Interest Rate and Currency Swap:

Interest Rate Swap:

An interest rate swap is a forward contract in which one stream of future interest
payments is exchanged for another based on a specified principal amount.
Interest rate swaps usually involve the exchange of a fixed interest rate for a
floating rate, or vice versa, to reduce or increase exposure to fluctuations in
interest rates or to obtain a marginally lower interest rate than would have been
possible without the swap.
A swap can also involve the exchange of one type of floating rate for another,
which is called a basis swap/plain vanilla swap.
LIBOR: London Inter-bank Offer Rate
MIBOR: Mumbai Inter-Bank Offer Rate
Swap Mechanism:
1. If a borrower who has borrowed at fixed rate expects that interest will
rise, then the borrower would want to continue with the existing interest
rate arrangement. In case the borrower expects the interest rate to fall, the
borrower will be better-off by swapping his existing arrangement against
a floating rate loan.
2. If the borrower has borrowed at floating rate and expects the interest
rate to fall, then the borrower would want to continue with the existing
interest rate arrangement. If the borrower expects interest rate to rise, he
will be better-off by swapping his floating rate loan against a fixed rate.
Note: Reverse will be in the case of investors in above 1 and 2 point.
E.g.: Doctor:
Mr. A (Ahmedabad) Mr. M (Mumbai)
Fixed Rate/ Drumsticks: ₹100 Floating Int/Broccoli: ₹100
Broccoli = ₹20 Drumsticks = ₹20
Swap Bank/MR. S (SURAT): Mr. M Gives me Drumsticks = ₹25
MR. A gives Broccoli = ₹25 (i.e. ₹20 plus ₹5 transportation cost)
Mr. C gives respective items to both the parties at ₹30 each.
Mr. A and Mr. B benefit (100-30) = ₹70 and Mr. C will benefit ₹10

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Example:
Amber has obtained a loan at fixed rate of 8% from HDFC. She expects
the interest rates to decline and is willing to take the benefit of declining
interest rates. She wants to convert her loan into a floating rate. HDFC
offers her the floating rate of MIBOR + 2%.
Another party, Sarika has borrowed from Yes Bank at floating rate of
MIBOR + 1.2%. She expects the interest rates to rise in future and this
will increase her commitment towards interest expenses. She is
therefore willing to convert her loans into a fixed rate. Yes bank offers
her fixed rate 10% p.a.
Both the parties approaches “Union Bank” (a swap bank) to find out
whether any swap deal can be effected and decide to swap their interest
obligations and the overall benefit of swap shall be shared by the 3
parties including the swap bank in the ratio of 5:5:4.
You are required to
1. Determine whether the interest rate swap deal can be affected
2. Determine the differential surplus that benefits each of the 3
parties
3. Show how the interest rate swap deal will be arranged
4. Show how each party is benefited from the swap deal

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Answer:
Swap Bank (Union Bank)

Ms. Amber Ms. Sarika

FIXED 8% M + 1.2% Floating

HDFC Yes Bank

M + 2% 10%

Revised Rate = M + 2% + 10% = M +12%

Existing Rate = 8% + M +1.2%= M + 9.2%

Revised Rate – Existing Rate = (M + 12%) – (M + 9.2%) = 2.8%

Amber: Sarika: Swap Bank = 5:5:4

Amber = 2.8 x 5/14 = 1%
Sarika = 2.8 x 5/14 = 1%
Swap Bank = 2.8 x 4/14 = 0.8%

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Determine whether a swap deal can be effected:
Existing Aggregate = 8 + (M+1.2) = M + 9.2
Revised Aggregate = (M+2) + 10 = M + 12
Revised – Existing = (M+12) – (M+9.2) = +2.8

Positive Difference

Swap Deal can be effected

If the differential surplus of 2.8% is to be shared among 3 parties i.e.
Amber, Sarika and Swap Bank, in the ratio of 5:5:4, then the interest
differential surplus for each will be:
Amber = 2.8 x 5/14 = 1
Sarika = 2.8 x 5/14 = 1
Swap bank = 2.8 x 4/14 = 0.8 2.8

