SWAPS AND ITS TYPES

PRESENTED BY: ABHINAV GUPTA(01-MBA-11) ADITYA PAUL SHARMA(02-MBA-11) AKHIL GOUR(03-MBA-11) AKHIL GUPTA(04-MBA-11) AMAN TALLA(06-MBA-11)
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SWAP: CONCEPT AND NATURE
• In the business world, swaps have been termed as private agreements between the two parties to exchange cash flows in the future according to a prearranged formula. • In simple words, a swap is an agreement to exchange payments of two different kinds in the future. • It involves exchange of cash flows or payments, hence, it is also called financial swap in global financial markets. • The swaps market has had an exceptional growth since its inception in 1979. • The swaps volume exceeds $10 trillion today.

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• In the context of financial markets, the term “swap” has two meanings. • First, it is a purchase and simultaneous forward sale or viceversa. • Second, it is defined as the agreed exchange of future cash flows, possibly, but not necessarily with a spot exchange of cash flows. • The second definition of swap is most commonly used stating as an agreement to the future exchange of cash flows. • Swaps not only often replace other derivative instruments such as futures and forwards, but also complement those products.
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EVOLUTION OF SWAP MARKET
• Most of the financial experts agree that the origin of the swap markets can be traced back to 1970’s when many countries imposed foreign exchange regulations and restrictions in order to control cross border capital flows. • In 1980’s, a few countries liberalized their exchange regulatory measures, as a result, some of the MNC’s treasures structured their portfolios and brought out new financial product, known as swaps. • The first swap was negotiated in 1981 between Deutsche Bank and an undisclosed counter party. Since then, the swap markets have grown very rapidly.
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5 . which was revised in 1986 and then in 1987. • In 1985 the ISDA published the first standardized swap code. it published its Standard Form Agreements.• The formation of the International Swap Dealers Association(ISDA) in 1984 was a significant development to speed up the growth in the swaps market by standardizing swap documentation.

through an intermediary which is usually a large international financial institution/ bank having network of its operations in major countries.FEATURES OF SWAPS • Counter Parties: All swaps involve the exchange of a series of periodic payments between at least two parties. ( known as swap facilitators). two different payment streams in terms of cash flows are estimated to have identical present values at the outset when discounted at the respective cost of funds in the relevant primary markets. – Swap dealers: They themselves become counter-parties and takeover the risk. • Cash Flows: In the swap deal. Swap facilitators can be classified into two categories: – Brokers: They function as agents that identify and bring the counter parties on the table for the swap deal. • Facilitators: Swap agreements are arranged mostly. 6 .

• Transaction Costs: The transaction costs in swap deals are relatively low in comparison to loan agreements. the problems of potential default by either counter party exists. therefore. otherwise such deals will not be accepted. • Termination: The termination requires to be accepted by counter parties. • Default Risk: Since most of the swap deals are bilateral agreements.• Documentations: Swap transactions may be set up with great speed sine their documentations and formalities are generally much less in comparable to loan deals. making them more risky products in comparison to futures and options. 7 . • Benefit to Parties: Swap agreements will be done only when the parties will be benefited by such agreement.

8 . currency. are relating to interest rate. climate and so on. commodity. – Equity Swaps.MAJOR TYPES OF FINANCIAL SWAPS • The basic objective of a swap deal is to hedge the risk as desired by the counter parties. • The major types of financial swaps that will be discussed are as: – Interest-Rate Swaps. credit. – Currency Swaps. equity. • The major risks that can be changed with the swap transactions.

