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A swap is a derivative in which one party exchanges a stream of interest payments for another

party's stream of cashflows. Interest rate swaps can be used by hedgers to manage their fixed or
floating assets and liabilities. They canalso be used by speculators to replicate unfunded bond
exposures to profit from changes in interest rates. Interest rateswaps are very popular and highly
liquid instruments.
Structure
A is currently paying floating, but wants to pay fixed. B is currently paying fixed butwants to pay
floating. By entering into an interest rate swap, the net result is that eachparty can 'swap' their
existing obligation for their desired obligation.
In an interest rate swap, eachcounterparty agrees to pay either afixed or floating rate
denominated in aparticular currency to the othercounterparty. The fixed or floating rateis
multiplied by a notional principalamount (say, USD 1 million). Thisnotional amount is generally
notexchanged between counterparties, butis used only for calculating the size of cashflows to be
exchanged.
The most common interest rate swap isone where one counterparty A pays afixed rate (the swap
rate) tocounterparty B, while receiving afloating rate (usually pegged to areference rate such as
LIBOR). According to usual market convention, the counterparty paying the fixed rate iscalled
the "payer" (while receiving the floating rate), and the counterparty receiving the fixed rate is
called the"receiver" (while paying the floating rate).A pays fixed rate to B (A receives variable
rate)B pays variable rate to A (B receives fixed rate).Consider the following swap in which Party
A agrees to pay Party B periodic fixed interest rate payments of 8.65%,in exchange for periodic
variable interest rate payments of LIBOR + 70 bps (0.70%). Note that there is no exchangeof the
principal amounts and that the interest rates are on a "notional" (i.e. imaginary) principal amount.
Also notethat the interest payments are settled in net (e.g. Party A pays (LIBOR + 1.50%)+8.65%
- (LIBOR+0.70%) = 9.45%net). The fixed rate (8.65% in this example) is referred to as the swap
rate.
[1] At the point of initiation of the swap, the swap is priced so that it has a net present value of
zero. If one party wantsto pay 50 bps above the par swap rate, the other party has to pay
approximately 50 bps over LIBOR to compensatefor this.
Fixed-for-floating rate swap, same currency
Party B pays/receives fixed interest in currency A to receive/pay floating rate in currency A
indexed to X on anotional amount N for a term of T years. For example, you pay fixed 5.32%
monthly to receive USD 1M Libormonthly on a notional USD 1 million for 3 years. The party
that pays fixed and receives floating coupon rates is saidto be
short
the interest swap because it is expressed as a bond convention (as prices fall, yields rise). Interest
rateswaps are simply the exchange of one set of cash flows for another.Fixed-for-floating swaps
in same currency are used to convert a fixed rate asset/liability to a floating rateasset/liability or
vice versa. For example, if a company has a fixed rate USD 10 million loan at 5.3% paid
monthlyand a floating rate investment of USD 10 million that returns USD 1M Libor +25 bps
monthly, it may enter into afixed-for-floating swap. In this swap, the company would pay a
floating rate of USD 1M Libor+25 bps and receive a5.5% fixed rate, locking in 20bps profit.
Fixed-for-floating rate swap, different currencies

Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency B


indexed to X on anotional N at an initial exchange rate of FX for a tenure of T years. For
example, you pay fixed 5.32% on the USDnotional 10 million quarterly to receive JPY 3M
(TIBOR) monthly on a JPY notional 1.2 billion (at an initialexchange rate of USD/JPY 120) for
3 years. For nondeliverable swaps, the USD equivalent of JPY interest will bepaid/received
(according to the FX rate on the FX fixing date for the interest payment day). No initial exchange
of the notional amount occurs unless the Fx fixing date and the swap start date fall in the
future.Fixed-for-floating swaps in different currencies are used to convert a fixed rate
asset/liability in one currency to afloating rate asset/liability in a different currency, or vice versa.
For example, if a company has a fixed rate USD 10million loan at 5.3% paid monthly and a
floating rate investment of JPY 1.2 billion that returns JPY 1M Libor +50bps monthly, and wants
to lock in the profit in USD as they expect the JPY 1M Libor to go down or USDJPY to goup
(JPY depreciate against USD), then they may enter into a Fixed-Floating swap in different
currency where thecompany pays floating JPY 1M Libor+50 bps and receives 5.6% fixed rate,
locking in 30bps profit against theinterest rate and the fx exposure.
Floating-for-floating rate swap, same currency
Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate in
currency A indexedto Y on a notional N for a tenure of T years. For example, you pay JPY 1M
LIBOR monthly to receive JPY 1MTIBOR monthly on a notional JPY 1 billion for 3
years.Floating-for-floating rate swaps are used to hedge against or speculate on the spread
between the two indexeswidening or narrowing. For example, if a company has a floating rate
loan at JPY 1M LIBOR and the company hasan investment that returns JPY 1M TIBOR + 30 bps
and currently the JPY 1M TIBOR = JPY 1M LIBOR + 10bps.At the moment, this company has a
net profit of 40 bps. If the company thinks JPY 1M TIBOR is going to comedown (relative to the
LIBOR) or JPY 1M LIBOR is going to increase in the future (relative to the TIBOR)
and wantsto insulate from this risk, they can enter into a float-float swap in same currency where
they pay, say, JPY TIBOR +30 bps and receive JPY LIBOR + 35 bps. With this, they have
effectively locked in a 35 bps profit instead of runningwith a current 40 bps gain and index risk.
The 5 bps difference (w.r.t. the current rate difference) comes from theswap cost which includes
the market expectations of the future rate difference between these two indices and thebid/offer
spread which is the swap commission for the swap dealer.Floating-for-floating rate swaps are
also seen where both sides reference the same index, but on different paymentdates, or use
different business day conventions. This can be vital for asset-liability management. An example
wouldbe swapping 3M LIBOR being paid with prior non-business day convention, quarterly on
JAJO (i.e. Jan, Apr, Jul,Oct) 30, into FMAN (i.e. Feb, May, Aug, Nov) 28 modified following:
Floating-for-floating rate swap, different currencies
Party P pays/receives floating interest in currency A indexed to X to receive/pay floating rate in
currency B indexedto Y on a notional N at an initial exchange rate of FX for a tenure of T years.
For example, you pay floating USD 1MLIBOR on the USD notional 10 million quarterly to
receive JPY 3M TIBOR monthly on a JPY notional 1.2 billion(at an initial exchange rate of
USDJPY 120) for 4 years.To explain the use of this type of swap, consider a US company
operating in Japan. To fund their Japanese growth,they need JPY 10 billion. The easiest option
for the company is to issue debt in Japan. As the company might be newin the Japanese market
without a well known reputation among the Japanese investors, this can be an expensiveoption.
Added on top of this, the company might not have appropriate debt issuance program in Japan
and theymight lack sophisticated treasury operation in Japan. To overcome the above problems,

it can issue USD debt andconvert to JPY in the FX market. Although this option solves the first
problem, it introduces two new risks to thecompany:FX risk. If this USDJPY spot goes up
at the maturity of the debt, then when the company converts the JPY to USD to pay
back its matured debt, it receives less USD and suffers a loss.USD and JPY interest rate
risk. If the JPY rates come down, the return on the investment in Japan might go
downand this introduces an interest rate risk component.The first exposure in the above can be
hedged using long dated FX forward contracts but this introduces a new risk where the implied
rate from the FX spot and the FX forward is a fixed rate but the JPY investment returns a
floatingrate. Although there are several alternatives to hedge both the exposures effectively
without introducing new risks,the easiest and the most cost effective alternative would be to use
a floating-for-floating swap in different currencies.In this, the company raises USD by issuing
USD Debt and swaps it to JPY. It receives USD floating rate (somatching the interest payments
on the USD Debt) and pays JPY floating rate matching the returns on the JPYinvestment.
The major risks involved in interest rate swaps are interest rate risk and credit risk.
Interest rate risk - the mismatch between interest rate movements and expectations are
associated with the interest rate risk. Virtually, the party receiving a fixed-rate payment profits if
interest rates fall and loses if interest rates rise. In contrast, the floating-rate payer profits if rates
rise and loses if rates fall.
Credit risk - the credit risk translates to the chance that the other party in the contract will
default on its responsibility. Since banks that deal with interest rate swaps have a very high rating
(AA or above) the probability of default is relatively small. However, it is still greater than that
of a Treasury bond.

Different Types of Swaps


Swaps are derivative instruments that involve an agreement between two parties to exchange a
series of cash flows over a specific period of time .(See related: An Introduction To Swaps.)
There are multiple reasons why parties agree to such an exchange:
Investment objectives or repayment scenarios may have changed.
It may be financially beneficial to switch to newly available alternate stream of cash flows
compared to the existing one.
Hedging can be achieved through swaps, like mitigation of risk associated with a floating rate
loan repayment.
Being OTC products, swaps offer great flexibility to design and structure contracts based on
mutual agreement. This flexibility leads to a lot of swap variations, each serving a specific
purpose. We will look at different types of swaps and how each participant in the swap benefits.
Interest Rate Swaps

The most popular types of swaps are plain vanilla interest rate swaps. They allow two parties to
exchange fixed and floating cash flows on an interest-bearing investment or loan.
Businesses or individuals take loans from the markets in which they have an advantage in order
to secure a cost-effective loan. However, their selected market may not offer their preferred loan
or loan structure. For instance, an investor may get cheaper loan in a floating rate market, but he
prefers a fixed rate. Interest rate swaps enable the investor to switch the cash flows, as desired.
Assume Paul prefers fixed rate loans and has loans available at either floating rate
(LIBOR+0.5%) or at fixed rate (10.75%). Mary prefers floating rate loan and has loans available
at either floating rate (LIBOR+0.25%) or at fixed rate (10%). Due to her better credit rating with
the lender, Mary has the advantage over Paul in both the floating rate market (by 0.25%) and in
fixed rate (by 0.75%). Her advantage is greater in the fixed rate market, so she goes for fixed rate
loan. However, since she prefers the floating rate, she gets into a swap contract with a bank to
pay LIBOR and receive a 10% fixed rate.
Paul borrows at floating (LIBOR+0.5%), but since he prefers fixed, he enters into swap contract
with the bank to pay fixed 10.10% and receive the floating rate.
interest-rate-swap-working
Benefits: Paul pays (LIBOR+0.5%) to the lender and 10.10% to the bank, and receives LIBOR
from the bank. His net payment is 10.6% (fixed). The swap effectively converted his original
floating payment to a fixed rate, getting him the most economical rate. Similarly, Mary pays 10%
to the lender and LIBOR to the bank, and receives 10% from the bank. Her net payment is
LIBOR (floating). The swap effectively converted her original fixed payment to the desired
floating, getting her the most economical rate. The bank takes a cut of 0.10% from what it
receives from Paul and pays to Mary. (See related: How To Value Interest Rate Swaps.)
Currency Swaps
The transactional value of capital that changes hands in currency markets surpasses that of all
other markets. Currency swaps offer efficient ways to hedge forex risk.
Assume an Australian company is setting up business in the UK and needs GBP 10 million.
Assuming AUD/GBP exchange rate at 0.5, the total comes to AUD 20 million. Similarly, a UKbased company wants to setup a plant in Australia and needs AUD 20 million. The cost of a loan
in the UK is 10% for foreigners and 6% for locals, while that in Australia is 9% for foreigners
and 5% for locals. Apart from high cost of a loan for foreign companies, it might be difficult to
easily get the loan due to procedural difficulties. Both companies have the competitive advantage
in their domestic loan markets. The Australian firm can take a low-cost loan of AUD 20 million
in Australia, while the English firm can take a loan of GBP 10 million in the UK. Assume both
loans need six monthly repayments. Both companies can get into a currency swap agreement.
At the start, the Australian firm gives AUD 20 million to the English firm, and receives GBP 10
million, enabling both firms to start business in their respective foreign lands. Every six months,
the Australian firm pays the English firm the interest payment for the English loan = (notional

