XIMR_AFM2_FinSwap_2010

8/8/2019 XIMR_AFM2_FinSwap_2010

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1XIMR AFM2 2010

AFM 2: Interest Rate Swaps

S Krishnamoorthy: [email protected], Cell:9821461488

IntRateSwaps


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2XIMR AFM2 2010IntRateSwaps

In finance, a swap is a derivative in which counterparties exchange certain

benefits / stream of cash flows based on an underlying financialinstrument/commitment of the counterparties to the swap

The benefits in question depend on the type of financial instruments involved. For

example, in the case of a swap involving two bonds, the benefits in question can

be the periodic interest (or coupon) payments associated with the bonds

Specifically, the two counterparties agree to exchange one stream of cash flows

against another stream

These streams are called the legs of the swap

The swap agreement defines the dates when the cash flows are to be paid and

the way they are calculated

Swaps


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Usually at the time when the contract is initiated at least one of these series of

cash flows is determined by a random or uncertain variable such as an interestrate, foreign exchange rate, equity price or commodity price

The cash flows are calculated over a notional principal amount, which is usually

not exchanged between counterparties

Consequently, swaps can be in cash or collateral

Swaps can be used to hedge certain risks such as interest rate risk, or to

speculate on changes in the expected direction of underlying prices

The counterparties to the swap should compulsory execute International Swap

Dealers Agreement [ISDA]

Swaps are dealt over the counter [OTC] and/or in Exchanges

Swaps


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In an IRS there is contractual agreement between the two counterparties

to make periodic payment to the other for an agreed period of time based upon a

notional amount of principal

The principal amount is notional because there is no need to exchange actual amounts

of principal in a single currency transaction and there is no foreign exchange

component to be taken account of

However, a notional amount of principal is required in order to compute the actual cash

amounts that will be periodically exchanged

Under the commonest form of IRS a series of payments calculated by

applying a fixed rate of interest to a notional principal amount is exchanged for a

stream of payments similarly calculated but using a floating rate of interest

This is a fixed-for-floating IRS

When both series of cash flows to be exchanged are based upon different underlying

floating indices for example upon 6 month LIBOR and 90 days MIBOR the swap is

known swap is known as a basis or money market swap

Interest Rate Swaps [IRS]


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5XIMS AFM2 2010IntRateSwaps

Corporate

Bank Swap Bank

Mibor + 30 bps

Pay Mibor

Receive Fixed 6%

Typical Interest Rate Swap [IRS]Bank has extended floating rate loan of Rs 100 cr to Corporate

Term is one year with bullet repayment

Interest is payable monthly based on average rate of 1 month Mibor + a spreadof30 bps

The Bank to manage interest rate risk has signed IRS deal with Swap Bank

The notional principal amount is Rs 100 cr

The term is for 1 yrIn exchange for Swap Bank paying monthly fixed 6% the Bank will pay

monthly based on average 1 month Mibor rate

By doing IRS bank has managed interest rate risk and also retained and

served a customer who wanted floating rate interest loan


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In a generic fixed-to-floating interest rate swap the difficulty to be overcome in pricing such a

swap would seem to be the fact that the future stream of floating rate payments to be made by

one counterparty is unknown at the time the swap is being priced

Neither counterparty know with absolute certainty what the 6 month Libor/Mibor rate will be in

12 months time or 18 months time

However money markets do possess a considerable body of information about the relationship

between interest rates and future periods of time

In many countries, for example, there is a deep and liquid market in interest bearing securities

issued by the government

These securities pay interest on a periodic basis, they are issued with a wide range of

maturities, principal is repaid only at maturity and at any given point in time the market values

these securities to yield whatever rate of interest is necessary to make the securities trade at

their par value

It is possible to plot a graph of the yields of such securities having regard to their varying

maturities. This graph is known generally as a yield curve i.e. the relationship between future

interest rates and time

And a graph showing the yield of securities displaying the same characteristics as government

securities is known as the par coupon yield curve (Example GOI bond or T-bill Yield Curve)

Pricing IRS


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A different kind of security to a government security or similar interest bearing note

is the zero-coupon bond and a graph of the internal rate of return (IRR) of zero-

coupon bonds over a range of maturities is known as the zero-coupon yield curve

Also at any time the market is prepared to quote an investor forward interest rates

If, for example, an investor wishes to place a sum of money on deposit for six

months and then reinvest that deposit once it has matured for a further six months,

then the market will quote today a rate at which the investor can re-invest his

deposit in six months time

The six month forward deposit rate is a mathematically derived rate which reflects

an arbitrage relationship between current (or spot) interest rates and forward

interest rates

In other words, the six month forward interest rate will always be the precise rate

of interest which eliminates any arbitrage profit

The graphical relationship of forward interest rates is known as the forward yield

curve

Pricing IRS based on Yield Curves


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Thus the market does possess a great deal of information concerning the yield

generated by existing instruments over future periods of time and future floating

rates of interest can be calculated using the forward yield curve

The issue with regard to calculating the fixed rate payments due under the swap can

be resolved based on the fact that the net present value (NPV) of the aggregate set of

cash flows due under any swap is at inception ZERO

The NPV of the complete swap must be zero, since it involves the exchange of one

zero net present value stream of payments for a second zero NPV stream of

payments

Since the floating rate payments due under the swap can be calculated as explained

above, the fixed rate payments will be of such an amount that when they are deducted

from the floating rate payments and the net cash flow for each period is discounted at

the appropriate rate given by the zero coupon yield curve, the NPV of the swap will be

zero ( In options pricing the Black Scholes model and a process called Boot Strapping

is used)

The pricing picture is now complete

Pricing IRS: NPV of Cash Flows is ZERO


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IRS are used by a wide range of commercial banks, investment banks, non-

financial operating companies, insurance companies, mortgage companies,

investment vehicles and trusts, government agencies, sovereign states and

corporate for the following reasons:

1. To obtain lower cost funding

2. To hedge interest rate exposure3. To obtain higher yielding investment assets

4. To create types of investment asset not otherwise obtainable

5. To implement overall asset or liability management strategies

6. To take speculative positions in relation to future movements in interest

rates

Users and Uses of IRS


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The advantages of interest rate swaps include the following:

1. A floating-to-fixed swap increases the certainty of an issuer's future

obligations

2. Swapping from fixed-to-floating rate may save the issuer money if

interest rates decline

3. Swapping allows issuers to revise their debt profile to take advantage of

current or expected future market conditions

4. IRS are a financial tool that potentially can help issuers lower the amount

of debt service

Advantages of IRS


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A Currency Swap involves exchanging principal and fixed rate interest payments

on a loan in one currency for principal and fixed rate interest payments on anequal loan in another currency. Just like interest rate swaps, the currency swaps

also are motivated by comparative advantage

A commodity swap is an agreement whereby a floating (or market or spot) price

is exchanged for a fixed price over a specified period. The vast majority of

commodity swaps involve crude oil

An equity swap is a special type of total return swap, where the underlying asset

is a stock, a basket of stocks, or a stock index. Compared to actually owning the

stock, in this case you do not have to pay anything up front, but you do not have

any voting or other rights that stock holders do have

A credit default swap (CDS) is a swap contract in which the buyerof the CDS

makes a series of payments to the sellerand, in exchange, receives a payoff if a

credit instrument - typically a bond or loan goes into default /fails to pay. Unlike an

actual insurance contract the buyer is allowed to profit from the contract and may

also cover an asset to which the buyer has no direct exposure

Other Types of Swaps


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XIMR_AFM2_FinSwap_2010