interest rate variation

1. OTC derivatives
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Interest Rate Swap (IRS)
Interest rate swap:
Interest rate swap (IRS) is an agreement to exchange a sequence of interest rate payment. IRS has two legs based on
different parameters; with one leg fixed and the other leg floating or both floating but on different benchmarks.
Usually interest rate swap involves:
(i) Payment of fixed rate interest for receiving floating rate of interest.
(ii) Receipt of fixed rate interest for paying floating rate of interest.
(iii) Payment of floating rate on one reference rate (say-LIBOR) for receiving floating rate on
other reference rate (say T-Bill).
Note: 100 bps (basis points) = 1%, 25bps = 0.25%, 30bps = 0.30%
Application of Interest rate swap
What is the benefit of exchanging the fixed payment in floating payment? Why we do it?
Hedging with the help of interest rate swap
Swaps alter the characteristics of an Deposti/Borrowing from fixed to floating or floating to fix without disturbing
the original contract. Transforming Deposit/Borrowings from fixed rate to floating or vice versa helps to hedge
against the adverse movement of interest rates.
Mr A Dealer
8% (Fixed rate)
LIBOR +25bps (Floating rate)
Mr A Dealer
8% (Fixed rate)
LIBOR +25bps (Floating rate)
Fixed Vs Floating
Mr A Dealer
T-Bill + 30bps (Floating rate)
LIBOR +25bps (Floating rate)
Floating Vs Floating
Uses of Interest rate Swap
Hedging with the help of
interest rate swap
Reducing cost of funds with
interest rate swap

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Hedging strategies with swaps
Nature Risk Hedging Action
Assets (i.e. deposit)
Fixed rate
(Refer example-1)
Rising interest rates Swap to transform nature of Deposit from
fixed rate to floating rate
Floating rate
(Refer example-2)
Falling interest rates Swap to transform nature of deposit from
floating rate to fixed rate
Liabilities (i.e. Borrowing)
Fixed rate
(Refer example-3)
Falling interest rates Swap to transform the Borrowing from fixed
rate to floating rate
Floating Rate
(Refer example-4)
Rising interest rates Swap to transform the Borrowing from
floating rate to fixed rate
Example 1:
[Transformation of Deposit interest form fixed income to floating income using swap]
Assume that Mr. Faltu has made an investment by subscribing to bonds carrying 9% fixed coupon.
Bonds have still some years to mature but the interest rate are showing a rising trend, which is expected to
continue. Mr. Faltu faces a potential loss of income. What can “Mr. Faltu” do?
Solution:
Changing the portfolio of bonds by selling fixed rate bonds and buying floating rate bonds is one solution.
Another solution is- enter the swap to pays fixed rate and receive floating.
The swap arrangement is shown below
The net receipts of floating due to swap = 9.00% - 8.5% + (MIBOR + .30%) = MIBOR + .80%
If MIBOR moves beyond 8.20 % in future, Faltu would be benefited from the situation.
In this case: Existing income = 9% and New income = 8.20% + 0.8% = 9%
Example 2:
[Transformation of Deposit interest form floating income to fixed income using swap]
Assume that Ms. Paltu has made an investment by subscribing to bonds carrying floating coupon “MIBOR+0.2%”.
Bonds have still some years to mature but the interest rate are showing a decreasing trend, which is expected to
continue. Mr. Paltu faces a potential loss of income. What can “Ms. Paltu” do?
MR. Faltu
Bank
(Seller of swap)
8.50%
MIBOR + .30%
9.00%
Bank is quoting following rate for swap:
MIBOR+.30% / MIBOR+.50% against 8.50% fixed.
Meaning of quotation:
Bank will pay MIBOR+.30% and receive MIBOR +0.50%.
In this swap bank pay floating rate, hence applicable rate is
MIBOR +0.30%
Note:
Payer of Fixed Buyer of swap
Payer of Floating  Seller of swap
Swap
Agreement
If increases Also increases