GBP amount * interest rate * period) = (10 million * 6% * 0.5) = GBP 300,000. While the
English firm pays the Australian firm the interest payment for the Australian loan = (notional
AUD amount * interest rate * period) = (20 million * 5% * 0.5) = AUD 500,000. Such interest
payments continue until the end of the swap agreement, at which time, the original notional forex
amounts will be exchanged back to each other.
Benefits: By getting into a swap, both firms were not only able to secure low-cost loans, but they
also managed to hedge against interest rate fluctuations. Variations also exist in the currency
swaps, including fixed v/s floating and floating v/s floating. Parties are able to hedge against
volatility in forex rates, secure improved lending rates, and receive foreign capital.
Commodity Swaps
Commodity swaps are common among people or companies that use raw material to produce
goods or finished products. Profit from a finished product may take a hit if the commodity prices
vary, as output prices may not necessarily change in sync with the commodity prices. A
commodity swap allows receipt of payment linked to the commodity price against a fixed rate.
Assume two parties get into a commodity swap over one million barrels of crude oil. One party
agrees to make six-monthly payments at a fixed price of $60 per barrel and receive the existing
(floating) price. The other party will receive the fixed and pay the floating.
Assume that price of oil shoots up to $62 at the end of six months, then the first party will be
liable to pay the fixed ($60 *1 million) = $60 million, and receive the variable ($62 * 1 million)
= $62 million from second. Net inflow will be $2 million from the second party to the first.
In case the price dips to $57 over next six months, the first party will pay net $3 million to the
second party.
Benefits: The first party has locked in the price of commodity using a currency swap, achieving
a price hedge. Commodity swaps are effective hedging tools against variations in commodity
prices or against variation in spreads between the final product and the raw material prices.
Credit Default Swaps (CDS)
Another popular type of swap, the credit default swap, offers insurance in case of default on part
of a third-party borrower. Assume Peter bought a 15-year long bond issued by ABC, Inc. The
bond is worth $1,000 and pays annual interest of $50 (i.e., 5% coupon rate). Peter worries that
ABC, Inc. may default, so he gets into a credit default swap contract with Paul. Under the swap
agreement, Peter (CDS buyer) agrees to pay $15 per year to Paul (CDS seller). Paul trusts ABC,
Inc. and is ready to take the default risk on its behalf. For the $15 receipt per year, Paul will offer
insurance to Peter for his investment and returns. In case ABC, Inc. defaults, Paul will pay Peter
$1,000 plus any remaining interest payments. In case ABC, Inc. does not default throughout the
15-year long bond duration, Paul benefits by keeping the $15 per year without any payables to
Peter.
Benefits: CDS work as insurance to protect the lenders and bondholders from borrowers default
risk. (Related: Credit Default Swaps: An Introduction)

Zero Coupon Swaps (ZCS)


Similar to the interest rate swap, the zero coupon swap offers flexibility to one of the parties in
the swap transaction. In a fixed-to-floating zero coupon swap, the fixed rate cash flows are not
paid periodically, but only once at the end of the maturity of the swap contract. The other party
paying floating rate keeps paying regular periodic payments following the standard swap
payment schedule.
A fixed-fixed zero coupon swap is also available, wherein one party does not make any interim
payments, but the other party keeps paying fixed payments as per the schedule.
Benefits: Such zero coupon swaps are primarily used for hedging. ZCS are often entered into by
businesses to hedge a loan in which the interest is to be paid at maturity, or by banks that issue
bonds with end-of-maturity interest payments.
Total Return Swaps (TRS)
A total return swap allows an investor all the benefits of owning a security, without actually
owning it. A TRS is a contract between a total return payer and total return receiver. The payer
usually pays the total return of an agreed security to the receiver, and receives a fixed/floating
rate payment in exchange. The agreed (or referenced) security can be a bond, index, equity, loan,
or commodity. The total return will include all generated income and capital appreciation.
Assume Paul (the payer) and Mary (the receiver) enter into a TRS agreement on a bond issued by
ABC Inc. If ABC Inc.s share price shoots up (capital appreciation) and it also pays a dividend
(income generation) during the swap contract duration, then Paul will pay Mary all those
benefits. In return, Mary will have to pay Paul a pre-determined fixed/floating rate during the
duration of swap.
Benefits: Effectively, Mary receives total rate of return (in absolute terms) without actually
owning the security. She has the advantage of leverage. Mary represents a hedge fund or a bank
that benefits from the leverage and the additional income without owning the security.
Paul transfers both the credit risk and market risk to Mary, in exchange for a fixed/floating
stream of payments. He represents a trader, whose long positions can be effectively converted to
a short-hedged position, using a TRS. He can also defer the loss or gain to the end of swap
maturity using a TRS.
The Bottom Line
Swap contracts, being OTC products, can be easily customized to meet the needs of all parties.
They offer win-win situations for all parties, including intermediaries like banks that facilitate
the transactions. Beyond the benefits, participants should also be aware of the pitfalls. Being
bilateral agreements in OTC markets without regulations, an investor should understand a swap
contract fully before entering into it.

TYPES OF SWAPS
There are a wide variety of swaps that financial professionals trade in order to hedge against risk. Listed below are a
few most common types of swap instruments traded in the market.

Interest Rate Swap


An interest rate swap is a contractual agreement between two counterparties to exchange cash flows on particular
dates in the future. There are two types of legs (or series of cash flows). A fixed rate payer makes a series of fixed
payments and at the outset of the swap, these cash flows are known. A floating rate payer makes a series of
payments that depend on the future level of interest rates (a quoted index like LIBOR for example) and at the outset of
the swap, most or all of these cash flows are not known. In general, a swap agreement stipulates all of the conditions
and definitions required to administer the swap including the notional principal amount, fixed coupon, accrual
methods, day count methods, effective date, terminating date, cash flow frequency, compounding frequency, and
basis for the floating index.
An interest rate swap can either be fixed for floating (the most common), or floating for floating (often referred to as a
basis swap). In brief, an interest rate swap is priced by first present valuing each leg of the swap (using the
appropriate interest rate curve) and then aggregating the two results.

Credit Default Swap


A credit default swap is a contract that provides protection against credit loss on an underlying reference entity as a
result of a specific credit event. A credit event is usually a default or, possibly, a credit downgrade of the entity. The
reference entity may be a name, a bond, a loan, a trade receivable or some other type of liability. The buyer of a
default swap pays a premium to the writer or seller in exchange for right to receive a payment should a credit event
occur. In essence, the buyer is purchasing insurance.

Asset Swap
An asset swap is a combination of a defaultable bond with a fixed-for-floating interest rate swap that swaps the
coupon of the bond into the cash flows of LIBOR plus a spread. In the case of a cross currency asset swap, the
principal cash flow may also be swapped. In a typical asset swap, a dealer buys a bond from a customer at the
market price and sells to the customer a floating rate note at par. The dealer then enters into a fixed-for-floating swap

with another counterparty to offset the floating rate obligation and the bond cash flows. For a premium bond, the
dealer pays the customer the difference of the bond price and its par. For a discount bond, the customer pays the
dealer the difference of the par and the bond price. In the swap with the counterparty, the dealer pays a fixed bond
coupon and receives LIBOR + a spread. The spread can be determined from the cash that the dealer pays/receives
and from the difference of the bond coupon and the par swap rate. When the bond redemption value is used for
exchange of principal at maturity, the present value of the difference between the bond redemption value and its par
value also contributes to the spread. Learn how to value an asset swap

Trigger Swap
A Trigger Swap is an interest rate swap in which payments are knocked out if the reference rate is above a given
trigger rate. FINCAD provides analytics for two types of trigger swaps: periodic and permanent. For a periodic trigger
swap, the exchange of payments depends on the reference rate set for that period. If the reference rate for a
particular period is greater than the trigger rate, the fixed and floating payments are knocked out. If the reference rate
is below the trigger rate in a subsequent period, regular fixed and floating payments are made. For a permanent
trigger swap, if the fixed and floating payments are knocked out for a particular period, then all subsequent payments
are knocked out as well.

Commodity Swap
A commodity swap is a swap in which one of the payment streams for a commodity is fixed and the other is floating.
Usually only the payment streams, not the principal, are exchanged, although physical delivery is becoming
increasingly common. Commodity swaps have been in existence since the mid-1970's and enable producers and
consumers to hedge commodity prices. Usually, the consumer would be a fixed payer to hedge against rising input
prices. The producer in this case pays floating (i.e., receiving fixed for the product) thereby hedging against falls in the
price of the commodity. If the floating-rate price of the commodity is higher than the fixed price, the difference is paid
by the floating payer, and vice versa.

Foreign-Exchange (FX) Swaps


An FX swap is where one leg's cash flows are paid in one currency, while the other leg's cash flows are paid in
another currency. An FX swap can be either fixed for floating, floating for floating, or fixed for fixed. In order to price an
FX swap, first each leg is present valued in its currency (using the appropriate curve for the currency).

Total Return Swap

A total return swap (TRS) is a bilateral financial contract in that one counterparty pays out the total return of a
specified asset, including any interest payment and capital appreciation or depreciation, in return receives a regular
fixed or floating cash flow. Typical reference assets of total return swaps are corporate bonds, loans and equities. A
total return swap can be settled at the terminating date only or periodically, e.g., quarterly. For convenience we call the
asset's total return a TR-leg and the fixed or floating cash flow a non-TR leg. Learn how to price a total return swap.