Swap Bank
8% 9%
Amber M+1% M+1.2% Sarika
8% M+1.2%
HDFC Yes Bank

M + 2% 10%

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Amber (Fixed Leg):
The Swap Bank shall borrow from Amber on Notional Basis at the
same rate that Amber pays to her bank i.e. 8%.
Thereby swap bank shall reimburse the interest of same amount to
Amber that she has paid to her bank.
In turn, Amber shall borrow from the swap bank on Notional Basis at
an interest rate which is 1% lower than the rate offered by her bank i.e.
@ M+1%.
With this arrangement, Amber could convert her fixed rate loan into a
Floating rate loan, that too at lower rate.
Sarika (Floating Leg):
The Swap Bank shall borrow from Sarika on Notional Basis at the
same rate that Amber pays to her bank i.e. M+1.2%.
Thereby swap bank shall reimburse the interest of same amount to
Sarika that she has paid to her bank.
In turn, Sarika shall borrow from the swap bank on Notional Basis at
an interest rate which is 1% lower than the rate offered by her bank i.e.
@ 9%
With this arrangement, Sarika could convert her fixed rate loan into a
Fixed rate loan, that too at lower rate.
Swap Bank: M = 8%: 50,00,000
Interest Income: 9% + (M+1%) = M + 10% = 18% = 900,000
Interest Expenses: 8% + (M+1.2%) = M+ 9.2% = 17.2% = 860,000
Differential Surplus = 0.8% = 40,000

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Example:
In the above question assume that both Amber and Sarika have
borrowed their respective Banks an amount of ₹50,00,000 each. For
interest rate swap arrangement consider a notional loan of ₹ 50,00,000.
Determine the net payoff under both the legs for each of the following
situations:
Case 1: MIBOR = 8% p.a.
Case 2: MIBOR = 9% p.a.

Swap Bank
8% 9%
Amber M+1% M+1.2% Sarika
8% M+1.2%
HDFC Yes Bank

M + 2% 10%
Without swap 8 + 2% = 10% 10%
500,000 500,000
With Swap: 450,000 450,000
50,000 50,000

Without Swap: 9 + 2 = 11% 10%

550,000 500,000
With Swap: 500,000 450,000
Profit 50,000 50,000

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Answer:
Case 1: MIBOR = 8% p.a.
Amber:
Interest paid to own Bank (50,00,000 x 8%) (Actual) (A)₹400,000
Interest received from swap bank (notional) ₹400,000
(50,00,000 x 8%)
Interest paid to swap bank (50,00,000 x (M +1%)9%) (notional) ₹450,000
Net Paid from Swap Bank (Actual) (B)₹50,000
Interest cost (Net) (A-B) = ₹450,000 (i.e. at M+1% of loan
50,00,000)
At 9% MIBOR = Int cost = 500,000
Sarika:
Interest paid to own bank (50,00,000 x (M+1.2%)9.2%) (Actual)(A)₹460,000
Interest received from swap bank (notional) ₹460,000
(50,00,000 x(M+1.2%) 9.2%)
Interest paid to Swap Bank (50,00,000 x 9%) (notional)₹450,000
Net Receipt from Swap Bank (Actual) (B) ₹10,000
Interest cost (Net) (A-B) = 450,000 (i.e. at 9% of loan 50,00,000)
At 9% MIBOR = Int. Cost = 450,000

Swap Bank: M = 8%
Net Receipt from Amber (9% - 8%) 50,00,000 x 1% = ₹50,000
Net Payment from Sarika (9% - 9.2%) 50,00,000 x 0.2% = (₹10,000)
Swap Bank will earn ₹ 40,000 (i.e. 0.8% of 50,00,000)

Calculate for Case 2: MIBOR = 9% p.a.

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Example:
In the above case, if swap bank is not involved as the intermediary
then Amber and Sarika could have shared the overall benefit of
2.8% just between two of them. How would you arrange a swap deal
in such a case where Amber and Sarika decide to share the net
differential equally without involving Union Bank as intermediately?
Explain how the internet rate swap deal will be arranged. Also specify
the benefit flowing to each party.
Consider the notional amount of loan as ₹80,00,000 and MIBOR = 7%.
Specify how much differential will be settled between the two parties
by the end of the year.
Answer:
Revised Rate = M + 2% + 10% = M +12%
Existing Rate = 8% + M +1.2%= M + 9.2%
Revised Rate – Existing Rate = (M + 12%) – (M + 9.2%) = 2.8%
Profit Sharing = 1.4% each (2.8%/2)
Amber Sarika
8% M+1.2%
HDFC Yes Bank
M+2% 10%
Step 1: Sarika pays to Amber 8%
Step 2: Amber pays to Sarika M+0.6% (M+2% - 1.4%)
Net Interest Expenses to Amber:
= (M+0.6%) + 8% – 8% = M+0.6%
This M + 0.6% is the target interest for Amber [(M+2%) – 1.4%]
Net Interest Expenses to Sarika:
= 8% + (M + 1.2%) – (M+0.6%) = 8.6%

