ACKNOLEDGEMENT

I take this opportunity with great pleasure to present before you this project on “swaps contract”
Which is a result of co-operation and hard work. I would like to express my deep sense of
gratitude toward all those people without whose guidance and inspiration this project would
never be fulfilled.

I’m grateful to Mumbai University for giving me the opportunity to work on this project. I
would also like to thank our Principal (Smt.) SUDHA VYAS for giving me such a brilliant
opportunity to present a creative outcome in the form of a project.

Any accomplishment requires the efforts of many people and this project is not different. I find
great pleasure in expressing my deepest sense of gratitude towards my project guide ”Mr.
MILIND SARAF”, whose guidance and inspiration right from the conceptualization to the
finishing stages proved to be very essential and valuable in the completion of the project.

I would like to thank the library staff and my classmates for their invaluable suggestions and
guidance for my project work. Last but not the least, I’d like to thank my parents without
whose cooperation and support it would’ve been impossible for me to complete this project.
Sr. no Index Pages

1. Introduction 1

2. Contract 2

3. Derivative 5-14

4. Swap 15-19

5. History 20-24

6. Use of swaps 25-34

7. Interest rate swap 35-48

8. Currency swap 49-55

9. Commodity swap 56-58

10. Credit default swap 59-65

11. Asset swap 66-68

12. Advantages & disadvantages 69-74

13. Conclusion 75

14. Bibliography 76
Introduction.

Many innovative financial products have appeared (and disappeared) during the past
couple of decades. With the benefit of hindsight, it is now clear that one of the most important
and lasting innovations developed in this era is the over-the-counter swap contract. The interest
rate and currency swap markets have become enormous in the sheer number and size of
transactions and participants. Perhaps the most telling statement of impact is that swaps have
attained "commodity status." These days, financial analysts routinely consider the effects of
"swapping" into or out of a particular interest rate or currency exposure. Although our primary
focus is on interest rate and currency swaps, we show that the same contract design can be used
to manage equity and commodity price risks as well. Broken down to its essential nature, a
swap contract is quite straightforward. Two counter- parties agree to a periodic exchange of
cash flows for a set length of time based on a specified amount of principal

In this project we will learn about financial derivative contract, swaps evolution of
swap, types of swaps and many more. This project contain introduction to the major event in
swap market from inception till now.

1
Contract.

A contract is a voluntary arrangement between two or more parties that is enforceable

by law as a binding legal agreement. Contract is a branch of the law of obligations in
jurisdictions of the civil law tradition. Contract law concerns the rights and duties that arise
from agreements. [1]

A contract arises when the parties agree that there is an agreement. Formation of a
contract generally requires an offer, acceptance, consideration, and a mutual intent to be bound.
Each party to a contract must have capacity to enter the agreement. Minors, intoxicated persons,
and those under a mental affliction may have insufficient capacity to enter a contract. Some
types of contracts may require formalities, such as a memorialization in writing.

A NARROW PERCEPTION OF CONTRACT All of the legal systems observed as well as

the legal texts analysis agree upon a narrow definition of contract. The contract is considered,
according to this restrictive approach, as a meeting of wills intended to produce legal effects.
The central element of this approach lies in the will of the party who takes on the obligation
and the respect for the promise made. Under most laws, the meeting of the wills produces real
effects as well as mandatory effects. The mandatory effects can be of varying nature. Some of
these effects are general in the sense that they can be found in nearly every contract, despite
the specific nature of the contract. This category includes behavioral effects (intangibility,
fairness, or irrevocability) which translate into obligations for the parties 5. Other effects are
specific to the characteristics of each contract. This is the case in respect of obligations intended
by the parties and implied obligation. In this narrow legal definition, the core element of the
contract is the meeting of wills of two parties in view of creating legal effects. In this case the
word “contract” can be used without ambiguity. Several indications from different
jurisdictions, including from French law, which is very attached to the protection of the will of
the party taking on an obligation, could justify a positive response. “If the contract is an
exchange which has as its purpose the division of labour and the best use of resources and if
this exchange is planned and regulated by reciprocal promises which take root in the
expectation that they have given rise to, the will to contract is no longer a psychological fact
and the subject is committed because he has led others to trust him.” 2
The objective would
therefore be to respect the expectations of the parties as to the consequences of their
acts.3Theissue is probably more theoretical than practical: it is about knowing if an offeror is
bound even without the acceptance of the offer by its recipient and without such recipient

2
having knowledge of the undertaking. In practice, this analysis will seldom be useful because
it will be possible to identify an implied acceptance by the recipient. Such is the position under
English law.

The question arises, however, as to the difference between a unilateral promise and a unilateral
undertaking? There does not appear to be an abstract and general definition of contract
anywhere else. This can be explained by the origin of the texts in questions. Community and
international legislation have had as their principal objective to encourage commercial
exchanges in specific sectors. As a simple legal tool for regulating the flow of wealth, the
contract is never really defined by these supranational texts .This absence of a definition
contrasts however with the abundance of definitions relating to the subject-matter of the
contract in these texts. The legislation seems to privilege an economic conception of contract
founded on the principle of reciprocity.

A review comparative law leads us to suggest two approaches to the notion of contract.
The first approach merely identifies the common traits of the notion and results in
proposing a narrow definition of contract founded on the existence, the consistency and the
integrity of the intention of the party taking on the obligation (I).
The second approach goes beyond the narrow framework of the intention to take on
an obligation. Instead Centre of gravity moves towards identifying the exchange which leads
to reliance: the binding force is no longer conceived as protecting the will of the parties but as
preserving the legitimate reliance of the parties concerned (II).
Whatever the approach adopted, it is relevant to question the nature of the
effects produced by a contract (III)
A contract is an agreement between two or more persons, and is enforceable by a
court of law or equity. To be enforceable, a contract must contain certain basic information that
courts have determined over the past several centuries to be necessary. The principles of what
must be agreed for a contract to be enforceable date back nearly to the foundations of the
English common law. An oral contract is also enforceable according to law. However, the
difficulty of proving the significant terms of an oral contract renders its enforceability far more
difficult .A contract arises when one person offers to do one or more specified acts on certain
terms (an “offer”) and the offer is accepted. An offer contains a promise (for example, "I will
produce a sculpture” or “I will dance at your theater”) and a request for something in return
(“if you will pay me $X”). The acceptance consists of an assent by the person to whom the

3
offer is made, showing that the person agrees to the terms offered .The offer may be terminated
before it becomes a contract, in a number of ways. For example, the person making the offer
may cancel it before it is accepted (a “revocation”), or the person to whom the offer is made
may reject it. When the person to whom the offer is made responds with a different offer (a
“counteroffer”), the original offer is terminated. Then the counteroffer may be accepted, or not,
by the person who made the original off

4
Derivative.

The past decade has witnessed the multiple growths in the volume of international
trade and business due to the wave of globalization and liberalization all over the world. As a
result, the demand for the international money and financial instruments increased significantly
at the global level. In this respect, changes in the interest rates, exchange rates and stock market
prices at the different financial markets have increased the financial risks to the corporate
world. Adverse changes have even threatened the very survival of the business world. It is,
therefore, to manage such risks; the new financial instruments have been developed in the
financial markets, which are also popularly known as financial derivatives .The basic purpose
of these instruments is to provide commitments to prices for future dates for giving protection
against adverse movements in future prices, in order to reduce the extent of financial risks. Not
only this, they also provide opportunities to earn profit for those persons who are ready to go
for higher risks. In other words, these instruments, indeed, facilitate to transfer the risk from
those who wish to avoid it to those who are willing to accept the same .Today, the financial
derivatives have become increasingly popular and most commonly used in the world of
finance. This has grown with so phenomenal speed all over the world that now it is called as
the derivatives revolution. In an estimate, the present annual trading volume of derivative
markets has crossed US $ 30,000 billion, representing more than 100 times gross domestic
product of India .Financial derivatives like futures, forwards options and swaps are important
tools to manage assets, portfolios and financial risks. Thus, it is essential to know the
terminology and conceptual framework of all these financial derivatives in order to analyze
and manage the financial risks. The prices of these financial derivatives contracts depend upon
the spot prices of the underlying assets, costs of carrying assets into the future and relationship
with spot prices. For example, forward and futures contracts are similar in nature, but their
prices in future may differ. Therefore, before using any financial derivative instruments for
hedging, speculating, or arbitraging purpose, the trader or investor must carefully examine all
the important aspects relating to them

5
What is a 'Derivative'?

A derivative is a security with a price that is dependent upon or derived from one or
more underlying assets. The derivative itself is a contract between two or more parties based
upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The
most common underlying assets include stocks, bonds, commodities, currencies, interest rates
and market indexes.

. For example, you have purchased gold futures on May 2003 for delivery in August
2003. The price of gold on May 2003 in the spot market is `4500 per 10 grams and for futures
delivery in August 2003 is `4800 per 10 grams. Suppose in July 2003 the spot price of the gold
changes and increased to `4800 per 10 grams. In the same line value of financial derivatives or
gold futures will also change.