An interest rate swap, in its simplest form, is a private


agreement between 2 counterparties to exchange a fixed
interest obligation for a floating rate obligation over a specified
duration. The payment is calculated by multiplying the interest
rate times a notional principal (aka notational principal),
which is not exchanged, but is simply a number used to
calculate both interest payments. The counterparty paying the
fixed amount is the fixed-rate payer and the counterparty
paying the floating rate is the floating rate payer. The fixed
payment of a swap is known as the fixed leg while the floating
payment is referred to as the floating leg.
However, only the net difference between these obligations is
paid, and who pays whom depends on whom the change in
interest rates favors. For instance, if the float rate rises above
the fixed rate, then the floating rate payer pays the fixed-rate
payer the difference between the floating rate and the fixed rate,
but if the floating rate falls below the fixed rate, then the fixedrate payer pays the floating rate payer the difference in interest
rates. It is possible for 1 counterparty to receive all of the
payments without paying anything, or it could go back and forth,
depending on how interest rates fluctuate.
The frequency of the payment is the tenor or coupon
frequency. Common tenors are 1 month, 3 months, 6 months,
and annually. Sometimes, the 2 legs of a swap have different
tenors.

The fixed rate is usually determined by a benchmark such as


a Treasury with a maturity equal to the time period of the swap
plus an additional risk premium, which equals the swap rate.
The size of the swap rate is called the swap spread, which is
sometimes used as an indicator of the systemic risk in the
economy. The floating rate is usually determined by
the London Interbank Offered Rate (LIBOR ), which is the
rate that large banks lend to each other, plus an additional risk
premium.
Although there are other types of swaps, such as currency swaps
and equity swaps, interest rate swaps are far more prevalent.
According to the Bank for International Settlements, the notional
principal for interest rate swaps was almost 347 trillion dollars
(USD) in June, 2007, while the total for equity-linked and
commodity derivatives was 9.2 trillion dollars for the same time
period. Because swaps are private agreements, there is no
organized exchange that lists them, and because they are
tailored specifically for the counterparties, they are difficult to
resell.

Swap Credit Risks


With any derivative, there is always the chance that the
counterparty will default on its obligation. To minimize this risk,
the contract generally specifies that collateral must be posted.
When a swap agreement is reached, the net present value of
both sides is zero, because no money changes hands at first.
This must be so, because no one would agree to an arrangement
where one party immediately benefits from the other without
compensation. How does that transfer risk? So, if one party
withdraws from the agreement before any liability is incurred,
there is no loss, for another counterparty can usually be found.
Only when interest rates change will there be a payment
obligation. However, it is only the difference between the

liabilities that is actually paid, which is considerably less than


what would be suggested by the notional principal.
For example, consider an interest rate swap for a 5-year period
with a fixed payment of 5% on the notional principal of
$1,000,000 and the LIBOR rate, which was also at 5% when the
contract was created. If the LIBOR rate rises to 6% during the
swap period and stays there, then the floating rate payer only
has to pay the 1% difference or $10,000 for each of the 5 years.
However, the present value of those payments is less than their
sum. Hence, the credit risk is significantly less than if the
principal were at stake.

Basis Swaps and Currency Swaps


Other interest rate derivatives include the basis swap, which
has 2 floating legs but no fixed leg. Thus, it is exchanging
payments based on a floating interest rate on one index to that
of another, such as the prime interest rate and the
LIBOR. Basis, as used here, is the difference between 2 rates,
such as the difference between spot prices and futures prices of
a given commodity, so risk can arise when basis changes.
Another type of interest rate derivative is the cross-currency
interest rate swap, or just currency swap, in which both
legs of the swap are denominated in different currencies. Most of
the swaps are set up to exchange a fixed interest rate in one
currency with a floating rate in the other currency. To remove
exchange rate risk, the notional amount of the swaps is
generally exchanged. So if the exchange rate at the signing of
the swap agreement is $1.25 to 1, and a company wants to
exchange a fixed rate based on 1,000,000 for a floating rate in
USD, then the euro party will give 1,000,000 to the other party
and receive $1.25 million in United States dollars. This removes
the exchange rate risk and the swap agreement itself removes
interest-rate risk, which was its purpose. If a company wanted

to remove foreign exchange risk without exchanging currencies,


then that risk can be hedged with a forward agreement
specifically, an FX forward or with interest
rate futures or options to mitigate its risk.

Swaptions
A swaption is an option for a swap at a specified rate before a
specified time, the expiration date. The buyer of the swaption
has the right, but not the obligation, to enter a swap and the
swaption seller is obliged to be the counterparty. Swaptions can
be American or European style. American style swaptions give
the holder the right to enter a swap at any time before the
expiration date, while the European style gives the holder the
right only at expiry.
A payer swaption (aka put swaption) gives the buyer the
right, but not the obligation, to pay a fixed rate and receive a
floating rate. The buyer pays the premium to the seller for this
right, which, like all options, may expire worthless. A receiver
swaption (aka call swaption) gives the option holder the
right to receive a fixed interest rate and pay a floating rate
based on a specified benchmark.
Some swaps can be canceled or extended. A cancelable
swap gives 1 party the right to cancel the swap on a specified
day before the final maturity date without an additional cost. A
cancelable swap can be created by combining a vanilla interestrate swap with a swaption. An alternative to the cancelable swap
is the extendable swap, where the buyer has the right to
extend the option for a set period.
Interest rate swaps are a common type of derivative security, which simply means that their value is derived from
underlying assets (in this case, loans andinterest rates). In a swap, two parties agree to exchange two streams of
cash flow; in an interest rate swap, these cash flows are the interest payments for some given amount of money. The
underlying money, known in this context as the notional amount, doesn't necessarily change hands. The two parties
just exchange the interest payments they would make if they had actually borrowed the notional amount.

There are three main types of interest rate swaps, as determined by the type of rates being swapped:
Fixed-for-fixed swaps involve the exchange of interest payments that both carry fixed rates determined

before the contract takes effect. Since there's no variability in either of the two rates, the payments will remain
the same over the life of the swap contract. Fixed-for-fixed swaps are used when each party uses a different
currency.

For example, suppose there are two companies in different countries, each of which wants to
borrow money to build facilities in the other country, and that both can borrow at a lower interest rate in their
home country. In this case, the companies can borrow money in their respective countries and swap with
each other, essentially borrowing for each other. Each saves money by taking advantage of the other firm's
lower cost of borrowing while also dodging currency conversion costs.
Fixed-for-floating, or "vanilla" swaps, commonly used as a type of investment, involve the exchange of a

fixed interest payment for a floating interest payment. The payment with the fixed rate (known as the swap rate)
doesn't change, while the payment with the floating rate is linked to some outside index (such as the LIBOR) and
rises and falls throughout the duration of the contract.

This type of swap can be used if a company wants to trade the floating rate on its debt for the
stability of a fixed rate. In the example, Firm A has a floating rate loan but pays a fixed rate to Firm B. Firm B
receives a fixed payment from Firm A and pays it a variable payment in return, which Firm A then pays to its
lender. In this case, Firm A thinks that interest rates will rise and hopes to avoid higher payments by trading
for a fixed rate. Firm B, on the other hand, probably thinks that rates will fall; if it's right, it will pay out less
than the fixed amount it receives from Firm A, making a profit off the difference.

Floating-for-floating, or "Basis" swaps, as the name implies, involve the trade of interest payments that
both have floating rates. The rates are based on different indexes, so each party is betting that either their
original rate will rise, the other party's original rate will fall, or some combination of the two.

Interest rate swaps are traded over the counter (OTC), most commonly on fixed income desks at investment banks.
Because they are not traded on open exchanges, interest rate swaps are not regulated by any government agency,
so parties have a great deal of flexibility when setting the terms of the swap. Globally, the total notional amount of
interest rate swaps outstanding was $309.6 trillion USD as of December 2007, accounting for 52% of the total OTC
market.[1]

Interest rate swaps are over-the-counter trades that allow two businesses to exchange interest
rates with one another in a way that benefits both of them. Reasons for doing such a trade can
vary, but commonly it is done to allow companies access to loans that differ from those types for
which they normally qualify. Swaps may also occur as a means of balancing a portfolio, hedging
against possible rate increases or taking advantage of a preferred rate structure. At the end of the
swap the only amount of money that exchanges hands is the difference between the total of the

amounts due. - See more at:


http://wiki.fool.com/Types_of_Interest_Rate_Swaps#sthash.3vEtHsmI.dpuf
Floating-for-Floating

A floating-for-floating interest rate swap occurs when both of the


parties involved have a floating loan, also known as a variable rate
loan. Most commonly the two loans come from different reference
rate indexes, usually either the London Interbank Offered Rate,
LIBOR, or the Tokyo Interbank Offered Rate, TIBOR, but they can
come from the same index as well. Payments on the loans are
usually set up to fall on different days, especially if the loans are
from the same index.
Fixed-for-Floating

In a fixed-for-floating interest rate swap, one of the companies


involved has a fixed-rate loan and the other one has a floating-rate
loan. The two agree to trade loans, with each of the companies
paying the portion, or leg, of the loan for which the other was
originally responsible. This means that the company that actually
acquired the fixed loan will make the payments on the floating leg,
and the original borrower on the floating loan will make payments on
the fixed leg. This allows companies access to loan types for which
they might not otherwise qualify.
Fixed-for-Fixed

The third type of interest rate swap is the fixed-for-fixed swap,


where both parties involved have fixed-rate loans. This swap is
used when the two businesses involved are using different
currencies. This is particularly beneficial to a company that wants to
expand into a country where it has not previously operated.
Currency exchange costs are eliminated and international
companies benefit from being able to access lower interest rates in
the country where the loan originated.
Settlement

When companies deal with interest rate swaps, the principle amount
does not change hands. Instead, after the pre-determined swap
period is over, the company that owes the greatest amount of
money will pay the other company the difference between what the
two owe during the settlement process. So, for example, if
Company X ends up owing a total of $500,000 on the swap while
Company Y owes only $450,000, the only money that actually
changes hands is $50,000, paid from Company X to Company Y.
- See more at: http://wiki.fool.com/Types_of_Interest_Rate_Swaps#sthash.3vEtHsmI.dpuf

Definition
An interest rate swap is a contractual agreement between two counterparties,
under which each agrees to make periodic payment to the other for an agreed
period of time based upon a notional amount of principal. The principal is notional
because it is not exchanged and is used only for the purpose of calculating the
amount of the interest payments. At the point of initiation of the swap, the swap is
priced so that it has a net present value of zero. Often, an interest rate swap
involves exchanging a fixed amount per payment period for a floating payment (the
floating side of the swap would usually be linked to another interest rate, often the
LIBOR).

