SWAPS. Definition of SWAP A swap is a derivative in which two counterparties agree to exchange one...
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Transcript of SWAPS. Definition of SWAP A swap is a derivative in which two counterparties agree to exchange one...
SWAPS
Definition of SWAP
A swap is a derivative in which two
counterparties agree to exchange one
stream of cash flows against another
stream. These streams are called the legs
of the swap.
The cash flows are calculated over a
notional principal amount, which is usually
not exchanged between counterparties.
Swaps can be used to hedge certain risks
such as interest rate risk, or to speculate
on changes in the underlying prices.
BACKGROUNDSwaps first evolved in 1981, in the form
of currency swaps, (IBM and the World
Bank for$210 million dollars and a term of
over ten years)
Interest rate swaps emerged, which offered
an alternative method to overcome asset-
liability mismatches and to lower the cost
of borrowing.
Swaps provide a level playing field for risk
management but still struggle to find a
future, especially in developing countries
TYPES OF SWAP
Interest Rate Swaps
Currency Swaps
Commodity Swaps
Equity Swaps
INTEREST RATE SWAPS
An interest rate swap is defined as a
mutual agreement among different
parties, to exchange interest payments
over a predetermined period.
The primary motives behind the
interest rate swaps are to lower the
costs of borrowing and to overcome the
asset liability mismatch.
INTEREST RATE SWAPS – Eg
Take the case of a plain vanilla fixed-to-
floating interest rate swap. Here party A
makes periodic interest payments to party B
based on a variable interest rate of LIBOR
+50 basis points.
Party B in turn makes periodic interest
payments based on a fixed rate of 3%. The
payments are calculated over the notional
amount. The first rate is called variable,
because it is reset at the beginning of each
interest calculation period to the then
current reference rate, such as LIBOR.
TYPES OF INTEREST RATE SWAPS
Fixed for Floating
Also known as Plain Vanilla swap
Customer receives cash flows at a fixed rate of interest
and simultaneously pays cash flows at a floating rate of
interest or vice versa.
The cash flows are calculated on a Notional Principal
amount.
The floating rate of interest is usually determined by
reference to a transparent benchmark
Fixed for Floating – CONT.
Investors call the parts of interest swap
agreements “legs.”
In a fixed-for-floating swap agreement, one
party agrees to pay the fixed leg of the swap,
with the other party agreeing to pay the
floating leg of the swap.
The fixed rate is the interest charged over the
life of a loan and does not change.
The floating rate is an interest rate pegged to
an international reference rate index and is
subject to change. The most commonly used
reference rate is London Interbank Offered
Rate or LIBOR.
An Example of a Plain Vanilla Fixed-for-Floating Interest
Party A- (Receives Floating Rate)Party B- (Pays the
Floating Rate)
Notional Principal- $40 million.
Fixed rate day count method is 30/360 day basis.
Floating rate is Six- Month LIBOR, determined on a
30/360 day basis.
Swaps origination: July 20, 1999.
Swaps termination: July 20, 2000.
First payment: January 20, 2000
Semiannual payments will be made on each July 20
and January 20.
TYPES OF INTEREST RATE SWAPS
Floating for Floating
In this kind of a swap, both the counter-
parties exchange interest amounts based on
two different floating reference rates,
through the life of the swap.
In a floating-for-floating interest rate swap
agreement, both parties agree to pay a
floating rate on their respective legs of the
swap.
Floating for Floating - CONTThe floating rates for each leg of the swap
generally come from different reference rate
indexes, but can also come from the same
index.
If both parties choose the same index,
generally they then choose different
payment dates.
The two main indexes investors use in a
floating for floating interest rate swap are
the LIBOR and the Tokyo Interbank
Offered Rate or TIBOR
TYPES OF INTEREST RATE SWAPS
Fixed for Fixed
In fixed-for-fixed interest rate swaps, both
parties agree to a fixed interest for their
respective legs of the swap.
The interest rate does not change over the life
of the loan for both parties.
Investors most commonly use fixed-for-fixed
interest rate swaps when they are dealing with
different currencies.
Companies often use fixed-for-fixed interest
rate swaps when they are building or expanding
their business in a foreign country.
TYPES OF INTEREST RATE SWAPS
Index Amortization Swap
A swap whereby the notional principal
amount of the agreement is amortized
according to the movement of an underlying
rate.
Forward Swaps
A swap agreement created through the
synthesis of two swaps differing in duration
for the purpose of fulfilling the specific time-
frame needs of an investor. Also referred to
as a "forward start swap," "delayed start
swap," and a "deferred start swap."
TYPES OF INTEREST RATE SWAPS
Off market Swap
An interest rate or other swap contract with
a fixed rate payment materially different
from current coupon rates on bonds or notes
of similar term. Ordinarily, this swap will
have a net present value that requires the
counterparties to exchange an extra
payment at the beginning or end of the
swap tenor. Also called Adjustment Swap
TYPES OF INTEREST RATE SWAPS
Callable Swaps & Putable Swaps
Fixed rate receiver has the right, but not the
obligation to terminate the swap at one or
more pre-determined times during the life
of the swap.
A Swap where the fixed rate payer has the
right to terminate is known as a Callable
Swap. Both the Putable and Callable Swaps
are also known as Cancellable Swaps.
