SWAPS

Swaps
 Simply means exchange.
 It is an agreement between two parties to
exchange a series of cash flows over a period
in the future.
 It is an agreement to exchange one stream of
cash flow for another in future.

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 Switch
 Exchange of one security or property for
another both in spot market.

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 Features of swaps
 Combination of forwards
 Two parties with equal and opposite needs.

 Necessity for an intermediary.

 Involves multiple future contract of exchange

 Long term agreement.

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 Terms used in swaps
 Parties : there are 2 parties and at least one
intermediary.
 Swap facilitators: generally referred to swap
banks. They are two:
 Swap broker: an intermediary- economic
agent- helps in identifying the potential
counter parties in swap deal against
commission.
 Swap dealer: associate himself with the
swap deal – some times he is a party. 5
 Terms used in swaps
 Notional principal : underlying amount in a
swap contract.
 Trade date: date on which entering in to the
contract.
 Effective date: date on which initial cash flows
in a swap contract begin.
 Reset date: date on which the LIBOR rate is
determined.
 Maturity date: date on which outstanding cash
flows stop in the contract. 6
 Advantages of swaps
 Source of finance.
 Long term hedge instrument.

 Flexible

 Meet financial needs of MNCs.

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 Disadvantages of swaps
 Difficult to find counter party.
 Termination of the contract requires mutual
consent of both the parties.
 Default risk

 Not easily tradable.

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 Uses of swaps
 Used by treasurers to hedge the risk.
 Uses to financial managers:

 Convert floating rate debt to fixed and

vice versa.
 To lock in an attractive interest rate in
advance of a future debt issue.
 Arbitrage.

 The financial institution use swap to balance

asset and liability position with out leveraging
up the balance sheet. 9
 Economic functions of swaps
 Transforming nature of liability.
 Transforming nature of asset

 Hedging

 Reducing the cost of fund

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 Types of swaps
 Interest rate swaps
 Currency swaps

 Credit risk swaps

 Commodity swaps

 Equity swaps

These are generic swaps. Most commonly used

swaps are currency and interest rate swaps

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 Currency swaps
 It is an exchange of interest flow in one
currency for interest in another currency.
 It is a foreign exchange agreement between
two parties to exchange a given amount of one
currency for another, and after a specified
period of time, to give back the original amount
swapped.

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 Mechanism of Currency swaps
 1st stage: Firm A borrows Euro at 6% interest.
Firm B borrows US dollar at LIBOR.
 2nd stage: the two firms exchange the borrowed
currencies with help of swap dealer. After that A
will possess US doller B will possess Euro.
 3rd stage: A will pay the LIBOR on US doller and
B will pay 6% on Euro.
 4th stage: the two principals are again exchanged
between two parties. A get back Euro and repays
it to the lender. And B get back doller and repay
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the same
 LOBOR & LIBID
 LIBOR: London Inter Bank Offered Rate. It is
the rate decided on daily basis based on a sample
of lending rates offered by leading banks in
London.
 LIBID: London Interbank Bid Rate. It is the bid
rate that a Euro market bank is willing to pay to
attract a deposit from another Euro market bank

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 Hedging through currency swaps
 An Indian firm needs US doller for its US
operations.
 In this case Indian Firm raise funds in INR and
commits to serve the interest obligation and the
final repayment in INR.
 find INR needed US firm through dealers.

 Exchange the currency.

 Pay the interest

 Re-Exchange the currency

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 Forms of currency swaps
 Fixed for floating currency swap
 Fixed for fixed currency swap

 Floating for floating currency swap

 Amortizing swap: principal amount repay over

the life of the swap.
 Basis swap: exchange of floating rate payments
calculated on different basis.

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 Advantages of currency swaps
 Hedging against foreign exchange risk.
 Increases the total amount that a firm can
borrow.
 Surplus funds can be effectively use in blocked
currencies.
 Exploiting the opportunities of arbitrage.

 Integrating the world capital market.

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 Interest rate swaps
 It is an instrument to hedge interest rate risk.
 It is an agreement between two 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.
 It is the exchange of interest rate.

 Conditions:

 Amount of loan should be same.

 Periodic payment of interest should be the same

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 Synchronization of interest
 Interest rate swaps
 The net difference between the two interest
payments is paid by the party whose payments
exceed the other’s is known as netting of swaps.
 The interest payments are called the legs of the
swaps and the fixed rate is called the swap
coupon.

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 Process of Interest rate swaps
 1st stage: A borrow floating rate loan and B
borrow fixed rate loan.
 2nd stage: inter exchange the interest liability with
each other with the help of dealer.
 3rd stage: at maturity the two firms repay the loan.