Fixed for Floating


Investors call the parts of interest swap agreements legs. In a fixed-for-floating swap
agreement, one party agrees to pay the fixed leg of the swap, with the other party agreeing to pay
the floating leg of the swap. The fixed rate is the interest charged over the life of a loan and does
not change. The floating rate is an interest rate pegged to an international reference rate index
and is subject to change. The most commonly used reference rate is London Interbank Offered
Rate or LIBOR.
Fixed-for-floating rate swap, same currency
Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to a
floating rate asset/liability or vice versa. For example, if a company has a fixed rate USD 10
million loan at 5.3% paid monthly and a floating rate investment of USD 10million that returns
USD 1M Libor +25bps monthly, it may enter into a fixed-for-floating swap. In this swap, the
company would pay a floating rate of USD 1MLibor+25bps and receive a 5.5% fixed rate,
locking in 20bps profit.
Fixed-for-floating rate swap, different currencies

Fixed-for-floating swaps in different currencies are used to convert a fixed rate asset/liability in
one currency to a floating rate asset/liability in a different currency, or vice versa. For example, if
a company has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating rate
investment of JPY 1.2 billion that returns JPY 1M Libor+50bps monthly, and wants to lock in the
profit in USD as they expect the JPY 1M Libor to go down or USDJPY to go up (JPY depreciate
against USD), then they may enter into a Fixed-Floating swap in different currency where the
company pays floating JPY 1MLibor+50bps and receives 5.6% fixed rate, locking in 30bps
profit against the interest rate and the FX exposure.
Floating for Floating
In a floating-for-floating interest rate swap agreement, both parties agree to pay a floating rate on
their respective legs of the swap. The floating rates for each leg of the swap generally come from
different reference rate indexes, but can also come from the same index. If both parties choose
the same index, generally they then choose different payment dates. The two main indexes
investors use in a floating for floating interest rate swap are the LIBOR and the Tokyo Interbank
Offered Rate or TIBOR
Floating-for-floating rate swap, same currency
Floating-for-floating rate swaps are used to hedge against or speculate on the spread between the
two indexes widening or narrowing. For example, if a company has a floating rate loan at JPY
1M LIBOR and the company has an investment that returns JPY1M TIBOR + 30bps and
currently the JPY 1M TIBOR = JPY 1M LIBOR + 10bps. At the moment, this company has a net
profit of 40bps. If the company thinks JPY 1M TIBOR is going to come down (relative to the
LIBOR) or JPY 1M LIBOR is going to increase in the future (relative to the TIBOR) and wants
to insulate from this risk, they can enter into afloat-float swap in same currency where they pay,
say, JPY TIBOR + 30bps and receive JPY LIBOR + 35bps. With this, they have effectively
locked in a 35 bit/s profit instead of running with a current 40bps gain and index risk. The 5bpss
difference (w.r.t. the current rate difference) comes from the swap cost which includes the market
expectations of the future rate difference between these two indices and the bid/offer spread
which is the swap commission for the swap dealer.
Floating-for-floating rate swap, different currencies
Party P pays/receives floating interest in currency A indexed to X to receive/payfloating rate in
currency B indexed to Y on a notional N at an initial exchange rate ofFX for a tenure of T years.
The notional is usually exchange at the start and at theend of the swap. This is the most liquid
type of swap with different currencies. Forexample, you pay floating USD 3M LIBOR on the
USD notional 10 million quarterlyto receive JPY 3M TIBOR quarterly on a JPY notional 1.2
billion (at an initialexchange rate of USDJPY 120) for 4 years; at the start you receive the
notional inUSD and pay the notional in JPY and at the end you pay back the same USDnotional
(10 millions) and receive back the same JPY notional (1.2 billions).
Fixed for Fixed
In fixed-for-fixed interest rate swaps, both parties agree to a fixed interest for theirrespective legs
of the swap. The interest rate does not change over the life of the loan forboth parties. Investors
most commonly use fixed-for-fixed interest rate swaps whenthey are dealing with different
currencies. Companies often use fixed-for-fixed interestrate swaps when they are building
or expanding their business in a foreign country.Party P pays/receives fixed interest in currency A
to receive/pay fixed rate in currencyB for a term of T years. For example, you pay JPY 1.6% on a

JPY notional of 1.2 billionand receive USD 5.36% on the USD equivalent notional of 10 million
at an initialexchange rate of USDJPY 120

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated)
directly between two parties, without going through an exchange or other intermediary. Products
such as swaps, forward rate agreements, exotic options and other exotic derivatives are
almost always traded in this way.

Definition of swaps market. A market in which a borrower with one type of loan exchanges it
with another borrower with a different type of loan. Each borrower is looking for an advantage
that the original loan did not have, for example that the loan is in a particular currency, has a
particular interest rate etc.

Swap Exchange of one type of asset, cash flow, investment, liability, or payment for another.
Common types of swap include:
(1) Currency swap: simultaneous buying and selling of a currency to convert debt principal from
the lender's currency to the debtor's currency.
(2) Debt swap: exchange of a loan (usually to a third world country) between banks.
(3) Debt to equity swap: exchange of a foreign debt (usually to a Third World country) for a
stake in the debtor country's national enterprises (such as power or water utilities).
(4) Debt to debt swap: exchange of an existing liability into a new loan, usually with an
extended payback period.
(5) Interest rate swap: exchange of periodic interest payments between
two parties (called counter parties) as means of exchanging future cash flows.

Swap
An arrangement in which two entities lend to each other on different terms, e.g., in different cur
rencies, and/or atdifferent interest rates, fixed or floating.

swap
the bilateral (and multilateral) exchange of a product, business asset, interest rate on a financial
debt, orcurrency for another product, business asset, interest rate on a financial debt, or currency,
respectively;
a. product swaps: individual A offers potatoes to individual B in exchange for a bicycle. See
BARTER;
b. business asset swaps: chemical company A offers its ethylene division to chemical compa
ny B in exchange for B'spaint division. This enables both companies to divest (see DIVE
STMENT) parts of their business they no longer wishto retain while simultaneously ente
ring, or strengthening their position in, another product area;
c. INTEREST-RATE swaps on financial debts: a company that has a variable-rate debt, for
example, may anticipatethat interest rates will rise; another company with fixed-rate debt
may anticipate that interest rates will fall. It thereforecontracts to make variable interestrate payments to the first company and in exchange is paid interest at a fixedrate. Interestrate swaps may be undertaken simultaneously on a variety of debt instruments thereby en
ablingcorporate treasurers to lower the company's total interest payments;
d. currency swap: the simultaneous buying and selling of foreign currencies. This can take t
wo main forms: aspot/forward swap (the simultaneous purchase or sale of a currency in t
he SPOT
MARKET coupled with an offsettingsale or purchase of the same currency in the FOR
WARD
MARKET); or a forward/forward swap (a pair of forwardcurrency contracts involving a
forward purchase and sale of a particular currency which mature at different futuredates).

Spot Transactions:
A spot transaction requires almost immediate delivery of foreign exchange.
In the interbank market, a spot transaction involves the purchase of foreign exchange
with delivery and payment between banks to take place, normally, on the second
following business day.
The date of settlement is referred to as the "value date."
Spot transactions are the most important single type of transaction (43 % of all
transactions).
Outright Forward Transactions:
A forward transaction requires delivery at a future value date of a specified amount of
one currency for a specified amount of another currency.

The exchange rate to prevail at the value date is established at the time of the agreement,
but payment and delivery are not required until maturity.
Forward exchange rates are normally quoted for value dates of one, two, three, six, and
twelve months. Actual contracts can be arranged for other lengths.
Outright forward transactions only account for about 9 % of all foreign exchange
transactions.
Swap Transactions:
A swap transaction involves the simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates.
The most common type of swap is a spot against forward, where the dealer buys a
currency in the spot market and simultaneously sells the same amount back to the same
back in the forward market. Since this agreement is executed as a single transaction, the
dealer incurs no unexpected foreign exchange risk.
Swap transactions account for about 48 % of all foreign exchange transactions.
A cross rate is an exchange rate between two currencies, calculated from their
common relationship with a third currency.

Currency Swaps
A currency swap involves exchanging principal and
interest payments in one currency for principal and
interest payments in another currency.
It requires the principal to be specified in each of the two
currencies.
Usually, the principal amounts are exchanged at the
beginning and at the end of the life of the swap.
The principal values are initially equivalent (using the
exchange rate) so that the swap is worth zero at inception.
We will only cover fixed-for-fixed currency swaps.
Currency Swaps
Just like interest rate swaps, currency swaps can
be used to transform loans and assets.
Loans: Transform borrowings in one currency to
borrowings in another currency.
Assets: Transform assets denominated in one
currency to assets in another currency.
Why should anyone use swaps?
Comparative Advantage. Currency Swaps
Just like interest rate swaps, currency swaps can
be used to transform loans and assets.
Loans: Transform borrowings in one currency to
borrowings in another currency.
Assets: Transform assets denominated in one

currency to assets in another currency.


Why should anyone use swaps?
Comparative Advantage.

Currency swaps can be divided into three categories: (a) fixed-to-fixed currency swap,
(b) floating-to-floating currency swap, and
(c) fixed-to-floating currency swap.
(a) A fixed-to-fixed currency swap is an agreement between two parties who exchange future
financial flows denominated in two different currencies. A currency swap can be understood as a
combination of simultaneous spot sale of a currency and a forward purchase of the same amounts
of currency. This double operation does not involve currency risk. In the beginning of exchange
contract, counterparties exchange specific amount of two currencies. Subsequently, they settle
interest according to an agreed arrangement. During the life of swap contract, each party pays the
other the interest streams and finally they reimburse each other the principal of the swap. A
simple currency swap enables the substitution of one debt denominated in one currency at a fixed
rate to a debt denominated in another currency also at a fixed rate. It enables both parties to draw
benefit from the differences of interest rates existing on segmented markets. A similar operation
is done with regard to floating-to-floating rate swap.
(c) A fixed-to-floating currency coupon swap is an agreement between two parties by which
they agree to exchange financial flows denominated in two different currencies with
different type of interest rates, one fixed and other floating. Thus, a currency coupon
swap enables borrowers (or lenders) to borrow (or lend) in one currency and exchange a
structure of interest rate against anotherfixed rate against variable rate and vice versa.
The exchange can be either of interest coupons only or of interest coupons as well as principal.
For example, one may exchange US dollars at fixed rate for French francs at
variable rate. These types of swaps are used quite frequently.