• It is an exchange of interest payment for a specific maturity on a agreed upon notional amount. • Maturity ranges from a year to over 15 years.INTEREST-RATE SWAPS • An interest-rate swap is a financial agreement between the two parties who wish to change the interest payments or receipts in the same currency on assets or liabilities to a different basis. however. • There is no exchange of principal amount in this swap. 9 . • The simplest example of interest rate swap is to exchange of fixed for floating rate interest payments between two parties in the same currency. most transactions fall within two years to ten years period.

they are willing to pay if they are fixed rate payers in swap(bid swap rates) and they are willing to receive if they are floating rate payers in a swap(ask swap rate). SIBOR. It is notional because the parties do not exchange this amount at any time. the interest amount whether fixed or floating is calculated on a specified amount borrowed or lent. • Banks or other financial institutions who make market in interest rate swaps quote the fixed rate. Floating Rate • It may be defined as one of he market indexes like LIBOR. which is used to calculate the size of fixed payment. 10 .FEATURES OF INTEREST-RATE SWAPS Notional Principal • In the interest rate swap agreement. on which basis the floating rate is determined in the swap agreements. Fixed Rate • This is the rate. MIBOR. primary rate etc. Treasury bill rate.

say at six-month LIBOR.Example For Fixed Rate • A bank might quote a US dollar floating to fixed 5-year swap rate: – Treasuries + 20 bp/Treasuries + 40bp vs six.month LIBOR • The quote indicates the following: – The said bank is willing to make fixed payment at a rate equal to the current yield on 5-year treasury notes plus 20 basis points (0.20 percent) in return for receiving floating payments. – The bank has offered to accept at a rate equal to 5-year treasury notes plus 40 basis points in return for payment of six month LIBOR. 11 .

Relevant dates for the floating payment: D(S) is the setting date on which the floating rate applicable for next payment is set. D(1) is that date from which the next floating payment starts to accrue and D(2) is such date on which the payment is due. 12 . Effective Date: It is the date from which the first fixed and floating payment start to accrue.Trade Date: It may be defined as such date on which the swap deal is concluded.

• Fixed and Floating payments: In a standard swap deal the fixed and floating payments are calculated as follows: – Fixed payment= (P)*(Rfx)*(Ffx) – Floating payment= (P)*(Rfe)*(Ffe) where P is the notional payment. Rfe is the floating rate set on the reset date. Ffx is the fixed rate day count fraction and Ffe is the floating rate day count fraction. Rfx is the fixed price. The last two are time periods over which the interest is to be calculated. 13 .

EXAMPLE OF INTEREST RATE SWAP 14 .

75% (YIELD) FIRM A FIRM B LIBOR + 0.SITUATION OF A AND B FIRMS BEFORE THE SWAP MORTGAGE PORTFOLIO $100 (M) PORTFOLIO 5-YEAR AVERAGE MATURITY LOAN PORTFOLIO $100 (M) PORTFOLIO 5-YEAR AVERAGE MATURITY 8.5% 6% $100(M) 5-YEAR MATURITY FLOATING RATE LENDERS EURO BONDS 15 .50% YIELD LIBOR+ 0.

In return for this payment.50% 16 .50% 6. • The net result to A is a follows: Receipt on portfolio Pay big bank Receive from big bank Pay on loan Cost of fund Locked in Spread 8.50 percent will be paid by Firm A to Big Bank for 5 years with payments calculated by multiplying the rate by $100(M) notional principal amount. • This is shown in the figure in the next slide relating to Firm A.50)= 7. Big Bank agrees to pay the Firm A six-month LIBOR over five years.50 + . Firm A may enter into interest rate swap deal with any Big Bank.• In order to eliminate the interest rate risk. with reset dates matching the reset on its floating rate loan. Assume that 6.00% 1.50% LIBOR (LIBOR + 50bp) (6.

50% 6.FIRM A INTEREST RATE SWAP AGREEMENT WITH BIG BANK MORTGAGE PORTFOLIO 8.5% FLOATING RATE LENDERS $100 (M) LOAN 5-YEAR MATURITY 17 .50% FIRM A LIBOR Big Bank NOTIONAL $100(M) FOR 5 YEARS LIBOR + 0.

The net result to B and swap are shown in the figure in next slide.• Similarly.40%.00% LIBOR – 0.75% LIBOR 6.40% 6.75% + 0.40%= 1. Firm B enters into portfolio with the Big Bank where it agrees to pay six-month LIBOR to Big Bank on an notional principal amount of $100(M) for 5 years for receiving payments of 6.40% 0.15% 18 . • The net result to B is as follows: Receipt on portfolio Pay big bank Receive from big bank Pay on euro bond Cost of fund Locked in Spread LIBOR + 0.