In general, from the aforementioned, derivatives refer to securities or to contracts that

derive from another—whose value depends on another contract or assets. As such the financial
derivatives are financial instruments whose prices or values are derived from the prices of other
underlying financial instruments or financial assets. Due to this reason, transactions in
derivative markets are used to offset the risk of price changes in the underlying assets. In fact,
the derivatives can be formed on almost any variable, for example, from the price of hogs to
the amount of snow falling at a certain ski resort .The term financial derivative relates with a
variety of financial instruments which include stocks, bonds, treasury bills, interest rate, foreign
currencies and other hybrid securities. Financial derivatives include futures, forwards, options,
swaps, etc. Futures contracts are the most important form of derivatives, which are in existence
long before the term ‘derivative’ was coined. Financial derivatives can also be derived from a
combination of cash market instruments or other financial derivative instruments.

During the nineteenth century, America was at its pinnacle of economic progress.
America was the center of innovation. One such innovation came in the field of exchange
traded derivatives when farmers realized that finding buyers for the commodities had become
a problem. There is evidence that the use of a type of forward contract was prevalent among
merchants in medieval European trade fairs. When trade began to flourish in the 12th century,
merchants created a forward contract called a lettre de faire (letter of the fair).The first record
of organized trading in futures comes from 17th century Japan. Feudal Japanese landlords
would ship surplus rice to storage warehouses in the cities and then issue tickets promising

6
future delivery of the rice. The result, in 1848, was the founding of the Chicago Board of Trade.
Other early exchanges involved in futures trading in the US included the New York
Cotton Exchange, established in 1870, and the New York Coffee Exchange, set up in
18855.In the 1980s, the financial derivatives were also known as off-balance sheet instruments
because no asset or liability underlying the contract was put on the balance sheet as such. Since
the value of such derivatives depend upon the movement of market prices of the underlying
assets, hence, they were treated as contingent asset or liabilities and such transactions and
positions in derivatives were not recorded on the balance sheet. Originally, derivatives were
used to ensure balanced exchange rates for goods traded internationally. With differing values
of different national currencies, international traders needed a system of accounting for these
differences. Today, derivatives are based upon a wide variety of transactions and have many
more uses. There are even derivatives based on weather data, such as the amount of rain or the
number of sunny days in a particular region.

Because a derivative is a category of security rather than a specific kind, there are
several different kinds of derivatives in existence. As such, derivatives have a variety of
functions and applications as well, based on the type of derivative. Certain kinds of derivatives
can be used for hedging, or insuring against risk on an asset. Derivatives can also be used for
speculation in betting on the future price of an asset or in circumventing exchange rate issues.
For example, a European investor purchasing shares of an American company off of an
American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while
holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a
specified exchange rate for the future stock sale and currency conversion back into Euros.
Additionally, many derivatives are characterized by high leverage

. In brief, the term financial market derivative can be defined as a treasury or capital
market instrument which is derived from, or bears a close re1ation to a cash instrument or
another derivative instrument. Hence, financial derivatives are financial instruments whose
prices are derived from the prices of other financial instruments .the key to making a sound
investment is to fully understand the risks associated with the derivative, such as the
counterparty, underlying asset, price and expiration. The use of a derivative only makes sense
if the investor is fully aware of the risks and understands the impact of the investment within a
portfolio strategy.

7
 NORMAL CONTRACT
 NORMAL CONTRACTS are
agreements between two or more
parties to do or abstaining from
doing something for reasonable
consideration
 NORMAL CONRACT dealt in real
time
 NORMAL CONTRACT are simple
financial instruments
 Normal contract basic type of
contract.
 Normal contract can be roots to the
risk.
DERIVATIVE CONTRACT
 DERIVATIVE CONTACTS are
contract between two or more
parties whose value is based on
and derived from an agreed
underlying financial asset ,index
or security
 DERIVATVE CONTRACT are
created for deferred dealing.
 Derivative contract are
complicated financial
instruments
 Derivative contract is tool to the
Contract.
 Derivative contract are used as
measure to lower risk
8
Type of DERIVATIVE CONTRACT.

Futures contract.
Futures are a popular day trading market. Futures contracts are how many different
commodities, currencies and indexes are traded, offering traders a wide array of products to
trade. Futures don't have day trading restrictions like the stock market--another popular day
trading market. Traders can buy, sell or short sell a futures contract anytime the market is open
.In finance, a futures contract (more colloquially, futures) is a standardized forward contract,
a legal agreement to buy or sell something at a predetermined price at a specified time in the
future. The asset transacted is usually a commodity or financial instrument and the transaction
is usually done on the trading floor of a futures exchange. The predetermined price the parties
agree to buy and sell the asset for is known as the forward price. The specified time in the
future -- which is when delivery and payment occur -- is known as the delivery date. Because
it is a function of an underlying asset, a futures contract is a derivative product.

Contracts are negotiated at futures exchanges, which act as a marketplace between

buyers and sellers. The buyer of a contract is said to be long position holder, and the selling
party is said to be short position holder. As both parties risk their counter-party walking away
if the price goes against them, the contract may involve both parties lodging a margin of the
value of the contract with a mutually trusted third party. For example, in gold futures trading,
the margin varies between 2% and 20% depending on the volatility of the spot market.

The first futures contracts were negotiated for agricultural commodities, and later
futures contracts were negotiated for natural resources such as oil. Financial futures were
introduced in 1972, and in recent decades, currency futures, interest rate futures and stock
market index futures have played an increasingly large role in the overall futures markets.

The original use of futures contracts was to mitigate the risk of price or exchange rate
movements by allowing parties to fix prices or rates in advance for future transactions. This
could be advantageous when (for example) a party expects to receive payment in foreign
currency in the future, and wishes to guard against an unfavorable movement of the currency
in the interval before payment is received. Futures contracts are traded by both day traders and
longer-term traders, as well as by non-traders with an interest in the underlying commodity.

9
For example, a grain farmer might sell a futures contract to guarantee that he receives a certain
price for his grain, or a livestock farmer might buy a futures contract to guarantee that she can
buy her winter feed supply at a certain price. Either way, both the buyer and the seller of a
futures contract are obligated to fulfill the contract requirements at the end of the contract term.
Day traders are not so concerned about these obligations because they do not hold the futures
contract position until it expires. All they have to do to realize a profit or loss on their position
is make an offsetting trade. For example, if they buy 5 futures contracts, they need to sell those
5 futures contracts before expiry.

Day traders don't trade futures contracts with the intent of actually taking possession
of (if buying) or distributing (if selling) the physical barrels of oil. Rather, day traders make
money on the price fluctuations that occur after taking a trade. For example, if a day trader
buys a natural gas futures contract (NG) at 2.065, and sells it later in the day for 2.105, they
made a profit. The price of a futures contract is constantly moving as new buy and sell
transactions occur.

Futures traders are traditionally placed in one of two groups: hedgers, who have an
interest in the underlying asset (which could include an intangible such as an index or interest
rate) and are seeking to hedge out the risk of price changes; and speculators, who seek to make
a profit by predicting market moves and opening a derivative contract related to the asset "on
paper", while they have no practical use for or intent to actually take or make delivery of the
underlying asset. In other words, the investor is seeking exposure to the asset in a long futures
or the opposite effect via a short futures contract.

Futures contracts are traded on a futures exchange, like the Chicago Mercantile
Exchange (CME) or Intercontinental Exchange (ICE).To trade a futures contracts require the
use of a broker. The broker will charge a fee for the trade, called a commission. Day traders
want a broker that provides them with low commissions, since they may only be trying to make
a several ticks on each trade. Futures are a popular day trading market because traders can
access indexes, commodities and/or currencies. Futures move in ticks, with an associated tick
value. This tells you how much you stand to make or lose for each increment the price moves.
Futures traders pay a commission on each trade they make. Each contract requires a certain
amount of margin, which affects the minimum balance required to trade. Brokers may set their
own margin requirements or trading account minimums

10
Forward contract.

In finance, a forward contract or simply a forward is a non-standardized contract

between two parties to buy or to sell an asset at a specified future time at a price agreed upon
today, making it a type of derivative instrument. [1][2] The party agreeing to buy the underlying
asset in the future assumes a long position, and the party agreeing to sell the asset in the future
assumes a short position. The price agreed upon is called the delivery price, which is equal to
the forward price at the time the contract is entered into.

The price of the underlying instrument, in whatever form, is paid before control of the
instrument changes. This is one of the many forms of buy/sell orders where the time and date
of trade is not the same as the value date where the securities themselves are exchanged.
Forwards, like other derivative securities, can be used to hedge risk (typically currency or
exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality
of the underlying instrument which is time-sensitive.