Participants in Swap Deals


Participants in swap markets are :
(a) financial institutions, (b) big enterprises, and (c) international organisations and
public sector institutions.
a) Financial institutions play a very important role in swap
operations. They influence, to a very great extent, the structure of operations and price of
swaps. Currency swaps are useful to financial institutions as they enable them to make
loans and accept deposits in the currency of their customers' choice. A financial
institution may participate in the swap deal either as a broker, a counterparty or an
intermediary.
When the financial institution acts as a broker only it is not a counterparty in the deal. It

should search for counterparties, facilitate negotiations, while preserving the anonymity
of counteiparties.
In the role of a counterparty, the financial institution incurs various riskscredit risk,
market risk and delivery risk. When the bank or financial institution is a counterparty to a
swap, it tries to arrange another swap having symmetrical features against another
company so as to balance its flows and reduce its own risk. Thus, if it has entered into a
Dollar-Euro fixed-to-fixed swap with a German company, it will try to find an American
company that would like a Euro-Dollar fixed-to-fixed swap involving the same amount
and for the same duration.
As an intermediary, the financial institution or the bank plays the role of a counterparty as
well as a broker at the same time. When the bank is a counterparty or an intermediary, it
is required to make quite complex arrangements m terms of several counterparties so as
to reduce its own risks.
Margins on swaps have diminished. They are lower even for currencies that are highly
traded. Depending on the currencies involved in a swap, a bank may gain 5 to 12 basis
points.
b) The second category of participants are enterprises. They are mostly multinationals, but
there may also be big and medium enterprises with good ratings. French Public
enterprises such as SNCF (French Railways) and EDF (French Electricity Company) take
recourse to swap markets in order to obtain more favourable interest rates. For example,
in May 1994, SNCF issued bonds worth 150 billion Italian lira on international capital
market which it exchanged with an American enteipnse for French francs through a swap
contract. Currency swaps involve a long position in one bond, combined with a short
position in another bond. They may also be considered as portfolio of forward contracts.
Enterprises use them when they have excess in one currency and shortage in another.
Sometimes, subsidized loans available for promoting exports may be swapped for a
desired foreign currency.
c) other institutions such as World Bank, and nation states also often take recourse
to currency swaps and currency coupon swaps.
Important Features of Swap Contracts
Minimum size of a swap contract is of the order of 5 million US dollar or its equivalent in
other currencies. But there are swaps of as large a size as 300 million US dollar, specially
in the case of Eurobonds. The US dollar is the most sought after currency in swap deals.
The dollar-yen swaps represent 25 per cent of the total while dollar-deutschemark
account for 20 per cent of the total. The swaps involving Euro are also likely to be widely
prevalent m European countries.
Life of a swap is between two and ten years. As regards the rate of interest of the
swapped currencies, the choice depends on the anticipation of enterprises. Interest
payments are made on annual or semi-annual basis.
Process of Swap Deals
If there are two enterprises which have symmetrical requirement of capital, in two
different currencies, a swap is possible.
Pricing a Currency Swap
As is clear from its definition, a swap is equivalent to borrowing and lending
simultaneously. So the value (or price) of a swap should be equal to the difference
between the present values of all inflows and all outflows. Pricing problem of a swap is

essentially to find out as to what rate should be quoted so that the two series of cashflows
have equal present value. For example, a bank is willing to swap 10 per cent fixed on
French franc with 8 per cent fixed on an equivalent US dollar principal for 3 years. This
means that the present value of franc payments at 10 per cent is equal to the present value
of the dollar payments at 8 per cent, both expressed in a common currency.
Reasons for Currency Swap Contracts
At any given point of time, there are investors and borrowers who would like to acquire
new assets/liabilities to which they may not have direct access or to which their access
may be costly. For example, a company may retire its foreign currency loan prematurely
by swapping it with home currency loan. The same can also be achieved by direct access
to market and by paying penalty for premature payment. A swap contract makes it
possible at a lower cost. Some of the significant reasons for entering into swap contracts
are given below.
Hedging Exchange Risk
Swapping one currency liability with another is a way of eliminating exchange rate risk.
For example, if a company (in UK) expects certain inflows of deutschemarks, it can swap
a sterling liability into deutschemark liability.

6.4. Swaps
A swap is an agreement whereby two parties (called counterparties) agree to exchange
periodic payments. The cash amount of the payments exchanged is based on some
predetermined principal amount, which is called the notional principal amount or simply
notional amount. The cash amount each counterparty pays to the other is the agreed-upon
periodic rate times the notional amount. The only cash that is exchanged between the
parties are the agreed-upon payments, not the notional amount.
A swap is an over-the-counter (OTC) contract. Hence, the counterparties to a swap are
exposed to counterparty risk.
Swap can be decomposed into a package of derivative instruments, e.g. a package of
forward contracts. However, its maturity can be longer than that of typical forward and
futures contracts, it is negotiated separately, can have quite high liquidity (larger than
many forward contracts, particularly long-dated (i.e., long-term) forward contracts).
The types of swaps typically used by non-finance corporations are:
interest rate swaps,
currency swaps,
commodity swaps, and
credit default swaps.
Interest rate swap is a contract in which the counterparties swap payments in the same
currency based on an interest rate. For example, one of the counterparties can pay a fixed
interest rate and the other party a floating interest rate. The floating interest rate is
commonly referred to as the reference rate.
Currency swap is a contract, in which two parties agree to swap payments based on
different currencies.
Commodity swap is a contract, according to which the exchange of payments by the

counterparties is based on the value of a particular physical commodity. Physical


commodities include precious metals, base metals, natural gas, crude oil, food.
A credit default swap (CDS) is an OTC derivative that permits the buying and selling of
credit protection against particular types of events that can adversely affect the credit
quality of a bond such as the default of the borrower.
Although it is referred to as a swap, it does not have the general characteristics of a
typical swap. There are two parties in the CDS contract: the credit protection buyer and
credit protection seller. Over the life of the CDS, the protection buyer agrees to pay the
protection seller a payment at specified dates to insure against the impairment of the debt
of a reference entity due to a credit-related event. The reference entity is a specific issuer.
The specific credit-related events are identified in the contract that will trigger a payment
by the credit protection seller to the credit protection buyer are referred to as credit events.
If a credit event does occur, the credit protection buyer only makes a payment up to the
credit event date and makes no further payment. At this time, the protection buyer is obligated to
fulfill its obligation. The contract will call for the protection seller to
compensate for the loss in the value of the debt obligation.

A swap contract is an obligation to pay a fixed amount and receive a floating amount at the end
of every period for a pre-specified number of periods.
Each date on which payments are made is called a settlement date. If the fixed amount exceeds
the floating amount on a settlement date, the buyer of the swap pays the seller the difference in
cash. If the floating amount exceeds the fixed amount on a settlement date, the seller of the swap
pays the buyer the difference in cash. In either case, this difference is conveyed in the form of a
difference check.
A swap contract is equivalent to a portfolio of forward contracts with identical delivery prices
and different maturities. Consequently, swap contracts are similar to forwards in that:
at any date, swap contracts can have positive, negative, or no value.
at initiation, the fixed amount paid is chosen so that the swap contract is costless.
The unique fixed amount which zeros out the value of a swap contract is called the swap price.

In a (standard) currency swap, the buyer receives the difference be-tween the dollar value of
one foreign currency unit (e.g., the dollar value of 1 pound) and a fixed amount of domestic
currency (e.g., 2 dollars) at every settlement date (e.g., every 6 months). Since the spot exchange
rate at each settlement date is random, the dollar value of the foreign currency unit is also

random. If this difference is negative, the swap buyer pays the absolute value of the difference to
the swap seller.
Similarly, in an equity index swap, the buyer receives the difference between the dollar value
of a stock index and a fixed amount of dollars at every settlement date.

The most common type of swap is an interest rate swap. The buyer of an interest rate swap
receives the difference between the interest computed using a floating interest rate (e.g., LIBOR)
and the interest computed using a fixed interest rate (e.g., 5% per 6 months) at every settlement
date (e.g., every 6 months). The interest is computed by reference to a notional principal (e.g.,
$100 mio.), which never changes hands. If the floating side of an equity index or interest rate
swap is calculated by reference to an index or interest rate in a foreign country, then there is
currency risk, in addition to the usual equity or interest rate risk.
If the currency is negatively correlated with the underlying, this currency risk is actually
desirable. Nonetheless, many swap con-tracts are quoted with a fixed currency component, so
that only the equity or interest rate risk remains.
Swap transactions provide a means for the bank to mitigate the currency exposure in a forward
trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange
against a
forward purchase (or sale) of an approximately equal amount of the foreign currency. To
illustrate,
suppose a bank customer wants to buy dollars three months forward against British pound
sterling. The
bank can handle this trade for its customer and simultaneously neutralize the exchange rate risk
in the
trade by selling (borrowed) British pound sterling spot against dollars. The bank will lend the
dollars for
three months until they are needed to deliver against the dollars it has sold forward. The British
pounds
received will be used to liquidate the sterling loan.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those
in the opposite direction.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather than have
calls and puts, the swaptions market has receiver swaptions and payer swaptions. A
receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed and receive floating.
Swaptions
Swaptions are options on interest rate swaps.
Caps and Floors
An interest rate cap gives the buyer the right, not the obligation, to receive the difference in the
interest cost (on some notional amount) any time a specified index of market interest rates rises
above a stipulated cap rate.
Caps evolved from interest rate guarantees that fixed a maximum level of interest payable on
floating rate loans.
The advent of trading in over the counter interest rate caps dates back to 1985, when banks began
to strip such guarantees from floating rate notes to sell to the market.
The leveraged buyout boom of the 1980s spurred the evolution of the market for interest rate
caps. Firms engaged in leveraged buyouts typically took on large quantities of short term debt,
which made them vulnerable to financial distress in the event of a rise in interest rates. As a
result, lenders began requiring such borrowers to buy interest rate caps to reduce the risk of
financial distress.
Similar in structure to a cap, an interest rate floor gives the buyer the right to receive the
difference in the interest cost any time a specified index of market interest rates falls below a
stipulated floor rate.
Swaptions and Caps Caps and swaptions are generally traded as separate products in the
financial markets, and the models used to value caps are typically different from those used to
value swaptions.

Furthermore, most Wall Street firms use a piecemeal approach to calibrating their models for
caps and swaptions, making it difficult to evaluate whether these derivatives are fairly priced
relative to each other.

Financial theory, however, implies no arbitrage relations for the cap and swaption prices.

