RU/SAMS/IFM/ANS

Lesson 30: Financial Swaps Learning Objectives:

To briefly touch upon the major types of Swap structures in existence To describe you about the motivation underlying swap To let you know about the evaluation of swap market To help you learn how interest rate swap functions in the Indian market. The geographical and functional integration of global financial markets present borrowers and investors with a wide variety of financing and investment vehicles in terns of currency, type of coupon-fixed or floating-index to which the coupon is tied LIBOR. US treasury bill rate and so on. Financial Swaps are an asset-liability management technique, which permits a borrower to access one market and then exchange the liability for another type of liability. Investors can exchange one type of asset for another with a preferred income stream. We will see below that there are several reasons why firms and financial institutions might wish to effect such an exchange Note that swaps by themselves are not a funding instrument; they are a device to obtain the desired form of financing indirectly which otherwise might be inaccessible or too expensive. The main purpose of this lesson is to provide an introductory exposition of the major prototypes of financial swaps and their applications. There are a large number of variations on, and combinations of the basic structures. We will briet1y examine some of them mainly to illustrate the tremendous flexibility offered by swaps in combination with other instruments for management of assets and liabilities. The growth in the volume and variety of swap transactions has outpaced the growth in the analytical literature dealing with theoretical explanations of swaps, their pricing, and valuation. Even then, the topic is vast enough for specialist works to have made their appearance during the last few years. The focus in the lesson will be on discussing a number of typical situation in which a firm can achieve its funding or investment objectives more effectively through a swap transaction rather than directly. MAJOR TYPES OF SWAP STRUCTURES All swaps involve exchange of a series of periodic payments between two parties, usually through an intermediary, which is normally a large international financial institution, which runs a "swap book". The two payment streams are estimated to have identical presents values at outset when discounted at the respective cost of funds in the relevant primary financial markets. The two major types are interest rate swaps (also known as coupon swaps) and currency swaps. The two are combined to give a cross-currency interest rate swap. A number of variations are possible within each major type. We will examine in some detail the structure of each of these below and indicate some of the variations.

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Interest Rate Swaps A standard fixed-to-floating interest rate swap, known in the market jargon as a plain vanilla coupon swap (also referred to as "exchange of borrowings") is an agreement between two parties, in which each contracts to make payments to the other on particular dates in the future till a specified termination date. One party, known as the fixed ratepayer, makes fixed payments all of which are determined at the outset. The other party known as the floating ratepayer will make payments the size of which depends upon the future evolution of a specified interest rate index (such as the 6-month LIBOR). The key features of this swap are:

The Notional Principal The fixed and floating payments are calculated as if they were interest payments on a specified amount borrowed or lent. It is notional because the parties do not exchange this amount at any time; it is only used to compute the sequence of payments. In a standard swap the notional principal remains constant through the life of the swap. The Fixed Rate The rate applied to the notional principal to calculate the size of the fixed payment. Where the transaction is a straightforward 'plain vanilla' fixed/floating interest rate swap with the principal amount remaining constant throughout the transaction, swap dealers openly display the rates at which they are willing to pay or to receive fixed rate payments. A dealer might quote his rates as: US dollar fixed/floating: 2 yrs Treasury (4.50%) + 45/52 3 yrs Treasury (4.58%) + 48/56 4 yrs Treasury (4.75%) + 52/60 5 yrs Treasury (4.95%) + 55/68 and so on, out to perhaps 10 years. The dealer is in fact saying "I am willing to be the fixed-rate payer in a 2-year swap at 45 basis points above the current yield on Treasury Notes (i.e. 4.95%). I am also willing to be the fixed rate receiver at 52 basis points above the Treasury yield (i.e. 5.02%)." As the floating rate will be LIBOR in both cases, the dealer thus enjoys a profit margin of 7 basis points in the 2-year swap market. The swap rates are close to long-term interest rates charged to top quality borrowers. . Obviously, if the counter party wishes to receive or make fixed payments at a rate other than the rates quoted by the bank, the bank will adjust the floating leg by adding or subtracting a margin over LIBOR. Thus suppose 5-year treasury notes are yielding 8.50%. The bank is willing to pay 8.80% fixed in return for LIB OR; a firm wishes to receive fixed payments at 9.25%. The bank will require floating payments at LIBOR + a margin. This is an example of what are called off market swaps.

