= Swaps a INTRODUCTION Senn ‘Necessity is the mother of invention’ is a popular saying, and pee the recent evolution of swaps as finan- tant ib. cial instruments is a classical example aie sank of its validity. There is near unanimity presence of exchange | among financial experts that swaps controlsthatrestricted | developed out of the constraints and the movement ofcapital — reaulatory controls exercised over cross-border capital flow, faced by large : corporations in the 1970s, When multi- national corporations (MNCs) operating in various countries could not freely remit funds back and forth among their subsid- iaries due to exchange controls exercised by various govern- ments on capital flows, they came out with the innovation of back-to-back or parallel loans among themselves. Upon removal of restrictions on capital flows, these loans developed into a full- fledged financial product called swaps. Since then, the market has grown to volumes as big as US $30.5 trillion in foreign exchange swaps and US $22.8 trillion in currency swaps! in December 2011—in terms of notional principal involved in swap transactions—and continues to grow at a rapid rate. Paralle| loans involve four parties that agree to re-exe currencies at a predetermined exchange rate on a pre-decided future date. The four parties usually involve two MNCs and a sub- sidiary each, in two different countries. Imagine IBM as a USA- based company with a subsidiary in London and British Telecom as another company with operations in New York. The subsidiary of British Telecom needs money in US dollars, while the subsid- iary of IBM in London requires funds in pound sterling. Due to regulatory controls, neither IBM USA nor British Telecom can TAs per Bank of International Settlements data available for the second half of 2011 Interest Rate and Currency Learning Objectives ‘After going through this chapter, readers should be fama wit + the basic concept of swaps, why ‘and how swaps evolved, and the terminology of swaps + the cferent types of interest rates and currency swaps + how to hedge interest rate risk + how to hedge exchange rate risk through financial swans + ‘Swap a a too! for reducing financing cost and also as a hedging too! + howto value a swap = as a pair of bonds and = a8 a series of forward contracts: + other swaps such as commodities and equityDerivatives and Risk Management to fund the requirement of IBM’ subsidiary in London, Similarly, IBM USA may raise funds in US dollars to fund the operations of British Telecom in New York. Such an arrangement is called back-to-back or parallel loan. These amounts would be re-exchanged at maturity ata rate determined in advance. Besides overcoming regulatory controls, there were other economic advantages that caused the development of swaps as full-blown financial products that became popular even afer the removal of regulatory controls, By this simple arrangement, each firm involved in a swap arrangement has tal markets in a foreign country, and can make use of the comparative advantage of borrowing in different capital markets. The growth cof swaps was so phenomenal that in 1984, a need for standardization and uniform practices in documentation, trading, and settlement was felt, leading to the formation of the International Swap and Derivatives Association (ISDA). Back-to-back/parallel loans pose several difficulties: finding matching parties with identi- cal needs in terms of amount of principal, timing, duration of loan, periodic Swaps overcame the | ity, and nature (fixed or variable) of interest payments, etc., all of which must ees bee, | match to conclude a successful deal. Solutions to these problems were found anddeveopedinioan | by intermediary banks, which later progressed to become dealers in swaps Instrument independent | from being mere arrangers of swaps between two parties. Back-to-back loans ‘of the undertying loan : were an example of financial swaps, which had their origin in the 1970s, By Fae the early 1980s, the same principle was adopted to develop another swap arrangement based on interest rates, known as interest rate swaps. Sa SNS Swap, in the simplest form, may be defined as an exchange of a series of future cash flows between two parties us agreed upon in the terms of a mutual contract. The basis of future cash flows can be the exchange rate for currency/ financial swaps and the interest rate for interest rate swaps. Apart from interest rates and currency rates, the formula for determina- tion of periodic cash flows can include equity returns, commodity prices, etc. In essence, one of the cash flows, called the fixed leg, would be fixed, while the other cash flow, called the floating leg, would be the variable, depending upon the value of the variable identified for the swap, fund their subsidiaries. To overcome the problem, British Telecom can arrange funds in pounds If the exchange of cash flows is done on the basis of interest rates prevalent at the relevant times, it is known as an interest rate swap. The simplest example of an interest rate swap is 4 forward contract where only one payment is involved. In a forward transaction of any com- modity, the buyer acquires the commodity and incurs an outflow of cash equal to the forward f the buyer, after acquiring the commodity, were to sell it for the spot pean hen there would be a cash inflow of 8. From the cash flow perspec- change of cash lows be- | tive, a forward contract for a buyer is a swap transaction with inflow of Sand tween two parties, based | outflow of F. The seller would have equivalent cash flows in opposite direc- ‘on terms and conditions tions. Therefore, a forward contract can be regarded as a swap with a single ene a ash flow or, alternatively, a swap can be viewed as a series of a _.’ several forward transactions taking place at different points of time. exchange ofSwaps—Interest Rate and ( FEATURES OF INTEREST RATE SWAP [iiisiiiniieirienrinrnenssn iene Mostly interest rate swaps involve payment of a fixed rate of interest for receiving a floating rate of interest. The basis of exchange of cash flows under an interest rate swap is the inter- est rate. This fixed-for-floating swap is commonly known as the plain vanilla swap, depicted in Fig. 8.1, where company A agrees to pay company B a fixed interest rate of 8.50% in exchange for receiving from company B interest at 30 bps (100 bps = 1%) above the float- ing interest rate MIBOR (Mumbai InterBank Offer Rate), at predetermined intervals of time. Fig, 8.1. Plain vanilla interest rate swap Assume that the swap contract between company A and company B is (a) for a period of three years, (b) with semi-annual exchange of interest, and (c) on a notional principal of %50 crore. The cash flows for company A for six semi-annual periods for an assumed MIBOR would as per Table 8.1. The amount received/paid by company A is paid/received by company B. Within the context of this example, the salient features of the swap con- tract may be noted as follows: © Effective date All the cash flows pertaining to the fixed leg are known at the time of entering the swap at 7 = 0, referred to as the effective date. © Resetting of floating leg cash flow The cash flow for the floating leg of the swap is determined one period in advance, when the floating rate is known. Thus, at the time of entering the swap, the first set of cash flows of interest is known. The first receipt of cash flow at T = 6 months is known at 7 = 0, and is done at the MIBOR of 8% plus Table 8.1 Cash flow under swap for company A Time, months: MIBOR, % 0 8.00 6 ans 12 8.20 —21250 18 ass 21250 24 8.90 =21250 20 850 =21250 6 875 -2250 | oon | 750 Note: Cash fw tor Hoang lg is decided one period in advance.Derivatives and Risk Management date. It will come up every six months in swaps with semi-annual payments. Notional principal No principal amount is exchanged either at the initiation or at the conclusion of the swap. It remains a notional figure for determination of the amount of interest applicable to both the legs. Exchange differemial cash flow The exchange of interest is done on a net basis, as depicted in the last column of Table 8.1, with positive signs indicating cash inflows and negative signs indicating cash outflows for company A. The cash flows for company B would be opposite to those for company A. Different conventions to calculate fixed and floating interests Since a swap is an over-the-counter (OTC) product, the method of calculation of interest on the two legs can be defined by the two parties involved. However, the conventions to calculate interest