Name of the Teacher: Gayathri Ravikumar

Department: Commerce PG.

Subject/Paper Financial Derivatives-5

Class M.com
Year II/SEM IV
Date 29/04/2020
Class Time 10:00-11:00am
Unit IV
Topic
Interest Rate Swaps

Interest Rate Swaps

Introduction

Need is the mother of invention is a general saying and the evolution of swap as a
financial instrument is the classical and a rather recent example of the proverb.
There is near unanimity among the financial experts that swaps developed out of
the constraints and the regulatory controls with respect to cross-border capital
flows faced by large corporations in the 1970s. When multinational corporations
operating in various countries could not remit funds back and forth among their
subsidiaries due to exchange controls exercised by various governments on the
capital flows, they came out with innovations of back-to-back or parallel loans
among themselves. Upon removal of restrictions on the capital flows, these loans
later developed into a full financial product called swaps. Since then the market has
grown to be as large as 414 trillion’ in 2009 as the amount of principal involved in
swap transactions and continues to further grow at a rapid rate.

Interest Rate SWAPS

If the exchange of cash flows is done on the basis of interest rates prevalent at the
relevant time, it is known as interest rate swap. The simplest example of interest
rate swap is a forward contract where only one payment is involved. In a forward
transaction of any commodity the buyer acquires the commodity and incurs an
outflow of cash equal to the forward price, F If the buyer after acquiring the
commodity were to sell it for the spot price 5, then there would be a cash inflow of S.
From the cash flow perspective a forward contract for the buyer is a swap
transaction with inflow of S and outflow of F. Likewise, the seller would have
equivalent cash flows in the opposite direction. Therefore, a forward contract can be
regarded as a swap with a single exchange of cash flow; alternatively swap can be
viewed as a series of several forward transactions taking place at different points of
time.

Features of SWAP
Usually, interest rate swaps involve payment/receipt of fixed rate of interest for
receiving/paying a floating rate of interest. The basis of exchange of cash flows
under interest rate swap is the interest rate. This fixed-to-floating swap, commonly
known as ‘plain vanilla swap’, is depicted in-Figure, where Company A agrees to pay
Company B fixed interest rate of 8.5011/o in exchange of receiving from it the
interest at 30 bps (100 bps = 111/6) above the floating interest rate, Mumbai Inter
Bank Offer Rate (MIBOR), at predetermined intervals of time.

Assuming that the swap between Company A and Company B is (a) for a period of three
years, (b) with semi-annual exchange of interest, (c) on notional principal of ` 50 crores
the cash flows for Company A for 6 semi-annual periods for an assumed MIBOR would
be as per Table. What is received/paid by Company A is paid/received by Company B.

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
Types of Interest Rate SWAPS

With the bank as intermediary and each party deals with the bank rather than each other.
Interest rate swaps (IRS) can be categorized as follows.

Fixed-to-Floating

In the fixed-to-floating rate swaps the party pays fixed rate of interest to the bank or swap
dealer and in exchange receives a floating rate interest determined on the basis of a
reference/benchmark rate at predetermined intervals of time.
Such a swap is used by a firm wich has floating rate liability and it anticipates a rise in
the interest rates. Through the swap the firm will cancel out the receipts and payments of
floating rate and have cash outflow based on the fixed rate of interest.

Floating-to-Fixed

In this kind of swap the party pays floating rate of interest to the bank or swap dealer and
in exchange receives a fixed rate interest at predetermined intervals of time.
Such a swap is used by a firm who has fixed rate liability and it anticipates a fall in the
interest rates. Through the swap the firm will cancel out the receipts and payments of
fixed rate liability and have cash outflow based on the floating rate of interest.

Basis SWAP

In contrast to the fixed-to-floating or floating-to-fixed where one leg is based on fixed

rate of interest, the basis swaps involve both the legs on floating rate basis. However, the
reference rates for determining the two legs of payment are different. Basis swaps are
used where parties in the contract are tied to one asset or liabilities based on one
reference rate and want to convert the same to other reference rate. For example, if a firm
having liabilities based on T-bills rate wants to convert it to MIBOR-based rate, then the
firm can enter a basis swap where it pays MIBOR-based interest to the swap dealer in
exchange of receiving interest based on T bills rate.