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RU/SAMS/IFM/ANS Floating Rate In a standard swap at market rates, the floating rate is one of market indexes such as LIB OR, prime rate, T -bill rate etc. The maturity of the underlying index equals the interval between Payment dates. Trade Date, Effective Date, Reset Dates, and Payment Dates" Fixed rate payments are generally paid semiannually or annually. For instance, they may be paid every March 1 and September 1 from March 1,2001 to September 1,2005, this being the termination date of the swap. The trade date is the date on which the swap deal is concluded and the effective date is the date from which the first fixed and floating payments start to" accrue. For instance a 5-year swap is traded on. August30, 2000 the effective date is September 1, 2000, and ten payment dates from March 1,2001 to' September 1,2005. Floating rate payments in a standard swap are "set in advance paid in arrears", that is; the floating rate applicable to any period is fixed at the start of the period but the payment occurs at the end of the period. Each floating rate payment has three dates associated with it as shown in Figure .1. D (S), the setting date is the date on which the floating rate applicable for the next payment is set. D (1) is the date from which the next floating payment starts to accrue and D (2) is the date on which the payment is due. D (S) is usually two-business day before D (l). D (l) is the day when the previous floating rate payment is made (for the first floating payment, D (1) is the effective date above). If both the fixed and floating payments are semiannual, D (2) will be the payment date for' both the payments and the interval D (1) to D (2) would be six months. It is possible to have the floating payment set and paid in arrears i.e. the rate is set and payment made on D (2). This is another instance of an "off-market" feature.

D (S)

D (1)

D (2)

Fig.1. Relevant dates for the floating payment Fixed and Floating Payments The fixed and floating payments are calculated as follows: Fixed Payment = P x Rfx x Ffx "Floating Payment = P x Rfx x Ffx Here, P is the notional principal, Rfx is the fixed rate, Ffx is the floating rate set on the reset date, Ffx is known as the "Fixed rate day count fraction" and FjI is the "Floating rate day count fraction". The last two are time periods over which the interest is to be calculated. For floating payments it is either [(D2 D1)/360] or [(D2 D1)/365] that is, [Actual no of days/(360 or 365)] depending upon the currency while for the fixed payments it is either one of these or a third convention known as "30/360" basis.5 The "Actual/365" basis is known as "bond basis" and the "Actual/360" basis is called "money market basis" in the US. 178

RU/SAMS/IFM/ANS It is to be noted that in an interest rate swap, there is no exchange of underlying principal; only the streams of interest payments are exchanged between the two parties.

Currency Swaps In a currency swap, the two payment streams being exchanged are denominated in two different currencies. Usually, an exchange of principal amounts at the beginning and a reexchange at termination are also a feature of a currency swap. A typical fixed-to-fixed currency swap works as follows. One party raises a fixed rate liability in currency X say US dollars, while the other raises fixed rate funding in currency Y say EUR. The principal amounts are equivalent at the current market rate of exchange. At the initiation of the swap contract, the principal amounts are exchanged with the first party handing over USD to the second, and getting EUR in return. Subsequently, the first party makes periodic EUR payments to the second, computed as interest at a fixed rate on the EUR principal, while it receives from the second party payments in dollars again computed as interest on the dollar principal. At maturity, the dollar and EUR principals are re-exchanged. A fixed-to-floating currency swap also known as cross-currency coupon swap will have one payment calculated at a floating interest rate while the other is at a fixed interest rate. It is a combination of a fixed-to-fixed currency swap and a fixed-to-floating interest rate swap. It is also possible to have both payments at floating rate but in different currencies. Contracts without the exchange and re-exchange of principals do exist. In most cases, an intermediary-a swap bank-structures the deal and routes the payments from one party to another. For both the interest rate and currency swaps, we have given 'examples of liability swaps, that is, exchanging one kind of liability for another. The same structures can be employed for asset swaps. For instance, a financial institution may have floating dollar assets (say corporate FRNs) funded with fixed rate dollar liabilities. It can contract to exchange the stream of floating payments with a stream of fixed rate payments with another party, which has the opposite problem. An investor with say CHF assets funded with USD denominated liabilities can enter into a currency swap to match the currency denomination of assets and liabilities. EVOLUTION OF SWAP MARKETS Most analysts agree that the origins of the swap markets can be traced back to 1970s, when many countries imposed exchange regulations and restrictions on cross-border capital flows. Borrowers and investors wishing to diversify the currency composition of their assets and liabilities had to find ways of circumventing these controls. Early precursors of swaps are seen in the so-called back-to-back and parallel loans. In a back-to-back loan, firm X, resident in country A, lends to firm Y, resident in country B in the currency of A, in return for Y lending to X in the currency of B. Thus, a UK firm with good access to domestic sterling market may keep a sterling deposit with the London branch of an American bank in return for a dollar loan from the parent bank in US. In a parallel loan, X lends to a subsidiary of Y located in country A while Y simultaneously lends to a subsidiary of X located in country B. The two loan transactions are distinct, each with its own documentation, jurisdiction, and no right of offset, that is, a default on the part of the subsidiary of Y located in country A does not automatically cancel the obligation of the 179

