Swaps

Swaps
• Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula.
• There are two type of swaps.

1. Interest rate swaps

2. Currency swaps
 Interest rate swaps

Interest rate swaps = A swap is a derivative in which

two counterparties exchange cash flows of one party's financial instrument for
those of the other party's financial instrument or we can say a company agree to
pay cash flow equal to interest at a predetermined rate on a notional principal for a
number of years in return it receive interest on the same notional principal for same
number of years
 Interest rate swaps

Swaps were first introduced to the public in 1981 when IBM and the World
Bank entered into a swap agreement.
Today, the total amount of interest rates and currency swaps outstanding is
more than $348 trillion in 2010.
 Interest rate swaps

There are three type of Interest rate swaps.

1. Fixed vs fixed
2. Fixed vs floating
3. Floating vs fixed
 Fixed vs fixed

Fixed vs fixed = Both Parties will exchange fixed

interest cash flow.
 Fixed vs floating

Fixed vs floating = First Parties will pay fixed interest

cash flow and receive floating interest rate cash flow and
vice - versa.
 Floating vs fixed

Fixed vs floating = First Parties will pay floating interest

cash flow and receive receive interest rate cash flow and
vice - versa.
Sir , can you tell me. Why we do
swap??????
First reason

A is currently paying floating, but wants to pay fixed. B is

currently paying fixed but wants to pay floating. By
entering into an interest rate swap, the net result is that
each party can 'swap' their existing obligation for their
desired obligation.
Second reason

The second reason for this exchange is to take benefit

from comparative advantage.
Sir, What is
comparative advantage.
Comparative advantage

Suppose two companies A and B wish to borrow 10 lakh

for 5 years.
company fixed Duration floating

A 4% 5 yr LIBOR – .1%

B 5.2% 5 yr LIBOR + .6%

Comparative advantage

Company A have comparative advantage in fixed but want

to borrow floating.
Company B have comparative advantage in floating but
want to pay fixed.
Comparative advantage

Company A and B can enter into a swap to take the benefit

of swap and change interest cash flows.
How????
Comparative advantage

Company A
Take loan @ 4% fixed interest rate.
Company B
Take loan @ LIBOR + .6%
enter into a swap contract
A will pay to B LIBOR and B will pay to A @ 4.35%
fixed interest rate
Comparative advantage

Company A
Net effect of company A will pay LIBOR - .35% (profit
from B 4 - 4.35%)
which is better then market.
Company B
Net effect of company B will pay 4.35% + .6% = 4.95%
(loss from A( LIBOR – (LIBOR - .6%))) which is better
then market.
 Currency swaps

• A currency swap involves exchanging principal and

interest payments on a loan in one currency for
principal and interest payments on an equal loan in
another currency.
Reason for currency swap is……

Comparative advantage.
Comparative advantage

Suppose two companies A (US)and B (IND) wish to

borrow $1 lakh and 50 lakh for 5 years(1$ = 50 rupee).
But company A want money in IND and company B in US

company US Duration IND

A 5% 5 yr 7.6%

B 7% 5 yr 8.0%
Comparative advantage

Company A have comparative advantage in US.

Company B have comparative advantage in IND.

Comparative advantage

Company A and B can enter into a swap to take the benefit

comparative advantage.
How????
Comparative advantage

Company A
Take loan @ 5% fixed interest rate in US.
Company B
Take loan @ 8% fixed interest rate in IND
enter into a swap contract
A will give loan to B in US @ 5% and B will give same
amount in IND to A @ 6.9%.
Comparative advantage

Company A
Net effect of company A will get loan in IND @ 6.9%
which is .7% better then market.
Company B
Net effect of company B will get loan in US @ 5 + 1.1%
( 8% – 6.9% ) = 6.1%
which is .9% better then market.
 Last
point
Generally all type of swap is
done through financial institution
and charge small commission.
THANK
YOU
VERY
MUCH
That’s all for the DAY!!!