3. OTC derivatives
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Solution:
Changing the portfolio of bonds by selling floating rate bonds and buying fixed rate bonds is one solution.
Another solution is- enter the swap to pay floating and receive fixed rate.
The swap arrangement is shown below:
The net receipts of fixed due to swap = (MIBOR+0.2%) – (MIBOR+.5%) + 8.5%= 8.2%
If MIBOR falls beyond 8.00 % in future, Ms Paltu would be benefited from the situation.
In this case: Existing income = MIBOR+0.2% and New income = 8.2%
Example 3:
[Transformation of Borrowing from fixed commitment to floating commitment using swap]
Five years back, Fasteners Ltd had raised loans thorough 10-year debenture issue worth 100 crore with fixed
interest of 12%.
After the issue the interest rates remained constant for some time. But now they have been at around 10% and are
likely to come down further.
Fasteners Ltd wish to contain the cost of funding for the remaining 5 years.
A bank has offered a swap rate of “9.5% - 9.6% against MIBOR” (it is different type of quotation called “All-in-cost”: for detail about quotation
see subsequent page) for a period of 5 years.
Depict the swap arrangement and find out the new nature of liabilities the firm can have.
Solution:
Fasteners Ltd has liability on a fixed interest of 12%. By entering swap with the bank it may transform the liability
from fixed rate to floating rate based on MIBOR.
Ms. Paltu
Bank
(Buyer of swap)
8.50%
MIBOR + .50%
MIBOR+0.2%
Bank is quoting following rate for swap:
MIBOR+.30% / MIBOR+.50% against 8.50% fixed.
Meaning of quotation:
Bank will pay MIBOR+.30% and receive MIBOR +0.50%.
In this swap bank receives floating rate, hence applicable
rate is MIBOR +0.50%
Swap
Agreement
8%+0.2% = 8.2%
If decreases
Also decreases
existing income
But New income should
be fixed i.e. 8.2%.
Benefit to Bank: (Concept)
Bank will earn profit of 0.2% from the swap deal as it will receive MIBOR+0.5% (from Ms. Paltu-see example-2)
and Pays MIBOR+0.3% (to Mr. Faltu-see example-1). Difference of 0.2% is profit to bank.
Bank is dealing like dealer, whose activity is to pay floating and receive floating.
What activity will do by bank will depend upon the customer’s requirement.

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Under the swap arrangement, fasteners Ltd can receive fixed and pay MIBOR. The buying rate of swap (9.5%)
would be applicable.
The swap arrangement is shown below
The cost of funds for Fasteners Ltd would be = 12% - 9.5% + MIBOR = MIBOR + 2.5%
In case interest rates fall below 9.5%, which is expected, the firm would end up paying lesser interest than what it is
paying now.
Existing Payment = 12% But New Payment = MIBOR +2.5% = less than 9.5% + 2.5% = less than 12%
Example 4:
[Transformation of Borrowing form floating commitment to fixed commitment using swap]
Let us consider company-A, which has borrowed from the market on floating rate basis at MIBOR + 25 bps. It pays
to its lenders at floating rate.
Further, the company considers that interest rates would rise in future. In view of rising interest rates it would like
to have liability that is fixed in nature rather than variable.
Therefore, it decides to enter into a swap with the bank paying fixed 8.50% (assumed) and receiving MIBOR + 30
bps. What is the result of this swap?
It simply transforms the liability to a fixed payment as shown below.
The net receipts of fixed due to swap = (MIBOR+0.25%) – (MIBOR+.30%) + 8.5%= 8.45%
Types of Interest rate swap:
Interest rate swaps can be categorized on the basis of nature of payment as follows:
Under basis swap payment of
interest on both legs should be
based on Floating rate with
Different reference rate.
Eg. One leg  LIBOR
Other leg  T-bill
We can interpret basis swap on
the basis of discussion of Fixed Vs
Floating Swap. (We are not going to
do further discussion on it)
Interest rate swap (IRS)
Floating Vs Floating
(Known as Basis Swap & also
known as Non-Generic swap)
Fixed Vs Floating
Under Plain Vanilla or generic swap payment of interest on one
leg would based on fixed interest rate and another leg would
based on floating interest rate.
Plain vanilla and generic swap are similar on the basis of
interest payment. However it differs on the basis of day count
convention (For Discussion on Day Count Convention- Refer subsequent page).
Day count convention of Generic swap is
0
0
. However day
count convention of plain vanilla swap is .
Plain Vanilla swap Generic swap
Fastener Ltd
Bank
(Buyer of swap)
9.5%
MIBOR12.00%
Company-A
Bank
(Seller of swap)
8.5%
MIBOR + .30%
MIBOR + .25%