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This 8.6% is the target interest rate for Sarika [(10-1.4%) = 8.6%]
In this arrangement, Sarika shall re-borrow from Amber on notional
basis at the same rate that Amber pays to her bank i.e. 8%
Thereby Sarika shall reimburse the interest of same amount to Amber
that she has paid to her bank.
In turn, Amber shall re-borrow from Sarika on Notional basis at an
interest rate which is 1.4% lower than the rate offered by her bank, i.e.
@ M+0.6%.
With this arrangement, Amber could convert her fixed rate loan into a
Floating rate loan and Sarika could convert her floating rate loan into a
fixed rate loan, that too at lower rates as compared to what was offered
by their respective banks.
Net Interest Expenses to Amber:
= (M+0.6%) + 8% – 8% = M+0.6%
This M + 0.6% is the target interest for Amber [(M+2%) – 1.4%]

Net Interest Expenses to Sarika:

= 8% + (M + 1.2%) – (M+0.6%) = 8.6%
This 8.6% is the target interest rate for Sarika [(10-1.4%) = 8.6%]

If notional loan amount is ₹80,00,000 and if MIBOR = 7%, then net

result will be as follows:
Particulars Amber Sarika
Interest Expenses (Without swap) (8%) 640,000 656,000 (M+1.2%)
Interest Expenses (With Swap) (M+0.6)608,000 688,000(8.6%)
Net Gain/Loss 32,000 (32,000)
End of the year Amber will pay ₹32000 to Sarika.

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Example:
Big Ltd. having very good credit rating offered by its bank, a fixed rate
of 8% or a floating rate of M + 1.5%. This company wants fixed rate.
Small Ltd. having very poor credit rating is offered by its bank, a fixed
rate of 10% or a floating rate of M + 2%. This company wants floating
rate to verify whether a swap can be affected.
Answer:
Big Ltd: Fixed
This company desires a fixed rate loan, it has two different options”
Option 1: Borrow at 8% p.a. Fixed rate directly from own bank
(without swap)
Option 2: Borrow from own bank at floating rate of M+1.5% & then
swap the same with Small Ltd. for fixed rate. (with Swap)
Small Ltd: Floating
This company desires a floating rate of interest, it has two different
options”
Option 1: Borrow at M+2% floating rate directly from own bank
(without swap)
Option 2: Borrow from own bank at fixed rate of 10% & then swap
the same with Big Ltd. for floating rate. (with Swap)
Determine whether swap deal can be effected.
Aggregate interest rate without swap
= 8% + M +2% = M + 10%
Aggregate interest rate with swap
= M + 1.5% + 10% = M + 11.5%
The aggregate interest rate with swap is (M+11.5%) higher than the
aggregate interest without swap (M+10%).

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Therefore, a swap deal is not advisable.
Both the parties are recommended to borrow from their respective
banks at their desired interest arrangements.

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Example:
Mr. A has obtained a loan at fixed rate of 7% from Kotak Mahindra
Bank. He expects the interest rates to decline and is willing to take the
benefit of declining interest rates. He wants to convert her loan into a
floating rate.
Another party, Mr. B has borrowed from IDFC Bank at floating rate of
MIBOR + 1%. He expects the interest rates to rise in future and this
will increase her commitment towards interest expenses. He is
therefore willing to convert his loans into a fixed rate.
Both the parties approaches “PNB Bank” (a swap bank) to find out
whether any swap deal can be effected and decide to swap their interest
obligations and the overall benefit of swap shall be shared by the 3
parties including the swap bank in the ratio of 4:4:4.
You are required to
1. Determine whether the interest rate swap deal can be affected
2. Determine the differential surplus that benefits each of the 3
parties
3. Show how the interest rate swap deal will be arranged
4. Show how each party is benefited from the swap deal
5. Calculate the payoff if the MIBOR rate is 6% and borrowing
amount from both the parties are ₹50,00,000 each.
6. If they want to remove the swap bank and share the swap profit
equally then how the payoff can be done?

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 Swap Bank (50,00,000 & MIBOR = 6%)
Pay to Mr. A 7% Pay to Mr. B M+1%
Receive Mr. A M+0.6% Receive Mr. B 8.2%

Mr. A (Pay M + 0.6%) (Receive 7%) Mr. B (Pay 8.2%) (Receive M+1%)
(330,000) 350,000 (410,000) 350,000
20,000 (60,000)
Kotak Notional Difference IDFC
Revised: M + 1.4% (370,000) 50,00,000 x 9% = 450,0000

Swap bank:
Interest Expenses:7% + M+1% = M + 8% = 14% X 50,00,000 =
700,000
Interest Income: M + 0.6% + 8.2% = M +8.8% = 14.8% = 740,000
Profit = 40,000 (50,00,000 x 0.8%)

