Swaps

Dr. N Vijayakumar
 Evolution of Swaps
• Swap as a financial instrument came into existence when
exchanges are controlling the movement of capital from one
country to another. This concept was originally conceived in
1970’s in UK which was named as ‘back -to- back loan or
parallel loan agreement’.
• Swaps overcame the operational difficulties faced in parallel
loans and developed into an instrument independent of the
underlying loan transaction.
• Parallel loan refers to an arrangement in which foreign
company borrows in its home country (where it has a relative
advantage in terms of interest cost) and given to the subsidiary
of a foreign company located in its country at a lower interest
rate than the subsidiary may have to pay in domestic market.
 Swaps
• Swap is simply defined as an exchange of future
cash flows between two parties as agreed upon
in accordance to the terms of the contract.
• The dictionary meaning of the word swap is “to
give in exchange.” A Swap is an arrangement for
exchange of commitments between two parties,
without nullifying the primary external
obligations of these parties.
• Swap arrangements can be used to hedge
interest rate risk or to hedge currency risk.
 Types of Financial Swaps
• Interest rate swaps
• Currency swaps
• Equity swaps
• Commodity swaps
Salient Features of swaps
• It is a contract between two parties (except triangular currency swap
which include three parties) whereby one party raises loan desired by
another party and exchange the interest.
• Principal amount of the loan remains notional and hence not exchanged
( except for currency swaps). Only interest payments are exchanged.
• The amount of loan required by both the parties and periodicity of
interest payments are identical.
• The amount of loan required by both the parties is in the same currency
unlike currency swap.
• The swap is generally structured for longer duration say for 5 to 10 years.
 Facilitators of Swaps
• Swap deal is generally agreed upon over telephonic in OTC market.
• But, to avoid confusion, the swap agreements are arranged by the intermediary such
as financial institutions and banks.
• In India, RBI permitted scheduled Commercial banks and financial institutions to act as
facilitators.
• International Swap Dealers Association (ISDA) plays a vital role by framing the rules
regarding documentation with respect to identification of the parties, payments,
representations, agreements, default, termination, tax matters, jurisdiction etc.

