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
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
Parties
• Two parties
• Counter parties
Swap
facilitators
/ swap
banks
• Swap broker (economic agent-identifying the
potential counter parties in swap deal)
• Swap dealer (often becomes an actual party-
financial intermediary-market maker
Notiona
l
principa
l
• Underlying amount in swap contract
• Amount does not vary- but the cash flows in the
swap are attached to this amount
7. Special terms
Trade
date
• Date on which both the parties in the swap deal are
enter into the contract
Effective
date
• Date when the initial cash flows in a swap contract
begin.
• Value date
• Maturity of contract is calculated from this date
Maturity
date
• The date on which the outstanding cash flows stop in
swap contract
Reset
date
• Date on which the LIBOR rate is determined
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
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
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
Parties involve exchange
debt obligations in different
currency
Each party agrees to pay the
interest obligation of the
other party
On maturity, principal
amounts are exchanged at
pre determined exchange
rate
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
Swap
20. Benefits from currency swap
1. Firm A and firm B gets the currency of their
own choice
2. Cost of borrowing gets reduced
3. Can be used as a tool for hedging foreign
exchange exposure
Firm A
• Without
Swap=LIBOR
• With swap
• 6%+LIBOR-6.80%
• Gain=0.80%
Firm B
• Without Swap=8%
• With swap
• 7%+LIBOR-LIBOR
• Gain=1%
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
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
1. Amount of loan –same
2. Periodic payment of interest-same currency
3. 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
Firm A
• Cost of floating rate loan
=LIBOR+0.3%
• Less floating rate
received=LIBOR
• Net cost
differential=0.3%
• Add swap coupon=9.0%
• Total cost of
borrows=9.3%
• Interest saving=9.5%-
9.3%=0.2%
Firm B
• Cost of fixed rate
borrowing =8.5%
• Less fixed rate
borrowing=8.9%
• Net cost differential=-
0.4%
• Total cost of borrowing
=LIBOR-0.4%
• Interest saving =0.4%
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
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 Bench mark rate is
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