for each of the two legs are different. Generally, the conventions followed in money markets are: ) 30 bps. The date on which the next floating rate payment is decided is called the reset for the fixed leg + actual/365 for the floating leg: actual/360 If the actual number of days in a 6-m period are 182, the amount of interest on both the legs for the first cash flow would be different from the interest rates shown in Table 8-1 and the exact amount is calculated as follows: For Fixed Leg: Principal X Interest rate Menus 2 = 50,00,000 x 0.08s x 182 = g2,11,918 365 For Floating Leg: Principal x Interest rate x Nes. of tans fs = 50,00,000 x 0.083 x 182 — 92,09,05 360 For simplicity of exposition in the example we assumed 180 days in each semi-annual period, with a 360-day year for both the legs. NEED FOR SWAP INTERMEDIARY: SWAP DEALER/BANK Sittin The illustration in the previous section assumed perfect matching of the needs of company A and company B, That brings up this interesting question: how do company A and company B find each other in this big world? Normally, firms prefer not to disclose their specific needs in terms of loans, borrowings, and interest rates. Even the importers and exporters are rarely involved in direct transactions of buying and selling foreign currency in the forward markets, All of them resort to banks for this purpose. Apart from difficulties in locating each other, if company A and company B were to set up a swap arrangement directly, they would most likely face the following problems. © Both of them would assume default risk (also known as counterparty risk) associated with the swap on each other, as either party may fail to honour its commitments under the swap.Swaps—Imterest Rate and Currency 219 ‘Swap intermediaries ¢ Matching mutual needs in terms of principal amount of borrowing, the ‘promote market develop- timing, the periodicity of payment of interest, and the final redemption of Ment by filing the gaps the borrowing could indeed be a difficult task. interms of matching of , " needs, warehousing, and The existence of intermediaries came into play in order to overcome this "assuming of counter- sort of problem in swap agreements. Without intermediaries, the swap mar- party sk. ket would remain extremely small. In fact, the growth in swaps is primarily attributed to the roles banks have played as swap intermediaries. We now proceed to write about the functions of a swap intermediary, Facilitating the swap deal Difficulties in finding a matching counterparty can be mitigated if an intermediary is involved. The intermediary or the swap dealer is normally a bank with a widespread network. Due to their deep knowledge of financial markets, huge networks of ‘customers, and exact understanding of client needs, banks are better placed to locate match- ing counterparties. Many banks offer forward rates to facilitate foreign exchange transac- tions. Similarly, a few banks act as market makers in swaps and offer a ready market with opportunities for firms to enter into and exit from swap deals. Warehousing Banks perform the role of market maker in swaps. One can obtain a quote on demand for a swap deal from a bank without waiting for a matching counterparty. There are several requirements that have to be matched, For example, one party may look for an interest rate swap for €100 crore on semi-annual basis for three years, while another party may want a swap for 280 crore on a quarterly basis for 2% years only. Here, the bank may take up exposure of 20 crore in the hope of finding another suitable party for that amount in the near future, This is called warehousing, where the bank may enter swaps on its own. The bank carries the risk of interest rate fluctuations till a matching counterparty is found, The risk of interest rate in the interim is normally covered through interest rate futures. Hedging through imerest rate futures has to be done only for net exposure in swaps, as banks are likely to have a portfolio of swaps that can nullify the interest rate risk for a major part of the exposure, Assuming counterparty risk Most important of all, banks mitigate counterparty risk for both the parties to the swap by becoming the counterparty to each of them. In the example depicted in Fig. 8.1, company A would be far more comfortable if the counterparty was a bank, rather than company B. The same would be true for company B. When a bank becomes ‘a counterparty, the overall risk attached to the swap transaction, which normally is large due to its long-term nature, stands reduced substantially. Of course, for providing facilitating role and assuming the counterparty risk, the swap dealer needs to earn some remuneration. This has to be borne by the two parties to the swap transaction, However, each of the party stands to gain in terms of having an exact deal, achiev- ing the desired timing, and reducing the counterparty risk. The benefits are worth the cost. Figure 8.2 depicts a swap transaction with a bank as an intermediary, charging 5 bps from each party, as each of them receives 5 bps less than what they would receive without the inter- mediary (see Fig. 8.1). Company A pays a fixed interest rate, 8.50%, to the bank, which pays only 8.45% to company B. In exchange, the bank receives a floating interest from company B at M + 30 bps, but pays 5 bps less to company A at M + 25 bps, The bank hence earns 10 bps.220 Detivatives and Risk Management -| =f (aa ae] Fig.8.2 Plain vanilla interest rate swap with intermediary APPLICATIONS OF INTEREST RATE SWAPS EEE Having explained the mechanism of the swap transaction, let us focus on what swaps can achieve. Swaps can be used to (a) transform a floating rate liability to a fixed rate liability and vice versa, (b) transform a floating rate asset to a fixed rate asset and vice versa, (c) hedge against fluctuating interest rates, and most importantly, (d) reduce the cost of funds. We now examine each of these factors. Transforming Nature of Liabilities Interest rate swaps are generally used for creating synthetic fixed or floating rate liabilities with a view to hedge against adverse movement of interest rates. Let us consider company A, which has borrowed from the market on a floating rate basis at MIBOR + 25 bps. It pays to its lenders at floating rate. Further, it considers that interest rates would rise in the future. In view of the possibility of rising interest rates, company A would like to have a liability that is fixed, rather than variable, in nature. Therefore, it decides to enter into a swap with a bank by paying a fixed 8.50% and receiving MIBOR + 30 bps, as depicted in Fig. 8.3. Company A pays a fixed interest rate, 8.50%, to the bank. The bank pays M + 30 bps in return, Company A continues to pay M + 25 bps to its lenders, as originally agreed. What is the result of this swap? It simply transforms the liability to a fixed rate at 8.45% p.a., as shown in Fig 8.3. Payment to lenders MIBOR + 25bps Less: receipt from bank under swap 8.50% Payment to bank under swap ~(MIBOR + 80 bps) Net payment, ed 8.45% Fig. 8.3 Swap to transform floating rate lability to fixed rateSwaps—Interest Rate and Currency 221 Similarly, company B can transform its fixed rate liability to a floating rate liability by entering a swap with a bank paying a floating interest rate and receiving a fixed one. Naturally, company B would use such a swap when it believes that interest rates are likely to fall in the future, and locking-in a lower floating rate would prove advantageous, Refer to Example 8.1 for an illustration. EXAMPLE 8.1 Changing nature of liability from fixed to floating Five years ago, Fasteners Ltd had raised loans through a 10-year debenture issue worth €100 crove with a fixed interest rate ‘of 12%, Alter the issue, the interest rates remained constant for some time, but have since come down to around 10%, and are likely to come down further. Fasteners Ltg wishes to contain the cost of funding for the remaining five years. A bank has olfered ‘a swap rate of 9.50-9,60% against MIBOR for a period of five years. Depict the swap arrangement and find out the new nature of liablities the firm can have. Solution Fasteners Ltd has 2 liabilty with a fixed interest rate of 12%. By entering into a swap with the bank, it may translonn interest (on the liability from a fixed rate to a floating rate based on MIBOR. Under the swap arrangement, Fasteners Ltd can receive 2 fixed rate and pay MIBOR. The bid rate of the swap (9.50%) would be applicable, The swap arrangement is shown as below: ‘The cost of funds for Fasteners Lid would be 