Types of Swap facilitators

• Brokers: the agents who identify and bring the counter-party on the table for swap
deal. They don’t bear the risk but initiate the swap deal according to their respective
requirements.
• Swap dealers: Act as counter-party to each of the party to the contract and undertake
the risk of default.
• Since, the swap dealers are the party to the swap deals and creators of the swap
portfolio, they face the problem of pricing the swap and managing the portfolio. The
swap dealers undertake the risk of default for which they charge higher commission.
 Benefits of Swaps
• Swap helps in obtaining desired form of funding
• Easy documentation
• Lower transaction cost
• Savings in the interest cost: the variation in the
interest rate spread applicable to two parties in
different market provides an opportunity to save
interest cost. Thus, the parties to the swap
contract enjoy more benefits. But there is a risk
of default by a party.
 Risk Borne by Swap dealers
• Credit risk- possibility of default by either party to the swap
dealer
• Mismatch risk- problem of finding party with perfect match in
terms of loan amount and period of the loan
• Sovereign risk- arises when the government of the a country to
either party put restriction on the flow of foreign exchange.
• Delivery risk- the two counter parties are located in different
time zones which differs in maturity date by one day.
• Interest rate risk- The swap dealer may face this risk because
the Fixed rate loans under the swap contract carry higher risk.
• Currency risk- Swap dealer simultaneously faces both interest
rate risk and the exchange rate risk by which the quantum of
risk will be higher.
 Terminologies of Swap
• Notional Amount: The principal amount to be borrowed by both the parties of the
swap deal is notional as the amount is not exchanged by the parties (Currency swaps
the principal is exchanged). It is used only to calculate fixed and floating interest
payments which are exchanged.
• Trade date: date on which the swap deal is formed and parties to the contract is
agreed to the terms.
• Termination date: the swap deal will be valid from effective date to termination date.
The swap deal terminated on a date by settling final payment of interest and
obligation of further payment of interest if any.
• Reset date (fixing date): the date on which a new floating rate becomes effective.
• Fixed and Floating Rate: One side the plain vanilla swap will be fixed and another side
will be floating. The fixed rate remain constant throughout the tenor of the swap deal
and floating rate fluctuates over the period since it is determined by the market
forces. The bench mark for floating rate swap can be London Inter- bank Offer Rate
(LIBOR), Prime rate, T-bill rate etc . In India, it can be domestic money market or debt
market rate such as Mumbai Inter-Bank Offer Rate (MIBOR), Mumbai Inter-Bank
Forward Rate (MIFOR) and Mumbai Inter-Bank Tomorrow Offer Rate (MITOR).
 Swap Quote
• Every Swap quote includes Bid and Ask rates. Ask rate
usually higher than the Bid rate. The swap dealer pay the
Bid rate and receive the Ask rate. The difference between
the Bid and Ask rate is the Swap spread which is the income
of swap dealer for undertaking the counterparty risk.
EX: The Swap quote of USD 5.70-5.90%
In the case of Currency swap, fixed bid-ask spread is given in
two different currencies. Consider a currency swap quote
5.20-5.40% in EUR and 6.10-6.30% in CHF against semi-
annual EUR LIBOR. In this case, the swap dealer will pay
fixed rate EUR at 5.20 and receives fixed rate CHF at 6.30%
semi-annually or will receive fixed rate EUR at 5.40% in
return for paying fixed rate CHF at 6.10%.
 Computation of Effective Cost/ Return of
Borrowing/ Deposit
The gain available for each party of the swap and effective cost
of borrowing (effective return on the investment in the case
of equity swap) are calculated as:
Interest Rate Swap:
Total Gain = Fixed Interest rate differential + /- floating Interest rate differential
Net Gain (for each party)= ½ (Total Gain – Swap dealers Commission)
Effective Cost of Borrowing = Desired form of Borrowing – Net Gain
Currency Swap:
Total Gain = Interest rate of the currency in country ‘A’ + /- Interest rate differential of currency in
country ‘B’
Net Gain (for each party)= ½ (Total Gain – Swap dealers Commission)
Effective Cost of Borrowing = Desired form of Borrowing – Net Gain
Equity Swap:
Total Gain = Fixed Interest rate differential + /- floating Interest rate differential
Net Gain (for each party)= ½ (Total Gain – Swap dealers Commission)
Effective Return on Investment = Return on Desired form of Investment – Net Gain
 Swaps
• In a swap one of the cash flow would be fixed,
called fixed leg while
• the other cash flow, called floating leg would
be variable depending upon the value of the
variable identified for the swap.
 INTEREST RATE SWAPS
An interest rate swap is an agreement between two parties who
exchange interest payments, based on a notional principal amount,
over an agreed period of time.
Objectives of interest rate swaps:
• To protect or alter the interest rate on borrowings.
• To alter the frequency and size of the cash flow profile.
 
• For example, a periodical fixed interest payment may be swapped into
a floating interest rate payment and vice versa. Thus, floating rate
borrowers can swap their commitments for a fixed rate and vice versa.
• A floating to fixed swap will be taken up if the borrower perceives that
the interest rates would move up.
• Similarly, if the borrower perceives that the interest rates will fall then
he will undertake a fixed to floating rate swap.
 Hedging with Swaps
When interest rates are rising:
• A floating rate liability must be converted to
fixed rate liability, and
• A fixed rate asset must be converted to floating
rate asset.
When interest rates are falling:
• A fixed rate liability must be converted to
floating rate liability, and
• A floating rate asset must be converted to fixed
rate asset.
 Key issues in swap