75% NOTIONAL $100(M) FOR 5 YEARS 6.FIRM B INTEREST RATE SWAP AGREEMENT WITH BIG BANK $100(M) FOR 5 YEARS LOAN PORTFOLIO LIBOR+ 0.40% Big Bank LIBOR FIRM B 6% $100 (M) FOR 5-YEAR MATURITY EURO BONDS 19 .

• As a financial intermediary. the risks net out is left with a speed of 10 basis points. 20 . The net result in each of these transactions is that the risk of loss due to interest rate fluctuations has been transferred from the counter party to Big Bank. the Big Bank puts together both transactions. • The Big Bank will only be interested to enter into such deals with Firm A and B if it will also be in beneficial position.• It is evident from the example that the cost of funds of FIRM B has been reduced to LIBOR less 40 basis points resulting FIRM B has been locked in spread on its portfolio of 115 basis points. • In this swap deal. • This is shown in the figure in next slide. the interest of Big Bank is to be assessed.

50% FIRM A 6.5% 6% FLOATING RATE LENDERS $100 (M) FOR 5-YEAR MATURITY EURO BONDS 21 .75% 8.50% 6.SWAP STRUCTURE MORTGAGE PORTFOLIO $100 (M) PORTFOLIO 5-YEAR MATURITY $100 (M) FOR 5-YEAR MATURITY LOAN PORTFOLIO LIBOR+ 0.40% Big Bank LIBOR LIBOR FIRM B LIBOR + 0.

50% 6.50. Big Bank receives compensation equal to $1 lac annually for the next five years on $100(M) swap deal.001(10 basis points) * 1 million= $ 1 lac Receive Pay Receive Pay Net 6.• Thus.6.40% LIBOR LIBOR (6.40)= 10 basis points 22 . • Swap profit to Big Bank – 0.

One month CP.TYPES OF INTEREST RATE SWAPS • It is also known as fixed-for-floating swap. T-Bill rate. These alternatives include three month LIBOR. Swap • The holders of zero coupon bonds get the full amount of loan and interest accrued at the maturity of the bond. alternative floating Alternative rates are charged in order to meet the exposure of other party. In other words. etc. to floating • The floating reference can be switched to other alternatives as per the requirement of the counter party. Usually swap period ranges from 2 years to over 15 years for a pre-determined Plain Vanilla notional principal amount. floating rate 23 . Most of the deals occur within 4 year period. one party with a floating interest rate liability is exchanged with fixed rate liability. In this swap. The fixed rate player makes a bullet payment at the end and floating rate player makes the periodic payment Zero coupon throughout the swap period.

• In this swap. • There is exchange of fixed rate payments for floating rate payments. one counter party pays one floating rate. It is also kind of swap involving fixed for floating interest rate. swap 24 . floating Forward swap • This swap involves an exchange of interest payment that does not begin until a specified future point in time. whereby the floating rate payments are capped. say. prime for a specified time period. LIBOR while the other counter party pays another. say. These swap deals are mainly used by the non-US banks to manage their Floating-todollar exposure. An upfront fee is paid by Rate-capped floating rate party for the cap.

Swaptions • These are combination of the features of two derivative instruments.. which allows fixed for floating counter party to extend the swap period. 25 . For example. • It involves the exchange of interest payment linked to the change in the stock index. Swaptions can be of two types: Call Swaptions or callable swap and put Swaptions or puttable swap.e. Extendable swap • It contains an extendable feature. an equity swap agreement may allow a company to swap a fixed interest rate of 6% in exchange for the rate of appreciation on a particular Equity swap index. say. BSE or NSE index. each year over the next four years. i. option and swap. The buyer of the Swaptions has the right to enter into an interest rate swap agreement by some specified date in future.

