6.1

SWAPS

FINANCIAL SWAPS

All swaps involve exchange of a series of periodic payments between two parties usually through an intermediary which runs a swap book.

Given the fact that swaps are off-balance sheet item ,they are beneficial both to users and banks.

Options, Futures, and Other Derivatives, 5th edition ©002 by John C. Hull

6.3

There are four types of swaps:

1. Interest Rate Swaps: Exchange of fixed-rate payments for floating-rate payments

2. Currency Swaps: Exchange of liabilities in different currencies

3. Cross-Currency Swaps: Combination of Interest rate and Currency swap

FEATURES OF INTEREST RATE SWAP

In a plain vanilla swap,one party agrees to pay to the other party cash flows equal to the interest at a predetermined fixed rate on a notional pricipal for number of years.

In exchange,the party receiving the fixed rate agrees to pay the other party cashflows equal to interest at a floating rate on the same notional principal for the same period of time.

Moreover,only the difference in the interest payments is paid/received ;the principal is used only to calculate interest rate amounts and is never exchanged.

USES OF INTEREST RATE SWAPS

• To obtain lower cost funds.

To hedge interest rate exposure

To obtain high yielding investment assets

To create types of investment assets not otherwise obtainable

To implement overall asset or liability management strategies.

INTEREST RATE SWAPS: ORIGIN

The market primarily consist of financial institutions and corporations who use the swap market to hedge more efficiently their liabilities and assets.

Many institutions create synthetic fixed- or floating-rate assets or liabilities with better rates than the rates obtained on direct liabilities and assets.

6

INTEREST RATE SWAPS: ORIGIN

Today there exist an interest rate swap market where trillions of dollars (in notional principal) of swaps of fixed-rate loans for floating-rate loans occur each year.

7

INTEREST RATE SWAPS(PLAIN VANILLA SWAPS

Interest rate swaps are simply the exchange of one set of cashflows (based on interest rate specifications) for another.

Because they trade OTC ,they are really just contracts set up between two or more parties,and thus can be customised in any number of ways.

The most common type of interest rate swaps are “plain vanilla” IRS.

Currently ,these are the only kind of swaps that are allowed by the RBI in India.

AN EXAMPLE OF A “PLAIN VANILLA” INTEREST RATE SWAP

An agreement by Microsoft with Intel to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million.

Next slide illustrates cash flows

INTEL AND MICROSOFT (MS) TRANSFORM A LIABILITY

Intel MS

floating

fixedPayment in the market

Payment in the market

FINANCIAL INSTITUTION IS INVOLVED

F.I.

floating

Intel MS

fixed

Payment in the

market

Payment in the market

ABSOLUTE ADVANTAGE

INDIA USA

PRODUCT-X 10 12

PRODUCT-Y 50 40

COMPARATIVE ADVANTAGE

INDIA USA

PRODUCT-X 15 18

PRODUCT-Y 20 25

Plain Vanilla Interest Rate Swaps: Terms

1. Parties to a swap are called counterparties. There are two parties:

Fixed-Rate PayerFloating-Rate Payer

2. Rates:Fixed rate is usually a T-note rate plus basis points.Floating rate is a benchmark rate: LIBOR.

3. Reset Frequency: Semiannual

4. Principal: No exchange of principal

5. Notional Principal (NP): Interest is applied to a notional principal; the NP is used for calculating the swap payments.

6. Maturity ranges between 3 and 10 years.

7. Dates: Payments are made in arrears on a semiannual basis:

Effective Date is the date interest begins to accrue

Payment Date is the date interest payments are made

8. Net Settlement Basis: The counterparty owing the greater amount pays the difference between what is owed and what is received—only the interest differential is paid.

9. Documentation: Most swaps use document forms suggested by the International Swap Dealer Association (ISDA) or the British Banker’s Association. The ISDA publishes a book of definitions and terms to help standardize swap contracts.

6.18

Fixed-rate payer can also be called the floating-rate receiver and is often referred to as having bought the swap or having a long position.

Floating-rate payer can also be referred to as the fixed-rate receiver and is referred to as having sold the swap and being short.

CURRENCY SWAPS

In currency swaps, the two payment streams being exchanged are denominated in two different currencies.

Usually an exchange of principal amounts at the beginning and a re-exchange at termination are also a feature of currency swap

DIFFERENCE BETWEEN

INTEREST RATE SWAPS AND CURRENCY

SWAPS

It involves an exchange of payments in two currencies

It also involves exchange of principal amount

Unlike interest rate swaps ,currency swaps are not off balance-sheet instrument since-they involve exchange of principal at the end of the period

FIXED TO FIXED CURRENCY SWAP

One party raises a fixed rate liability in currrency say Dollars while other party raises fixed rate funding in currency say Euro.

The principal amounts are equivalent at the current market rate of exchange.

At the initiation of swap contract ,the principal amount is exchanged.

Subsequently ,first party makes a periodic Euro payments to the second while receive dollar payments from the second.

At the maturity Dollar and euro principals are re-exchanged.

Swap Market Structure

Swap Banks: The market for swaps is organized through a group of brokers and dealers collectively referred to as swap banks.

As brokers, swap banks try to match counterparties.

As dealers, swap banks take temporary positions as fixed or floating players; often hedging their positions with positions in Eurodollar futures contracts or with spot fixed-rate and floating-rate bond positions.

24

Swap Market Structure

• Brokered Swaps: • The first interest rate swaps were very

customized deals between counterparties with the parties often negotiating and transacting directly between themselves.

AParty BPartyPayerRateFixed

PayerRateFloating

Brokered Swaps:

• The financial institutions role in a brokered swap was to bring the parties together and to provide information; their continuing role in the swap after it was established was minimal; they received a fee for facilitating the swap.

Swap Market Structure

• Dealers Swaps: • With dealer swaps, the swap bank acts as swap dealer

making commitments to enter a swap as a counterparty before the other end party has been located. In this market, the end parties contract separately with the swap bank, who acts as a counterparty to each.

AParty BPartyPayerRateFixed

PayerRateFloating

BankSwapPayerRateFixed

PayerRateFloating

m50$NP

AParty

m25$NP

BParty

PayerRateFixed

PayerRateFloating

BankSwap

PayerRateFixed

PayerRateFloating

m25$NP

CParty

PayerRateFloating

PayerRateFixed

Swap Market Structure