both legs of the swap are denominated in the same currency, and interest payments are netted. The notional principal does not change during the life of the swap, and there are no embedded options.

13. Types of Plain Vanilla Swap The most common plain vanilla swap is a floating rate interest rate swap. Now, the most common floating rate index is the London Interbank Offered Rate (LIBOR), which is set daily by the International Commodities Exchange (ICE). LIBOR is posted for five currencies—the U.S. dollar, euro, Swiss franc, Japanese yen, and British pound. Maturities range from overnight to 12 months. The rate is set based on a survey of between 11 and 18 major banks. The most common floating rate reset period is every three months, with semi-annual payments. The day count convention on the floating leg is generally actual/360 for the U.S. dollar and the euro, or actual/365 for the British pound, Japanese yen, and Swiss franc. The interest on the floating rate leg is accrued and compounded for six months, while the fixed-rate payment is calculated on a simple 30/360 or 30/365 basis, depending on the currency. The interest due on the floating rate leg is compared with that due on the fixed-rate leg, and only the net difference is paid.

14. Example of a Plain Vanilla Swap In a plain vanilla interest rate swap, Company A and Company B choose a maturity, principal amount, currency, fixed interest rate , floating interest rate index, and rate reset and payment dates. On the specified payment dates for the life of the swap, Company A pays Company B an amount of interest calculated by applying the fixed rate to the principal amount, and Company B pays Company A the amount derived from applying the floating interest rate to the principal amount. Only the netted difference between the interest payments changes hands.