The notional principal is $35 million.30% per annum. Let us assume Party X on a semi annual basis. The current six-month LIBOR rate is 6. pays 7%of interest rate on the notional amount and receives from the Party Y LIBOR + 30 basis points. 7.EXAMPLE OF PLAIN VANILLA SWAP • Let us consider a simple example of plain vanilla swap to show the net cash flow arisen in the swap. : STRUCTURE OF PLAIN VANILLA SWAP Party Y received fixed. receives floating LIBOR + 30 bp FIG.00% Party X pays fixed. pays floating 26 .

The difference between the two-rate computation is the number of days in a year conversion employed.643. Party X pays Party Y the net difference.833. • Amount to be paid as per floating rate: The floating side is quoted on a money market yield basis.67.00.33 = $53. Therefore.833.810 27 .00.67.21.643.00.000(182/360)(7. : $12. the interest is paid every six months is: – Notional principal(Days in period/365)(Interest rate /100) – = $35.83-$11.83 – It is assumed that there are 182 days in a particular period.33 • In a swap. Therefore.000(182/365)(7.00/100)= $11. In this case.00.00/100)= $12. the payments are netted.• Amount to be paid as per fixed rate: The fixed rate in a swap is usually quoted on a semi-annual bond equivalent yield basis. the payment is: – Notional principal(Days in period/360)(Interest rate/100) – =$35.21.

Thus. the value of swap could be expressed as the value of fixed rate bond and value of the floating rate underlying the swap. 28 . an interest swap can be valued either as a long position in one bond combined with short in another bond or as portfolio of forward contracts. • The principal amount is not exchanged and further amount is paid in the same currency. B1 is the value of fixed rate bond underlying the swap and B2 is the value of floating rate bond underlying the swap. • Interest rate swap can be valued by treating the fixed rate payments as being equivalent to the cash flows on a conventional bond and the floating rate payments as being equivalent to a floating rate note(FRN).VALUATION OF INTEREST RATE SWAP • Assuming no default risk. • It may be expressed as: V= B1 – B2 where V is the value of swap.

𝑟𝑖 is the discount rate corresponding to maturity t. Therefore. Value of the bond B2 = Q𝑒 −𝑟1 𝑡1 + K*𝑒 −𝑟1 𝑡1 where K* is the floating rate payment.• In the previous equation. −𝑟𝑖 𝑡𝑖 – Value of the bond B1 = 𝑛 + Q𝑒 −𝑟𝑛 𝑡𝑛 𝑖=1 𝐾𝑒 where K is the periodic fixed payment in the swap. valuation of swap depends upon the valuation of fixed rate bond and floating rate bond. r1 is the discount rate and t1 is length of the time to the next interest payment. it is appropriate to use the same discount rate for both the bonds B1 and B2. 29 . To find out valuation. – No. Q is the principal sum and 𝑡𝑖 is length of the time to corresponding maturity. Q is the principal sum. the discount rate used should reflect the riskness of the cash flows.

EXAMPLE 30 .

a firm which has borrowed Japanese yen at a fixed interest rate can ‘swap away’ the exchange rate risk by setting up a contract whereby it receives yen at a fixed rate in return for dollars at either a fixed or a floating interest rate.CURRENCY SWAPS • A swap deal can also be arranged across currencies. • The two payment streams being exchanged are denominated in two different currencies. • For example . It is an oldest technique in the swap market. 31 .

involving two counter parties with different but complimentary needs being bought by a bank. – On-going exchange of interest. • Normally three basic steps are involved which are as under: – Initial exchange of principal amount. – Re-exchange of principal amounts in maturity. also two party transaction. like interest rate swap. 32 .• The currency swap is.

EXAMPLE OF CURRENCY SWAP 33 .

Then cash flows resulting from the interest rates are real.: Transaction under currency swap Dollar principal to bond holders • From the example. 34 . Fig. The benefits arising out of such swap to counter parties depend upon the movements in underlying currency exchange rates and interest rates there on. it is noted that exchange of principal amounts.Step III Exchange of Final Contract Swiss franc forward contract Dollar forward contract Firm A Firm B Swiss franc principal to bond holders. both at the beginning and at the end of swap contract is notional and not real.