Mr. A
Bank offers him the floating rate of MIBOR + 1.4%. 330,000 (350,000
- 20,000) _ 370,000 (50,00,000 x 7.4%) = 40,000 profit

Mr. B
IDFC bank offers her fixed rate 9% p.a. 410,000 (350,000 +60,000) –
450,000 (50,00,000 x 9%) = 40,000

Existing Rate = 7% + M+1% = M + 8%

Revised Rate = M + 1.4% + 9% = M + 10.4%

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Revised – Existing = (M + 10.4%) - (M +8%) = 2.4%
4:4:4
Mr. A = 2.4 x 4/12 = 0.8%
Mr. B = 2.4 x 4/12 = 0.8%
Mr. Swap Bank = 2.4 x 4/12 = 0.8%

2.4% benefit amongst Mr A Mr. b equally = 1.2%

Mr. A pays to Mr. B (M+1%)
Mr. B pays to Mr. A (7%)
Mr. A Mr. B
Existing: 7% M+1%
Kotak IDFC
Revised: M +1.4% 9%
Mr B pays to Mr. A (7.8%)
Mr. A pays to Mr. B (M+0.2%)

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 Speculative Interest Rate Swaps:
If the speculator expects interest rates to rise, he will prefer receiving interest at
floating rate and paying interest at fixed rate.
(Floating Rate Receiver and Fixed Rate Payer)
If the speculator expects interest rates to fall, he will prefer receiving interest at
fixed rate and paying interest at floating rate.
(Fixed Rate Receiver and Floating Rate Payer)

Example: (Receiver 6% & Pay at 8%) (Rec. 10% & pay 8%

Mr. Suresh expects interest rates to rise. (Receive at Floating & Pay at Fixed Rate)
Mr. Hiren expects interest rate to fall. (Pay at Floating & Receive at Fixed Rate)
(Pay at 6% & Receive at 8%) (Pay at 10% & Rec. 6%)
They enter a swap deal whereby Mr. Suresh becomes floating rate receiver at
MIBOR flat and payer at fixed rate of 8% p.a. Notional loan amount is ₹ 10 crore
and contract period is 1 year.
Determine the net pay-off at both the legs under following cases:
Case 1: MIBOR = 6% p.a. Hiren
Case 2: MIBOR = 10% p.a. Suresh

Answer:
Case 1: MIBOR = 6% p.a.
Mr. Suresh (Fixed rate payer and floating rate receiver)
Interest received from Mr. Hiren (Notional) ₹60,00,000
(₹100,00,000 x 6%)
Interest paid to Mr. Hiren (Notional) (₹80,00,000)
(₹100,00,000 x 8%)
Net differential paid to Mr. Hiren (Actual) ₹20,00,000

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Mr. Hiren (Floating rate payer and fixed rate receiver)
Interest received from Mr. Suresh (Notional)
(₹10,00,000 x 8%) 80,00,000
Interest paid to Mr. Suresh (Notional) (60,00,000)
(₹10,00,000 x 6%)
Net differential received from Mr. Suresh (Actual) ₹20,00,000

Case 2: MIBOR = 10% p.a.

Mr. Suresh (Fixed Rate Payer and Floating Rate Receiver)
Interest Rate received from Mr. Hiren (Notional) ₹10,00,000
(₹100,00,000 x 10%)
Interest paid to Mr. Hiren (Notional) (₹8,00,000)
(₹100,00,000 x 8%)
Net difference received from Hiren (Actual) ₹200,000

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Example:
A dealer quotes “All-in-Cost” for a generic swap at 6% against six months
LIBOR flat if the notional principal amount of swap is ₹10,00,000.
I. Calculate semi-annual fixed payment.
II. Find the first floating rate payment for (I) above, if the six-month period
from the effective date of swap to the settlement date comprises 181 days
and that the corresponding LIBOR was 4% on the effective date of swap.
At 360 days.
III. In (II) above, if the settlement is on NET basis, how much the fixed rate
payer would pay to the floating rate payer? Generic swap is based on
30/360 days.
Answer:
I. Semi-annual fixed payment:
₹10,00,000 x 6% x 6/12 = ₹30,000
II. Floating rate payment
₹10,00,000 x 4% x 181/360 = ₹20,111
III. If the settlement is on the net basis, the Net differential paid by fixed rate
payer to floating rate payer.
i.e. ₹ 9889 (₹30,000 - ₹20,111)

Example:
Derivative Bank entered a plain vanilla swap through an OIS (Overnight Index
Swap) on a principal of ₹1 crores and agreed to receive MIBOR overnight
floating rate for a fixed payment on the principal. The swap was entered into on
Monday, 19th October 2020 and was to commence on 20th October 2020 and run
for a period of 7 days. Respectively MIBOR rates for Tuesday to Monday were:
6.5%, 7%; 6.75%, 6.6%, 6.7% and 7%.
If derivative bank received ₹500 net on settlement, calculate fixed rate and
interest under both legs.
Notes:
I. Sunday is Holiday.
II. Working in rounded rupees and avoid decimal working.

