Swaps

Derivatives & Risk Management

 What are Swaps?
• An agreement to exchange cash flows at
specified future times according to certain
specified rules
 How swaps developed
• Restrictions on cross-border capital flows
• Gave rise to parallel or back-to-back loans
• Difficulties in back-back loans
– Finding counterparty with matching needs in terms of
amount, duration, periodicity of interest etc
– Assuming the risk of counterparty default
• Banks step in as intermediaries – initially as brokers,
later as ‘market makers’
• Concept of ‘warehousing’
• Benefits to all parties involved
 First swap deal in history
• First interest rate swap arranged by Salomon Brothers between
World Bank and IBM
• World Bank wanted to borrow in Deutsche Mark and Swiss
Franc as these were low-interest currencies
• It could not do so as it had already borrowed maximum
permissible amount in these currencies
• IBM had earlier raised loans in DM and CHF
• The appreciation of USD against DM and CHF had lowered
the dollar value of these borrowings
• IBM wanted to convert its foreign currency borrowing to
dollar borrowing so as to hedge its currency risk and match its
borrowing cost with dollar revenues
 Mechanics of the swap
• Under the swap
– World Bank issued dollar bonds and used the proceeds to
buy DM and CHF in the spot market
– World Bank and IBM swapped their liabilities
– IBM paid interest on USD loan taken by World Bank
– World Bank paid interest on DM loans of IBM
• Effectively, IBM had transformed its DM loans into a
USD loan, thus hedging currency risk
• World Bank had transformed its dollar loan into a
DM loan and avoided the capital market restrictions
 Applications of Swaps
• Transforming nature of asset or liability
through off-balance sheet transactions
• Hedging against fluctuating interest rates
• Reducing the cost of funds
 Transforming nature of
asset/liability
• Example 1–Floating rate asset to fixed rate asset
– CR Ltd has invested Rs.50 crore in MIBOR-linked securities
currently yielding 8% with MIBOR at 7.5%. Its treasurer
anticipates a steady decline in interest rates. Company’s banker
has offered a 3-year MIBOR based swap at 7.30%-7.40%. What
is the outcome of the swap arrangement?
• Example 2 – Fixed rate liability to floating rate liability
– Shriram Transport Ltd raised funds of Rs.1000 crore through 10
year non-convertible debentures carrying 12% two years ago.
Interest rates have since declined to 10% and are expected to
decline further. The Company wishes to reduce its funding cost
through swaps. Bank has offered a 5-year swap at 9.5%-9.6%
against MIBOR. What is the outcome of the swap arrangement?
Hedging against interest rate risk
Nature Risk Action

Fixed rate asset Interest rates may Convert asset from

rise fixed rate to floating
rate using swaps
Floating rate asset Interest rates may fall Convert asset from
floating rate to fixed
rate using swaps
Fixed rate liability Interest rates may fall Convert liability from
fixed rate to floating
rate using swaps
Floating rate liability Interest rates may Convert liability from
rise floating rate to fixed
rate using swaps
 Reducing cost of funds
• Theory of ‘Comparative Advantage’ or ‘arbitrage on credit rating’
• Example – Two companies Megasoft Ltd rated AAA and MiniSoft
Ltd rated AA wish to raise finances of Rs.500 crore. Rates offered
by investors are:

Megasoft Ltd believes rates will decline and wants to borrow at

a floating rate while Minisoft Ltd wants to raise fixed-rate funds. A
banker agrees to broker a swap for a fee of 5 bps from each. What
kind of swap arrangement can be worked out? What is the saving to
each company?
 Currency Swaps
• Exchange of principal and interest payments in
one currency for principal and interest
payments in another currency
• Principal is specified in each currency
• Principal amounts usually exchanged at the
beginning of the swap and exchanged back at
the end of the swap
 Why currency swaps?
• Transformation of liabilities and assets
• Comparative advantage
 Pricing a generic IRS
• Pricing means finding the fixed rate to be quoted
on a new swap
• Consider a par bond, i.e. where the coupon =
yield
• Suppose the bond is purchased and financed by
borrowing at floating rate of LIBOR
• Combining the cash inflows of the bond and cash
outflows on the financing gives the same cash
flows as on a fixed-floating interest rate swap
 Pricing a generic IRS
• The fixed rate on a generic interest rate swap
is the same as the yield and coupon on a par
bond
• K-period Swap rate = (1 – discount factor for
kth period)/(Sum of all discount factors till kth
period)
 Pricing a generic IRS
• Alternatively, fixed rate on a generic IRS
would be the rate at which
– Value of fixed leg = value of floating leg
– i.e. NPV of swap is zero
 Quotes By a Swap Market
maker
Maturity Bid (%) Offer (%) Swap Rate (%)
2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850
 Valuation of a swap
• Finding the value of an existing swap entered into
some time ago
• Two methods for valuation
– As the difference between a fixed rate bond and a
floating rate bond
– As a portfolio of FRAs
 Valuation as a pair of bonds
• For a floating rate payer
– Swap is like a long position in a fixed rate bond and short
position in floating rate bond
– PV of fixed leg - PV of floating leg
• For a fixed rate payer
– Swap is like a long position in a floating rate bond and
short position in fixed rate bond
– PV of floating leg - PV of fixed leg