Swap

SWAP

1. Dr.Divya M Assistant Professor in Commerce MES Keveeyam College, Valanchery SWAP

2. Contents Meaning and Definition Development Structure of swap dealing for risk management Interest rate swap Forward swap and swap options contracts Cancellable and extendable swaps Non-generic swap transactions Currency swap Pricing and valuation of swap Risk management function of swap transactions

3. Swap “ Necessity is the mother of invention” Swap is based on the Ricardo’s theory of Comparative Advantage”

4. Exchange Agreement between two parties to exchange a series of cash flows over a period in the future. The parties of swap contract are known as Counter parties Swap is an agreement to exchange one stream of cash flow for another in future. The two streams of cash flows are known as two legs of a swap contract. Swap-not a funding instrument, rather just like a device to obtain a desired form of financing indirectly , which otherwise might be inaccessible or too expensive. Cash settled OTC derivative. Switch= exchange of one security for another in spot market

5. Features of Swap Combination of forwards. So all the features of forward contract. Requires two parties with equal and opposite needs must come into contact with each other. Involves multiple future points of exchange Like long dated forward contract Intermediary-Swap facilitator (large financial institutions/banks) bilateral contract-more risky-chance of default risk Do not involve upfront payment-zero value at start

6. Special terms

7. Special terms

8. LIBOR=London Inter Bank Offered Rate Rate decided on daily basis based on a sample of lending rates offered by leading banks in London It is the offer rate that a Euro market bank demands in order to place a deposit at or make a loan to another Euromarket bank. LIBID-London Interbank Bid rate- Bid rate that a Euro market bank is willing to pay to attract deposit from another Euro market bank (No formal correspondent responsible for fixing the daily rate)

9. Advantages Obtain cheaper finance Can arrange funds Long term hedge instrument Flexible in maturity, amount and other contract terms Meeting the financial needs of MNCs Useful when there are market fluctuations

10. Disadvantages Difficult to find counter party Termination of contract-mutual consent Inherent default risk OTC, not exchange traded Not easily tradable-secondary market is not fully developed

11. Uses To treasurers Rising interest rates Reducing borrowing cost Financial managers Converting floating rate debt to fixed rate and vice versa To lock in an attractive interest rate Position fixed rate liabilities in anticipation of decline in interest rate Arbitrage debt price differentials in capital market Financial institutions

12. Evolution Parallel loans and back to back loans (1960s and 1970s) Parallel loans=four parties Back to back loans=two parties First currency swap=august 1981 ( solomon brothers)

13. Structure of swaps Swap dealer-bank-intermediary Eg : fixed for floating rate swap One of the counter parties agrees to make fixed rate payment to other. In return the second counter party agrees to make floating rate payment to the first counter party. These two payments are known as the legs or the sides of the swap. Fixed rate is known as swap coupon These payments are calculated on the basis of hypothetical amount called notional principal. Exit swap contract- Opposite position Sell the swap by Marking the swap to market (seasoned swap)

14. Economic functions of swap transactions Transforming the nature of liabilities ( fixed-to-floating & floating –to- fixed) Transforming the nature of asset Hedging Reducing the cost of funds

15. Types of swap

16. Currency swap Foreign exchange agreement between two parties to exchange a given amount of one currency for another, and after a specified period of time , give back the original amounts swapped. Used to hedge against foreign exchange risk Involve two different currencies Banks are intermediaries between the two parties to swap Currency swap is a contract or agreement, not a loan by itself

17. Currency swap gives the parties the right to offset, namely the non payment of principal or interest with corresponding non payment in the other currency In currency swap there is always an exchange of principal amount at maturity, based on the original amounts of currency at the predetermined exchange rate. In practice , currency swap also include interest rate swap