A closely related contract is a futures contract; they differ in certain respects. Forward
contracts are very similar to futures contracts, except they are not exchange-traded, or defined
on standardized assets. Forwards also typically have no interim partial settlements or "true-
ups" in margin requirements like futures – such that the parties do not exchange additional
property securing the party at gain and the entire unrealized gain or loss builds up while the
contract is open. However, being traded over the counter (OTC), forward contracts
specification can be customized and may include mark-to-market and daily margin calls.
Hence, a forward contract arrangement might call for the loss party to pledge collateral or
additional collateral to better secure the party at gain. In other words, the terms of the forward
contract will determine the collateral calls based upon certain "trigger" events relevant to a
particular counterparty such as among other things, credit ratings, value of assets under
management or redemptions over a specific time frame, e.g., quarterly, annually, etc.

Forward contracts offer users the ability to lock in a purchase or sale price without
incurring any direct cost. This feature makes it attractive to many corporate treasurers, who can
use forward contracts to lock in a profit margin, lock in an interest rate, assist in cash planning,

11
or ensure supply of a scarce resources. Speculators also use forward contracts to make bets on
price movements of the underlying asset derivative.

Many corporations and banks will use forward contracts to hedge price risk by
eliminating uncertainty about prices. For instance, coffee growers may enter into a forward
contract with Starbucks (SBUX) to lock in their sale price of coffee, reducing uncertainty about
how much they will be able to make. Starbucks benefits from contract because it is able to lock
in their cost of purchasing coffee. Knowing what price it will have to pay for its supply of
coffee ahead of time helps Starbucks avoid price fluctuations and assists in planning.

12
What is an 'Options Contract'?

An option contract, or simply option, is defined as "a promise which meets the
requirements for the formation of a contract and limits the promisor's power to revoke an offer."

An option contract is a type of contract that protects an offeree from an offeror's ability
to revoke their offer to engage in a contract.

Consideration for the option contract is still required as it is still a form of contract,
cf. Restatement (Second) of Contracts § 87(1). Typically, an offeree can provide consideration
for the option contract by paying money for the contract or by providing value in some other
form such as by rendering other performance or forbearance.

An options contract is an agreement between two parties to facilitate a potential

transaction on the underlying security at a preset price, referred to as the strike price, prior to
the expiration date. The two types of contracts are put and call options, which can be purchased
to speculate on the direction of stocks or stock indices, or sold to generate income.

Options contracts are an important tool which give traders the opportunity to hedge
their stock positions. Options allow for a leveraged position on a stock, while mitigating the
risk of the full purchase. Similarly, in real estate, an options contract may permit a buyer to
secure options contracts on multiple parcels before having to execute the purchase on any single
one, ensuring that the buyer will be able to assemble them all before moving ahead.

Call Option Contracts.

The terms of an option contract specify the underlying security, the price at which the
underlying security can be transacted, referred to as the strike price and the expiration date of
the contract. A standard contract covers 100 shares, but the share amount may be adjusted for
stock splits, special dividends or mergers.

In a call option transaction, a position is opened when a contract or contracts are

purchased from the seller, also referred to as a writer. In the transaction, the seller is paid a
premium to assume the obligation of selling shares at the strike price. If the seller holds the
shares to be sold, the position is referred to as a covered call.

13
 For example, with shares trading at $60, a call writer might sell calls at $65 with a
one-month expiration. If the share price stays below $65 and the options expire, the call writer
keeps the shares and can collect another premium by writing calls again. If the share price
appreciates to a price above $65, referred to as being in-the-money, the buyer calls the shares
from the seller, purchasing them at $65. The call-buyer can also sell the options if purchasing
the shares is not the desired outcome.

Put Options.

Buyers of put options are speculating on price declines of the underlying stock or
index and own the right to sell shares at the strike price of the contract. If the share price drops
below the strike price prior to expiration, the buyer can either assign shares to the seller for
purchase at the strike price or sell the contract if shares are not held in the portfolio.

THE swap market is the largest fixed income market in the world being
approximately six times the size of the bond market. In an era of diminishing liquidity in
government bond markets, and the advent of the euro, the swap market has become the
primary means of price discovery in the euro denominated fixed income market. The factors
which contributed to this included the size and homogeneity of the swap market, compared to
combined government bond markets, and the decline in government bond issuance, together
with growing non-government and corporate bond issuance .the turnover of the swap market,
on the other hand consistentlytrends upwards.

14
Swap

15
Swap‘s.

A swap is a derivative contract through which two parties exchange financial

instruments. These instruments can be almost anything, but most swaps involve cash flows
based on a notional principal amount that both parties agree to. Usually, the principal does not
change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed,
while the other is variable that is, based on a benchmark interest rate, floating currency
exchange rate or index price.

The most common kind of swap is an interest rate swap. Swaps do not trade on
exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-
counter contracts between businesses or financial institutions.

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. The benefits in question
depend on the type of financial instruments involved. For example, in the case of a swap
involving two bonds, the benefits in question can be the periodic interest (coupon) payments
associated with such bonds. Specifically, two counterparties agree to exchange one stream of
cash flows against another stream. These streams are called the legs of the swap. The swap
agreement defines the dates when the cash flows are to be paid and the way they are accrued
and calculated .Usually at the time when the contract is initiated, at least one of these series of
cash flows is determined by an uncertain variable such as a floating interest rate, foreign
exchange rate, equity price, or commodity price.

The cash flows are calculated over a notional principal amount. Contrary to a future,
a forward or an option, the notional amount is usually not exchanged between counterparties.
Consequently, swaps can be in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on
changes in the expected direction of underlying prices .Swaps are non-standardized contracts
that are traded over the counter (OTC). However, to facilitate trading, market participants have
developed the ISDA Master Agreement, which covers the 'non-economic' terms of a swap
contract, such as representations and warranties, events of default and termination events.
Parties to the trade still need to negotiate the rate or price, notional amount, maturity, collateral,
etc.

16
 Swaps are contracts that exchange assets, liabilities, currencies, securities, equity
participations and commodities. Some are simple, such as floating-for-fixed-rate loans or
Japanese yen for British pound sterling, while others are quite complex incorporating multiple
currencies, interest rates, commodities and options. Both types are flexible in terms of
specifications such as pricing or evaluation benchmarks, timing or contractual horizons,
settlement procedures, resets, and other variables.

Generally, swaps are used for risk management by institutions such as banks, brokers,
dealers and corporations. Some qualified individuals may also be suitable users of these basic
derivatives products. The following lists highlight common swaps transactions.

 Commodities: agricultural, energy, metals

 Currencies: amortization or amortizing, differential, forward rates, forward start
 Equities: basket, differential or spread, indexed, individual security related
 Interest Rates: amortization or amortizing, arrears, basis, fixed for floating,
Forward start, inverse floater, zero coupon

Swaps and the swap market for the most part are a mystery to everyday individual
investors and casual followers of the financial markets. However, one might be surprised to
learn about the sheer size of the swap market and the importance it plays in the global financial
marketplace. In this article we will take a closer look at swaps and the swap market as a whole
in the hopes demystifying what might be considered a confusing subject for many who don't
deal with swaps on a regular basis.

Swaps have been growing at an increasing rate. The market is designing creative and
complex structures to provide tailor-made solutions. The regulators are unable to design
systems to effectively assess risks involved in these transactions. Today the term “swap
financing” is used to describe a funding and a currency exposure management technique. It
enables corporations, agencies and institutions to cope with the problems of fluctuating rates,
imperfect capital markets, restrictive exchange control regulations and accounting standards.
Swaps are derivatives, which involve a private agreement between two parties to exchange cash
flows in the future according to a prearranged formula. The underlying instruments are
liabilities or assets with interest expenses or incomes. Swap is essentially a derivative used for
hedging and risk management.

17
 The two primary reasons for a counterparty to use a currency swap are to obtain debt
financing in the swapped currency at an interest cost reduction brought about through
comparative advantages each counterparty has in its national capital market, and/or the benefit
of hedging long-run exchange rate exposure. These reasons seem straightforward and difficult
to argue with, especially to the extent that name recognition is truly important in raising funds
in the international bond market. The two primary reasons for swapping interest rates are to
better match maturities of assets and liabilities and /or to obtain a cost savings via the quality
spread differential (QSD). In an efficient market without barriers to capital flows, the cost-
savings argument through a QSD is difficult to accept. It implies that an arbitrage opportunity
exists because of some mispricing of the default risk premiums on different types of debt
instruments. If the QSD is one of the primary reasons for the existence of interest rate swaps,
one would expect arbitrage to eliminate it over time and that the growth of the swap market
would decrease. Thus, the arbitrage argument does not seem to have much merit. Consequently,
one must rely on an argument of market completeness for the existence and growth of interest
rate swaps. That is, all types of debt instruments are not regularly available for all borrowers.
Thus, the interest rate swap market assists in tailoring financing to the type desired by a
particular borrower. Both counterparties can benefit (as well as the swap dealer) through
financing that is more suitable for their asset maturity structures .credit default swap
(CDS)market is a large and fast-growing market that allows investors to trade credit risk.
Multiple derivatives on CDS currently trade over the counter including CDO-like tranches and
options. The rise of standardized, liquid, and high-volume CDS indexes has created the
possibility of exchange-traded CDS index options. Exchange-traded options would increase
liquidity in the CDS option market and allow retail and smaller investors to trade credit risk
much more easily than with current products. The primary users of the exchange-traded options
will be speculators as existing products, such as individual CDS or the CDS indexes, are cost-
effective hedges for most players.