A cap can be represented as a portfolio of options on individual for-ward rates. In contrast, a


swaption can be viewed as an option on the forward swap rate, which is a portfolio of individual
forward rates.
This implies that the relation between cap and swaption prices is driven primarily by the
correlation structure of forward rates.
Interest Rate Swap: an interest rate swap is an agreement between two entities, whereby one
entity pays the long-term interest rate times a notional amount minus the short-term interest rate
times the notional amount. The other counterparty the entity on the other side does the
reverse.
SWAPS
A swap can be defined as the exchange of one stream of future cash flows with another stream of
cash flows with different characteristics.
A swap is an agreement between two or more people/parties to exchange sets of cash flows over
a period in future. Swaps can be divided into two types viz., (a) Currency Swaps, (b) Interest
Rate Swaps.
Currency Swaps: The currency swap is an agreement between two parties to exchange (swap)
payments or receipts in one currency for payment or receipts in other currency. Suppose if two
entities are trading in currency, the rationale for currency swap between them lies in the fact that
one borrower has a comparative advantage in borrowing in one currency, while the other
borrower has an advantage in borrowing in another currency.
Interest Rate Swaps: An interest rate swap is an agreement whereby one party exchanges one
set of interest rate payment for another rate over a time period. The most common arrangement is
an exchange of fixed interest rate payment for another rate over a time period. The interest rates
are calculated on notional values of principals.

In finance, a swap is a derivative in which two counterparties agree to exchange one stream of
cash flows against another stream. These streams are called the legs of the swap.
The cash flows are calculated over a notional principal amount, which is usually not exchanged
between counterparties. Consequently, swaps can be used to create unfunded exposures to an
underlying asset, since counterparties can earn the profit or loss from movements in price
without having to post the notional amount in cash or collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in
the underlying.
Most swaps are traded Over The Counter (OTC), tailor-made for the counter parties.
Some types of swaps are also exchanged on future markets, for instance Chicago Mercantile
Exchange Holdings Inc., the largest US futures market, the Chicago Board Options Exchange
and Frankfurt-based Eurex AG.
SWAPTION
A swaption is an option granting its owner the right but not the obligation to enter into an
underlying swap. While options can be traded on a variety of swaps, the term swaption
typically refers to options on interest rate swaps.
Properties of Swaption
Unlike ordinary swaps, a swaption not only hedges the buyer against downside risk, also lets the
buyer take advantage of any upside benefits. Like any other option, if the swaption is not
exercised by maturity, it expires worthless.
If the strike rate of the swap is more favourable than the prevailing market swap rate, then the
swaption will be exercised as detailed in the swaption agreement.
It is designed to give the holder the benefit of the agreed upon strike rate if the market rates
are higher, with the flexibility to enter into the current market swap rate if they are lower.
The converse is true if the holder of the swaption receives the fixed rate under the swap
agreement. Investors can also use swaptions to trade the volatility of the underlying swap rate.

Swap Deals:

Swap contracts can be arranged across currencies. Such contracts are known as currency swaps
and can help manage both interest rate and exchange rate risk. Many financial institutions count
the arranging of swaps, both domestic and foreign currency, as an important line of business.
This method is virtually cheaper than covering by way of forward options. Technically, a
currency swap is an exchange of debt service obligations denominated in one currency for the
service in an agreed upon principal amount of debt denominated in another currency. By
swapping their future cash flow obligations, the counterparties are able to replace cash flows
denominated in one currency with cash flows in a more desired currency.
A swap deal is a transaction in which the bank buys and sells the specified foreign currency
simultaneously for different maturities. Thus a swap deal may involve:
(i) simultaneous purchase of spot and sale of forward or vice verse ; or
(ii) Simultaneous purchase and sale, both forward but for different maturities. For instance, the
bank may buy one month forward and sell two months forward. Such a deal is known as
forward swap.
A swap deal should fulfill the following conditions:
There should be simultaneous buying and selling of the same foreign currency of same value for
different maturities; and
(i) The deal should have been concluded with the distinct understanding between the banks that it
is a swap deal.

A swap deal is done in the market at a difference from the ordinary deals. In the ordinary deals
the following factors enter into the rates:
(i) The difference between the buying and selling rates ; and
(ii) The forward margin, i.e., the premium or discount.
In a swap deal the first factor is ignored and both buying and selling are done at the same rate.
Only the forward margin enters into the deal as the swap difference.
In a swap deal, both purchase and sale are done with the same bank and they constitute two legs
of the same contract. In a swap deal, it does not really matter as to what is spot rate. What is
important is the swap difference which determines the quantum of net receipt of payment for the
bank as a result of the combined deal. But the spot rate decides the total value in rupees that
either of the banks has to deploy till receipt of forward proceeds on the due date. Therefore, it is
expected that the spot rate is the spot rate ruling in the market. Normally, the buying or selling
rate is taken depending upon whether the spot side is respectively a sale or purchase to the
market-maker. The practice is also to take the average of the buying and selling rates. However,
it is of little consequence whether the purchase or selling or middle rate is taken as the spot rate
Need for Swap Deals:
Some of the cases where swap deal may become necessary are described below:
(1) When the bank enters into a forward deal for a large amount with the customer and cannot
find a suitable forward cover deal in the market, recourse to swap deal may become necessary.

(2) Swap may be needed when early delivery or extension of forward contracts is effected at the
request of the customers. Please see chapter on Execution of Forward Contracts and Extension of
Forward Contract.
(3) Swap may be carried out to adjust cash position in a currency. This explained later in the
chapter on Exchange Dealings.
(4) Swap may also be carried out when the bank is overbought for certain maturities and
oversold for certain other maturities in a currency.
Swap and Deposit/Investment:
Let us suppose that the bank sells USD 10,000 three months forward, Instead of covering its
position by a forward purchase, the bank may buy from the market spot dollar and kept the
amount in deposit with a bank in New York. The deposit will be for a period of three months. On
maturity, the deposit will be utilized to meet its forward sale commitment. Such a transaction is
known as swap and deposit. The bank may resort to this method if the interest rate at New
York is sufficiently higher than that prevailing in the local market. If instead of keeping the
amount in deposit with a New York bank, in the above case, the spot purchased is invested in
some other securities the transaction is known as swap and investment.
Ready Transactions: In cases where the agreement to buy and sell the foreign exchange takes
place and actual settlement is finished (i.e., delivery of foreign exchange and the receipt of the
price, i.e., exchange transaction proper is completed on that day itself, it is called ready
transaction. It is also known as Value today.
Spot Transactions: In some transactions, the deal will be struck; but the actual exchange of
currencies will take place, say, after two days from the date of contract. This type of transaction
is known as Spot Transaction. For example, if the contract for certain amount of foreign
exchange is made on an agreed rate, say on Monday, the actual delivery, i.e., completion of
transaction will take place on Wednesday. If that day happens to be a holiday, the delivery will
take place on the very next day, i.e., Thursday, it is on this day, the contract is fulfilled by paying
rupees and receiving dollars or vice versa.
Forward Transaction: On the other hand, the deal will be struck on a particular day, wherein rate
will be agreed upon. But the actual transaction will take place at a specified future date. This is
called Forward Transaction. The Forward Transaction may be for one month, two months or
even three months. This means, the actual contract will take place on a particular day. This
forward contract for delivery of currencies will take place after one month, two months or three
months decided according to the contract.
The concept of the SWAPS:
The aim of swap contract is to bind the two counterparties to exchange two different payment
stream over time, the payment being tied, or at least in part, to subsequentand uncertain
market price developments. In most swaps so far, the prices concerned have been exchange rates
or interest rates, but they increasingly reach out to equity indices and physical commodities. All
such prices have risk characteristics in common, in quality if not degree. And for all, the allure of
swaps may be expected cost saving., yield enhancement, or hedging or speculative opportunity.

Portfolio management requires financial swaps which are simple in principle, versatile in
practice yet revolutionary. A swap coupled with an existing asset or liability can radically modify
effective risk and return. Individually and together with futures, options and other financial
derivatives, they allow yield curve and currency risks, and liquidity and geographic market
considerations, all to be managed separately and also independently of underlying cash market
stocks.
Growth of the SWAP Market:
In the international finance market most of the new products are executed in a physical market
but swap transactions are not. Participants in the swap market are many and varied in their
location character and motivates in exciting swaps. However, in general the activity of the
participants in the swap market have taken on the character of a classical financial market
connected to , and integrating the underlying money, capital and foreign exchange market.
Swap in their current form started in 1981 with the well-publicised currency swaps, and in the
following year with dollar interest rate swaps. The initial deals were characterized by the three
critical features.
1. Barter- two counterparties with exactly offsetting exposures were introduced by a third party.
If the credit risk were unequal, the third party- if a bank might interpose itself or arrange for a
bank to do so for a small fee.
2. Arbitrage driven- the swap was driven by a arbitrage which gave some profit to all three
parties. Generally, this was a credit arbitrage or market-access arbitrage.
3. Liability driven- almost all swaps were driven by the need to manage a debt issue on both
sides.
The major dramatic change has been the emergence of the large banks as
aggressive market makers in dollar interest rate swaps. Major US banks are in the business of
taking credit risk and interest rate risk. They, therefore, do not need counterparties to do dollar
swaps. The net result is that spreads have collapsed and volume has exploded. This means that
institutional investors get a better return on their investments and international borrowers pay
lower financing costs. This, in turn, result in more competitively priced goods for consumers and
in enhanced returns pensioners. Swap therefore, have an effect on almost all of us yet they
remain an arcane derivative risk management tool, sometimes suspected of providing the
international banking system with tools required to bring about destruction.
Although the swap market is now firmly established , there remains a wide divergence among
current and potential users as to how exactly a given swap structure works, what risks are
entailed when entering into swap transactions and precisely what the swap market is and,
for that matter is not.
The basic SWAP Structures
The growth and continued success of the swap market has been due small part to the creativity of
its participants. As a result, the swaps structures currently available and the future potential
structures which will in time become just another market norm are limited only by the
imagination and ingenuity of those participating in the market. Nonetheless, underlying the swap
transactions seen in the market today are four basic structures which may now be considered as
fundamental. These structures are:
- the Interest Rate Swap
- the Fixed Rate Currency Swap

