SWAP CONTRACT

A report is submitted in the partial fulfilment of 4th

Mid-Semester Examination, 2024
SUBMITTED BY:
Ananya Anandita Sai [171R0022002]
Disha Pradhan [171R0022016]
Madhusmita Mansingh [171R0022019]
Reetanjali Naik [171R0022028]
SUBJECT:
Derivatives and Risk Management
PAPER CODE:
HC-401
UNDER THE GUIDANCE OF:
Dr. Gouri Prava Samal
Assistant Professor

P.G. DEPARTMENT OF COMMERCE

RAMA DEVI WOMEN’S UNIVERSITY
2022-24
 CONTENTS

SL NO. TOPICS PAGE NO.

1 SWAPS 1
2 EVOLUTION OF 3
SEAPS
3 FEATURES OF 5
SWAPS
4 WHY SWAPS? 6
5 TYPES OF SWAPS 7
6 CONCLUSION 13
7 PHOTO 14
 SWAP

Swap derivative contracts are financial agreements between two parties to exchange
cash flows or other financial instruments over a specified period. These contracts
can involve the exchange of interest rates, currencies, commodities, or other
financial variables. The purpose is often to manage risk, speculate on future price
movements, or achieve specific financial objectives. In a swap derivative, the terms
of the swap, such as payment amounts and frequency, are predetermined, allowing
the involved parties to customize their exposure to various market factors. In a swap
derivative contract, two parties agree to exchange cash flows or other financial
instruments based on predetermined terms. The common types of swaps include
interest rate swaps, currency swaps, and commodity swaps. Here's a basic overview
of how a generic swap works:

1. Agreement: Two parties enter into a contractual agreement specifying the terms
of the swap, such as the notional amount, the reference rate or prices, payment
frequency, and the duration of the swap.

2. Notional Amount: The notional amount is the hypothetical principal on which

the swap is based. It's used to calculate the cash flows exchanged between the parties,
but it's not actually exchanged.

3. Cash Flows: The parties agree to exchange cash flows based on the notional
amount. For example, in an interest rate swap, one party may agree to pay a fixed
interest rate, while the other pays a floating interest rate.

4. Payment Frequency: Payments are typically made periodically, such as quarterly

or annually, depending on the terms of the swap. The frequency can vary based on
the type of swap and the agreement between the parties.
5. Duration: The swap has a predetermined lifespan, and the cash flows continue
for the agreed-upon duration. At the end of the swap, the contract is settled, and any
final payments are made.

6. Risks and Benefits: Swaps allow parties to manage risk, hedge against
fluctuations in interest rates or currency exchange rates, or even speculate on future
market movements. Each party gains certain advantages based on their exposure and
market expectations.

7. Counterparty Risk: There is a counterparty risk involved, where one party may
default on its obligations. To mitigate this risk, parties may require collateral or use
credit support agreements.

Overall, swap derivative contracts provide flexibility for entities to tailor financial
arrangements to their specific needs and market views, facilitating risk management
and investment strategies.
 EVOLUTION OF SWAP

Swaps have evolved significantly in risk management over the years. Initially
developed in the 1980s, swaps were primarily used for interest rate risk management.
However, their applications have expanded, encompassing various types of risks.

1. Not Executed in physical market: Like most other new products/instruments

in the international finance, “swaps” are not executing in a physical market.
Participants and dealer in the swap markets are many and varied in their
location, character and motives in existing swaps.

2. Traced Bank in 1970s: Most of the financial experts agree that the origin of
the swap markets can be traced back to 1970s when many counties imposed
foreign exchange regulations and restrictions in order to control cross border
capital flows.

3. Bretton wood system in 1971-73: Some experts are of the opinion that swap
markets owe their origin to the exchange rate instability that followed the
demise of Britten Wood System during the years 1971 to 1973. As a result,
most of the borrowers and investors if the international level wishing to
diversity their assets and liabilities compositions in varied currencies in order
to control losses arising due to fluctuations in exchange rates.

4. 1st swaps interest rate swap (1980s); The early days of swaps were dominated
by interest rate swaps, allowing entities to exchange fixed-rate and floating-
rate cash flows, managing interest rate.
5. In 1980s to 1990s currency swap gained popularity. global markets expanded,
currency swaps gained popularity, enabling entities to manage exchange rate
risk by exchanging cash flows in different currency.
6. International swap dealers Association (ISDA) in 1984: The formation of the
International Swap Dealers Association (ISDA) in 1984 was a significant
development to speed up the growth in the market by standardizing swap
documentation. In 1985, the ISDA published the first standardized swap code.
These contracts are structured as master agreements.
7. Commodity Swap (1990s-2000s): Swaps evolved to include commodities,
providing a tool for businesses to hedge price fluctuations in commodities like
oil, natural gas, and agricultural products.
8. Innovation & Complexity (2000s-2010s) Financial engineers created more
complex derivatives and structured products using swaps, often tied to
underlying assets, indices, or customized cash flows.
9. Technology & Automation (2010s-2020s): Advance in technology facilitated
the automation of swap trading and processing. Electronic trading platform
and centralized clearing houses improved efficiency, transparency, and risk
management practices.
10.Environment, Social & Governance (2020s): With the growing emphasis on
sustainable finance, ESG-linked swap emerged. These allow market
participants to integrate environmental, social and governance considerations
into their risk management strategies.