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 hedging of Interest rate risk
 Suppose a person borrow Rs.100000 at fixed rate
12%. If he anticipate fall in the price and would
like to convert floating rate.
 Then make a swap with a bank.

 When interest rate is 12%: bank give 12000 and

borrower give 12000.
 When interest rate is 10%: bank give 12000 and
borrower give 10000. - profit
 When interest rate is 13.5%: bank give 12000 and
borrower give 13500.- loss 21
 hedging of Interest rate risk
 Suppose a person borrow Rs.100000 at floating
rate. If he anticipate raise in the price and would
like to convert fixed rate at 12%.
 Then make a swap with a bank.

 When interest rate is 12%: bank give 12000 and

borrower give 12000.
 When interest rate is 13.5%: bank give 13500 and
borrower give 12000. - profit
 When interest rate is 10%: bank give 10000 and
borrower give 12000.- loss 22
 Various forms of Interest rate swaps
 Coupon swap: trade fixed rate interest payment
for floating rate interest and vice versa.
 Basis swap: floating rate payments but based on
different instruments or rates.
 Putable swap: gives the seller the chance to
terminate the swap at any time before its
maturity.
 Callable swap: gives the buyer the right to
terminate the swap at any time before its maturity
 Rate capped swap: right to both parties 23
 Advantages of Interest rate swaps
 Does not involve exchange of principal amount.
 Documentation charges is minimum.

 Off balance sheet item.

 Flexibility

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 Advantages of Interest rate swaps
 Does not involve exchange of principal amount.
 Documentation charges is minimum.

 Off balance sheet item.

 Flexibility

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 Types of swap risk
 Interest rate risk: uncertainty regarding interest rate
 Exchange risk: difference in exchange rate of
currencies.
 Market risk: associated with finding a suitable
counter party
 Mismatch risk: risk in matching

 Basis risk: different floating rate

 Sovereign risk: due to changes in principles / rules

regarding currency dealings.
 Credit risk: default risk 26
Swaps futures

OTC contract Standard contract

Specified time MtM

Long period Short period

Chance of default risk Guarantee default risk

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 Swaps derivatives
Combination of one or more derivative with
swaps.
Forward swaps: combination of forwards and
swaps.
Swaptions: option on swaps give the buyer the
right but not the obligation to enter into swap.
Receiver swaption (receive fixed rate), payer
swaption ( pay fixed rate)

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 Swaps derivatives
Total return swaps: party A pays the total return
of an asset and party b makes periodic interest
payments.
Credit default swap: agreement between two
parties on port folio of asset in which one party
pays a fee to second party over the life of the
contract in return the protection of assuming
default risk.

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 Swaps derivatives
Cancelable swap: swaps can be cancelable befor
expiration
Extendable swap: swaps provide the right to
extent the swaps at the end of the agreed period
for a further predetermined period.
Cross currency interest rate swap: currency
swap+ interest rate swap

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 Exotic/ nongeneric Swaps
Structure are very complex.
It is the combination of swaps, bonds, and many
other potential elements like credit related
instruments.
 1st generation non generic swaps

 2nd generation non generic swaps

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 1st generation non generic Swaps
Forward starting swap: combination of swap
having different duration.
Roller coaster swap: interest rate risk can be
shifted by converting floating rate liability to
fixed rate liability.
Amortising swap:
Accreting swap: the principal amount increases at
pre specified points of time over the life of the
swap.
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 1st generation non generic Swaps
Constant maturity swap: allows purchaser to fix
the duration of swap
In arrear swap: this is a swap that pays and resets
at same time.
Quanto swap: different interest rate but in one
currency
Leveraged swap: the counter party on the floating
interest rate makes the payments which are
multiple.
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 1st generation non generic Swaps
Power swap: the floating rate payer pays the
floating rate square or cubic or any power of
the rate to the counter party
Overnight index swap: this is a fixed for floating
interest rate swap with the floating interest rate
tied to an index of daily inter bank rate or
overnight or call money index.

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 2nd generation non generic Swaps
Index amortising swap: notional amortization
schedule is linked to a floating rate
Bermudan swap: used to hedge structured bonds
as well as providing additional flexibility on
the date of exercise.
Asian swap: combination of other exotic features
and LIBOR is average.
Digital swap: pays a certain fixed amount if the
rates is above or below a certain level.
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 2nd generation non generic Swaps
Barrier swap: pay off is activated or deactivated
when a certain floating rate goes above or
below a certain threshold.
Chooser swap: swaption
Range accrual swap: ribbon of digital options

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