- the Currency Coupon Swap


- the Basis Rate Swap
The Currency SWAP Market: Main Features
The oldest and the most creative sector:
The currency swap market is the oldest and most creative sector of the swap market. This is not
distinguished in market terms between the fixed rate currency swap and the currency coupon
swap. There is no distinction in market terms between these two types of currency swaps because
the only difference is whether the counter currency receipt/payment is on a fixed or floating
basis- in structure and result, the two types of swaps are identical and it is a matter of taste (or
preference) for one or both counterparties to choose a fixed or floating payment. When the dollar
is involved on one side of a given transaction, the possibility to convert a fixed rate preference on
one side to a floating rate preference on the other side through interest rate swap market makes
any distinction even more irrelevant. However, for those who like fine distinctions, there is a
tendency in the market to regard the fixed rate currency swap market as more akin to the long
date forward foreign exchange market (because when one is executing a fixed currency swap one
may often be competing with the long-date FX market) and the currency coupon swap market as
more akin to the dollar bond/ swap market (because the dollar bond issuer compares the below
LIBOR spread available in the dollar market to that available, say, through tapping the Swiss
Franc market.)
The fixed rate currency Swap:
A fixed rate currency swap consists of the exchange between two counterparties of fixed rate
interest in one currency in return for fixed rate interest in another currency.
Following are the main steps to all currency swaps:
1. Initial Exchange for the Principal:
The counterparties exchange the principal amounts on the commencement of the swap at an
agreed rate of exchange. Although this rate is usually based on the spot exchange rate, a forward
rate set in advance of the swap commencement date can also be used. This initial exchange may
be on a notional basis of alternatively a physical exchange. The sole importance of the initial
exchange on being either on physical or notional basis, is to establish the quantum of the
respective principal amounts for the purpose of (i) calculating he ongoing payments of interest
and (ii) the re- exchange of principal amounts under the swap.
2. Ongoing Exchanges of Interest:
Once the principal amounts are established, the counterparties exchange interest payments based
on the outstanding principal amounts at the respective fixed interest rates agreed at the outset of
the transaction.
3. Re-exchange of the Principal Amounts:
On the maturity date the counterparties re-exchange the principal amounts established at the
outset. This straight forward, three-step process is standard practice in the swap market and
results in the effective transformation of a debt raised in one currency into a fully-hedged fixedrate liability in another currency.
The Currency Coupon SWAP:
The currency coupon swap is combination of the interest rate swap and the fixed-rate currency
swap. The transaction follows the three basic steps described for the fixed rate currency swap
with the exception that fixed-rate interest in one currency is exchanged for floating rate interest
in another currency. By using the currency coupon swap the benefit which can be obtained, can

be explained with the following example. Suppose an Indian corporate wished to enter a major
leasing contract for a capital project to be sited in Japan. The corporate wanted to obtain the
advantage of funding through a Japans lease which provided lower lease rentals due to the Japan
tax advantages available to the Japan lessor. However, the Corporate was concerned by both the
currency and interest rate exposure which would result from the yen based leasing contract. The
structure provided by Hankers Trust enabled the Corporate to obtain the cost benefits available
from the Japan lease and at the same time convert the underlying lease finance into a fully
hedged fixed-rate yen liability. Under the structure Bankers Trust paid, on a quarterly basis, the
exact payments due on the Corporates yen based Japan lease in return for the Corporate paying
an annual amount of fixed Japanese Yen to Bankers Trust. The amount for fixed Japanese Yen
payable reflected the beneficial level of the Japanese Yen lease payments.
Swaps:
Swaps are agreements to exchange one series of future cash flows for another. Although the
underlying reference assets can be different, eg equity or interest rate, the value of the underlying
asset will characteristically be taken from a publicly available price source. For example, under
an equity swap the amount that is paid or received will be the difference between the equity price
at the start and end date of the contract.
Swaptions:
These are non-standard contracts giving the owner the right but not the obligation to enter into an
underlying swap. The most common swaptions traded are those dependent on interest rates
which allow funds to create bespoke protection. Contracts can be preconfigured to provide both
upside and downside protection if an event occurs. For example, a party can purchase a swaption
to protect itself from the 10-year interest rate swap rate going below 1% in 3 months time.
A swap bank is a generic term to describe a
financial institution that facilitates swaps
between counterparties.
The swap bank can serve as either a broker
or a dealer.
As a broker, the swap bank matches counterparties but
does not assume any of the risks of the swap.
As a dealer, the swap bank stands ready to accept either
side of a currency swap, and then later lay off their risk,
or match it with a counterparty.
INTEREST RATE SWAPS AND SWAP VALUATION
Introduction
An interest rate swap is a contractual agreement between two counterparties to exchange cash
flows on particular dates in the future. There are two types of legs (or series of cash flows). A
fixed rate payer makes a series of fixed payments and at the outset of the swap, these cash flows
are known. A floating rate payer makes a series of payments that depend on the future level of

interest rates (a quoted index like LIBOR for example) and at the outset of the swap, most or all
of these cash flows are not known. In general, a swap agreement stipulates all of the conditions
and definitions required to administer the swap including the notional principal amount, fixed
coupon, accrual methods, day count methods, effective date, terminating date, cash flow
frequency, compounding frequency, and basis for the floating index.
An interest rate swap can either be fixed for floating (the most common), or floating for floating
(often referred to as a basis swap). In brief, an interest rate swap is priced by first calculating the
present value of each leg of the swap (using the appropriate interest rate curve) and then
aggregating the two results.
An FX swap is where one leg's cash flows are paid in one currency while the other leg's cash
flows are paid in another currency. An FX swap can be either fixed for floating, floating for
floating, or fixed for fixed. In order to price an FX swap, first each leg is present valued in its
currency (using the appropriate curve for the currency).

An interest rate swap is a contractual agreement between two parties to exchange interest
payments.
HOW IT WORKS (EXAMPLE):
The most common type of interest rate swap is one in which Party A agrees to make payments to
Party B based on a fixed interest rate, and Party B agrees to make payments to Party A based on
a floating interest rate. The floating rate is tied to a reference rate (in almost all cases, the London
Interbank Offered Rate, or LIBOR).
For example, assume that Charlie owns a $1,000,000 investment that pays him LIBOR + 1%
every month. As LIBOR goes up and down, the payment Charlie receives changes.
Now assume that Sandy owns a $1,000,000 investment that pays her 1.5% every month. The
payment she receives never changes.
Charlie decides that that he would rather lock in a constant payment and Sandy decides that she'd
rather take a chance on receiving higher payments. So Charlie and Sandy agree to enter into an
interest rate swap contract.

Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on a
$1,000,000 principal amount (called the "notional principal" or "notional amount"). Sandy agrees
to pay Charlie 1.5% per month on the $1,000,000 notional amount.
Let's see what this deal looks like under different scenarios.
Scenario A: LIBOR = 0.25%
Charlie receives a monthly payment of $12,500 from his investment ($1,000,000 x (0.25% +
1%)). Sandy receives a monthly payment of $15,000 from her investment ($1,000,000 x 1.5%).
Now, under the terms of the swap agreement, Charlie owes Sandy $12,500 ($1,000,000 x
LIBOR+1%) , and she owes him $15,000 ($1,000,000 x 1.5%). The two transactions
partially offseteach other and Sandy owes Charlie the difference: $2,500.

Scenario B: LIBOR = 1.0%


Now, with LIBOR at 1%, Charlie receives a monthly payment of $20,000 from his investment
($1,00,000 x (1% + 1%)). Sandy still receives a monthly payment of $15,000 from her
investment ($1,000,000 x 1.5%).

With LIBOR at 1%, Charlie is obligated under the terms of the swap to pay Sandy $20,000
($1,000,000 x LIBOR+1%), and Sandy still has to pay Charlie $15,000. The two transactions
partially offset each other and now Charlie owes Sandy the difference between swap interest
payments: $5,000.

Note that the interest rate swap has allowed Charlie to guarantee himself a $15,000 payout; if
LIBOR is low, Sandy will owe him under the swap, but if LIBOR is higher, he will owe
Sandy money. Either way, he has locked in a 1.5% monthly return on his investment.
Sandy has exposed herself to variation in her monthly returns. Under Scenario A, she made
1.25% after paying Charlie $2,500, but under Scenario B she made 2% after Charlie paid her an
additional $5,000. Charlie was able to transfer the risk of interest rate fluctuations to Sandy, who
agreed to assume that risk for the potential for higher returns.
One more thing to note is that in an interest rate swap, the parties never exchange the principal
amounts. On the payment date, it is only the difference between the fixed and variable interest
amounts that is paid; there is no exchange of the full interest amounts.
WHY IT MATTERS:

Interest rate swaps provide a way for businesses to hedge their exposure to changes in interest
rates. If a company believes long-term interest rates are likely to rise, it can hedge its exposure to
interest rate changes by exchanging its floating rate payments for fixed rate payments
Interest-rate swaps have become an integral part of the fixed-income market. These derivative
contracts, which typically exchange or swap fixed-rate interest payments for floating-rate
interest payments, are an essential tool for investors who use them to hedge, speculate, and
manage risk.
This article aims to explain why swaps have become so important to the bond market. It begins
with a basic definition of interest-rate swaps, outlines their characteristics and compares them
with more familiar instruments, such as loans. Later, we examine the swap curve, some of the
uses of swaps, and the risks associated with them.
What is a Swap?
An interest rate swap is an agreement between two parties to exchange one stream of interest
payments for another, over a set period of time. Swaps are derivative contracts and trade overthe-counter.
The most commonly traded and most liquid interest rate swaps are known as vanilla swaps,
which exchange fixed-rate payments for floating-rate payments based on LIBOR, the interest
rate high-credit quality banks (AA-rated or above) charge one another for short-term financing.
LIBOR, The London Inter-Bank Offered Rate, is the benchmark for floating short-term
interest rates and is set daily.) Although there are other types of interest rate swaps, such as those
that trade one floating rate for another, plain vanilla swaps comprise the vast majority of the
market.