However, the growth in the absolute size of the market for swaps tends to mask the
more subtle changes in the nature of the market. The primary objective of this paper is to
examine the changing nature of this market and to provide an analysis of the reasons underlying
the changes.

As the International Finance in Practice box suggests, the market for currency
swaps developed first. Today, however, the interest rate swap market is larger. Size is measured
by notional principal, a reference amount of principal for determining interest payments. The

18
exhibit indicates that both markets have grown significantly since 2000, but that the growth in
interest rate swap has been by far more dramatic. The total amount of interest rate swaps
outstanding increased from $48,768 billion at year-end 2000 to $349.2 trillion by year-end
2009, an increase of 616 percent. Total outstanding currency swaps increased 417 percent, from
$3,194 billion at year-end 2000 to over $16.5 trillion by year-end 2009

As the market for swaps matured and the classic credit arbitrage diminished to
the point where a simple euro dollar bond issue combined with an interest rate swap could no
longer be relied upon to routinely produce sub-LIBOR funding, there were many who predicted
the demise of swaps. However, swap transactions, unlike many other recent financial
innovations such as original issue discount bonds, debt-equity swaps and debt defeasance
which relied on special accounting or tax treatments for their economic benefit and were
therefore susceptible to changes in the relevant regulations, have continued to grow and
prosper. The general flexibility of the swap concept and its adaptability to various market
situations has almost certainly guaranteed swaps a permanent place in corporate finance. The
market seems likely to develop further in the two directions already identified.

19
HISTORY

The first swap that gained notoriety in the financial marketplace was the now famous
cross currency swap between The World Bank and IBM (Ludwig 13), however some believe
that cross currency swaps were taking place as early as 1979 (Marshall 5). The first interest
rate swaps followed the first currency swaps and are believed to have taken place in late 1981
in London (Marshall 6). The conditions that led to cross currency swaps first taking place are
fascinating. In Great Britain, during the 1970’s, the British government sought to encourage
domestic investment by taxing foreign-exchange transactions on its own currency (Marshall
6). This control made it difficult for British multinational companies to transact in the foreign
exchange market. As a result, British companies often engaged in what was known as back-
to-back loans. Exhibit illustrates the back-to-back loan procedure. A back-to-back loan
involves two companies located in separate countries. Each company will borrow money in
their domestic financial market place and then lend this borrowed money to the other firm. By
this simple exchange, each company can access the capital markets in the other country without
involving foreign exchange transactions (Marshall 6-8).The currency swap is merely a simple
extension of the back-to-back loan concept. The back-to-back loan suffered two problems that
caused currency swaps to be introduced. Firstly, such back-to-back loans required one
counterparty to find another counterparty with mirror image needs – often an exhaustive task
for a corporation. Secondly, as these back-to-back loans were two different loans, they were
evidenced by two loan agreements, completely separate from one another (Marshall 5). These
are the very two problems discussed earlier to which currency swaps provided the solution.
The currency swap would operate in a manner such that two counter parties would be brought
together by a central matchmaker, or swap dealer (often an investment house)thus eliminating
the exhaustive search costs to the corporation of finding another counter party. Secondly, the
transaction would now be witnessed by one document that would spell out the circumstances
and provisions under the possibility of default by one counterparty (Marshall 5).The World
Bank and IBM currency swap in 1981 showcased the benefits of currency swaps in the financial
markets. The World Bank desired to borrow Swiss francs, but the size of its borrowing could
not be absorbed by the small Swiss francs debt capital markets. The World Bank, however,
could borrow cheaply in dollars. By completing a currency swap with IBM, brokered by
Solomon Brothers, the World Bank was able to obtain the Swiss franc financing it needed
without actually borrowing in the Swiss franc markets (Ludwig 13-14). Thus, although swaps
originated as a response to circumvent foreign exchange controls in Great Britain, it was their

20
cost-reducing and risk-transferring measures that led to their popularity and widespread
usefulness (Marshall 6). Indeed, with the exchange rate volatility of the late 1970’s and
early1980’s after the collapse of the Bretton Woods agreement, swaps were clearly excellent
structures through which foreign exchange risks could be controlled (Marshall 5). Additionally,
interest rate differentials around the world, particularly as Ludwig notes, the “much higher
yields in New Zealand and Australia” helped boost the currency swap market (Ludwig 14).As
interest rate swaps are merely cross currency swaps with both legs of the swap denominated in
a single currency, it was not long before financial market participants realized that they could
convert fixed rate to floating rate borrowing via an interest rate swap. Such a realization came
at a time when the U.S. markets were undergoing a period of extremely high interest rates.
Banks did not want to lend at such high fixed rates for long periods of time and investors did
not want to miss out on even higher rates that they felt were soon to come. Thus, the interest
rate swap market provided a way for banks and investors to manage their interest rate risk. The
first major interest rate swap is often considered to be Sallie Mae’s fixed for floating
transaction in 1982 (Marshall 6).It is interesting to note that the innovation of swaps was
entirely solution driven – that is ,they were brought about to codify and simplify the tedious
back-to-back loans that were painstakingly being employed by corporations. Once these first
swaps were conducted, their ability to transfer risk was recognized and thus growth exploded.
Having an investment house, known as a swaps dealer, match up counterparties essentially
made each swaps desk its own miniature swaps exchange. It is interesting to contrast the
introduction of swaps to the introduction of index futures, another financial derivative
introduced in the United States in the early 1980’s. Whereas index futures were subject to
extreme regulation by the government (Schiffrin,) swaps were completely unregulated. This
lack of regulation in the swaps market is primarily the result of the way swaps were initially
conducted – in an over the counter market wherein the investment houses and the counterparties
themselves were the only ones who knew a swap had even been conducted. The lack of
regulation in the swaps market continues today and for nearly their entire history swaps have
been considered to be “off-balance sheet transactions” (Marshall 20, Ludwig 30). Though
swaps have not been regulated by governmental entities, standardization of swaps did begin to
take place in the mid -1980’s.

The International Swap Dealers Association (now known as the International Swaps
and Derivatives Association or ISDA) established a set of standard terms for interest rate swaps
that made negotiating a swap much easier (Arditti 256). Additionally the Basle Accord in 1992

21
followed up on the 1988 Basle agreement that focused on monitoring credit/default risk in
financial markets (Coopers 139, Marshall 21). This standardization helped fuel the swaps
markets by setting up protocol for the way in which swaps would be transacted .As noted,
swaps transactions were completely matched (each trade had two counter parties that were
mirror images of each other) by swaps dealers for most of the 1980s. In an interest rate swap,
the dealer would merely extract a bid-ask spread by receiving fixed interest rate payments at a
higher interest than it was paying fixed interest rate payments while paying and receiving the
same floating rate (Arditti 248). Such a transaction is outlined in Exhibit 5. The dealer merely
stands in the middle of the trade, effectively collecting a fee in return for matching the two
counterparties. The only risk to the swaps dealer was that one of the two counterparties would
default, but with the standardization of swaps agreement via ISDA, such provisions were often
accounted for (Ludwig 26-27).The swaps market grew exponentially during the 1980’s.

As Exhibit 6 shows with partial data from the1980’s, the swaps market had grown
from practically nothing to a trillion dollar market. Noting that the 1980’s were a time
extremely volatile interest rates in the United States, absolute interest rate differentials around
the world were large and foreign exchange rates were fluctuating greatly made swaps a risk
management vehicle of choice(Coopers IX). The popularity of swaps continued in the 1990’s
and further innovation and sophistication was introduced. Indeed, today’s swaps market is
vastly more complicated than that in the 1980s. Looking at the structure and mechanics of
today’s swaps markets will provide illustrate how derivatives markets have evolved and how
they are now essential in current financial markets .The Current Swaps Market the swaps
market has continued its amazing growth during the 1990’s. The main reason for this growth
is due to the way investment banks have handled their swaps books. As noted, throughout most
of the 1980’s investment banks ran completely matched books, actively seeking out
counterparties to take on the opposite side of a trade and effectively serving merely as a
middleman. However as the market for swaps became more widespread, swap dealers began
“warehousing swaps” (Marshall 13, Hull 128). In warehousing swaps, dealers would conduct
the swap directly with the counterparty without finding another counterparty to immediately
take the opposite side of the trade. The swaps dealer could hedge out the risk of the swap in the
financial marketplace. The treasury market was the initial vehicle of choice to make these
hedges as it is extremely liquid (Marshall 15). For instance, if a company wants to receive fixed
and pay floating in a swap for 5 years, the swaps dealer can hedge out this risk in the financial
markets ;this is illustrated in Exhibit 7 (which is adapted from Marshall 52-54). The dealer will

22
go long a 5year Treasury bond to hedge its risk that fixed rates fall and will short a three month
treasury bill and roll over this short position every three months to hedge the risk that short
term floating rates fall (Marshall 52-54). Eventually, the dealer will take off this hedge when a
counterparty is available to take the other side of the trade (Ludwig 48-49). In the meantime
however, the lack of a matching counterparty does not preclude Party A from swapping with
the swaps dealer. It should be noted that the hedge illustrated in Exhibit 7 is not perfect. The
dealer is receiving10 floating rate payments of 3 month Libor and is effectively paying short
floating Treasury rates .The risk to the dealer is that the correlation between 3 month Libor and
the treasury bills (this risk is often known as basis risk) is not perfect. The dealer is exposed if
3 month Libor falls more than the 3 month Treasury bill. Now if a dealer wishes to take a
position on the future of rates, it could leave its swaps book to benefit from a rise or fall in
rates, depending on its particular view .Swap dealers, by warehousing swaps, were effectively
making markets in swaps and as swaps served a great deal of purposes for a variety of end-
users, the market grew quickly .Exploring some of the basic uses of swaps will enable a more
detailed analysis of the current swaps market.