12.0% — 9.50% + MIBOR = MIBOR + 2.50%. ‘in case the interest rates fal below 8.50%, whichis expected, the finm would end up paying less interest han what itis paying now, The interest rate payable would be market based. Transforming Nature of Assets Assets provide income to investing firms based on the interest rates. If the interest rates fall, the income too falls. In circumstance of falling interest rates, firms would like to change the complexion of assets that are on floating rates to fixed rates. Similarly, in times of rising interest rates, firms earning fixed rates of interest would like to remain with the market trend, Now assume that company A has made an investment by subscribing to bonds carrying a 9% fixed coupon. The bonds have still some years to mature but the interest rates are showing ‘4 rising trend, which is expected to continue. Company A faces a potential loss of income. What should company A do to mitigate the risk associated with the rising See avi aoe interest rates? Changing its portfolio of bonds by selling fixed rate bonds and acieristics of an asset buying floating rate bonds is one solution. An easier way is to enter the swap orliablty!rom tedto | depicted in Fig. 8.4, where it receives a floating, MIBOR + 30 bps and pays ‘ioating or floating to a fixed rate, 8.50%, ‘xed, without disturbing By doing so, the nature of income is transformed from a fixed 9.00% to FE AE OTE: a floating MIBOR + 80 bps:222 Derivatives and Risk Management [BATE | cow Fig. 84 Swap to transform fixed rate asset inte floating rate Receipt from investments 900% Less: Payment to bank under swap ~B50% Receipt from bank under swap MIBOR + 30 bps. Net receipts, floating MIBOR + 60 bps If MIBOR moves beyond 8.20% in the future, company A would benefit from the situation. Similarly, one can transform a floating rate income to fixed rate income by entering a swap receiving fixed and paying floating. Naturally. a firm would use such a swap when it believes that interest rates are likely to fall in the future. Hedging with Swaps These examples of changing the nature of liabilities or assets from fixed to floating and vice versa demonstrate the hedging applications of swaps. The need to change the Mtoe complexion of assets and liabilities arises only when the firms stand to gain trom fixed rate to float. from such an exercise. Swaps can be fruitfully used to hedge against an ingrate.or vce versa) | adverse interest rate situation, as condensed in Table 8.2. ‘helps hedge against the ‘There are many ways to hedge against adverse situations but sometimes a ‘adverse movement of | swap agreement hedges the anticipated risk more efficiently. For example, a Wesrest tes. firm may have borrowed for 10 years on a fixed rate basis. After a few years, if the interest rates start a downward movement, one possible recourse for the firm is to approach the lender to change the nature of loan from fixed to floating, The lender might resist switching to a floating rate of interest. A better course of action is to set up @ swap arrangement with another party. The firm achieves its objective without involving the original lender and any of its additional terms and conditions. Table 8.2 Hedging strategies with swaps Nature Risk Fixed rate Rising interest rates Floating rate Falling interest rates ‘Swap to transform the nature of asset trom fixed rate to floating rate. ‘Sap to transform the nature of asset from oating rate to fixe rate Liabilities ‘Swap to transform the Kabily from fixed rate to lating rae ‘Swap to transform the lablity form floating rate to fixed rate. Fixed rate ] Faling intevest ates Floating rate Rising interest ratesSwaps—interest Rate and Currency 223 Interest rate swaps in India—Overnight swap ‘With the view of deepening the money market and enabling banks, primary dealers, and altindia financial institutions to hedge interest ‘ale ks, the Reserve Bank of India has allowed scheduled commercial banks, primary dealers, and all-india financial institutions to make merkets in interest raie swaps from July 1989. Honever the market thal has taken off most seriously so far is the one based ‘on ovemight index swaps. The benchmarks for tenor beyond avemight have not become popular due to the absence of a vibrant interbank term money market. ‘The National Stock Exchange (NSE) in India oublishes MIBOR rates for three other terms, that is, 14 days, one month, and three: ‘months. The other longer-tenor benchmark that is available is the yet based on forex fonward premiums. This is called MIFOR a ese ves rome se ee NNN 8h 6m, and 1-year MIFORs are the market standard for this ‘The overnight index swap is @ rupee interest rate swap where the floating rate is inked to an overnight intertvank call money index. ‘The swap will be flexible in tenor, i¢., there is no restnction on the tenor of the swap. Interest would be computed on a notional principal ‘amount and settled on a net basis at maturity. On the tioating rate side, the interest amounts are compounded on a daily basis, based ‘on the index. At the moment, the NSE ovemight MIBOR is the most widely used floating rate index, the Reuters’ ovemight MIBOR ‘beng the other reference rate used. For example, consider that bank A isa fired rate receiver for &5 crore for ¢ period of one week at 10%, and bank B is a recelver of {cating rate linked to the ovemight index. The NSE MIBOR raies for seven days are taken and settled at the end of the swap pariod. ‘Atthe end of the period of one week, ie., the eighth day, bank B will have to pay to bank A 295,690 (which is the interest on £5 crore for seven days at 10%), and has to receive 897,508 from A. The payments are netied and the only payment that takes place is a ‘Payment by A of 21606 (97,508 — 95,890) to 8. 5,00,83,101 5,00,97,508 Similarly, a fund may have subscribed to a portfolio of fixed rate bonds to generate a desired level of income. If interest rates rise subsequent to the subscription, the fund loses the opportunity to raise its income. One of the alternatives available is to change the portfo- lio from fixed rate to floating rate bonds. This may face serious limitations, such as lack of availability of such bonds and transaction costs associated with change of the portfolio. An attractive alternative is to enter a swap to transform the nature of assets from fixed to floating, where the fund receives a cash flow based on floating in exchange for paying a fixed rate. More importantly, the swap transaction remains off the balance sheet, thereby keeping the much-desired confidentiality. Reducing Cost of Funds Perhaps the most important application of swaps, which also seems to be the primary reason for its popularity and growth, is its potential of saving the cost of financing. ‘An example will illustrate how swaps can be used to reduce financing cost, Assume that a highly rated firm, rated AAA, can raise funds in the fixed rate market at 10% and in the224 Derivatives anc Risk Management floating rate market at MIBOR + 100 bps. The current rate of MIBOR is 8%, Another firm, comparatively rated lower, at *A’, can mobilize capital at 12% and MIBOR + 200 bps in the fixed rate and floating rate markets, respectively, Clearly, firm rated AAA has an advantage over firm rated A, both in the fixed market as well as in the floating market. This advantage can be tabulated as follows: Firm rated AAA Fixed rate 10% Floating rate MIBOR + 100 bps ‘We further assume that firm rated AAA is interested in borrowing at a floating rate (at MIBOR + 100 bps) and firm rated A wants to borrow in the fixed rate market (at 12%). Notice that for the lower-rated firm, the spread in the fixed rate market is more than for the higher-rated firm. The two firms can set up a swap as follows: © Firm rated AAA goes to the fixed rate market and borrows at 10%, rather than tapping the floating rate market at MIBOR + 100 bps. © Firm rated A mobilizes funds from the floating rate market at MIBOR + 200 bps, rather than mobilizing from the fixed rate market at 12%, * Having accessed different markets by going against their original choice, now the firms enter a swap where, ® firm rated AAA pays the firm rated A floating at MIBOR + 200 bps = firm rated A pays firm AAA fixed at 11.5% ‘These actions and the resultant impact on the cost of funds for firm rated AAA and firm rated A are shown in Fig. 8.5, an (ene = Cost of funds for firms AMA A 1. Payment to investors 10% MIBOR + 2% 2. Payment to counterparty MIBOR + 2% 11.5% 3, Receipt trom counterparty - 115% MIBOR + 2% Cost of borrowing (1 + 2 — 3) MIBOR + 0.5% 115% Fim can raise funds at