SWAPS

What are swaps?

Swap market terminology 

Swap facilitators Swap broker Notional principal Swap coupon 

Trade date Effective date Maturity date LIBOR      

Reason for the growth of swap market    

Interest rate swap create a link between distinct markets with differential access to fund sources creating globalization of finance markets. Interest rate swaps provide a way to reduce the total funding cost for debt. Interest rate swap is flexible and convenient way for companies to manage balance sheet and reduce the mismatch between the maturities of asses and liabilities. Swaps are desirable because they minimize the costs of regulations and tax loans.

Size and growth of the market (Interest swap)
Year 1987 1988 1989 1990 1991 1992 Total new business 3,87,856 5,68,113 8,33,535 1,229,241 1,621,779 2,822,635 Total outstanding 6,82,888 1,010,203 1,539,320 2,311,544 3,065,065 6,177,352

Size and growth of the market (currency swaps)
Year 1987 1988 1989 1990 1991 1992 Total new business 85,823 122,661 169,631 212,763 328,394 301,858 Total outstanding 182,807 316,821 434,849 577,535 807,167 860,387

Basic types of swaps 
Interest

rate swaps swaps 

Currency

Interest Rate Swaps 
  

 

Contractual agreement Between two counterparties Each agrees to make periodic payment to the other for an agreed period of time Based upon a notional amount of principal. Principal amount in a single currency. To Manage the fluctuations in interest rates.

Plain Vanilla Interest Rate Swaps   

Exchange of a fixed rate loan to a floating rate loan or vice-versa. Life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage.

Key features of this swap 

The notional principal The fixed rate Floating rate  

Types of interest rate swap 

Basis swaps Forward swaps Putable swaps  

Cont«««.. 

Deferred rate swaps Callable swaps Extendible swaps  

The key advantage of interest rate swap

Other types of interest rate swap 

Liability based interest rate swap 

Asset based interest rate swap

Liability based interest rate swaps 
Floating

rate liabilities

Asset based interest rate swaps 
Floating

rate asset

Practical examples of interest rate swaps
1.

IBM and NALCO
IBM NALCO INTEREST DIFFRENTIAL

FLOATING RATE FIXED RATE

LIBOR + 3/8 % LIBOR + 11½% 11/8% 13% (IF AVAILABLE)

¾% 1½%

2. Interest rate cap (ceiling)
Interest paid Air India No of days in period Interest rate (%) Interest rate differential to be paid Dollar amount payable by Citibank to Air India

01.04.89-30.09.89 30.09.89-31.03.90 31.03.90-30.09.90 30.09.90-31.03.91 31.03.91-30.09.91 30.09.91-31.03.92

183 183 183 183 183 183

08.50 09.00 10.50 11.75 10.25 09.75

_ _ 0.50 1.75 0.25 _

_ _ 1,25,342 4,38,873 62,675 _

3. Floating-floating swaps

Interest rate swap- The Indian scenario

The examples from Indian market 

SBI-HUDCO enter into Yen-swap deal Nalco contains loss on yen-swap deal 

Currency swaps

Various reasons why a company use currency swaps  

  

Currency swaps may be used to hedge against foreign exchange risk. It increases the total amount that a firm can borrow. A firm may be able to use their surplus funds more effectively in blocked currencies. Swaps may be used as a way of circumventing exchange control regulation. Currency swap can be used as a mean of exploiting arbitrage opportunities.

Various forms of currency swaps 

Cross-currency fixed-to-fixed swaps Cross-currency floating-to-fixed swaps Cross-currency floating-to-floating swaps Basis swaps Amortizing swaps    

Cont«. 

Roller-coaster swaps Zero-coupon swaps Commodity swaps  

Limitation of swap market   

The swap deal cannot be terminated without the agreement of the parties involved in the transaction. Swaps are not easily tradable as a result of very slow development of standardized documentation. It is difficult to identify a counter-party to take the opposite side of the transaction.

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