Swaps

Evolution of Swaps
In 1970’s the concept of swaps originated from
the British pounds(BP) and US dollars (USD)
parallel loans arranged between British and
American entities.
If British parent have subsidiary in US and US
parent company have subsidiary in Britian then
exchange of loans can be done.
The first currency swap was executed in August
1981 between the World Bank and IBM.
 Swaps - Meaning
It literally means an exchange.
A financial swap may be defined as a contract whereby
two parties (known as counterparties), exchange two
streams of cash flows over a defined period of time,
usually through an intermediary like a financial
institutions.
The principal used is notional in the sense that it is just
used as a reference amount for calculating interest due
at regular intervals.
Swaps are OTC agreements and are not exchange traded.
 Swap Contract
Notional Amount of Principal

Fixed Rate Fixed Rate

Firm A Bank Firm B

Floating Rate Floating Rate

 Types of Swaps
There are two types of swap structures
1. Interest-rate swaps (IRS) &
2. Currency swaps

IRS: An IRS is a contractual agreement between

counter-parties to exchange a series of
interest payments for a stated period of time.
 Features of IRS
• It involves exchanging fixed and floating interest
payments in the same currency.
• There is no exchange of principal amount.
• It reduces credit risk by exchanging only interest
payments between counterparties.
• Any underlying loan or deposit is not affected by the
swap. It is separate transaction.
• Dealer is called as banker
• Difference between interest amount are exchanged at
the end of the contract.
 Currency swaps
It is a contractual agreement between
counterparties in which one party makes
payments in one currency and the other party
makes payment in different currency for a
stated period of time.
 Features of currency swaps
• Exchange of currencies between counterparties.
• The interest payments on the two currencies
can be calculated on a fixed or floating basis for
both currencies.
• Due to the exchange of principal as also
exchange of interest payments in full, the credit
risk in a currency swap is higher than that in an
IRS.
 Terminologies
• Notional principal amount: is the amount
involved in the swap which is never
exchanged.
• LIBOR: London Inter Bank Offered Rate. It is
used at international level.
• MIBOR: Mumbai Inter Bank Offered Rate. It is
used at domestic level.