MIBOR + 0.50"%, | Firm can raise funds at 19.5% as PACT 28 against MIBOR + 1% without the swap, | against 12% without the swap, gaining 0.50% gaining 0.50% Fig. 85. Interest rate swap—reducing cost of fundsSwaps—Lnterest Rate and Currency 225 As against a fixed payment of 10% to its original lenders, firm rated AAA pays a floating rate of MIBOR + 200 bps and receives a fixed rate of 11.5%. This not only transforms the liability from fixed to floating rate, as the firm wanted in the first place, but also reduces the cost to MIBOR + 50 bps, as against MIBOR + 100 bps that it would have incurred without the swap, thereby gaining an advantage of $0 bps. Similarly, firm rated A too can transform to a fixed rate as it initially desired, and can also reduce the cost of funds to 11.50%, as against the 12.00%, which it would have incurred if it were to go to the market directly. The swap again gives an advantage of 50 bps. RATIONALE FOR SWAP—COMPARATIVE ADVANTAGE Sittin ‘The remarkable characteristic of the swap agreement was its ability to reduce the cost of funds for both the firms, as shown in Fig. 8.5. Normally, one expects to gain at the expense of the other, as it is reasonable to assume that derivatives are a zero-sum game. The explana- tion behind why both the parties in a swap agreement gain lies in the theory of comparative advantage. Regardless of the fact that the firm rated AAA held an edge over the firm rated A in both types of borrowing, comparative advantage played a significant role in the successful completion of the swap transaction between the two firms. Firm rated AAA had an absolute advantage of 200 bps in the fixed rate market and 100 bps in the floating rate market. Alter natively, we ean say that firm rated AAA had a comparative advantage of 100 (difference between the two absolute advantages) in the fixed rate market, Put another way, firm rated A had a relative advantage in the floating rate market. The comparative advantage of 100 bps was available for exploitation by both the firms, at the expense of distortions in the financial market. Therefore, it makes sense for the firm rated AAA to access the fixed rate market. where it had a greater absolute advantage, and then enter into the swap to transform its fixed rate liability into a floating rate one, Similarly, firm rated A must access the floating rate market and then enter into the swap to transform its floating rate liability into a fixed rate one. The total benefit for both the firms would remain fixed at 100 bps, and the amounts of fixed and floating rates would determine who gets how much of the benefit, Of course, sharing of benefit would depend upon the negotiating powers of the two firms involved. The aggregate advantage remains fixed at a comparative advantage of 100 bps. In ease of a direct deal between the firm rated AAA and the firm rated A as depicted in Fig, 8.5, the benefit was shared equally by both the firms. In case such a deal were to be structured by an intermediary, such as a bank, serving as counterparty to each, some part of the benefit would be sacrificed by each of the party. This benefit goes to the bank. One such deal, where the bank gets 20 bps (10 bps each) is depicted in Fig. 8,6 and Table 8.3 Peeccton te posit. The exploitation of the comparative advantage by the firms is a clear case funding through swaps is of arbitrage on the credit rating, The fixed rate market demanded a greater based on the principle of | premium from the lower rated firm than did the floating rate market, forcing comparative advantage, the firni to access the floating rate market. The premium demanded by the ‘and is aclassical applica: | higher rated firm for a fixed rate was lower than the market, making the swap fion of rest arbitage. | eat attractive. The question that arises is: how can a competitive market226 dei wes and Risk Management EXAMPLE 8.2 Interest rate swap to reduce funding cost. oh ‘Two Indian firms, IndoPlas and IndoCar, are contemplating raising finance of @100 crore each. They have been offered thé following foans by a bank. ‘Another bank, acting as a swap intermediary, is willing to work out a swap arrangement for a fee of 5 bps from each firm. indoCat boalieves that the inlerest rate would fall and, hence, wants to raise funds on a floating rate basis. IndoPlas feels otherwise, and wants to raise funds on a fixed interest rate basis, What swap can be arranged betwaen the two parties? What would be the ‘saving in financing cost for each firm if benefits of swap are shared equelly? ‘Solution re eee re REY eS eee ae GRE ee ee ee tee IndoCar wants to raise finance at a floating rate, the fim must access the fixed rate market and then enter into a swap with IndoPlas to convert the ability from fixed rate to floating rate. The total beneft to be availed of is 60 bps, the differential of absolute advantage for IndoCar in the two markets, The bank would charge 10 Dps as a fee, The remaining 50 bps may be Shared equally by both the panies through a swap. One such structure is presented as tollows: Interest rate swap: A schematic view with an intermediary |_| cam =m =-=—=—- Cost of borrowing = Indocar Payment to investors 1% Payment to bank MIBOR + 0.05% Flecsipt from bank 11% Cost of borrowing (1 + 2 ~ 3) MIBOR + 0.05% ‘The aggregate cast of funds for indoCar would be MIBOR + 5 bps, @ saving of 25 bps if it accesses the floating rate market. ‘Similarly, IndoPlas obtains funds at 11.75% against 12%. without the swap deal, resulting in an advantage of 25 bps, Fig. 8.6 Interest rate swap: A schematic view with intermediarySwaps—Interest Rate and Currency 227 Table 8.3 Sharing benelits of swap A MIBOR + 2.00%. ‘MIBOR + 2.00% 11.50% Receipt from bank 11.40% MIBOR + 1.90% Cost of borrowing (1 + 2 — 3) MIBOR + 0.50% 11.60% ‘Cost with direct access to the market MIBOR + 1.00% 12.00% ‘Savings s0bps 40 bps Earning for the bank 11.50% — 11.40% + (M + 2.00%) — (M + 1.90%) = 0.20% or 20 bps: allow this aberration to take place? The answer seemis to lic in the gap in the information the market has on firm rated AAA and the firm rated A. Lenders, while lending on a floating rate basis, have the opportunity to review rates every six months, and for the firm rated higher, the spread would usually be a smaller one. In the fixed rate market, the spread would be larger for lower-rated firms. Lenders could rely more on firm tated AAA than they could on firm rated A. The spread in the two markets are unequal due to unequal rating of the firms, The differential of spread reflects the differential of likely default by firm rated A relative to firm rated AAA. The theory of comparative advantage has been used to structure swap transactions in a manner that both parties in the swaps are able to reduce their costs of funds. Generally, a firm with higher credit rating is able to procure funds at lower rates of interest than a firm with lower credit rating, irrespective of whether the borrowing is on a fixed or a floating rate basis. The firm with higher credit rating is said to enjoy an absolute advantage over the firm with lower credit rating in both the fixed rate and the floating rate markets. The advantage of the higher-rated firm over the lower-rated firm is called the credit quality spread. Despite « credit quality spread in both the fixed rate and the floating rate markets, it may be beneficial for the higher-rated firm to engage in a swap deal with the lower-rated firm due to the likelihood that the credit spreads in both the markets would not be equal, The differential ‘of the two absolute advantages measures the comparative advantage, which in turn forms the basis of the swap deal. This comparative advantage is the aggregate benefit that both parties to the swap deal can share, in proportion to the bargaining powers of each. Swaps are, therefore, a product resulting from arbitrage on credit rating. The question is, will this credit arbitrage continue? Most likely, the answer is *yes’, as long as gaps in information and credibility remain, TYPES OF INTEREST RATE SWAPS SSRs ne nanny Interest rate swaps can be categorized as follows: Fixed-to-floating In fixed-to-floating rate swaps, the party pays a fixed rate of interest to the bank or swap dealer and in exchange, receives a floating rate of interest determined on228 Derivatives and Risk Management the basis of a seference/benchmark rate at predetermined intervals of time, Meier cinetce tah | Such a swap is used by a firm that has a floating rate liability and anticipates ‘ofwhich maybetased | a rise in the interest rates, Through the swap. the firm will