11.Post-2008 Financial Crisis Reassessment (2010s): The 2008 financial crisis

led to increased scrutiny of derivatives, including swaps. Regulatory changes,
such as Dodd- Frank in the U.S., aimed to bring transparency and stability.
 FEATURES OF SWAPS

1. Counter Parties: Financial swaps involve the agreement between two or

more parties to exchange cash flows or the parties interested in exchanging
liabilities.
2. Facilitators: The amount of cash flow exchange between parties is huge and
also the process is complex. Therefore, to facilitate the transaction, an
intermediary comes into the picture which brings different parties together for
the big deal. These may be brokering whose objective is to initiate the
counterparties to finalize the swap deal. While swap dealers are themselves
counter-partied and bear the risk and provide portfolio management services.
3. Cashflows: The present values of future cash flows are estimated by the
counterparties before entering into a contract. Both parties want to get
assurance of exchanging the same financial liabilities before the swap deal.
4. Less Documentation: Less documentation is required in the case of swap
deals because the deals are based on the needs of parties, therefore, less
complex and less risk-consuming.
5. Transaction Costs: Generating a very less percentage is involved in the swap
agreement.
6. Benefit to Both Parties: The swap agreement will be attractive only when
parties get the benefits of these agreements.
7. Default Risk: Default risk is higher in swaps than in the option and futures
because the parties may default on the payment.
 WHY SWAP?

There are several reasons why counterparties may want to engage in swap
transactions. They include:

• Risk Management: Swap transactions serve as a risk management tool in

hedging against probable. losses emanating from the characteristic fluctuation
in commodity prices, interest rates, exchange rate and equity prices;
• Financing Access: Swap transactions enable a company to access cheap
finance by tapping into the cash reserves of another firm;
• Tool for Hedging: Swaps are typically hedging to 11/36 are used to guide
against exposures to unanticipated interest rate, exchange rate, commodity
price and equity risks;
• Instrument of Unconventional Monetary Policy: In recent times, bilateral
currency swap agreements between economies have been utilized as a tool for
managing liquidity and foreign exchange pressure;
• Flexibility: Swap agreements are both negotiable and renewable up to at least
10 years. Also, most swap agreements are non-obligatory, that is, if a party
defaults, the other party is not bound to continue the contract;
• Minimizes Transaction Costs and Taxes: Swap enables users to reduce and,
in some cases, avoid transaction costs. For instance, investors can access
foreign markets without having to contend with margin, capital control, and
institutional rules. Firms can also access finance from their subsidiaries
abroad through the engagement of counterparties in the host country as in the
case of a currency swap, thus, bypassing stiff regulations and avoiding
transaction taxes.
 TYPES OF SWAPS

Swaps are derivative instruments that represent an agreement between two parties
to exchange a series of cash flows over a specific period of time. Swaps offer great
flexibility in designing and structuring contracts based on mutual agreement. This
flexibility generates many swap variations, with each serving a specific purpose.
There are multiple reasons why parties agree to such an exchange:

Investment objectives or repayment scenarios may have changed.

• There may be increased financial benefit in switching to newly available or

alternative cash flow streams.
• The need may arise to hedge or mitigate risk associated with a floating rate
loan repayment.

1.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 attempt to secure cost-effective loans
but their selected markets may not offer preferred loan solutions. For instance, an
investor may get a cheaper loan in a floating rate market, but they prefer a fixed
rate. Interest rate swaps enable the investor to switch the cash flows, as desired.

Assume Paul prefers a fixed rate loan and has loans available at a floating rate
(LIBOR+0.5%) or at a fixed rate (10.75%). Mary prefers a floating rate loan and
has loans available at a floating rate (LIBOR+0.25%) or at a fixed rate (10%). Due
to a better credit rating, Mary has the advantage over Paul in both the floating rate
market (by 0.25%) and in the fixed rate market (by 0.75%). Her advantage is greater
in the fixed rate market so she picks up the 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 a swap contract with the bank to pay fixed 10.10% and
receive the floating rate.

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.

