Basis Swap

Presented by Ankita Gulab Rai (CIBOP – 85)

 What are SWAP?
A basis rate swap (also known as a basis swap) is an agreement between two parties to swap variable interest rates based on
different money market reference rates.
Swap is a financial derivatives in which two companies exchange their cash flow at a certain period of time.
Swaps used mainly for hedging purpose and to reduce the cost of borrowing.
Issuer of swap can contract to pay a floating rate and receiver a fixed rate or vice versa.
The goal of a basis rate swap is for a company to limit the interest rate risk it faces as a result of having different lending and
borrowing rates.
Swaps can be executed
• In advance of the issuance of either fixed rate or variable rate debt.
• At any time during the outstanding life of the underlying bonds
Basic kind of swaps
• Interest rate swap
• Currency swap
In this agreement there is one speculator who enter in this to make profit from fluctuations and on other hand there is hedger
who enter in this contract to reduce the risk of interest rate.
 Types of swaps

Interest rate swap

Currency swap

Commodity swap

Total return swap

Credit default swap

Debt equity swap

 Interest
Interest rate
rate swaps
swaps

Interest rate swap in which two companies exchange their

interest rate or two parties must have opposite needs.
The notional principal remains the same and interest payment
are netted
Types:
• Floating for Fixed
• Fixed for Floating
• Floating for Floating
Interest Rate Swap
Two parties must have opposite needs Company A Company B
Assume LIBOR – 7% Fixed Rate 10% 11%
A took a loan at Fixed rate Floating Rate Libor + 4% Libor + 5%
B took a loan at floating rate
Here A thinks the LIBOR Rate will go down and he want the
advantage of that and hence he want a floating rate loan
B thinks the LIBOR rate will go up and he want to be safe in that case
and hence he wants a fixed rate loan
Both parties can enter into SWAP agreement

Floating Rate

Company A Bank Company B

Fixed Floating
Rate Fixed Rate Rate

Bank A Bank B

Both parties will assumes a Notional Amount which will never be exchanged
for eg: LIBOR+ 4%
Company A Company B

11%

10% LIBOR + 5%

Company A = LIBOR + 4% + 10% - 11% = LIBOR + 3%

Company B = LIBOR + 5% + 11% - LIBOR + 4% = 12%

Both companies got the interest rate they wanted at 1% lesser cost compared to their respective Banks

If Libor increases, Company B will get the benefit and if it decreases then Company A get benefit
Currency swaps
In Interest rate Swaps only interests are exchanged but not the principal
amount rather it is only assumed as a notional amount
But in currency swaps, the principal amount is also exchanged
Tata has subsidiary in USA and Microsoft has a subsidiary in India
Tata subsidiary in US, TCS (Tirupati Courier Services), wants capital
through Loan
But if TCS takes Loan in US – Higher interest rate because not a US
company
Microsoft’s subsidiary in India, AWS (Automatic Windows Services) will
face the same problem as above
For Example:
Microsoft TATA
US. Int Rate 6% 8%
India Int. Rate 15% 12%
 Indian Bank US Bank

RS. 50,00,000 12% $ 1,00,000 6%

RS.50,00,000

$ 1,00,000

Suppose $1 = RS.50

Both parties will agree to exchange the principal amount at same rate at the end of the period
Here both the parties will enter into a SWAP agreement to provide loans to other
party’s subsidiaries at local interest rate
They also fix exchange rate at which the principal will be swapped at the end of the
period
So, if they are taking loan when $1= Rs.50, then irrespective of the exchange rate at
the end of the period, the principal will be swapped at $1 = Rs.50 only
Then they will swap the interest rates at every interval(monthly)
Can Microsoft take loan from US bank and then convert it to INDIAN Rs.
And then provide it to its Indian subsidiary?
Ans. No because of exchange rate risk (Ex.If $1 becomes Rs.100 then AWS will have
to pay double amount of interest than earlier)
 Commodity Swaps
A commodity swap is a type of derivative contract where two parties
agree to exchange cash flows dependent on the price of an underlying
commodity.
A commodity swap is usually used to hedge against price swings in
the market for a commodity, such as oil and livestock.
Commodity swaps are not traded on exchanges; they are customized
deals that are executed outside of formal exchanges and without the
oversight of an exchange regulator.
 Total Return Swaps
In a total return swap, one party makes payments according to a set rate, while
another party makes payments based on the rate of an underlying or reference
asset.
Total return swaps permit the party receiving the total return to benefit from the
reference asset without owning it.
The receiving party also collects any income generated by the asset but, in
exchange, must pay a set rate over the life of the swap.
The receiver assumes systematic and credit risks, whereas the payer assumes no
performance risk but takes on the credit exposure the receiver may be subject to.
 Credit Default Swap
Credit default swaps, or CDS, are credit derivative contracts that
enable investors to swap credit risk on a company, country, or other
entity with another counterparty.
Credit default swaps are the most common type of OTC credit
derivatives and are often used to transfer credit exposure on fixed
income products in order to hedge risk.
Credit default swaps are customized between the two counterparties
involved, which makes them opaque, illiquid, and hard to track for
regulators
 Credit Default Swap
Credit default swaps, or CDS, are credit derivative contracts that
enable investors to swap credit risk on a company, country, or other
entity with another counterparty.
Credit default swaps are the most common type of OTC credit
derivatives and are often used to transfer credit exposure on fixed
income products in order to hedge risk.
Credit default swaps are customized between the two counterparties
involved, which makes them opaque, illiquid, and hard to track for
regulators