cancel out the on dierent parameters. receipts and payments of the floating rate and have a cash outflow based on wihoneleg fkedend =| the fixed rate of interest, the other floating, or with : both foating, buton dit —-Floating-to-fixed — In this kind of swap. the party pays a floating rate of ferent benchmarks. interest to the bank or swap dealer and in exchange. receives a fixed rate of "= interest at predetermined intervals of time. Such a swap is used by a firm that has a fixed rate liability and anticipates a fall in the interest rates. Through the swap, the firm will cancel out the receipts and payments of the fixed rate liability and have a cash outflow based on the floating rate of interest Basis Swap In contrast to the fixed-to-floating or floating-to-fixed swaps, where one leg is based on the fixed rate of interest, the basis swap involves cash flows of both the legs based on a floating rate, However, the reference rates for determining the two legs of payment are different, Basis swaps are used where the parties to the contract are tied to one asset or liabil- ity based on one reference rate, and want to convert to another reference rate. For example, if.a firm having liabilities based on the T-bills rate wants to convert them to a MIBOR-based Tate, then the firm can enter a basis swap where it pays a MIBOR-based interest to the swap dealer in exchange for receiving interest based on the T-bills rate. CUTTS Ina currency swap, the exchange of cash flows between counterparties takes place in two dif ferent currencies on the basis of a predetermined formula of exchange rates. Since two eur- rencies are involved, currency swaps are different from interest rate swaps in Cureney swaps ao their uses. functionality, and administration. The first recorded curreney swap called financial swaps, | was initiated in 198] between IBM and the World Bank ate exchanges otcash | © More complex swaps involve two currencies with fixed and floating rates flows in two siferent ns cupbeieieg Sct ‘ ya Ti of interest in two currencies, Such swaps are called cocktail swaps—an be ena ay example isa swap where one party pays 4% in US dollar and receives in ee LIBOR-based Swiss franc. World Bank-IBM Currency Swap The idea of sw: entered a swap de was provided by a historical deal in August 198] when the World Bank with IBM through Salomon Brothers. The World Bank and IBM entered into a deal to exchange, whereby the two exchanged liabilities in US dollars, Swiss francs, and Deutsche marks. It was the first ever curreney swap that recognized the cost-saving potential of the instrument for borrowing by the two parties involved, ‘The World Bank was looking for fands at a minimum cost for onward lending to develop- ing countries for various projects. The cost consideration was paramount for them because of their inability to charge higher rates of interest from developing countries. In August 1981, the prevailing interest rates for US dollars were around 17%. In contrast, the interest ratesSwaps—Interest Rateand Carrency 229 in Switzerland and Germany were 8% and 11%, respectively. This interest rate scenario sug- gested depreciation of the dollar by about 9% against the Swiss frane and 6% against the Deutsche mark. The World Bank believed that depreciation of the dollar would not be as much as suggested by the interest rate differentials. and, hence, it would be inexpensive to borrow in Swiss francs and Deutsche marks. The World Bank had borrowed its permissible limit in Switzerland and the same was true of the then West Germany. The World Bank, with a credit rating of AAA and backing by several nations such as the USA, Germany, and Japan, was well placed to get a lower financ- ing rate in US dollars at the treasury rate plus 40 bps in the bond market. Another worldwide corporation, IBM, could mobilize funds in US dollar at treasury plus 55 bps. In the Swiss market, the World Bank could raise funds at the Swiss treasury rate plus 20 bps. The problem forthe World Bank was that it had exhausted its borrowing capacity in the Swiss and German. markets. Constantly searching for low cost funds, the World Bank had approached Swiss and German bond markets frequently in the past. Having already borrowed heavily in both the markets, it had reached saturation levels. Further borrowing was discouraged by lenders, The discouragement to borrow further was manifested in raised interest rates, as is the practice in all markets to contain excessive exposures. In comtrast to this, IBM could raise funds in the Swiss market at the best rate. It could borrow at the Swiss treasury rate and held an advantage of 20 bps over the World Bank, but had a poor rate if it were to borrow in US dollars. At the same time, IBM believed that the US. dollar would depreciate much beyond the interest rate differentials of the US dollar vis-a-vis the Swiss frane and the Deutsche mark. It already had loans outstanding in Swiss francs and Deutsche marks, as given in Table 8.4. The desire of the World Bank to raise money in Swiss francs and Deutsche marks and the existing obligations of IBM in these currencies along with its willingness to raise funds in US dollars created a common meeting ground for the two. The contrasting views of IBM and the World Bank regarding the expected depreciation of the US dollar (the World Bank anticipated a lesser depreciation and IBM expected a higher depreciation of the dollar than reflected by the interest rate differentials) was the main motivation for fruitful engagement ina swap deal, Table 8.4 Details of foans of IBM for swap with the World Bank ‘Swiss franc (CHF) loan | Deutsche mark (DM) loan Principal, in milions 200.00 300.00 ‘Due date for bullet repayment of the principal 90 Mareh 1986 ‘90 March 1986 Annual interest outtiow due March 30 each year, in millions 12.375, 0.000 Effective interest rate e 6.187% 10.000% Interest rate prevailing in August 1981 8.00% 11.00% | Present valve of loans in August 198, in lions | Exchange rate prevailing in August 1961, untsidotar | Equivalent dollar of present value of foans, in millions230 Derivatives and Risk Management The loan liabilities of IBM in Swiss franc and Deutsche mark added up to US $205.48 million in present value terms, as shown in Table 8.4. IBM was willing to pay 16% on a US dollar loan. After adjusting for the issue expenses, the World Bank issued a debt aggregating to US $210 million with maturity on 31 March 1986, coinciding with IBM’s loans. Subse- quent to the debt raised by the World Bank, cash flaws were exchanged whereby IBM paid US dollar obligations at 16% for a principal of US $210 million and the World Bank paid the Swiss franc and Deutsche mark obligations of IBM. A schematic diagram of the swap is presented in Fig. 8.7. Flows of principal amount from World Bank to IBM and vice erea and its repayment at the end of the swap were not required. These flows are shown in Fig. 8.7 to enable an understanding of the mechanism of a swap transaction. August 1961: Raising loans and exchanging principal Debt read US $205.48 m US $205.48 m | World Bank |, CHF87.78m DMs17.70 m Existing debt of CHF and DM March 1982-March 1986: Exchanging interest obligations and re-exchange of principal | CHFZ00 m and O00 m in March 86 x US $336mpa Work Bank | CHF12.375m p.a,_| |__0M30.00 m 0. US $210 min March 86 | Fig. 8.7 Swap transaction of IBM and the World Bank ‘The advantage of the swap arrangement was that IBM got US dollars at a lower rate and at the same time the World Bank also received Swiss franc and Deutsche mark loans at lower nates, capitalizing on the strength of each other in the tespective currencies. Both IBM and the World Bank got what they wanted, If the World Bank borrowed US dollars and lent them to IBM at US Treasury + 40 bps, it would not incur any loss, and IBM would get a better tate, ITIBM borrowed Swiss franes and lent them to the World Bank at Swiss Treasury + 10 bps, IBM would make 10 bps, and so would the World Bank. If both the loans were raised, it would have resulted in a profit of 15 bps to IBM and a profit of 10 bps to the World Bank. Since 1BM and World Bank both borrowed the same amount of money, there is no need to exchange the principal since they cancel each other. On each due date, IBM would pay interest on the US dollar loan of the World Bank and receive interest on the Swiss franc and Deutsche mark loans from the World Bank. However, as the principals were not exchanged in the first Place, it was not necessary to te-exchange the principal subsequently. Counterparty risk, i.e., risk of default, was almost