INTEREST RATE AND CURRENCY SWAPS

Interest Rate SwapsAnd

Currency Swaps

Interest Rate And Currency Swaps 2

Meaning of Financial Swaps A swap is an contractual agreement to

exchange cash flows at specified future times according to certain specified rules (between two parties)


BackgroundSwaps first evolved in 1981, in the form of

currency swaps, (IBM and the World Bank for $210 million dollars and a term of over ten years)

Interest rate swaps emerged, which offered an alternative method to overcome asset-liability mismatches and to lower the cost of borrowing.

Swaps provide a level playing field for risk management but still struggle to find a future, especially in developing countries like India.


Types of swapsInterest Rate Swaps

Currency Swaps

Commodity Swaps

Equity Swaps


http://en.wikipedia.org/wiki/Day_count_convention


Interest rate swapsAn interest rate swap is defined as a mutual

agreement among different parties, to exchange interest payments over a predetermined period.

The primary motives behind the interest rate swaps are to lower the costs of borrowing and to overcome the asset liability mismatch.


Uses of an Interest Rate SwapConverting a

liability fromfixed rate to floating rate

floating rate to fixed rate

Converting an investment from fixed rate to floating rate

floating rate to fixed rate


Types of Interest SwapsPlain Vanilla SwapsOff Market SwapsIndex Amortization SwapsFloating – Floating SwapsForward SwapsCallable SwapsPutable Swaps



Fixed to FloatingAlso known as Plain Vanilla swap

customer receives cash flows at a fixed rate of interest and simultaneously pays cash flows at a floating rate of interest or vice versa. The cash flows are calculated on a Notional Principal amount. The floating rate of interest is usually determined by reference to a transparent benchmark


An Example of a Plain Vanilla Fixed-for-Floating InterestParty A- (Receives Floating Rate) Party B- (Pays the Floating Rate)

Notional Principal- $40 million.

Fixed rate day count method is 30/360 day basis.Floating rate is Six- Month LIBOR, determined on a 30/360 day basis.

Swaps origination: July 20, 1999.Swaps termination: July 20, 2000.First payment: January 20, 2000Semiannual payments will be made on each July 20 and January 20.



7% fixed rate

6 month LIBOR

A B



Valuation Of Plain Vanilla SwapThe present value of a plain vanilla swap can easily be

computed using standard methods of determining the present value (PV) of the fixed leg and the floating leg.

value of the fixed leg:where; C is the swap rate, M is the number of fixed payments, P is the notional amount, ti is the number of days in period i, Ti is the basis according to the day count convention dfi is the discount factor.



value of the floating leg:

Where, N is the number of floating payments, fj is the forward rate, P is the notional amount, tj is the number of days in period j,Tj is the basis according to the day count

convention dfj is the discount factor.



Floating to FloatingIn this kind of a swap, both the counter-

parties exchange interest amounts based on two different floating reference rates, through the life of the swap.



Index Amortization SwapA swap whereby the notional principal

amount of the agreement is amortized according to the movement of an underlying rate.



Forward SwapsA swap agreement created through the

synthesis of two swaps differing in duration for the purpose of fulfilling the specific time-frame needs of an investor. Also referred to as a "forward start swap," "delayed start swap," and a "deferred start swap."



Off market SwapAn interest rate or other swap contract with a

fixed rate payment materially different from current coupon rates on bonds or notes of similar term. Ordinarily, this swap will have a net present value that requires the counterparties to exchange an extra payment at the beginning or end of the swap tenor. Also called Adjustment Swap



Callable Swaps & Putable SwapsFixed rate receiver has the right, but not the

obligation to terminate the swap at one or more pre-determined times during the life of the swap.

A Swap where the fixed rate payer has the right to terminate is known as a Callable Swap. Both the Putable and Callable Swaps are also known as Cancellable Swaps.

The foreign exchange version of a Cancellable Swap is called the Break Forward or Cancellable Forward.



Limitations of Swap DealsCounter Party Risk

Fund Requirement

Cordial Relationships

Information Network



Currency swapsForeign currency swaps involve the exchange

of the principal at the beginning of the contract and the re-exchange of the principal at the end of the contract.

A Currency Swap involves exchange of principal and/or interest payments on a loan or on an asset in one currency for principal and/or interest payments on an equivalent loan or on an asset in another currency, with a predetermined prevailing spot / predetermined forward rate (for forward start swaps) as agreed on the date the transaction is entered into.



In an interest rate swap the principal is not exchanged

In a currency swap the principal is exchanged at the beginning and the end of the swap


Uses of a Currency SwapConversion from a liability in one currency to

a liability in another currencyConversion from an investment in one

currency to an investment in another currency


Types of currency swapsFixed for fixed

Fixed for floating

Floating for fixed

Floating for floating


Fixed-for-Fixed Currency SwapExample

24

Party C Party DDM 25 million

$10 million

DM Lender

DM 25 mil

US$ Lender

US$ 10 mil

1. Initial Cash Flow (Exchange of Principal)


US$ 1 million

US$ 1 milDM 2 million

DM 2 mil Party C Party D

DM Lender US$ Lender

2. Periodic Annual Interest Payments

$10 millionUS$ 10 mil

DM 25 million

DM 25 milParty C Party D

DM Lender US$ Lender

3. Final Cash Flow (Repayment of Principal)


Fixed-for-Floating Currency SwapExamplePrincipal 1: ¥2080million and rate of interest

is 1%Principal 2: $20 million @ six month LIBORSettlement date is every 6 month

Swaps origination: July 20, 1999.Swaps termination: July 20, 2000.



• ¥ 2080Mn. @ 1% fixed int.

• $ 20 Mn.@ 6m LIBOR

A B



Valuation of Currency SwapsLike interest rate swaps, currency swaps can

be valued either as the difference between 2 bonds or as a portfolio of forward contracts.



Thank You…

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INTEREST RATE AND CURRENCY SWAPS