The history of swaps wrote another chapter during the 2008 financial crisis when
credit default swaps on mortgage backed securities (MBS) were cited as one of the contributing
factors to the massive economic downturn. Credit default swaps were supposed to provide
protection for the non-payment of mortgages, but when the market started to crumble, parties
to those agreements defaulted and were unable to make payments. This has led to substantial
financial reforms of how swaps are traded and how information on swap trading is
disseminated. Swaps were historically traded over the counter, but they are now moving to
trading on centralized exchanges.
Thus, it is readily apparent that swaps play an integral role in many fixed income
markets. This is a result of the importance of benchmarking in financial markets. As noted with
respect to the S&P 500 index futures contract the importance of finding a benchmark in
financial markets cannot be understated. With its variety of uses and applications throughout
the fixed income world, making a case for swaps as a new benchmark fixed income instrument
would certainly be viable, if the treasury debt continues to be reduced as expected and a new
benchmark is necessary

Secondary Market in Swaps a useful distinction can be made between primary

and secondary market transactions. A primary market transaction usually refers to a transaction

23
between two counterparties, in contrast, a secondary market transaction refers to subsequent
transactions involving the original contract between the counterparties.

This secondary market in swaps has emerged for two reasons; firstly, the emergence
of market makers who must eventually move to "square" their temporary risk position
(protected by hedges) created by entering into one side of the swap by entering into an equal
and opposite swap which provides the only "perfect" hedge; and secondly, the move by
borrowers to actively manage their asset or liability portfolios by entering into swaps then
subsequently unwinding their initial position.

Both types of transactions envisaged can be accomplished by one of two methods.

Under the first, the Page 15 reversal is accomplished by entering into a" mirror" or identical but
reverse position but at current market rates, while under the second, the reversal is done by
effectively selling, at the prevailing market rate, to another participant the swap obligation
entered into by the party now wishing to reverse its initial position.

It is in this area of terminating existing swaps that significant differences and opinions
exist. Some participants want swaps to become freely transferable, so that a transaction can be
terminated by a simple assignment to another company without the original party having to
take a position as principal, except for a short period. The alternative is to transact reverse
swaps whereby the intermediary enters into a new transaction each time a transaction is
matched, creating an ever increasing number of "open" transactions on the intermediary's
books.

However, several difficulties exist, in practical terms, to a fully transferable secondary

market in swaps. The lack of standard documentation, pricing indexes or bench marks, sizes
and maturities as well as the absence of standardized measures of counterparty risks in swap
transactions are clear obstacles to increasing the depth and liquidity of the secondary market.
The major participants in swap markets set up the International Swap Dealers Association
("ISDA") to seek solutions to these difficulties.

The ISDA has recently published the Code of Standard Wording, Assumptions and
Provisions for Swaps 1985 Edition ("the Code"). The Code seeks to establish a uniform
vocabulary for US dollar rate swap. By standardizing the principal terms of interest rate swaps,
the Code should facilitate swap transactions and lead to a more efficient market. The ISDA
hopes that future versions of the Code will include additional provisions for matters that are
relevant to cross-border interest rate swaps and currency swaps.

24
Uses of swap.

As we have noted, the origin of swaps lies in the splitting of comparative advantage.
This provides a profit-motive for encouraging the swap parties to enter the swap contract.
However, there must be a fundamental need for fixed-or floating-rate debt on the part of the
firms entering the swap.

Floting rate
Company A Company B

Fixed rate

For example, company A in Figure may believe that interest rates have peaked and
are about to fall. Accordingly, it may think it is best to have floating-rate debt to take advantage
of falling rates. With a swap, it can do this “artificially”, continuing to service its fixed-rate
obligations in the physical market, but using a swap to provide the mechanism for floating-rate
borrowings. What about company B Clearly, its needs must be different. It may desire fixed-
rate debt in order to lock-in its interest costs—that is, to reduce funding-cost uncertainty. Or, it
might be hedging an asset or portfolio that has a fixed-rate earning stream, and thus it may
want fixed-rate debt to avoid mismatches that could occur should the cost of floating funds rise
relative to the fixed rate earned on assets .In the case of company B, it is clear that the swap
user has a hedging motive. However, company A is taking a speculative position, using the
swap in the expectation that it will reduce future funding costs should interest rates fall.
However, if rates rise, hindsight will prove the swap was inappropriate, leaving the firm to
carry the burden of paying floating rates via the swap or to seek to unwind the swap in ways
mentioned above. The problem is that, in circumstances of rising rates, the firm would most
likely find itself exposed to a loss on the swap.16

Traders and speculators can use swaps to seek profit opportunities, substituting swaps
for actions that would otherwise be carried out in the physical markets. For example, if a bond
trader expects long- term rates to fall, it might build up a portfolio of long-term bonds whose
price will rise in the event of a rate decrease (remember from Chapter 4 that security prices rise
in response to rate falls). Alternatively, the trader could use a swap to pay floating and receive

25
fixed, thus creating a fixed-interest stream allied to that of bond coupons (in other words,
creating effectively a long-term financial security). If rates were to fall subsequently, there
would be a profit on selling the swap in the secondary market.

In the Indian market Banks are allowed to run a book on swaps which have an Indian
Rupee leg. Banks can offer swaps, which do not have an Indian Rupee leg, to their customers
but have to cover these with an overseas bank on a back-to-back basis.

Corporations can apply swaps to a number of different things of value, usually

currency or specific types of cash flows. Simply speaking, they allow corporations to benefit
from transactions that otherwise would not be possible to them in a timely or cost-effective
manner. Of the four most common derivatives, the swap is easily the most confusing. Why?
Because each swap involves two agreements rather than just one. Swaps occur when
corporations agree to exchange something of value with the expectation of exchanging back at
some future date. Following are uses of swap

Risk management and swap derivatives.

Swaps are used to manage risk in a couple ways. First, you can use swaps to ensure
favorable cash flows, either through timing (as with the coupons on bonds) or through the types
of assets being exchanged (as with foreign exchange swaps that ensure a corporation has the
right type of currency). The exact nature of the risk being managed depends on the type of
swap being used.

The easiest way to see how companies can use swaps to manage risks is to follow a
simple example using interest-rate swaps, the most common form of swaps.

1. Company A owns ₹ 1,000,000 in fixed rate bonds earning 5 percent annually, which is
₹ 50,000 in cash flows each year.
2. Company A thinks interest rates will rise to 10 percent, which will yield ₹100,000 in
annual cash flows (₹50,000 more per year than their current bond holdings), but
exchanging all ₹1,000,000 for bonds that will yield the higher rate would be too costly.
3. Company A goes to a swap broker and exchanges not the bonds themselves but the
company’s right to the future cash flows.

26
4. Company A agrees to give the swap broker the ₹50,000 in fixed rate annual cash flows,
and in return, the swap broker gives the company the cash flows from variable rate bonds
worth ₹1,000,000.
5. Company A and the swap broker continue to exchange these cash flows over the life of the
swap, which ends on a date determined at the time the contract is signed.

In this example, swaps help Company A manage its risk by making available to
Company A the possibility of altering its investment portfolio without the costly, difficult, and
sometimes impossible process of actually rearranging asset ownership.

As a result, Company A makes an additional $50,000 per year in bond returns. Of

course, like with many investments, the company could also lose money if interest rates were
to decrease rather than increase as Company A projected.

Each side typically benefits from swaps, and it’s the job of the swap broker to help
different corporations that would benefit from swapping together to find each other. The swap
broker earns money by charging a fee.

Revenue generation and swap derivatives.

When pursuing opportunities to generate revenue through swaps, the process is no

different, but the motivation behind the swap is to take advantage of differentials in the spot
and anticipated future values related to the swap. To see how revenue generation works with
swaps, consider the following example, which involves foreign exchange swaps, a simpler but
less common form of swap

1. Company A has USD 1,000 and believes that the Chinese Yuan (CNY) is set to increase in
value compared to the USD.
2. Company A gets in touch with Company B in China, which just happens to need USD for
a short time to fund a capital investment in computers coming from the U.S.
3. The two companies agree to swap currency at the current market exchange rate, which for
this example, is USD 1 = CNY 1.