The foreign exchange version of a
Cancellable Swap is called the Break
Forward or Cancellable Forward
LIMITATIONS OF SWAP DEALS
Counter Party Risk
Fund Requirement
Cordial Relationships
Information Network
CURRENCY SWAPS
DEFINITION
A currency swaps (or cross currency
swap) is a foreign exchange agreement
between two parties to exchange a given
amount of one currency for another and,
after a specified period of time, to give back
the original amounts swapped.
Currency swaps were originally done to get
around exchange controls.
EXAMPLE
For example, suppose a U.S.-based company needs to
acquire Swiss francs and a Swiss-based company needs
to acquire U.S. dollars. These two companies could
arrange to swap currencies by establishing an interest
rate, an agreed upon amount and a common maturity
date for the exchange. Currency swap maturities are
negotiable for at least 10 years, making them a very
flexible method of foreign exchange.
Types of currency swaps
Fixed for fixed
Fixed for floating
Floating for fixed
Floating for floating
RISKS OF INTEREST RATE AND CURRENCY SWAPS
Sovereign Risk
Mismatch Risk
Credit Risk
Exchange rate Risk
Basis Risk
Interest Rate Risk
RISKS OF INTEREST RATE AND CURRENCY SWAPS
Interest Rate Risk
Interest rates might move against
the swap bank after it has only gotten half
of a swap on the books, or if it has an
unhedged position.
Basis Risk
If the floating rates of the two
counterparties are not pegged to the
same index to the same index.
RISKS OF INTEREST RATE AND CURRENCY SWAPS
Exchange rate Risk
In the example of a currency swap
given earlier, the swap bank would be
worse off if the pound appreciated.
Credit Risk
This is the major risk faced by a
swap dealer—the risk that a counter party
will default on its end of the swap.
RISKS OF INTEREST RATE AND CURRENCY SWAPS
Mismatch Risk
It’s hard to find a counterparty that
wants to borrow the right amount of
money for the right amount of time.
Sovereign Risk
The risk that a country will impose
exchange rate restrictions that will
interfere with performance on the swap.
ROLE OF FINANCIAL
INTERMEDIARY
MEANING
In the financial markets, a
company with the need for
swapping a fixed rate liability
may not easily find another
company with a matching need
in the reverse direction (same
notional principal, maturity
period, fixed rate and floating
rate)
MEANING
In such cases, the company
needing an interest rate swap may
approach a financial intermediary
such as a bank which is prepared
to enter into swap agreement with
the company.
The intermediary would then find
out a party or a combination od
parties with the matching need in
the reverse direction
ROLE OF FIs IN INTEREST RATE SWAP
Two limitations,
There is a cost of time and resources associated
with searching for a suitable swap candidate
and negotiating the swap terms
Each swap participant faces the risk that the
counter participant could default on payments
ROLE OF FIs IN INTEREST RATE SWAP- eg
Company A has borrowed Rs.5 lac from the
lender X on fixed interest rate at 12%. The
company wishes to convert the fixed rate
liability into floating rate liability and
approaches a bank(FI) for a swap deal. The bank
agrees to receive interest at floating rate from
company A in exchange for interest payment at
fixed rate to company A.
ROLE OF FIs IN INTEREST RATE SWAP- eg
Meanwhile company B has borrowed Rs.5 lac
from lender Y at floating interest rate specified
as LIBOR+0.50%. It wants to exchange this
floating rate liability into fixed rate liability. The
financial intermediary would enter into a swap
deal with company B agreeing to pay interest at
floating rate to company A and receive interest at
fixed rate from company A
ROLE OF FIs IN CURRENCY RATE SWAP
A currency swap can be used to transform a
loan in one currency into a loan in another
currency.
A typical situation that necessitates currency
swap is when a firm has liability
denominated in one currency and an income
stream denominated in another currency
ROLE OF FIs IN CURRENCY RATE SWAP- eg
An Indian firm may have borrowed Japanese yen
to finance the acquisition of equipment from
Japan. This firm engaged in exporting goods to
the U.S and would therefore be receiving its
income in U.S dollars. Thus, the firm has to
make payments in Japanese yen to meet its loan
commitment when it receives its income in U.S
dollars.
ROLE OF FIs IN CURRENCY RATE SWAP- eg
The U.S dollars would have to be converted to
Japanese yen whenever interest payments and
principal repayments have to be made. This firm is
exposed to forex risk as there is a possibility that the
U.S dollar may weaken against the Japanese yen in the
future. The firm would then suffer a loss in conversion
of U.S dollar into yen as more dollars would have to
be converted into yen to meet its loan commitment
WAREHOUSING
MEANING
One of the problems with swaps is
the difficulty of finding a potential
counterparty with matching needs.
This problem is resolved by swap
dealers, working for invt banks,
commercial bans and merchant
banks, who take one side of the
transaction themselves, this is called
positioning the swap or booking
the swap.
MEANING
Positioning of swaps is also
called warehousing swaps.
Swap dealers becomes
counterparty to the swap. For its
services, the dealer earns a pay-
receive spreads.
It is also known as bid-ask
spreads
MEANING
The problem of finding a suitable
counterparty can also be solved
by employing a swap broker.
Brokers match counterparties
without themselves becoming
counterparties to swap.
They do this exchange for
commission
MEANING
Two types of facilitators,
BROKERS: financial institutions
first became involved in the role
of swap brokers to find
counterparties with matched
needs.
Its role is limited to that of
agent.
MEANING
Two types of facilitators,
SWAP DEALERS: he plays a role
similar to that of dealers in other
financial markets.
He helps counterparties to
complete swap transaction
He may serves a broker or
dealer