Introduction to swaps A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. The first interest rate swap occurred between IBM and the World Bank in 1981. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices. For example, a company might ideally want to borrow in the fixed rate market, but finds it cannot do so at any reasonable rate. It might therefore take out a floating rate loan, and enter into a swap contract under which it pays amounts equivalent to fixed rate interest on a notional principal sum, and receives amount equivalent to floating rate interest on the same notional principal. A Swap is not a lending facility. It is an interest rate management tool that can be used in conjunction with any variable rate lending facility, including a facility with another lender. The basic idea behind swaps is that parties involved get access to markets at better terms than would be available to each one of them individually. The gains achieved by the parties are divided amongst them depending on their relative competitive advantage Types of swaps . INTERESR RATE SWAPS: An interest rate swap is contractual agreement entered into b/w two counter parties under which agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal .There is no need to exchange actual amounts of principal and it is a sngle currency transaction. The primary motives behind the interest rate swaps are to lower the costs of borrowing and to overcome the asset liability mismatch Plain Vanilla Interest Rate Swap The most common and simplest swap is a "plain vanilla" interest rate swap. Consider a three year swap initiated on March 15,2005 between Infosys and Wipro. We assume Infosys agrees to pay to Wipro an interest rate of 5% p.a. on a notional principal of 100 crores and in return Wipro agrees to pay Infosys six month LIBOR rate on the same notional principal. We assume that agreement specifies that payments are exchanged every six months, and the 5% rate is quoted with semi annual compounding. Cash flow to Infosys in a rs 100 cr three year interest rate swap when a fixed rate is paid and labor is recieved

date Sept 15,05 March 15,06 Sept 15,06 March 15,07

6 month libor 4.8 5.3 5.5 5.6

Floating cash got +2.1 +2.4 2.65 2.75

Paid fixed cash -2.50 2.50 2.50 2.50

Net cash flow -0.40 -0.10 +0.15 +0.25

25% = LIBOR-25 basis point .50 2. both parties can take advantage of the 100 bass point spread differential.07 March 15. Interest rate swap of BANK and NALCO NALCO will pay 7.25% to IBM Net rate to IBM is =LIBOR +7% -7.35% of $100 million to bank.9 6.35%-LIBOR = 7.95 2. NALCO will take flating loan from a lead bank (under the syndicated management)at an nteresr rate of LABOR+0.50 +0. can raise money in both the fixed and floating rate loans markets at more advantageous terms IBM Floating rate Fixed rate LIBOR 7% NALCO LIBOR+0.Sept 15.85% Interest rate swap of BANK and IBM IBM will give LIBOR on $100 million BANK will pay interest of 7.85 2.five year bond carryng a fixed rate of 7%.08 5.To reduce risk and in order to take advantage of possible downward movements in interest rates IBM would like to borrow on a floating rate NALCO would like to borrow a fixed rate loan IBM being the stronger company having a better international credit rating than NALCO.At the same time IBM will issue a bond $100 milolion .5% 8.4 2. Wipro is similarly long a fixed rate bond and short a floating rate bond. Net rate to NALCO is =LIBOR + 0. IBM and NALCO will enter into interest rate swaps with bank. Thus net cash flow for Infosys is positive and thus a gain for it Classic swap transaction: IBM and NALCO Both firms require $100 million for a five year period.5 ponts.5% Through an interest rate swap.30 +0.45 Infosys whose position is described in the table is long a floating rate bond and short a fixed rate bond.5% +7.5% Interest rate dfferential . Bank will pay six month LIBOR over 5 years.5% 1.

it pays a principal ofGBP 10 million and receives a principal of $15 million . 2002. Initially the principal amounts flow in opposite direction to the arrows. Each year during the life of the swap contract .35% (7.GAINS FOR BANK Receive(frm NALCO) Pay to IBM Receive(frm IBM) Pay to IBM Net - 7.IBM receives $ 1.85% instead of 8. Thus at the outset IBM receives GBP 10 million and pays$15 million. Suppose IBM pays a fixed rate of interest of 11% in sterling and receives a fixed rate of interest of 8% in dollars from British Petroleum. The principal amounts are chosen to be approximately equivalent using the exchange rate at the swap¶s initiation.5% y BANK also get benefit of 10 basis points CURRENCY SWAPS A Currency Swap involves exchange of principal and/or interest payments on a loan or on an asset in one currency for principal and/or interest payments on an equivalent loan or on an asset in another currency. Consider a hypothetical five year currency swap between IBM (a US based Co) and British Petroleum (a UK based Co) into on Feb 1. with a predetermind rate Currency swap agreement requires the principal to be specified in each of the two currencies and they are exchanged at the beginning and at the end of the life of the swap.20 million (8% of $15million) and pays GBP 1. This type of swap is known as fixed currency swap because interest rates in both the currencies are fixed.25) LIBOR (LIBOR) 10 basis points RESULT Of INTEREST RATE SWAP y IBM get loan at LIBOR-25 basis points instead ofLIBOR y NALCO get fixed loan at 7.10 million ( 11% of GBP 10 million) At the end of the life of the swap. Interest payments are made once a year and principal amounts are $15 million and GBP 10 million.

the first counterpartymakes periodic payment to the second at a per unit fixed price for a given quantity of some commodity The second counterparty pay the first a per unit floating price for a given quantity of some commodity.COMMODITY SWAP In commodity swap. The rate. commodity price movement) To implement overall asset liabilities management strategies Enter new markets INDIAN SCENARIO The Mumbai Inter bank offered rate s being compled by NSE has been used as bench mark in all interest rate swaps deals The cost of one-year interest-rate swaps. rose six basis points to 6. or derivative contracts used to guard against fluctuations in borrowing costs.INTEREST RATE SWAP AND CURRENCY SWAPS AND their Pratical application. Spot price Oil producer Refinery $20 Advantages of swap To reduce the cost of capital Manage risk (interest rate. a fixed payment made to receive floating rates. increased to the highest level since October 2008. exchange rate. .62 percent. LEARNING Thus we have understood the concept of SWAPS.

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