They swap USD 1,000 for CNY 1,000. The swap agreement states that they’ll
exchange currencies back in one year at the forward rate (also USD 1 = CNY 1; it’s a very
stable market in Example-World).

27
 In the example, Company B needs the currency but doesn’t want to pay the transaction
fees, while Company A is speculating on the change in exchange rate. If the CNY were to
increase by 1 percent compared to the USD, then Company A would make a profit on the swap.

If the CNY were to decrease in value by 1 percent, then Company A would lose money
on the swap. This potential for loss is why using derivatives to generate income is called
speculating. (Did you know the term speculate means “to come by way of very loose
interpretation” or “to guess”?)

An interest rate swap involves the exchange of cash flows between two parties based
on interest payments for a particular principal amount. However, in an interest rate swap, the
principal amount is not actually exchanged. In an interest rate swap, the principal amount is
the same for both sides of the currency and a fixed payment is frequently exchanged for a
floating payment that is linked to an interest rate, which is usually LIBOR.

A currency swap involves the exchange of both the principal and the interest rate in
one currency for the same in another currency. The exchange of principal is done at market
rates and is usually the same for both the inception and maturity of the contract.

In general, both interest rate and currency swaps have the same benefits for a
company. Essentially, these derivatives help to limit or manage exposure to fluctuations in
interest rates or to acquire a lower interest rate than a company would otherwise be able to
obtain. Swaps are often used because a domestic firm can usually receive better rates than a
foreign firm. For example, suppose company A is located in the U.S. and company B is located
in England. Company A needs to take out a loan denominated in British pounds and company
B needs to take out a loan denominated in U.S. dollars. These two companies can engage in a
swap in order to take advantage of the fact that each company has better rates in its respective
country. These two companies could receive interest rate savings by combining the privileged
access they have in their own markets.

Swaps also help companies hedge against interest rate exposure by reducing the
uncertainty of future cash flows. Swapping allows companies to revise their debt conditions to
take advantage of current or expected future market conditions. As a result of these advantages,
currency and interest rate swaps are used as financial tools to lower the amount needed to
service a debt.

28
Participants of SWAP market.

Hedger

A hedge is an investment position intended to offset potential losses or gains that may
be incurred by a companion investment. In simple language, a hedge is used to reduce any
substantial losses or gains suffered by an individual or an organization.

A hedge can be constructed from many types of financial instruments, including

stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles,[1] many
types of over-the-counter and derivative products, and futures contracts.

Public futures markets were established in the 19th century [2] to allow transparent,
standardized, and efficient hedging of agricultural commodity prices; they have since expanded
to include futures contracts for hedging the values of energy, precious metals, foreign currency,
and interest rate fluctuations.

Hedging is the practice of taking a position in one market to offset and balance against
the risk adopted by assuming a position in a contrary or opposing market or investment. The
word hedge is from Old English hecg , originally any fence, living or artificial. The use of the
word as a verb in the sense of "dodge, evade" is first recorded in the 1590s; that of insure
oneself against loss, as in a bet, is from the 1670s. [3]

Hedgers are traders who want to protect their investment from the price fluctuation
risk. They pass on the risk to those who are willing to take risk at a predetermined cost. Hence
hedgers just pass it to others by paying a price to protect their assets from price fluctuation risk.

If a person has 2000 shares of XYZ ltd and the current price of the share is around ₹200. But
the person wants to hold the stock for 3 months but he is worried that the price of the stock
could fall by that time & also does not wants to sell the stock today because he wants to take
the benefit of near term price appreciation. So he would in future want to receive at least Rs.190
per share & no less at the same time he would like to benefit if the price is above. ₹200 per
share by selling the stocks after 3 months. So by paying a predetermined price which is called
premium he buys a derivative product called “option” which allows all the above mentioned

29
requisite features. So this way a hedger transfers the risk to a person who wants to take the risk
and secures his assets.

Hedging is analogous to taking out an insurance policy. If you own a home in a flood-
prone area, you will want to protect that asset from the risk of flooding – to hedge it, in other
words – by taking out flood insurance. There is a risk-reward tradeoff inherent in hedging;
while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn't
free. In the case of the flood insurance policy, the monthly payments add up, and if the flood
never comes, the policy holder receives no payout. Still, most people would choose to take that
predictable, circumscribed loss rather than suddenly lose the roof over their head.

A perfect hedge is one that eliminates all risk in a position or portfolio. In other words,
the hedge is 100% inversely correlated to the vulnerable asset. This is more an ideal than a
reality on the ground, and even the hypothetical perfect hedge is not without cost. Basis risk
refers to the risk that an asset and a hedge will not move in opposite directions as expected;
"basis" refers to the discrepancy.

30
SPECULATOR

Speculation is the purchase of an asset (a commodity, goods, or real estate) with the
hope that it will become more valuable at a future date. In finance, speculation is also the
practice of engaging in risky financial transactions in an attempt to profit from short term
fluctuations in the market value of a tradable financial instrument—rather than attempting to
profit from the underlying financial attributes embodied in the instrument such as capital gains,
dividends, or interest.

A speculator is a person or an entity that trades securities essentially as bets that the
price will go up or down, and as such, typically has an above-average risk tolerance .commodity
futures, currencies, fine art, collectibles, real estate, and derivatives.

Many speculators pay little attention to the fundamental value of a security and instead
focus purely on price movements. Speculation can in principle involve any tradable good or
financial instrument. Speculators are particularly common in the markets for stocks, bonds,

E.g. Let us consider a hedger had a view that the price of the XYZ Company may fall
and eat up into his profits but a speculator in the derivative market might have the view that
the share price of XYZ Company will go up in 3 months. Hence the speculator will enter into
an agreement with the hedger that he will pay the difference of XYZ shares if the price falls
below Rs.190. For this the hedger has to pay a predetermined price called premium for the
option which the speculator is offering him. Thus the speculator earns the compensation if the
stock does not fall & the hedger receives protection if the stock price falls and can gain profits
from the price hike. So speculators always hunt for higher risk opportunity where they can
make higher returns.

Although one can argue that all investment is speculation, an acknowledged

speculator will buy or sell a security solely to reap a typically short-term profit from the price
movement of that security. This motivation differs significantly from those of more traditional
investors or hedgers.

For example, consider the purchase of corn futures. A hedger may purchase these
securities in order to offset any negative movements in the price of corn and thus stabilize his
or her portfolio (these people might be corn growers or cereal companies, for instance). A
speculator, however, may buy the very same security simply because he or she has reason to

31
believe the position will increase in value. He or she simply bets on which way the market is
going to go.

Speculation can sometimes drive securities prices away from their intrinsic value,
either becoming overpriced during a buying frenzy or becoming underpriced during a huge
sell-off. Although speculators sometimes get a bad rap in the press for this reason, they are a
crucial lubricant to the markets, particularly the commodities markets. Although they don't
want to physically possess any of the commodities they're trading (that is, they don't really
want a truckload of rice delivered to their door), their trading activity brings liquidity to the
market, which in turn provides stability and efficiency to those markets.

32
ARBITRAGE

In economics and finance, arbitrage is the practice of taking advantage of a price

difference between two or more markets: striking a combination of matching deals that
capitalize upon the imbalance, the profit being the difference between the market prices. When
used by academics, an arbitrage is a (imagined, hypothetical, thought experiment) transaction
that involves no negative cash flow at any probabilistic or temporal state and a positive cash
flow in at least one state; in simple terms, it is the possibility of a risk-free profit after
transaction costs. For instance, an arbitrage is present when there is the opportunity to
instantaneously buy low and sell high.

In principle and in academic use, an arbitrage is risk-free; in common use, as in

statistical arbitrage, it may refer to expected profit, though losses may occur, and in practice,
there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit
margins), some major (such as devaluation of a currency or derivative). In academic use, an
arbitrage involves taking advantage of differences in price of a single asset or identical cash-
flows; in common use, it is also used to refer to differences between similar assets (relative
value or convergence trades), as in merger arbitrage.

An arbitrageur is a type of investor who attempts to profit from price inefficiencies in

the market by making simultaneous trades that offset each other and capturing risk-free profits.
An arbitrageur would, for example, seek out price discrepancies between stocks listed on more
than one exchange, and buy the undervalued shares on one exchange while short selling the
same number of overvalued shares on another exchange, thus capturing risk-free profits as the
prices on the two exchanges converge.

E.g. If an arbitrager purchase 100 shares at Rs.2000 per share in cash market and the
same share is quoting at Rs.2001 in derivative markets. Then the arbitrager sells the 100 shares
in the derivative market and makes a profit of Rs.1 per share from this trade.