Issue 1: Credit risk implicit in interest rate swap

• A swap arrangement involves exchange of interest
only. There is no principal payment between the
two swapping parties.
• Since there is an exchange of obligation of interest
payment between two counter parties, there is an
element of credit risk in a swap arrangement.
• However, only the interest amount and not the
principal amount is exchanged, the risk is not high.
 Issue 2: Pricing of an interest rate swap
• The swap deal involves in exploiting the spread available. Typically, the floating
interest rate is quoted as “base rate plus margin.” Thus you have a rate such as
LIBOR + Margin (say 0.5).
• Pricing a swap means deciding on the margin i.e. deciding on whether it should
be 0.5 or 1.0 or 0.75 etc. This is also referred to as spread over the base
reference rate.
• The most hurdle part is that the stream of “floating rate payments” will not be
known at the time of initiating the swap. It is not easy to predict the future
benchmark rates but there are techniques and tools that help.

Some of them are:

• Yields on Government Securities (yield curve that denotes the relationship
between interest rates and time-periods)
• Forward interest rate yield curve (to estimate the likely level of rates that would
offset any arbitrage benefit)
• Zero coupon yield curve (which is the IRR) of Zero coupon bonds over a range
of maturities.
 Swap arrangement
• Technically, the swap is so priced that the present value
of the net cash flows under the two streams of cash
flows that are exchanged is zero. In effect, an interest
rate swap is a series of forward contracts on interest
rates.
Advantages of a swap arrangement
• Swapping from floating to fixed increases the certainty
of an issuer’s future obligations.
• Swapping from fixed to floating could save the original
borrower if interest rates decline.
• Swapping also acts as liability management tools and
could help in generating speculative gains.
 Pre-requisites to a swap

• One party should be stronger than the other.

This would mean that it enjoys lower
borrowing rates than the other.
• The two parties should have opposite views
about the direction of the movement in
interest rates.
 Steps for computation of Swap
Step 1: Indentify the rates
• This involves tabulating the fixed rates and variable rates applicable to
the two companies.
Step 2: Compute the Net Differential
• (a) Difference in Fixed Rates
• (b) Difference in Floating Rates
• Net Differential [(a-b) or (b-a) as the case may be]
Step 3: Split the Net Differential
• Decide how much of the Net Differential should be pocketed by each
company. This of-course is a matter of negotiation.
Step 4: Identify the sequence of operations
• In doing this we shall always proceed from the angle of the Stronger
Company. The sequence would depend on whether the Stronger
Company wants to move to a Fixed Rate or wishes to move to a Floating
Rate.
 Remember two principles

• Principle 1: A switch from Fixed Rate to

Floating Rate by the Company is possible only
when the differential in Fixed Rate available to
the two parties is greater than the differential
in Floating Rate.
• Principle 2: A switch from Floating Rate to
Fixed Rate by the Company is possible only
when the differential in Floating Rate available
to the two parties is greater than the
differential in Fixed Rate.
 Sequence of payments and receipts

Sequen Strong Company Weaker Company

ce Wants Floating Rate Wants fixed rate

A Pays to Bank at fixed Pays at its floating

B Receives from counter party Pays the fixed rate identified
fixed as per sequence A plus in the sequence B to the
strong company share of gain. counter party.

C Pays the counter party the Receives the floating rate

floating rate which strong is identified in the sequence C
entitled to from the market. from the counter party.

D Aggregate after correctly Aggregate after correctly

considering the signs. There will considering the signs. There
be Strong's revised floating will be Weak’s revised fixed
rate. rate.
 Problem. 1
Grades Ltd. enjoys a high credit rating, and is
capable of raising term funds either at a fixed
rate of 10% p.a. or at a floating rate of 40 basis
points over MIBOR.
Levels Ltd. enjoys a relatively lower credit rating,
and is able to borrow either at 80 basis points
over MIBOR, or at a fixed rate of 11%.
Levels Ltd. wants to borrow at fixed rate whereas
Grades would like to enjoy a floating rate.
Structure a swap arrangement such that
Grades gains 2/3rd of the total gain. Assume
that there are no intermediaries involved.
Step 1: Identify the rates