By convention, each participant in a vanilla swap transaction is known by its relation to the fixed
rate stream of payments. The party that elects to receive a fixed rate and pay floating is the
receiver, and the party that receives floating in exchange for fixed is the payer. Both the
receiver and the payer are known as counterparties in the swap transaction.
Investment and commercial banks with strong credit ratings are swap market-makers, offering
both fixed and floating-rate cash flows to their clients. The counterparties in a typical swap
transaction are a corporation, a bank or an investor on one side (the bank client) and an
investment or commercial bank on the other side. After a bank executes a swap, it usually offsets
the swap through an interdealer broker and retains a fee for setting up the original swap. If a
swap transaction is large, the interdealer broker may arrange to sell it to a number of

counterparties, and the risk of the swap becomes more widely dispersed. This is how banks that
provide swaps routinely shed the risk, or interest-rate exposure, associated with them.
Initially, interest rate swaps helped corporations manage their floating-rate debt liabilities by
allowing them to pay fixed rates, and receive floating-rate payments. In this way, corporations
could lock into paying the prevailing fixed rate and receive payments that matched their floatingrate debt. (Some corporations did the opposite paid floating and received fixed to match their
assets or liabilities.) However, because swaps reflect the markets expectations for interest rates
in the future, swaps also became an attractive tool for other fixed-income market participants,
including speculators, investors and banks.
As a result, the swap market has grown immensely in the past 20 years or so; the notional dollar
value of outstanding interest rate swaps globally was $230 trillion at the end of 2006, according
to the Bank for International Settlements. Swap volume is termed notional because principal
amounts, although included in total swap volume, are never actually exchanged. Only interest
payments change hands in a swap, as described below.
Characteristics of Interest Rate Swaps
The swap rate is the fixed interest rate that the receiver demands in exchange for the
uncertainty of having to pay the short-term LIBOR (floating) rate over time. At any given time,
the markets forecast of what LIBOR will be in the future is reflected in the forward LIBOR
curve.
At the time of the swap agreement, the total value of the swaps fixed rate flows will be equal to
the value of expected floating rate payments implied by the forward LIBOR curve. As forward
expectations for LIBOR change, so will the fixed rate that investors demand to enter into new
swaps. Swaps are typically quoted in this fixed rate, or alternatively in the swap spread, which
is the difference between the swap rate and the U.S. Treasury bond yield (or equivalent local
government bond yield for non-U.S. swaps) for the same maturity. Swap spreads are discussed in
more detail in the next section.
In many ways, interest rate swaps resemble other familiar forms of financial transactions, and it
is helpful to think of swaps in these terms:

Exchanging Loans. Early interest rate swaps were literally an exchange of loans, and
this model still provides an intuitive way to think about swaps. Consider two parties that
have taken out loans of equal value, but one has borrowed at the prevailing fixed rate and
the other at a floating rate tied to LIBOR. The two agree to exchange their loans, or swap
interest rates. Since the principal is the same, there is no need to exchange it, leaving only
the quarterly cash flows to be exchanged. The party that switches to paying a floating rate
might demand a premium or cede a discount on the original fixed borrowers rate,
depending on how interest rate expectations have changed since the original loans were
taken out. The original fixed rate, plus the premium or minus the discount, would be the
equivalent of a swap rate.

The Financed Treasury Note. Receiving fixed rate payments in a swap is similar to
borrowing cash at LIBOR and using the proceeds to buy a U.S. Treasury note. The buyer
of the Treasury will receive fixed payments, or the coupon on the note, and be liable for
floating LIBOR payments on the loan. The concept of a financed Treasury illustrates an
important characteristic that swaps share with Treasuries: both have a discrete duration,
or interest rate sensitivity, that depends on the maturity of the bond or contract.

Uses for Swaps


Interest rate swaps became an essential tool for many types of investors, as well as corporate
treasurers, risk managers and banks, because they have so many potential uses. These include:

Portfolio management. Interest rate swaps allow portfolio managers to add or subtract
duration, adjust interest rate exposure, and offset the risks posed by interest rate volatility.
By increasing or decreasing interest rate exposure in various parts of the yield curve
using swaps, managers can either ramp-up or neutralize their exposure to changes in the
shape of the curve, and can also express views on credit spreads. Swaps can also act as
substitutes for other, less liquid fixed income instruments. Moreover, long-dated interest
rate swaps can increase the duration of a portfolio, making them an effective tool in
Liability Driven Investing, where managers aim to match the duration of assets with that
of long-term liabilities.

Speculation. Because swaps require little capital up front, they give fixed-income traders
a way to speculate on movements in interest rates while potentially avoiding the cost of
long and short positions in Treasuries. For example, to speculate that five-year rates will
fall using cash in the Treasury market, a trader must invest cash or borrowed capital to
buy a five-year Treasury note. Instead, the trader could receive fixed in a five-year
swap transaction, which offers a similar speculative bet on falling rates, but does not
require significant capital up front.

Corporate finance. Firms with floating rate liabilities, such as loans linked to LIBOR,
can enter into swaps where they pay fixed and receive floating, as noted earlier.
Companies might also set up swaps to pay floating and receive fixed as a hedge against
falling interest rates, or if floating rates more closely match their assets or income stream.

Risk management. Banks and other financial institutions are involved in a huge number
of transactions involving loans, derivatives contracts and other investments. The bulk of
fixed and floating interest rate exposures typically cancel each other out, but any
remaining interest rate risk can be offset with interest rate swaps.

Rate-locks on bond issuance. When corporations decide to issue fixed-rate bonds, they
usually lock in the current interest rate by entering into swap contracts. That gives them
time to go out and find investors for the bonds. Once they actually sell the bonds, they
exit the swap contracts. If rates have gone up since the decision to sell bonds, the swap
contracts will be worth more, offsetting the increased financing cost.

Risks Associated with Interest Rate Swaps


Like most non-government fixed income investments, interest-rate swaps involve two primary
risks: interest rate risk and credit risk, which is known in the swaps market as counterparty
risk.

With the context of the example just described, the following salient features of the swap
may be noted.
1. Effective Date All the cash flows pertaining to fixed leg are known at the time of
entering the swap at T = 0, referred as effective date.
2. Resetting of Floating Leg Cash Flow The cash flow for floating leg of the swap is
determined one period in advance when the floating rate becomes known. Therefore,
at the time of entering the swap both the amounts of interest are known. The first
receipt of cash flow at T = 6 months is known at T = 0 and is done at MIBOR of 8%
plus 30 bps. The date on which the next floating rate payment is decided is called
reset date.
3. Notional Principal No principal amount is exchanged either at initiation or conclusion
of the swap. It remains a notional figure for determination of amount of interest on
both the legs.
4. Exchange Differential Cash Flow The exchange of interest is done on net basis as
depicted in last column of Table, with positive sign as cash inflows and negative
signs as cash outflows for Company A. The cash flows for Company B would be
opposite to that of Company A.
5. Different Convention to Calculate Fixed and Floating Interests The method of
calculation of interest on the two legs can be defined in the swap agreement being
an over-the-counter (OTC) product between two parties. However, the convention
is to calculate the two legs of interest are different and as follows:
For Fixed Leg : Actual/365, and
For Floating Leg : Actual/360
(As is the practice in the money markets)
To illustrate, if actual number of days in the six-month period is 182, amount of
interest for both the legs for the first cash flow would be somewhat different than those
shown in Table
For Fixed Leg: Principal x Interest rate No.of days
365
50, 00,000 0.085 182
365
= ` 2, 11,918
For Floating Leg: Principal Interest rate
No.of days
360
50, 00,000 0.085 182

360
= ` 2, 09,805
For simplicity of exposition, in the example 180 days are assumed for all semi-annual
periods with 360-day year.
Currency Swaps
A currency swap involves exchanging principal and
interest payments in one currency for principal and
interest payments in another currency.
It requires the principal to be specified in each of the two
currencies.
Usually, the principal amounts are exchanged at the
beginning and at the end of the life of the swap.
The principal values are initially equivalent (using the
exchange rate) so that the swap is worth zero at inception.
We will only cover fixed-for-fixed currency swaps.
Valuation of Currency Swaps
Two ways of valuing a fixed-for-fixed
currency swap:
Difference between 2 bonds (one foreign bond
and one local bond).
A portfolio of forward contracts.

value of 1 pound) and a fixed amount of domestic currency (e.g., 2 dollars) at every settlement
date (e.g., every 6 months). Since the spot exchange rate at each settlement date is random, the
dollar value of the foreign currency unit is also random. If this difference is negative, the swap
buyer pays the absolute value of the difference to the swap seller.
Similarly, in an equity index swap, the buyer receives the difference between the dollar value of
a stock index and a fixed amount of dollars at every settlement date.
The most common type of swap is an interest rate swap. The buyer of an interest rate swap
receives the difference between the interest computed using a floating interest rate (e.g., LIBOR)
and the interest computed using a fixed interest rate (e.g., 5% per 6 months) at every settlement
date (e.g., every 6 months). The interest is computed by reference to a notional principal (e.g.,
$100 mio.), which never changes hands. If the floating side of an equity index or interest rate
swap is calculated by reference to an index or interest rate in a foreign country, then there is
currency risk, in addition to the usual equity or interest rate risk.
If the currency is negatively correlated with the underlying, this currency risk is actually
desirable. Nonetheless, many swap con-tracts are quoted with a fixed currency component, so
that only the equity or interest rate risk remains.

Forward Premium and Forward Discount


A foreign currency is said to be a premium currency if its interest rate is lower than the domestic
currency. On the other hand, a foreign currency is said to be a discount currency if its interest
rate
is higher than the domestic currency. Forwards will exceed the spot for a premium currency and
will be less than the spot for a discount currency. For example, on November 9, 1994 (see
Example
I.6 below), the (forward) British pound was a discount currency. That is, the British pound is
cheaper in the forward market.
It is common to express the premium and discount of a forward rate as an annualized percentage
deviation from the spot rate. When annualized, the forward premium is compared to the interest
rate differential between two currencies. The forward premium, p, is calculated as follows:
p = [(Ft,T - St)/St] x (360/T).
Note that p could be a premium (if p > 0), or a discount (if p < 0).
Example I.6: Using the information from Example I.7 below, we obtain the 180-day USD/GBP
forward rate and the spot rate. The 180-day forward rate is 1.6167 USD/GBP, while the spot rate
is 1.62 USD/GBP. The forward premium is:
p = [(1.6167 - 1.62)/1.62] x (360/180) = -.0041.
The 180-day forward premium is -.41%. That is, the GBP is trading at a .41% discount for
delivery in 180
days.
The Foreign Exchange Swap Market
As mentioned above, in a foreign exchange swap transaction, a trader can simultaneously sell
currency for spot delivery and buy that currency for forward delivery. A foreign exchange swap
involves two transactions. For example, a sale of GBP is a purchase of USD and a purchase of
GBP is a sale of USD. A foreign exchange swap can be described as a simultaneous borrowing of
one currency and lending of another currency.

Cross-Exchange Rate (Cross-rate)


Exchange rate between two currencies based
on each of their exchange rates with a third
currency
5-12
U.S. perspective:
You have $/ and $/ exchange rates
Cross rate would be / calculated using $
exchange rates
/ = (/$) x ($/)

Cross Rates
Suppose that ($/) = 1.50
i.e. $1.50 = 1.00
and that S($/) = 0.01
i $0 01 1 00
5-13
i.e. 0.01 = 1.00
What must the / cross rate be?
0.006667
= 1.00 1.00 $0.01
$1.50 1.00
or, 1.00 = 150

The forward rate for a currency, say the dollar, is said to be at premium with respect to the spot
rate when one dollar buys more units of another currency, say rupee, in the forward than in the
spot rate on a per annum basis.
The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot
rate when one dollar buys fewer rupees in the forward than in the spot market. The discount is
also usually expressed as a percentage deviation from the spot rate on a per annum basis.
The forward exchange rate is determined mostly be the demand for and supply of forward
exchange. Naturally when the demand for forward exchange exceeds its supply, the forward rate
will be quoted at a premium and conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand
for forward exchange, the forward rate will tend to be at par.