Fixed-income arbitrage is primarily used by hedge funds and leading investment

banks. The most common fixed-income arbitrage strategy is swap-spread arbitrage. This
consists of taking opposing long and short positions in a swap and a Treasury bond. Such
strategies provide relatively small returns and, in some cases, huge losses. That's why these
strategies are often referred to as "picking up nickels in front of a steamroller"

33
SWAP BANKS.
One party to an interest rate swap receives a fixed cash flow and wants to
exchange it for a flow based on current interest rates. The other party has the opposite goal --
exchanging floating for fixed. A swap intermediary, also known as a swap bank, is in the
business of matching potential swap counter-parties and helping to negotiate a deal between
them. Frequently, the swap counter-parties are unknown to each other even after the deal is
consummated, because each party deals only with the swap intermediary. The intermediary
takes a fee or a percentage of the swap cash flows, depending on the contract details.

Swap counter-parties often value anonymity because of competitive considerations.

To put it bluntly, a counter-party might not want its competitors to know how it’s conducting
business, offsetting its risks and financing its capital. All of these tidbits of information could,
if revealed to a competitor or other market participants, have an adverse effect on the counter-
party. For example, a hedge fund might form an opinion on prices in a particular market and
engage in large swaps to benefit from the opinion. The hedge fund would not want to tip off
others, because this might affect prices in the market covered by the swap.

A swap intermediary often administers all of a swap’s cash flows. It collects and
forwards periodic payments between counter-parties, thereby maintaining anonymity.
Frequently, the intermediary also performs credit services, including assessing the
creditworthiness of the counter-parties and even guaranteeing timely payment of cash flows.
For a fee, the intermediary agrees to make good on all or part of a cash payment if one of the
counter-parties defaults on its obligations.

Swaps can become very complicated. A trusted intermediary can be a valued asset to
a swap counter-party because of all the specialized knowledge the intermediary brings. This
can give the intermediary a strong negotiation position on your behalf, resulting in the most
favorable deal with the least risk. A well-established swap intermediary also gives a new
counter-party access to large potential counter-parties in a particular market

34
Interest rate swaps.

35
Preface

When borrowing money, the borrower pays interest to the lender to compensate for
the use of the money. The interest rate that is charged on the loan may be a fixed interest rate
or a variable interest rate. A fixed interest rate is a rate that is determined at the time of the loan
and will not change during the term of the loan even if interest rates in the market change. This
means that the borrower and the lender can agree to a repayment schedule that will not change
over the term of the loan. For example, ABC Life Insurance Company borrows 10 million that
will be repaid at the end of five years. ABC will pay 6% interest at the end of each year. In this
example, the interest rate is a fixed interest rate of 6% and the annual interest payment is
600,000.

For other loans, the interest rate on the loan will be variable. A variable interest rate
is adjusted periodically, upward or downward, to reflect the level of market interest rates at the
time of the adjustment. The procedure for adjusting the interest rate will be specified in the
loan agreement. A variable interest rate is often referred to as a floating interest rate, which is
a synonymous term .For example, DEF Life Insurance Company borrows 10 million that will
be repaid at the end of five years. DEF will pay interest on the loan at the end of each year. The
interest rate on the loan will be adjusted each year. The interest rate to be paid will be the one-
year spot interest rate1 at the beginning of the year. Thus, the annual interest payment on the
loan could change each year.

Most bank loans to corporations or businesses, as well as some home mortgage loans,
contain a variable interest rate. Most of the time, the interest rate to be charged is linked to an
outside index. The most common indexes used are the London Inter-Bank Offered Rate
(LIBOR) and the prime interest rate.

LIBOR is the interest rate estimated by leading banks in London that the average
leading bank would be charged if borrowing from other banks. LIBOR rates are calculated for
five currencies and seven borrowing periods ranging from overnight to one year. The prime
interest rate is the rate at which banks in the U.S. will lend money to their most favored
costumers and is a function of the overnight rate that the Federal Reserve will charge banks.
The Wall Street Journal surveys the 10 largest banks in the U.S. and daily publishes the prime
interest rate.

The variable interest rates charged on the loans are typically one of the above indexes
plus a spread. For example, the variable interest rate may be LIBOR plus 2.5%. This is typically

36
expressed in term of basis points or bps. A basis point is 1/100 of 1%. Therefore, the above
rate would be LIBOR plus 250 bps. The spread is negotiated between the borrower and the
lender. The spread is a function of several factors, such as the credit worthiness of the borrower.
The spread will be larger if the credit risk associated with the borrower is greater.

In the loan to DEF above, the interest rate can change annually. The period of time
between adjustments of the interest rate does not need to be a one-year period. It could be reset
more frequently, such as every 90 days.

A loan with a variable interest rate adds a level of uncertainty (and potentially risk) to
the loan that a borrower may want to avoid. An interest rate swap can be used to remove this
uncertainty. However, a party that has income based on the current level of interest rates, may
prefer to have a variable interest rate. This would result in a better matching of income with
the expected loan payments, which would reduce the risk for the party. In that case, if the party
has a fixed rate loan, they may enter into a swap to change the fixed rate into a variable rate.

37
Definitions

An interest rate swap is an agreement between two parties in which each party makes
periodic interest payments to the other party based on a specified principal amount. One party
pays interest on a variable rate while the other party pays interest on a fixed rate.

The fixed interest rate is known as the swap rate. The swap rate will be determined at
the start of the swap and will remain constant for each payment. In contrast, while the variable
interest rate will be defined at the start of the swap (e.g., equal to LIBOR plus 100 bps), the
rate will likely change each time a payment is determined.

The “swap rate” is the fixed interest rate that the receiver demands in exchange for
the uncertainty of having to pay the short-term LIBOR (floating) rate over time. At any given
time, the market’s forecast of what LIBOR will be in the future is reflected in the forward
LIBOR curve.

The two parties in the agreement are known as counterparties. The counterparty who
agrees to pay the swap rate is called the payer. The counterparty who agrees to pay the variable
rate, and thus receive the swap rate, is called the receiver. At the time of the swap agreement,
the total value of the swap’s fixed rate flows will be equal to the value of expected floating rate
payments implied by the forward LIBOR curve. As forward expectations for LIBOR change,
so will the fixed rate that investors demand to enter into new swaps. Swaps are typically quoted
in this fixed rate, or alternatively in the “swap spread,” which is the difference between the
swap rate and the equivalent local government bond yield for the same maturity.

The specified principal amount is called the notional principal amount or just notional
amount. The word “notional” means in name only. The notional principal amount under an
interest rate swap is never paid by either counterparty. Thereby, it is principal in name only.
However, the notional amount is the basis upon which the exchange of payments is determined.
One counterparty will owe a payment determined by multiplying the swap rate by the notional
amount. The other counterparty will owe a payment determined by multiplying the variable
interest rate by the notional amount.

38
 MIBOR MIBOR

Company A Swap banks Company B

6% 6.5%

5% MIBOR +

1%

Bank A Bank B

Basic structure of interest rate swap.

In above example of interest rate swap the two parties to the swap
agreement are company A and company B. Company A is paying 5%fixed rate while having
option to pay MIBOR floating rate and company B is paying (MIBOR+1%) floating rate
payment with option to pay 8%fixed rate to their respective creditors, both the company wants
to lower down their cost of borrowing, so company A wants to exchange their fixed rate with
floating rate and vice versa for company B, The deal of the interest rate swap would be conduct
through swap bank , acting as intermediary between both company. company A will pay fixed
rate to bank A (creditor ) and MIBOR rate to swap bank as shown in the figure ,while company
B will pay MIBOR +1% to bank B(creditor) and 6.5% to swap banks ,

Now swap bank will transfer the whole of MIBOR rate received from company A to
company B, and also transfer 6%of fixed rate to company A the 0.5% difference between fixed
rate paid by both company would be earning of bank

39
 In the net result company A will pay MIBOR-1% (fixed rate
5%+MIBOR-6%) Lesser than floating rate in current market. Company B will pay 7.5% which
is lesser than current market rate of 8%.

The specified period of the swap is known as the swap term or swap tenor.

An interest rate swap will specify dates during the swap term when the exchange of
payments is to occur. These dates are known as settlement dates. The time between settlement
dates is known as the settlement period. Settlement periods are typically evenly spaced. For
example, settlement periods could be daily, weekly, monthly, quarterly, annually, or any other
agreed upon frequency. The first settlement period normally begins immediately with the first
payment at the end of the settlement period. For example, if the settlement period is every three
months, then the first swap payment is made at the end of three months.

In Section 1, we introduced the concept of variable rate loans. An interest rate swap
can be used to change the variable rate into a fixed rate. In this case the borrower would enter
into an interest rate swap with a third party. Entering into a swap does not change the terms of
the original loan. A swap is a derivative instrument that is used to exchange variable rate
payments for fixed rate payments.

However, two parties can enter into an interest rate swap without any loan being
involved. One reason for doing this is speculation. One counterparty is “betting” that the
variable rates are going to increase from current expectations while the other counterparty is
betting that the variable rates are going to decrease. Other reasons include managing the
duration of a portfolio or to swap a series of cash flows linked to interest rates, but where the
cash flows are not from a loan.

At the time that each exchange of payments is to occur, the two payments are netted
and only one payment is made. For example, Tyler and Graham enter into an interest rate swap.
Based on this swap, at the end of one year, Tyler owes Graham 32,000 and Graham owes Tyler
27,000. Rather than each counterparty making a payment, the two payments would be netted
and Tyler would pay Graham 5,000. This is known as the net swap payment.