Company Fixed Floating

Grades 10% M+0.4
Levels 11% M+0.8

Step 2: Compute the Difference

a. Fixed rate differential 11%-10%= 1%
b. Floating Rate differential 0.8%-0.4%= 0.4%
c. Net (a-b) = 0.6%
Step 3: Split the Gain in the ratio of 2:1
Grades get 0.4% and Levels get 0.2%
Effective Cost of borrowing for Grades= M+0.4 - 0.4 = M
Effective Cost of borrowing for Levels= 11% - 0.2%= 10.8%
Sequence Strong company Weak company
A (10%) (M+0.8%)
B 10+0.4 =10.4% (10.4)
C (M+0.4) M+0.4
D -10+10.4-(M+0.4)= (M) -(M+0.8%)-(10.4)+M+0.4 = (10.8)

Thus, Strong company effectively pays MIBOR only instead of M+0.4, whereas, the
weak company effectively pays 10.8% instead of 11% . Hence Strong company has
gained 0.4% and the Weak company has gained 0.2%.
 Currency Swaps
• Currency swaps also called financial swaps.
• Currency swaps are exchange of cash flows in two
different currencies based on exchange rates.
In Interest rate swaps the payments exchanged will be
denominated in single common currency.
Currency swap are useful in:
a) hedging the exchange rate risk,
b) transforming asset/liability from one currency to
another, and
c) reducing the financing cost.
• This may be done without altering the original contract.
 How does the currency swap works?
• Mechanics of a currency swaps are very similar to Interest
rate swap.
• Example: KBS ltd approaches SBI for a fixed rate loan in
Euros. It can raise EURO funds at fixed rate of 4.25% but it is
ready to pay LIBOR +25 basis points for a USD loan. Another
client, XYB Ltd located in USA enjoys high rating and is raising
finance in USD at LIBOR minus 25 basis points. Now XYB ltd
wish to raise Euro funds at a fixed cost of no more than 4%
pa.
Here we can proceed to match the needs of both the parties,
and conclude a currency swap arrangement on the following
lines:
Step 1: Identify the interest rates
Company Fixed Floating
KBS 4.25% in Euro Can pay LIBOR + 25 Basis points for USD
funding
XYB 4 % in Euro Is able to pay LIBOR minus 25 basis points

Step 2: Compute the Net Differential

a. Difference in floating rates 0.50
b. Difference in fixed rates 0.25
c. Net differential (a-b) 0.25
Step 3: Split the Net differential: we will assume that they split equally and
the part it to the Bank as Banks margin.
Step 4: Identify the sequence of operations
Change in floating rate > Change in fixed rate. Hence the swap is possible if
strong wants to go to fixed.
 Based on what the stronger company does, the
weaker entity’s sequence is determined, as
Under:
Sequence Stronger Company wanting Fixed Weaker Company wanting a
Rate Floating Rate

A PAYS to bank at its Floating Rate (L – PAYS to bank at its Fixed Rate
0.25)% (4.25)%
B RECEIVES from Counter Party A+ strong RECEIVES from strong Sequence C
share of gain L+0.25% + 0.125% (4%)

C PAYS Counter Party Strong's Fixed rate PAYS Strong's sequence B

(4%) (L+ 0.25% + 0.125%)

D AGGREGATE after correctly considering AGGREGATE after correctly

the signs. 3.875% considering the signs.
The gain of 0.125% will be parted to the bank as bank’s
commission such that strong ends with 4%
Step 5: Compute the net differential: the net differential
in floating rate is relevant in the instant case. The
floating rate differential is 50 basis points , i.e. the
eligible rate of LIBOR + 25 basis points for XYB.
Step 6: Conclude the Swap in the following manner:
In effect, SBI client KBS receives a floating USD funding
at LIBOR + 25 basis points while client XYB is able to
raise Euro funds at 4% Euro. You as intermediary keep
50 basis points, but sacrifices 25% basis points for
Euro towards KBS’s leg of the Swap, and retain the
balance of 25 basis points as compensation for
residual currency risk.