RU/SAMS/IFM/ANS subsidiary of X to the parent Y in country B. As exchange controls were liberalized in the eighties, currency swaps with the same functional structure replaced parallel and back-to-back loans. Swaps were more flexible and required simpler documentation. The entire deal is covered by a single documentation, subject to a single jurisdiction, and has a right of offset built into the contract. Further impetus to the growth of swaps was given by the realisation that swaps enable the participants to lower financing costs by arbitraging a number of capital market imperfections, regulatory and tax differences. The disinter mediation process of eighties, in which more and more borrowers started approaching the investors directly rather than through banks, encouraged merchant and investment bankers to look for other sources of income such as front-end fees for arranging swaps. In the early years, banks only acted as brokers to match the two counter parties with complementary requirements and market access. Thus when a firm wishing to swap out of a floating rate liability approached a bank, the bank located a counter party wishing to swap out of a fixed rate liability, arranged a swap and collected a fee -normally such deals were associated with new borrowings. With the increase in the use of swaps as an active asset liability management tool, banks became market makers, that is, the bank would "take a swap on its own books" by itself becoming a counter party in a swap. As market makers, they provide bid/offer quotes for both interest rate and currency swaps. Subsequently, the bank will lay off its exposure by entering into one or more swaps to achieve an overall balanced book in terms of currency and interest rate basis-floating and, fixed. In the meanwhile, it would hedge its exposure using other instruments such as futures, FRAs, treasury notes, and T-bills. With banks prepared to act as market makers, there was a tremendous increase in the liquidity of the. Swap markets in major convertible currencies. The outstanding volume (i.e. underlying principal amounts) of interest rate and currency swaps is estimated to be in excess often trillion dollars equivalent with about two-thirds of it in plain interest rate swaps. When a bank takes the swap onto its books, it subjects itself to a variety of risks. It assumes the credit risk of the counter party exchange rate risk, interest rate risk, basis risk and so forth. Even with laying off the swaps, it is impractical to attempt to find an exact match in terms of currency maturity payment frequencies, floating index, and so on, for each swap in its portfolio of swaps. Some residual risk always remains and may have to be hedged with other instruments. Also, there is the question of counter party credit risk. Suppose a bank has a coupon swap with counter party A in which it pays fixed and receives floating; it has offset this with another swap with counter party B in which it pays floating and receives fixed. If counter party A defaults, that is, fails to make its floating payments, the agreement allows the bank to stop making the fixed payments to A. However, it must continue to meet its obligations under the swap with party B. Thus now it has a mismatched structure with fixed payments coming in and floating payments going out. It faces the risk of rising interest rates. It might attempt to replace the swap with A, by another swap with some counter party C. But it may have to do so at rates, which result in a net loss. Lately, banks have realised that a large swap portfolio exposes them to risks, which are very complex in nature and difficult to hedge. The topic of managing the risk of a swap portfolio is beyond the scope of this chapter. The reader is referred to specialist works on the subject some of which are cited in the bibliography.

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INTEREST RATE SWAPS IN THE INDIAN MARKET In the RBI Governor's statement on Mid-Term Review of Monetary and Credit Policy for 1998-99 announced on October 30, 1998 it was indicated that RBI would facilitate introduction of interest rate swaps (IRS) as another step towards liberalising and deepening the Indian money markets. Guidelines on FRAs and IRS were issued on July 7, 1999. Banks and financial institutions are permitted to make a market in interest rate swaps without any restrictions on the size of the notional principal and the tenor of the agreement. Corporate are allowed to enter into IRS agreements only to hedge underlying exposures, and market making banks are required to obtain evidence to that effect before making a deal with a corporate client. Banks are allowed to assume uncovered positions. Limits on these positions in different maturity buckets should be evolved by the bank's top management board and vetted by RBI. Banks must observe capital adequacy norms and the procedure for computing minimum capital ratios has been specified in the guidelines. We have described it in the appendix to this chapter. Details pertaining to documentation, accounting treatment and reporting of swaps are also contained in the guidelines which are available on RBI's website. VALUATION OF SWAPS As we saw above, a swap is equivalent to a borrowing plus an investment. The value of a swap therefore is the difference between the present values of all inflows and all outflows. The market valuation of a series of cash flows depends upon the discount rate used. This in turn incorporates risk-free interest rate and a risk premium. Valuation of a swap is necessary for the purpose bf reporting to the shareholders, as well as when the contract is terminated prematurely by negotiation or default. The problem of pricing a swap is closely related to that of valuation. In essence, the pricing problem is to determine what rate should be quoted for on leg of the swap (e.g. the fixed rate in an interest rate swap), for a specified sequence of counter payments (e.g. floating payments at LIBOR), so that the two sequences have equal present values. We will discuss here the problem of valuing default-free, "plain vanilla" swaps. Further, we will assume a flat term structure of interest rates. A par swap is a swap, which values to zero. Consider for instance a fixed-to-floating 5-year interest rate swap. A market maker bank is willing to swap a fixed payment at 8.5% s.a. against 6-month LIBOR, paid every six months. It will quote these rates for a top credit. By definition, the present values of the fixed and floating legs of the swap must be equal (In practice, a market maker would quote a bid and in offer swap rate as we have seen above. The spread is the market maker's compensation). The value of the swap as of today is zero. Consider a currency swap. Again, suppose a market maker is willing to exchange 9% fixed on sterling with 6.5%, fixed on an equivalent DEM principal for five years. This means that the present value of the sterling payments at 9% is equal to the present value of the DEM payments at 6.5% both expressed in a common currency. Like a forward foreign exchange contract at market rates, a swap at market rates has zero value.

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