18. Three aspects

19. Mechanism of currency swap Firm A Firm B Available Euro-Fixed rate 6% US $ -floating rate-LIBOR Euro-Fixed rate 8% US $ -floating rate-LIBOR Need Floating rate –US $ Fixed rate –Euro Borrow Fixed rate 6% -Euro Floating rate –LIBOR –US $ Possess Floating rate –US $ (LIBOR) Fixed rate –Euro(6%) Interest rate flows US $---Swap dealer---Firm B Firm B will pay fixed rate of interest to swap dealer that will be more than 6%, but less than 8%... 7% (swap dealer charges commission ---balance (6.80%)----Firm A Maturity Get Euro and repay to the lender Get US $ -repay to the lender Swap

20. Benefits from currency swap Firm A and firm B gets the currency of their own choice Cost of borrowing gets reduced Can be used as a tool for hedging foreign exchange exposure

21. Hedging through currency swap Hedging foreign exchange risk Eg : Indian Firm –Borrow fund from India-doing operation in US –Acquire assets in USA-get profit from USA in $ Dollar depreciate- risk (lesser rupee amount for the fixed return earned in US $) Similarly US firm –borrow from US market-doing operation in India- Acquire asset in India Rupee depreciate- risk (lesser dollar amount for the fixed return earned in Indian rupee)

22. Under swap transactions , the mismatch of cash inflow and cash outflow in different currency for both the firms can be eliminated=US firm agreeing to pay rupee generated out of its Indian operations to Indian firm in exchange of Indian firm agreeing to pay dollar generated out of its US operations Both the firms avoid the conversion of currencies from one to another Eliminates exchange rate risk-currency risk

23. Types of currency swap

24. Advantages-currency swap Hedge against foreign exchange risk Increases the total amount that the firm can borrow Facilitates economies of scale Reduces operating costs Surplus fund can be used effectively in blocked currencies Means for exploiting the opportunity for arbitrage Integrating the world’s capital markets

25. Interest rate swap/Generic swap/Plain vanilla swap 1980s Contractual agreement entered into between two counter parties under which each agrees to make periodic payment of interest to the other for an agreed period of time based on the principal amount. Swap Buyer= The counter party who pays the fixed rate cash flow Swap Seller = The counter party who receives the fixed rate cash flow Exchange of interest payments

26. Occurs when a person or firm need fixed rate loan but is able to get floating rate loan. It finds another party who needs floating rate loan but is able to get a fixed rate loan. The two parties are known as counter parties . Conditions Amount of loan –same Periodic payment of interest-same currency Synchronization of interest between two parties- one getting cheaper fixed rate fund and another also get cheaper floating rate fund The interest payments are called the legs of the swap Fixed rate is called swap coupon

27. Mechanism of interest rate swap Firm A Firm B Available Floating rate fund available @ LIBOR +0.3% Fixed rate fund @ 8.5% Need Fixed rate fund @ 9.5% Floating rate fund available @ 6 month LIBOR flat Borrow Floating rate fund available @ LIBOR +0.3% Fixed rate fund @ 8.5% Approach swap dealer (Bank)

28. Mechanism of interest rate swap Firm A Firm B Pay to Swap dealer Pay fixed rate interest to swap dealer , which is greater than interest rate of firm B (8.5%) and lower than interest rate of firm A (9.5%)= 9% 6 month LIBOR Pay to lender Pay LIBOR+0.3% to the lender 8.5% Pay by the swap dealer LIBOR 9.00%-0.1%(commission) =8.9%

29. Cost of Borrowing

30. Hedging of interest rate risk Apart from reducing cost of borrowing, interest rate swap are also used for hedging interest rate risk Eg : A person borrows fixed interest rate loan , expect a price fall…..convert it into floating rate Like a person borrows floating rate loan , expect a price rise= convert it into fixed rate loan

31. Various forms of interest rate swap Coupon swap (same as plain vanilla# fixed interest payment- lumpsum , floating =periodically) Basis swap (different instruments) Putable swap =give the swap seller(floating rate) the right to terminate before its maurity , if interest rate rises) Callable swap =give the swap buyer (fixed rate) the right to terminate before its maturity, if interest rate falls) Rate capped swap=fix a capped rate Protect the borrower against the rise in interest rate Interest rate floors=protect the depositor against a fall in interest rate Interest rate collar=combination of cap and floor

