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UNDERSTANDING
SW
A
PS
SW
A
PS
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MEANINGGENERAL
Give something in exchange for something else.(Oxford Advanced Learners Dictionary)
FINANCEExchange of Risk/Return
(ALAN McDOUGALL, Mastering Swaps Market, Prentice Hall)
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EXAMPLE
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DEFINITION
A derivative in which two parties agree
To exchange one stream of cash flows against another.
To exchange their risk.
R
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TYPES Interest Rate Swap
Bond Swap
Commodity Swap
Credit Default Swap
Non-Deliverable Swap
Total Return Swap
Currency Swap
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C D S
$45 TRILLION
INSURANCE MARKET
TO
GAMBLING MARKET
The buyer of a credit swap receives credit protection, whereas the
seller of the swap guarantees the credit worthiness of the
product. By doing this, the risk of default is transferred from
the holder of the fixed income security to the seller of the swap.
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EXAMPLE
50,00,000
PRABHU CEMENT HOUSE
2,00,000
X
5
=
10,00,000
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PARALLEL SITUATION
BOND
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COMMON IN AIG&
EXAMPLE
50,00,000$400 BILLION
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CDS (USES)
SPECULATION
HEDGING
ARBITRAGE
Risk
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INTEREST RATE
SWAPS(IRS)An agreement between two parties in which theycontracts to make payments of interest amount ontheir outstanding debt to the other in future till aspecified termination date.
Generally involve fixed-to-floating rates of interest
Two Parties:
Also called Plain Vanilla Swaps
Fixed Rate Payer
Floating Rate Payer
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TERMINOLOGY
NOTIONAL PRINCIPAL
BASIS POINTS
SWAP COUPON
FIXED RATE
FLOATING RATE
LIBOR
DATES
TRADE
EFFECTIVE
RESET
PAYMENT
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USES & USERSUSES
To,
Lower Cost ofFunding
Hedge Interest Rate Exposure
Obtain HigherYielding InvestmentAssets Speculate
USERS
Commercial Banks
Investment Banks
Investment Companies
Mortgage Companies
GOVTAgencies etc
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EXAMPLEFixed Rate Bond Floating Rate Bond
Quality Co 9% LIBOR+1/2%
Risky Co 10.5% LIBOR+1%
QUALIT
YCORISKY
CO
INVESTOR
S
INVESTOR
S
Fixed
Paymentsat 9%
Variable
Paymentsat LIBOR+1%
Variable Payments at LIBOR+1/2%
Fixed Payments at 9.5 %
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CONSIDERING NOTIONAL
PRINCIPAL
Year LIBOR Quality Co Payment Risky Co Payment Net Payment
1 8 8.5%*$50m=$4.25 9.5%*$50m= $4.75m Risky pays $0.5m
2 7 7.5%*$50m=$3.75 9.5%*$50m= $4.75m Risky pays $0.5m
35.5 6
%*$50
m=
$3m 9.5%*$
50m
=$4.7
5m Risky pays $
0.5
m
4 9 9.5%*$50m=$4.75m 9.5%*$50m= $4.75m Risky pays $0.5m
5 10 10.5%*$50m=$5.25m 9.5%*$50m= $4.75m Risky pays $0.5m
In the previous example if we consider Notional Principal as
$50m, then
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CURRENCY SWAP (CS)
A swap that involves the exchange ofprincipal and interest in one currency for thesame in another currency.
Like,
Sell
Repurchase
SWAP RATE
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TYPES
FX SWAP
BACK TOBACKLOAN
CROSSCURRENCY
SWAP
CURRENCY SWAPS
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EXAMPLE
A Canadian company wants to borrow 10 million.
The company, however, believes that it can get better
terms if it issues $-denominated bonds in Canada where
it is well known, and then swap the $ for with aGerman company that wants to borrow $ but for the
same reasons finds it easier to borrow in Europe
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SOLUTION
Ca a ia
Com a yCan$ Coupon rincipalp
Ca a ia
I vestors
o
Can$ap
ayments
DMap
ayments
q
Germa
Com a yDM Coupon rincipalp
Germa
I vestots
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EXAMPLE
If the $ depreciates relative to the , denominatedassets and liabilities will be worth more $.
Because the bank has more denominated liabilities
than denominated assets, it will suffer losses.
Assets Amount Liabilities Amount
$-Denominated
-Denominated
$188m
$12
m
$-Denominated
-Denominated
$50m
$30 m
#(7.5 m @ $1.6/)
(18.75 m @ $1.6/)
*Net worth =$120 m
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Now, if the $/ exchange rate increases to $1.7, then the bank
will have a capital loss of $1.05 m, as can be seen:
To reduce its exposure to the $/ exchange rate risk, the bank could swap$18 million of its denominated liabilities for$ denominated liabilities.
This would leave the bank with $12 million in denominated liabilities,which matches its $12 million of denominated assets.
With denominated assets = denominated liabilities, a change in $/exchange rate does not change the banks net worth.
Assets Amount Liabilities Amount
$-Denominated
-Denominated
Total
$88 m
$112.75
$200.75
$-Denominated
-Denominated
Net worth
Total
$50m
$31.8
$118.95
$200.75
#(7.5 m @ $1.7/)
(18.75 m @ $1.7/)
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LIMITATIONS
Exposed to credit risk as either one or both the
parties could default
V
ulnerable to the central governments interventionin the exchange markets.
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CS (USES)
To secure cheaper debt
To hedge against exchange rate
fluctuations
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