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Answer:
Day Rate Notional Balance Interest
Tuesday 6.5% 100,00,000 1781
Wednesday 7% 100,01,781 1918
Thursday 6.75% 100,03,699 1850
Friday 6.6% 100,05,549 1809
Saturday & Sunday 6.7% (2 days) 100,07,358 3674
Monday 7% 100,11,032 1920
Floating Int. 12952
Less: Net payoff 500
Fixed Int 12452
12452/100,00,000 x 365/7 = 6.49% p.a.

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Currency Swap:
A currency swap is an agreement in which two parties exchange the principal
amount of a loan and the interest in one currency for the principal amount of a
loan and the interest in one currency for the principal and interest in another
currency.
It is an advance level swap than plain vanilla or generic swap (int. rate swap)
because in currency swap not only interest but also principal is swap.
For currency swap it is mandatory to have borrowings and borrowing must be
equivalent of both the parties.

Example:
AB Ltd. is an Indian company having a subsidiary in U.S. and is looking to raise
$100,000 for funding its subsidiary. It can borrow at the following rates:
$ 3%
₹ 8%
PQ Ltd. is a US based company having a subsidiary in India and is looking to
raise ₹75,00,000 for funding its subsidiary. It can borrow at the following fixed
rates:
$ 2%
₹ 10%
The current spot rate is $1=₹75. Show how a currency swap would work in the
circumstances described, assuming the swap is only for one year and that interest
is paid at the end of the year concerned.
Answer:
Interest Cal. AB PQ
Without Swap ($100,000 x 3%) $3000 (7500,000 x 10%) ₹750,000
With Swap ($100,000 x 2%) $2000 600,000(75 lacs x 8%)
Saving in Int. Cost $1000 ₹150,000

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Swap Process: AB Ltd. PQ Ltd.
Now:
Step 1: Borrowing from Banks ₹75,00,000 @ 8% $100,000 @2%
Step 2: Exchange principal Pay 75 lacs to PQ Pay $1lac to AB
Receive $1 Lac Receive 75 lacs
End of one Year:
Step 3: Pay interest to banks Pay ₹600,000 int Pay $2000 Int.
Step 4: Exchange Int. Pay $ 2000 & Rec. ₹6 lacs Pay 6 lacs &
PQ. Ltd AB Ltd Receive $2000

Step 5: Swap Bank Principal Pay $ 1 lac to PQ Ltd. Pay ₹7500,000 to AB Ltd.

Receive 75 lacs Receive $ 1 lac

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Example:
US Ltd. is a US based company having a subsidiary in India and is looking to
raise ₹80,00,000 for funding its subsidiary. It can borrow at the following fixed
rates:1% x 80,00,000 = ₹100,000
$ 1.50%
₹ 8.50%
IN Ltd. is an Indian company having a subsidiary in U.S. and is looking to raise
$100,000 for funding its subsidiary. It can borrow at the following rates:
$ 2.25%
₹ 7.25%
The current spot rate is $1=₹80. Show how a currency swap would work in the
circumstances described, assuming the swap is only for one year and that interest
is paid at the end of the year concerned.

Example:
In the above example US Ltd and IN Ltd. don’t know one another so, UI Ltd.
(Swap Bank) arranged the swap between the two companies and earn 0.50%
profit sharing in 1:1 proportion from both the parties.

Example:
Derivative Bank entered into a plain vanilla swap through an OIS (Overnight
Index Swap) on a principal of ₹10 crores and agreed to receive MIBOR overnight
floating rate for a fixed payment on the principal. The swap was entered into on
Monday, 23rd November 2020 and was to commence on 24th November 2020 and
run for a period of 7 days. Respectively MIBOR rates for Tuesday to Tuesday
were: 3.5%, 5.25%; 4.85%, 4.9%, 4.75% and 5.5%.
If derivative bank paid ₹1000 net on settlement, calculate fixed rate and interest
under both legs.
Notes:
I. Sunday is Holiday and on 30th holiday due to Shri Guru Nanak Jayanti.
II. Working in rounded rupees and avoid decimal working.

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