35 . these are namely fixed-to-fixed currency swap. where forward is the current spot rate.TYPES OF CURRENCY SWAPS • The structure of currency swaps differs from interest rate swaps in a variety of ways. floatingto-floating currency swap and fixed to floating currency swap. behaves like a long dated forward. there is always an exchange of principal amounts at maturity at a predetermined exchange rate. is foreign exchange contract. • The major difference is that in a currency swap. • The swap contract. • The currency swaps can be of different types based on their term structure.

Fixed-to-fixed Floating-to-floating Fixed-to-floating • The currencies are exchanged at fixed rate. say. the dollar and pound principal are reexchanged. • At maturity. • The counter parties will have payments at floating rate in different currencies. The principal amounts are equivalent at the current market rate of exchange. • It is a combination of fixed-tofixed currency swap and floating swap. while the other party makes the payment at a floating rate in currency Y. • In swap deal. say USD while the other firm raises fixed rate funding in currency Y. in turn gets dollars computed at interest at a fixed rate on the respective principal amount of both currencies. Pound. • One party makes payment at fixed rate in currency X. • Contracts without the exchange and re-exchange of principals do not exist. first party will get Pound whereas the second party will get Dollars. the first party will make periodic (pound) payments to the second. Subsequently. One firm raises a fixed rate liability in currency X. 36 .

EXAMPLE 37 .

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4% in DEM. who transfers the same to firm X@6% p. 39 . • In this figure.ALTERNATIVE STRATEGY FOR CURRENCY SWAP • There can be different alternative arrangements depending upon the firm’s considerations.a. firm Y borrows DEM@ 6. firm Y bears some foreign exchange risk because it pays 10% in FRF and 6. who in turn transfers the same to firm Y @9% p. • On the other hand.4% in its market and lends to the bank.a. • An alternative arrangement in the previous example is shown as follows: • The firm X borrows FRF@ 9% and lends to the bank.

• The value of foreign currency bond. and the corresponding value of a domestic currency bond would be taken considered which are as under: – V= SBF – BD where V is the value of the swap. • The technique used for valuation of currency swap is just synonymous to valuation of interest rate swap. S is the current exchange rate . 40 . BF is the value in foreign currency of the foreign currency bond and BD is the value of local currency bond underlying the swap.VALUATION OF CURRENCY SWAP • The swap can be valued as the difference between he current values of two conventional bonds.

• Calculation of BD : The bond equivalent to the foreign currency interest flows has the value as shown in the following equation: −𝑟𝐷𝑖 𝑡𝑖 – BD = 𝑛 + S′Q𝑒 −𝑟𝐷𝑛 𝑡𝑛 𝑖=1 𝐾𝐷 𝑒 where 𝐾𝐷 is the constant foreign currency interest payment. 𝑟𝐷𝑖 is discount rates for various periods to cash flows. S’ is exchange rate at the time that swap was agreed and Q is foreign currency principal sum converted into the equivalent domestic currency principal sum 41 .• Calculation of BF : The bond equivalent to the foreign currency interest flows has the value as shown in the following equation: −𝑟𝐹𝑖 𝑡𝑖 – BF = 𝑛 + Q𝑒 −𝑟𝐹𝑛 𝑡𝑛 𝑖=1 𝐾𝐹 𝑒 where 𝐾𝐹 is constant foreign currency interest payment. 𝑟𝐹𝑖 is the foreign currency discount rate. 𝑡𝑖 is length of those periods to cash flows. 𝑡𝑖 is corresponding periods to the interest payments and Q is the principal sum in foreign currency.

EXAMPLE 42 .

a firm buys a country’s debt on the secondary loan market at a discount and swaps it into local equity. • This market was developed in 1985 and by 1988. 43 . • A market for less developed countries (LDC) debt-equity swap has developed that enable the investors to purchase the external debts of such under-developed countries to acquire equity or domestic currencies in those same countries. the same market reached to $15 billion in size and further it is on rising trend.DEBT-EQUITY SWAP • In debt-equity swap. • Debts are exchanged for equity by one firm with the other.

THANK YOU AND HAVE A NICE DAY…  44 .

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