32. Advantages Does not involve any exchange of pricnipal amounts Documentation charge is minimum Off balance sheet item Used for hedging and increasing profitability Borrower can raise funds at a fixed rate when the interest rates are rising and then switch to floating rates in case they are falling

33. Difference between interest rate swap and currency swap Interest rate swap Currency swap Cash flow exchanged are in the same currency In different currency One notional principal amount Two notional principal amount Notional principal amount is not exchanged Notional principal amount are exchanged No counter party risk Counter party risk Bench mark rate is MIBOR( Mumbai Inter Bank Offered Rate) Bench mark rate is LIBOR

34. Credit default swap Credit derivative contract between two counter parties The buyer of CDS is known as protection buyer The seller of the CDS is known as protection seller The protection buyer makes a series of payment to the protection seller and in exchange receives a pay off if an underlying credit instrument defaults or experiences a similar credit event

35. Equity swap An equity stock is a transaction in which one party agrees to make a series of payments determined by the return on the stock or a group of stock or stock index to another party in return for a cash flow that could be based on a fixed rate, floating rate or a return on another stock or stock index . Different from interest rate swap Stock returns can be negative Return of the stock is known at the end of the period.

36. Commodity swap Agreement between two counter parties to exchange cash flows depending upon the price of a given commodity One party will pay a fixed price for a given commodity, while the counter party will pay floating price for the same commodity on the settlement date.

37. Swap market Market where the swaps are traded Buyers, sellers and intermediaries Commercial bank and investment banks=intermediaries/ swap dealers Direct swap market= no intermediaries, but default risk With intermediaries= default risk is covered by them

38. Type of swap risks Interest rate risk Exchange rate risk Market risk Mismatch risk Basis ris Sovereign risk Credit risk

39. Valuation of interest swap The net difference between the present value of the payments to be received and the present value of the payments to be made. Swap valuation Swap as a portfolio of two bonds made Inflow and outflow of the interest at periodic intervals equivalent to that of bond A) cash inflow equivalent to the interest on the bond owned B) cash outflow equivalent to paying the interest on the bond issued

40. The value of swap for one receiving fixed and paying floating will be equal to the differential of the fixed leg and floating rate cash flows Vs= Vc-Vf Vs=Value of swap Vc =Value of Fixed coupen

41. Valuation of currency swap Vs= Vf-Vl Vf =value of foreign currency bond Vc =value of local currency bond

42. Difference between swap and futures swap Future OTC contracts negotiated directly by counter parties Payments at times specified in the swap agreement Long time horizons (20 yrs) No default risk Standatised contract with fixed principal amount Marked to market daily Donot trade for more than 2 or 3 years Default risk

43. Forward Swap Forward contract to enter into swap Forward contract on swap Commencement date is delayed to a future date Mostly useful to those investors who donot need fund immediately but would like benefit from the existing rate of interest. A contract that obliges the two parties to enter into a swap at al later date at a fixed rate agreed to in advance

44. Swaptions Option on swap Give the buyer the right to enter into swap contract at some future date for payment of a premium Receiver swaption Payer swaption Rate on expiry Payer swaption Receiver swaption Interest>strike rate Exercise Do not exercise Interest <strike rate Do not exercise Exercise

45. Non generic/exotic swap First genaration Forward starting swap Roller coaster swap Amortising swap Accreting swap Constant swap In-arrear swap Quanto swap Leveraged swap Power swap Overnight index swap

46. Non generic/exotic swap Second genaration Index amortising swap Bermudan swap Range accrual swap Asian swap Digital or Binary swap Barrier swap Chooser swap or swaption Corridor swap

47. Risk mgt fn of swap transactions To hedge against the risk of rising interest rates To hedge against the risk of falling interest rates To hedge against the market price risk and interest rate risk To derive the benefit of comparative advantage in borrowing or lending To hedge against the risk of decline in revenue stream To hedge against the risk of increase in cost