2.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 a business in the UK and
needs GBP 10 million. Assuming the AUD/GBP exchange rate is at 0.5, the total
comes to AUD 20 million. Similarly, a UK-based company wants to set up 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 in Australia it's 9% for foreigners and 5% for
locals. Apart from the high loan cost for foreign companies, it might be difficult to
get the loan easily due to procedural difficulties. Both companies have a 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 low-cost
loan of GBP 10 million in the UK. Assume both loans need six monthly repayments.

Both companies then execute 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 a 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. 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 able to secure low-cost loans
and hedge against interest rate fluctuations. Variations also exist in currency swaps,
including fixed vs. floating and floating vs. floating. In sum, parties are able to
hedge against volatility in forex rates, secure improved lending rates, and receive
foreign capital.
3.Equity swap
An equity swap is a financial derivative contract (a swap) where a set of future cash
flows are agreed to be exchanged between two counterparties at set dates in the
future. The two cash flows are usually referred to as "legs" of the swap; one of these
"legs" is usually pegged to a floating rate such as LIBOR. This leg is also commonly
referred to as the "floating leg". The other leg of the swap is based on the
performance of either a share of stock or a stock market index. This leg is commonly
referred to as the "equity leg". Most equity swaps involve a floating leg vs. an equity
leg, although some exist with two equity legs. An equity swap involves a notional
principal, a specified duration and predetermined payment intervals.
Equity swaps are typically traded by delta one trading desks.

Parties may agree to make periodic payments or a single payment at the maturity of
the swap ("bullet" swap).Take a simple index swap where Party A swaps £5,000,000
at LIBOR + 0.03% (also called LIBOR + 3 basis points) against £5,000,000
(FTSE to the £5,000,000 notional).In this case Party A will pay (to Party B) a
floating interest rate (LIBOR +0.03%) on the £5,000,000 notional and would receive
from Party B any percentage increase in the FTSE equity index applied to the
£5,000,000 notional.

In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely
180 days, the floating leg payer/equity receiver (Party A) would owe
(5.97%+0.03%)*£5,000,000*180/360 = £150,000 to the equity payer/floating leg
receiver (Party B).At the same date (after 180 days) if the FTSE had appreciated by
10% from its level at trade commencement, Party B would owe 10%*£5,000,000 =
£500,000 to Party A. If, on the other hand, the FTSE at the six-month mark had
fallen by 10% from its level at trade commencement, Party A would owe an
additional 10%*£5,000,000 = £500,000 to Party B, since the flow is negative. For
mitigating credit exposure, the trade can be reset, or "marked-to-market" during its
life. In that case, appreciation or depreciation since the last reset is paid and the
notional is increased by any payment to the floating leg payer (pricing rate receiver)
or decreased by any payment from the floating leg payer (pricing rate
receiver).Equity swaps have many applications. For example, a portfolio manager
with XYZ Fund can swap the fund's returns for the returns of the S&P 500 (capital
gains, dividends and income distributions). They most often occur when a manager
of a fixed income portfolio wants the portfolio to have exposure to the equity markets
either as a hedge or a position. The portfolio manager would enter into a swap in
which he would receive the return of the S&P 500 and pay the counterparty a fixed
rate generated from his portfolio. The payment the manager receives will be equal
to the amount he is receiving in fixed-income payments, so the manager's net
exposure is solely to the S&P 500 (and risk that the counterparty defaults). These
types of swaps are usually inexpensive and require little in terms of administration.

4.Commodity Swaps

Commodity swaps are common among individuals or companies that use raw
materials to produce goods or finished products. Profit from a finished product may
suffer if commodity prices vary, as output prices may not change in sync with
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 rate and pay the floating.

If crude oil rises to $62 at the end of six months, 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 the second party. Net cash flow in this scenario will be $2
million transferred from the second party to the first. Alternatively, if crude oil
drops to $57 in the next six months, the first party will pay $3 million to the second
party.

Benefits: The first party has locked in the price of the commodity by 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 raw material prices.

5.Credit Default Swaps

The credit default swap offers insurance in case of default by 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 executes 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. If ABC, Inc. defaults, Paul will pay Peter $1,000 plus any remaining
interest payments. If ABC, Inc. does not default during the 15-year long bond
duration, Paul benefits by keeping the $15 per year without any payables to Peter.
 CONCLUSION
Swaps derivatives offer a dynamic and versatile tool in the financial derivatives
market. Their ability to be customized allows for tailored financial solutions,
addressing specific needs that standardized instruments like futures and options may
not fulfil. While the complexity and risks associated with swaps need careful
consideration, their strategic use can significantly aid in risk management and
achieving specific financial goals. Understanding the nuances of these financial
instruments, including their differences from other derivatives, is vital for informed
decision-making in the ever-evolving world of finance.