non-existent, as both the parties had a sound AAA credit rating.Swaps—Interest Rate and Currency 231 Banks and financial intermediaries were quick to seize upon the idea, and soon started broking swap deals for a fee. The swap had greater appeal in saving borrowing cost rather than in managing risk. The development of the swaps market has been rapid since the IBM— World Bank swap, It has grown tremendously. Today, swaps are possibly the largest deriva- tive in the market. According to the Bank of International Settlement (BIS), there is over 60 trillion dollars of notional value of transactions in the year 2001, out of a market total of 180 trillion dollars. According to the triennial survey of BIS in 2010, the daily average in foreign currency swaps amounted to US $1745 million out of a total daily turnover of US $3370 million. This is estimated to be more than 15 times the size of the US public equities market, In 1987, according to the ISDA, swaps had a total notional value of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, and in the first half of 2010, it stood at $434 willion. Back-to-back’ parallel loans posed several difficulties: finding parties with identical needs in terms of amount of principal, timing and duration of loans, periodicity, and nature (fixed or variable) of interest payments, All of these parameters must match to conclude a success- ful deal. Solutions to these problems were found by intermediary banks, which progressed ater to becoming dealers in swaps, from mere arrangers of swaps between two parties. Back- to-back loans, which originated in the 1970s, are examples of financial swap agreements. Problems associated with back-to-back loans were overcome by banks, and the intermediary role played by banks made these loans a very popular financial product, The underlying principle that underlines the swap is the exploitation of the comparative advantage of two counterparties, as was done in the World Bank-IBM swap. Although the first swap was a currency swap between the World Bank and IBM, the swap market has been mainly driven by the fixed-for-floating interest rate swaps market. Hedging Against Exchange Rate Risk with Currency Swap Currency swaps cover different kind of risk. They are one way of converting liabilities or assets from one currency to another, While in the case of interest rate swaps, assets or liabili- ties are transformed from fixed interest rates to floating rates or vice versa, providing a hedge against fluctuating interest rates, currency swaps provide a hedge against exchange rate risks, ‘as they transform liabilities/assets from one currency to another. Let us consider an example to see how MNCs face currency risks and how these could be overcome through a swap deal. Assume that an Indian firm needs funds for its US operations. The firm raises funds in Indian rupees and commits itself to serve its interest obligations and the final repayment in Indian rupees, The funds raised in rupees are converted to US dollars to acquire assets in the USA. These assets provide income in US dollars. The Indian firm is subject to the risk of appreciation of the rupee (depreciation of the dollar) value in the currency markets, as it would then receive lower rupee amounts for fixed returns earned in US dollars. Similarly, a US firm, which needs to acquire assets in India while it raises dollar funds in the USA, faces the same risk. Its earnings would be in Indian rupees, and the liabilities need to be serviced in US dollars. Like the Indian firm, the US firm also faces a risk of shortfall in the US dollar if it appreciates (and the rupee depreciates)232 Derivatives and Risk Management The vulnerability of both the Indian firm and the US firm is due to the uncertainty of exchange rate movement, which may take place in cither direction. Depreciation of the dollar harms the Indian firm, while it benefits the US firm, Risks for both the firms arise because the future movement of exchange rates cannot be predicted accurately. However, an estimate of the likely direction of exchange rates is made based on many theories, such as purchasing power parity and interest rate parity. In this sub-section, we focus on the unexpected and adverse movement of exchange rates, as parties factor in likely movements while making estimates. The clement of risk can be removed if the Indian firm and the US firm enter inte a swap: agreement, as depicted in Fig. 8.8. A cursory look would reveal that the Indian firm has financed its US operations by creating a rupee liability. This liability. to be serviced by the income generation in US dollars, faces a currency exchange rate risk. Likewise, the US firm, having funded its Indian operations through a US dollar loan, would be serviced by income in rupees, and needs to be converted to US dollars for payment of interest and principal in the future, whenever they fall due. US asset Deliae income Doar tabinty Fig. 8.8 Currency swap: Converting asseV/ability from one ‘currency to another Under the swap transaction, the mismatch of cash inflow and cash outflow in different currencies for both the firms can be eliminated by (a) the US firm agreeing to pay the rupees: generated out of its Indian operations to the Indian firm, and (b) in exchange, the Indian firm agreeing to pay US dollars generated out of its US operations. Thus, the rupee asset income flows to the Indian firm, facilitating service of its rupee liability, In exchange, US dollar asset income flows to the US firm to meet its US dollar obligations. Both the firms avoid any conversion of currencies from one to another and thus eliminate exchange rate risks, Through the swap, both the firms will have assets and liabilities maintained in the same currency, eliminating currency risk. Reducing Cost of Funds with Currency Swaps Like interest Nite swaps, currency swaps can also be used to reduce funding cost for MNCs needing funds in different currencies, Again, the guiding Principle is the theory of com- parative advantage. In an interest rate swap, the comparative advantage emanates from theSwaps—Interest Rate and Currency 238 oi |! | EXAMPLE 83 Currency swap to hedge against exchange rate risk ‘Assume that an Indian software fim, Inso Lid, wants to acquire a US firm at a cost of $2.00 crore. For this purpose, it raises the required capital of £80 crore (current exchange rate ot €45idollat) at 12% The US acquisition is expected 10 yeld a 15% retum. At the same time, a US engineering firn, USENG Inc., ss negotiating a jant venture to contribute US $2.00 crore, which ‘promises to yield a 15% return in india, USENG Inc. raises the dollars required at a cost of Bs. Assume that al liablties need annual payments, {a}, Examine the risk taced by Inso Ltd and USENG Inc. ifthe () rupee appreciates to 44, 42, 40, 98, and 36 per dollar for the next five years (#) rupee appreciates to 46, 48, 50, 52, and 54 per dollar for the next five years: {b) Show how a swap arrangement between the two can help ‘eliminate the risk of exchange rate fluctuations. Solution {@) nso Lid is targeting an annual profit of €270 lakh as fol tows: Income in US $ = 15% of $200 lakh = $30 lakh pa Equivalent value in rupees = 11360 lek pa Interest payment = 12% of £9,000 takn Anteipated proft = 1,350 — 1,080 if the indian rupee appreciates, inso Lid, would receive a lesser income than expected, and, hence, carries the risk of reduction in profit due fo appreciation ofthe rupee, as is iabilty is fixed in rupees. Similarly, USENG Inc. is targeting an annual profit of $14 lakh as follows: Income in rupees = 15% of $9,000 lakh Equivalent value in US dollars Interest payment = BM of $200 iakh Anteipated profit = 30-16 = $18 lakh pa. ifthe Indian rupee Gepreciates, the fi will receive a lesser annual income than expected, and, hence, faces the risk of reduction in profit to the extent of depreciation in the rupee, as its [billy is fixed in US doltars White appreciation of the rupee is good for the US fim and detrimental to the Indian firm, the position reverses if the rupee epreciates, The impact on the spreads of both the fers for the excharige rate scenario is presented as follows: Favourable to the Indian firm and unfavour- able to the US firm Favourable to the US firm and unfavourable to ‘the Indian firm Year 5 4 3 2 1 Now 1 2 3 4 5 (b) By entering nto a swap arrangement, both the firms elmi- at the current rate of 845 per dollar: ‘ale voltilty in the spread, Under the Swap arrangement, i) The US firm wil pay the Indian fir €1,380 lakh annually, earned out ofits joint venture in India i) The Indian firm will pay $30 lakh annually, eamed out of its acquisition in the USA (Contd)234 © Derivatives and Risk Management EXAMPLE 83 contd Currency swap: converting asseUfiability from one currency to another US asset $20 kh pa le | ‘Swap transaction Rupee liability 127 $30 ohn pa, >, ee ee 9.000 lakh p.a if 5 pa +~—_—_——_|_ neous. | a res Interest 21,080 fakh p.a. US $16 lakh p.a. 21,380 lakh pa Indian asset ‘A schematic diagram of the swap arrangement is shown here. The spread alter the swap arrangement becomes fixed for both the firms, irrespective of the exchange rate. The US firm will Jack-in a retum of $16 lakh and the Indian firm will be assured of a profit of £270 lakh after the swap arrangement. Cash flows after swap Figure in jakh pa. Inso Lid USENG Inc. Income earned abroad + $30 + 21,350 Paid to counterparty = $0 = 81,550, | Received trom countemary [+ %1,350 +930 Interest obligation = 871080 = $14 ‘Spread + 8270 +316 Without the swap agreement, income tor both the ferms in the USA and India was subject to fluctuations due to currency exchange rate changes, differential in pricing in the floating rate and the fixed rate markets, Here, the comparative advantage results from two distinet and separate markets in different currencies that are gov- erned by altogether different sets of rules and operate in vastly different economic conditions, Although the exchange rate mechanism provides a link among these markets and econo- mics, the link is a frail one compared to the strong linkages the capital and debt markets have in a single economy. The quality spread in domestic mar- kets is based on the credit rating of the parties, In the international markets, the credit rating for a given firm may vary substantially across nations, as firms are generally better known in their home country than in foreign coun- trics. Further, exchange control regulations of @ given land may discourage borrowing by non-residents by stipulating a higher rate. Therefore, the com- parative advantage is likely to be more pronounced in two markets in two different economies, as compared to similar markets of the same economy for one currency. As such, the credit quality spread is expected to be larger in the markets for different currencies than the credit quality spread in the markets for fixed and floating rates.Swaps—Interest Rate and Currency 235 A greater spread in credit quality increases comparative advantage. Increased comparative advantage opens up more avenues for currency swaps. However, the size of the market may be limited, as only MNCs will be the beneficiaries of such currency swap transactions. As a simple example. consider two MNCs, one Indian and one British. Both the firms enjoy excellent and equivalent credit rating in their countries. However, their funding require- ments are confined to their own countries. Now they need to raise funds across boundaries for their ever-increasing expansion needs. In doing so, they can capitalize on any interest rate differentials that may exist in two currencies. The costs of capital for the two firms in India and Britain in their respective currencies are as follows: ‘Advantage to the British fim Clearly, the Indian firm enjoys an advantage over the British firm in India, and the British firm commands more credibility in Britain as compared to the Indian firm. Notice that the absolute advantage may not be in favour of the same firm as in the interest rate swap case. The comparative advantage here is 6%. If the two firms borrow in the required currencies, the total cost of funds will be 20%, ie., the Indian firm borrows pound at 6% and the Brit- ish firm borrows rupees at 14%, However, if they borrow as per the comparative advantage theory and exchange each other’s commitment, the total cost of funds can be reduced to 14%, with the British firm borrowing pounds at 4% and the Indian firm borrowing rupees at 10%. Both the firms can benefit by 6% in aggregate if they enter into a swap arrangement wherein the following sequence is followed © The Indian firm mobilizes funds in rupees in the Indian market at 10%, * It lends the rupee funds to the British firm at 11%. © The British firm raises funds in the British market in pounds at 4%. . . . It lends the same funds to the Indian firm at 5%. The two firms exchange interest payments periodically. Finally, they exchange the principal amounts upon redemption. The schematic diagram of the swap arrangement and cost of funds for both the firms is shown in Fig. 8.9. ‘We assumed in the example that the Indian firm and the British firm exchanged the princi- pal amounts of borrowing, and as a natural outcome, would have to exchange the repayment amounts at the time of redemption. However, it is not essential to do so, as both the firms can use the spot market for buying and selling the currencies required independent of each other, both at the time of raising funds and at the time of redemption. ‘Through the swap the Indian firm is new able to obtain pound funds at 4% as against 6% in the absence of swaps; a benefit of 2%. Similarly British firm has access to rupee funds at 10% as against 14%; a benefit of 4%. The aggregate benefit is equal to the comparative advantage of 6% which may be shared by the two firms depending upon negotiating skills and strength of the two firms involved.236 Derivatives and Risk Management 2 Principal 81% 210% < 5% ~.___£ Principal 1, Payment to investors rupee 10% 2, Payment to counterparty pound 5% rupee 11% $3, Receipt irom counterparty rupee 11% pound 5% Cost of borrowing (1 + 2 ~ 3) pound 4% rupee 10% Fig. 8.9 Currency swap to reduce cost of funds DISTINGUISHING FEATURES OF CURRENCY SWAPS [ittittinnninnensntttne It may be noticed that the mechanism of a currency swap is similar to that of a parallel loan. The existence of an intermediary in a swap contract helps to minimize counterparty risk by locating a suitable counterparty; it makes swaps better than parallel loans. However, working on the same principle of comparative advantage, currency swaps differ operationally from interest rate swaps. Under a currency swap, the cash flows are as follows: * exchange of principal amounts at the time of setting the swap deal at the current ‘Spot rate * exchange of periodic interest payments ‘© reverse exchange of the principal amounts upon maturity at exchange rates prevailing then Under an interest rate swap, there is no exchange of principal at the beginning of the swap or at its conclusion. Currency swaps may be classified as follows, i ' . ik Se Fixed-to-fixed In a fixed-to-fixed currency swap, the interest rates in the Some whan _ | ‘0 currencies involved are fixed, For example, a British firm may raise a erent curences, are | loan in pounds and exchange it for US dollars with a US firm, Interest pay-= exchanged both atthe | ments may be made by the British firm in dollars, while it receives interest in initiation andthe conclue pounds from the US firm, The US firm would do the reverse, making interest Payments in pounds and receiving US dollar interest payments, The interest ‘ates in both the US dollar and the pound are fixed. Fixed-to-floating Ina fixed-to-foating currency swap, the interest rate on one of the cur- Fencies is fixed, while it is floating on the other. In the earlier example in this chapter of the British and US firms, if the British firm paid interest in US dollars at a fixed rate while feoeiving interest in pounds, based on LIBOR, from the US firm, such a swap would be a fixed-to-floating swap. Such swaps not only transform the nature of the asset/ liability fromSwaps—Interest Race and Currency — 237, one currency to another but also change it from a fixed rate to a floating rate. They become complex tools suitable for hedging mst currency risks as well as interest rate risks. Floating-to-floating In a floating-to-floating currency but in , both interest rates are floating, ferent currencies. In the British firm-US firm example, if the British firm makes interest payment in US dollars based on the prime rate in the USA while receiving interest in pounds, based on LIBOR, from the US firms such a swap would be of the floating-to- floating type. Swap pricing is important for two reasons, First, as stated earlier in this chapter, banks function as warehouses of swaps. and are ready to offer swaps to desiring customers. For this purpose, they are required to quote swap rates for paying or receiving a fixed rate of interest for receiving or paying the benchmark floating rate. The second reason for valuing a swap is for the purpose of terminating an existing swap. For reasons of