5. OTC derivatives
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Swap Market Convention for Fixed Vs Floating Swap:
A fixed Vs Floating Swap should be characterized by:
(i) A notional principal amount upon which total interest payment are based.
(ii) A fixed interest rate
(iii) A Floating interest rate which is periodically re-set (i.e. periodically revise)
(i) Notional Principal
Under interest rate swap, there is no exchange of underlying principal, only interest on notional principal are
exchanged between two parties on “NET BASIS”
(ii) Fixed Interest rate:
 Fixed Interest rate refers to the rate that will “not change” over the life of the instrument.
 Fixed interest rate is based on “Treasury security (not Treasury bill i.e. T-bill) with a maturity corresponding to the
term of the swap Agreement.
 Fixed rate payer is designated as buyer of swap and is said to be “LONG SWAP” (Similar to FRA buyer, where FRA buyer
also pay fixed and receive floating)
 Fixed payments are calculated as following:
Fixed payment = Notional principal Fixed rate day count fraction
 Day count fraction / Day count Convention:
- Fixed payment can be quoted on days count fraction. It means “Actual no of days” in a
payment period and “ 0 or 5 days” in a year.
- Fixed payment on generic swap typically is based on
0
0
days count fraction. It means 30 days in a
month and 360 days in a year.
Example: Calculation of payment under Fixed Leg: See subsequent page
(iii) Floating Interest rate: [Also known as Variable rate or Adjustable rate]
 Floating interest rate refers to the rate that does not have a fixed rate over the life (i.e. rate vary according to the
prevailing rate on market) of instrument.
 Example of Floating rate
- LIBOR  London Inter Bank Offering rate
- MIBOR  Mumbai Inter Bank offering rate
- EURIBOR  Euro Inter Bank Offering rate
- PLR  Prime Lending Rate
- T-Bill Treasury-Bill Rate
- CP  Commercial paper
- Federal Fund etc.
 Floating rate payer is designated as Seller of swap and is said to be Short the swap (Similar to FRA seller, Where FRA
seller also pay floating and receive fixed)
 Floating Payment are calculated as follows:
Floating payment = Notional principal Floating rate day count fraction
 Day count fraction / Day count Convention:
- Floating payment can be quoted on days count fraction. It means “Actual no of days” in a
payment period and “ 0 or 5 days” in a year.
Note: Never use
0
0
days count fraction for floating payment even it is Generic swap.
Different dates used in swap
(i) Trade date(TD): Trade date is the date when swap deal is concluded (or entered).
(ii) Effective date(ED): The effective date is the date from which the first fixed and floating payments starts to
accrue. Normally it is (Trade date + 2 business day). It is also called start date.

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For example: A 5-year swap is traded on August 30, 2010 The effective date is September 1, 2010.
(iii) Reset dates (revision date)(RD): This date is relevant only for floating payment.
Reset date is the date on which the floating rate applicable for the next payment is set. Reset date is usually 2
business day before the date from which the first floating payments starts to accrue.
(iv) Payment dates(PD): Payment date is the date on which
- the fixed payer under swap pays Fixed payment and
- the floating payer under swap pays Floating payment.
Example for Reset dates and payment dates:
Notes on: Reset period and repayment date
(i) If floating rate is indexed to 3-month LIBOR then reset period is 3 month & also compounded on 3 month
time (i.e. compounded quarterly).
However, payment of interest may be on each 3 month or on maturity.
(ii) If floating rate is indexed to 6 – month LIBOR then reset period is at each 6 month (i.e. interest rate revise on
each 6 month) & also compounded on 6- month time.
However, Payment of interest may be on each 6 month or on maturity.
(iii) If interest rate is indexed LIBOR daily, then interest is compounded daily and if indexed to LIBOR after 2 days
then interest is compounded on 2 days.
Price Quotation (i.e. Swap quotation)
A. Floating rate quotation:
Floating rate can be based on an index of short – term market (i.e. LIBOR, MIBOR) plus or minus margin.
Example:-
Rate quoted by swap bank is as follows:
(i) (MIBOR + 25 bps)/(MIBOR + 45 bps) against 10% fixed
(ii) (T-bill + 30 bps)/(T-bill + 50bps) against 10% fixed
(iii) (LIBOR 25 bps)/(LIBOR + 10bs) against 12% fixed
Meaning of above quotation: (i) Swap bank willing to pay (MIBOR + .25%) against 10% fixed and receive
(MIBOR + .45%) against 10% fixed.
B. Fixed rate Quotation :
All in cost (AIC) quotation: Fixed rate is quoted on All-in-cost basis. All in cost means the fixed interest rate is
quoted relative to (against to lat loating rate index.
Example:
(i) Treasury (4.50%) + 45/52 against LIBOR flat.
(ii) 8.00% / 8.25% against PLR flat
(iii) 10.50% / 10.75% against LIBOR flat
Meaning of above quotation:
(i) Swap bank is willing to be fixed rate payer at 4.95% and willing to be fixed rate receiver at 5.02% against
LIBOR flat. In this case bank is dealing in swap at 7 bps (i.e. 0.07%) spread/profit.
TD ED
1st Payment Period 2nd Payment Period
RD for 1st pmt RD for 2nd pmt 1st PD 2nd PD
2 Day 2 Day 2 Day
Say 3 month Say 3 month
RD for 3rd pmt