economy, a firm may like to cancel its obligations under a swap after some time by abandoning the remain- ing part of obligations undertaken by it, by paying or receiving the value of the swap at that point of time. Ne e Currency India and Japan agree to $15 billion currency swap ‘On 28 December 2011, India and Jaan agreed to 2 dolar swap agreement of US $15 bilion. An earlier US $3 bilion arrangement ‘hat came into force in 2008 had expired in June 2011. Currency swaps involve an exchange of cash flows in two diferent currencies. By ther special nature, these instuments are used for hedging risk arising out o volatity in the foreign exchange markets, The agreement wil enable the two countnes to swap currencies for US dollars and tap into each other's foreign exchange reserves 10 ease any Iquiity problems. Under the deal, the two central banks wit supply each other with up to $5 bilion from their toreign ‘currency reserves for possible market intervention in the event of financial turmol ‘The genesis of the deal lls in the need to remove vokatty nthe foreign currency markets. The indian rupee had fallen more than 15% ina year. The Japanese yen has also been volatile i the wake of an uncertain global outock. ‘There were growing concems about foreign institutional investors (Fils) pulling out of the indian capital markets dye to fears of a slowdown in the Indian economy. The Fils watdrew almost $600 milion from the Indian secures market in November 2011. This ‘huge capital outflow fis hurt he Indian currency, which hit an alltime low against the US dol. There have also been fears over he performance of the overall Indian economy du 10 the protracted sovereign-debt crsis in the Global francial markets, A weakening ‘currency atlds to the cost of imported goods, The two Nations agreed to support each othar i the event of @ run on their currencies, ‘Under the plan, Japan would lend dollars and other currencies, should India find &s foreigr-exchange reserves dedining dispropor- Beastie red ek Woe rani ncoee de ee ck oa aN and, simiarty, ‘ncka wil ake yen and send dolars to Japan it speculators seek to rash the respective curencies. Besides containing voiailty in the curencies, the swap would help 15 boost trade between the two counties. The move would strengthen the Indian canal bank's armoury 10 tackle any Bquicty crisis or voatity in the currency market. For India, the swap arrangement is all the more. important, and it ight actualy draw trom the facility, given the situation of net capital outfows, an exacerbating current account defct (which cimbed to a troublesome 4.9% of GOP for the October-December quarter) and the weak composition of reserves. Incka was strugging to meet the projected level of $72 bilion in capital iftows tit March 2012, and even the ‘most optimistic forecasts did no! pu! the figure at above $60 bilicn to $86 bilion,238 Derivatives and Risk Management Valuing Interest Rate Swaps An interest rete swap can De seen as a pair As stated earlier in this chapter, an interest rate swap consists of a fixed rate cash flow and a floating rate cash flow in the opposite direction. At the time of inception of the swap, the present value of these payments must be equal in the opinions of both the parties to the swap, or else they would not agree to it. Therefore, at inception, the value of a swap is zero, implying that the present values of cash inflows and outflows are equal and its aggregate flow is zero. However, the circumstances would change after the swap is initiated. The value of an inter- est rate swap at any time is the net difference between the present values of the payments to be received and payments to be made. It becomes positive for one party and is equivalently negative for the other. This tells how much cash the two parties must exchange to nullify the remaining obligations in the swap. From the valuation perspective. a swap transaction may be interpreted in at least two ways, It can be considered either as a pair of bonds or as series of forward agreements. Either interpretation of a swap helps in its initial pricing as well as its valuation if and when either or both parties want a premature closure. We take the pricing of swaps by both methods: by treating the swap as a pair of bonds and as a series of forward agreements Swap as Pair of Bonds The most common interpretation of interest rate swaps is to consider the inflows and outflows of interest at periodical intervals, equivalent to that } of bonds, In an interest rate swap. one leg of the transaction is on a fixed rate of bonds: one afioating | and the other leg is on a floating rate of interest. We know that the owner of fate bond andthe otter | a bond receives interest and the issuer of bond pays imterest. Therefore, a a fixed rate bond rep- swap is a composite of these two cash flows: resenting the two cash | ‘flows, floating and fixed, 1. Cash inflow equivalent to the interest on the bond owned of the swap. 2. Cash outflow equivalent to payment of the interest on the bond issued Therefore, a swap is a pair of bonds, one issued and one owned. A swap where one pays a fixed rate and receives a floating rate can be viewed as a combination of (a) having issued a fixed rate bond paying the fixed coupon rate, and simultaneously (b) owning a floating rate bond receiving a floating rate as per market conditions, as depicted in Fig. 8.10. While setting up the swap, the coupon rate (the fixed leg receipts/payments) is fixed in ‘such a manner that the values of cash inflows and cash outflows are equal and both the par- ies to the swap arrangement are in equilibrium; the net present value of the cash flows is zeto. This forms the busis for fixing the initial price of the swap, determined in terms of a fixed rate of interest payable or receivable upon exchange of a floating benchmark rate, For Fixed 7% ———» Issue of bond with coupon of 7% Fiem A (ae | Floating MIBOR + 1%*+—— Qwn a floating rate bond with 8 coupon of MIBOR + 1% Fig. 8.10 Swap as pair of bondsSwaps—Interest Race and Currency 239 firm A in Fig. 8.10, the equivalent of MIBOR may be taken as 6%, at the time of initiating the swap. However, interest rates are dynamic, and the value of cash flows as determined at the start of a swap will not remain the same as time elapses, The value of the swap will depend upon the behaviour of bond prices with respect to changes in the interest rates. The following rules about bond prices may be kept in mind while valuing swaps: © The value of a fixed rate bond will increase with a fall in the interest rates. * The value of a fixed rate bond will decrease with an increase in the interest rates, © The value of a floating rate bond remains equal to its par value, as the coupon rate is aligned with market rates on each periodic payment of interest. The value of a floating rate bond changes subsequent to each interest payment, if the interest rate structure has changed since then. © The value of a floating rate bond gets aligned again to the par value on the next (and each) date of payment of interest. Since any change in the value of a floating rate bond will only be nominal and temporary (it changes only during the two interest payment dates), the value of a swap aeeleedtence, | isdetermined on the basis of the difference between the present values of the ‘finding the value of the fixed leg and that of the floating leg, and thus is predominantly dependent - swap subsequent to its upon the yalue of the fixed rate bond, fntiaton, The valve ot The value of the bond with fixed rate payments will be equal to the sum of Sites 2eowhent | coupon payments and the notional principal amount discounted at an appropri ate rate. The discount rate to be used for each coupon payment is known from the term structure of interest rates. The value of the fixed leg, V, is given by: ey ee ee K a fry +r ae 7 where C, = coupon payment at time i n iscount rate for period ¢ umber of periods remaining P = notional principal amount Similarly, we can find the value of the floating rate bond, V’, which is equal to the present value of the next interest payment and the principal. As we know that the value of a floating tate bond conyerges to its par value on each payment date, the value of the floating leg can be expressed as: eee ee (8.2) (ltr) +n) S where F; = next payment of interest 1 = discount rate for period | P = notional principal amount The value of the swap at any time for the party receiving a fixed rate and paying a floating rate will be equal to the differential between the fixed leg and floating rate cash flows, given by Eq. 8.3.