The vast majority of interest rate swaps have a level notional amount over the swap
term. However, this is not always the case. For example, a swap could have a notional amount
that follows the outstanding balance of an amortization loan. Such a swap is known as an
amortizing swap as the notional amount is decreasing over the term of the swap. Similarly, a

40
swap could have a notional amount that increases over time. This is known as an accreting
swap.

A swap typically has the first settlement period beginning at time zero. However, a
swap could be a deferred swap. For deferred swaps, the exchange of payments does not start
until a later date. An example is a swap where settlements occur quarterly over a three year
period, but the first settlement period does not start for two years. This means that the first
exchange of payments will be at the end of two years and three months because settlement
occurs at the end of the settlement period that starts at time 2 and ends at time 2.25. With a
deferred swap, the swap rate is determined at the time that the swap is initiated even though
the first payment will not occur until after the deferral period. The swap term or swap tenor for
a deferred swap includes the deferral period. For the example in this paragraph, the swap term
would be five years.

There is no cost to either counterparty to enter into an interest rate swap. This is
because the swap rate is determined such that the expected future payments for each
counterparty has the same present value. This will be our basis for determining the swap rate.
Since the actual payments are netted as noted above, this results in the present value of the net
payments that each counterparty is expected to receive in the future being equal to zero.
It should be noted that in practice customized swaps may not have a value of zero at
inception, in which case a premium would be paid by one counterparty to the other
counterparty. However, for the purpose of this study note, we assume the present value of the
swap is always zero at inception.
Although the factors accounting for the remarkable growth of the swaps market are
yet to be fully understood, financial economists have proposed a number of different
hypotheses to explain how and why firms use interest rate swaps. The early explanation,
popular among market participants, was that interest rate swaps lowered financing costs by
making it possible for firms to arbitrage the mispricing of credit risk. If this were the only
rationale for interest rate swaps, however, it would mean that these instruments exist only to
facilitate a way around market inefficiencies and should become redundant once arbitrage leads
market participants to begin pricing credit risk correctly. Thus, trading in interest rate swaps
should die out over time as arbitrage opportunities disappear—a prediction that is at odds with
actual experience. Other observers note that the advent of the interest rate swap coincided with
a period of extraordinary volatility in U.S. market interest rates, leading them to attribute the
rapid growth of interest rate derivatives to the desire on the part of firms to hedge cash flows

41
against the effects of interest rate volatility. The timing of the appearance of interest rate swaps,
coming as it did during a period of volatile rates, seems to lend support to such arguments. Risk
avoidance alone cannot explain the growth of the swaps market, however, because firm scan
always protect themselves against rising interest rates simply by taking out fixed-rate, long-
term loans or by bypassing credit markets altogether and issuing equity to fund investments
.Recent research emphasizes that interest rate swaps offer firms new financing choices that
were just not available before the advent of these instruments, and thus represent a true financial
innovation. This research suggests that the financing choices made available by interest rate
swaps may help to reduce default risk and may sometimes make it possible for firms to
undertake productive investments that would not be feasible otherwise. The discussion that
follows explains the basic mechanics of interest rate swaps and examines these rationales in
more detail.

FUNDAMENTALS OF INTEREST RATE SWAPS The most common type of interest rate
swap is the fixed/floating swap in which a fixed-rate payer promises to make periodic payments
based on a fixed interest rate to a floating-rate payer, who in turn agrees to make variable
payments indexed to some short-term interest rate. Conventionally, the parties to the agreement
are termed counterparties. The size of the payments exchanged by the counterparties is based
on some stipulated notional principal amount, which itself is not paid or received. Interest rate
swaps are traded over the counter. The over-the-counter (OTC) market is comprised of a group
of dealers, consisting of major international commercial and investment banks, who
communicate offers to buy and sell. Swap dealers intermediate cash flows between different
customers, acting as middlemen for each transaction. These dealers act as market makers who
quote bid and asked prices at which they stand ready to either buy or sell an interest rate swap
before a customer for the other half of the transaction can be found. (By convention, the fixed-
ratepayer in an interest rate swap is termed the buyer, while the floating-rate payer is termed
the seller.) The quoted spread allows the dealer to receive a higher payment from one
counterparty than is paid to the other .Because swap dealers act as intermediaries, a swap
customer need be concerned only with the financial condition of the dealer and not with the
creditworthiness of the other ultimate counterparty to the agreement. Counter-party credit risk
refers to the risk that a counterparty to an interest rate swap will default when the agreement
has value to the other party. Managing the credit risk associated with swap transactions requires
credit-evaluation skills similar to those commonly associated with bank lending. As a result,

42
commercial banks, which have traditionally specialized in credit-risk evaluation and have the
capital reserves necessary to support credit-risk management, have come to dominate the
market for interest rate swaps (Smith, Smithson, and Wakeman 1986).The discussion that
follows largely abstracts from counterparty credit risk and the role of swap dealers. In addition,
the description of interest rate swaps is stylized and omits many market conventions and other
details so as to focus on the fundamental economic features of swap transactions. Mechanics
of a Fixed/Floating Swap The quoted price of an interest rate swap consists of two different
interest rates. In the case of a fixed/floating swap, the quoted interest rates involve a fixed and
a floating rate. The floating interest rate typically is indexed to some market-determined rate
such as the Treasury bill rate or, more commonly, the three-or six-month London Interbank
Offered Rate, or LIBOR .Such a swap is also known as a generic, or plain-vanilla, swap. The
basic mechanics of a fixed/floating swap are relatively straightforward.

Consider an interest rate swap in which the parties to the agreement agree payments
at the end of each of T periods, indexed by the variable t=1, 2, …T. Let rs denote the fixed rate
and rs(t) denote the floating interest rate on a fixed/floating swap. Payments between the fixed-
and floating-rate payers commonly are scheduled for the same dates, in which case only net
amounts owed are exchanged. The net cost of the swap to the fixed-rate payer at the end of
each period would be rs−rs(t) for each $1 of notional principal .If the swap’s fixed rate is greater
than the variable rate at the end of a period(i.e.,rs>rs(t)), then the fixed-rate payer must pay the
difference between the fixed interest payment on the notional principal to the floating-rate
payer .Otherwise, the difference rs−rs(t) is negative, meaning that the fixed-rate payer receives
the difference from the floating-rate payer. The net cost of the swap to the floating-rate payer
is just the negative of this amount. For the sake of notational convenience, the discussion that
follows assumes that all swaps have a notional principal of $1, unless otherwise noted.

43
Uses of Interest Rate Swaps—Synthetic.

Financing Firms use interest rate swaps to change the effective maturity of interest-
bearing assets or liabilities. To illustrate, suppose a firm has short-term bank debt out-standing.
At the start of each period this firm refinances its debt at the prevailing short-term interest rate,
rb(t). If short-term market interest rates are volatile, then the firm’s financing costs will be
volatile as well. By entering into an interest rate swap, the firm can change its short-term
floating-rate debt into a synthetic fixed-rate obligation. Suppose the firm enters into an interest
rate swap as a fixed-rate payer. Its resulting net payments in each period t=1, 2... T of the
agreement are determined by adding the net payments required of a fixed-rate payer to the cost
of servicing its outstanding floating-rate debt. Period t cost of servicing outstanding short-term
debt rb(t) +Period t cost of interest rate swap payments rs−rb(t)= Period t cost of synthetic
fixed-rate financing rs+[rb(t)−rs(t)]Thus, the net cost of the synthetic fixed-rate financing is
determined by the swap fixed rate plus the difference between its short-term borrowing rate
and the floating-rate index .Banks often index the short-term loan rates they charge their
corporate customers to LIBOR. Suppose the firm in this example is able to borrow at LIBOR
plus a credit-quality risk premium, or credit-quality spread , q(t).Suppose further that the
swap’s floating-rate index is LIBOR. Then , rb(t)−rs (t)=[LIBOR(t)+q(t)]−LIBOR(t)=q(t).The
period t cost of synthetic fixed-rate financing in this case is just rs+q(t),the swap fixed rate plus
the short-term credit-quality spread q(t).

Now consider the other side to this transaction. Suppose a firm with out-standing
fixed-rate debt on which it pays an interest rate of rb enters into a swap as a floating-rate payer
so as to convert its fixed-rate obligation to a synthetic floating-rate note. The net period t cost
of this synthetic note is just the cost of its fixed-rate obligation plus the net cost of the swap
:Period t cost of synthetic floating rate note=rs(t)+(rb−rs).The cost of synthetic floating-rate
financing just equals the floating rate on the interest rate swap plus the difference between the
interest rate the firm pays on its outstanding fixed-rate debt and the fixed interest rate it receives
from its swap counterparty .Thus, interest rate swaps can be used to change the characteristics
of a firm’s outstanding debt obligations. Using interest rate swaps, firms can change floating-
rate debt into synthetic fixed-rate financing or, alternatively, a fixed-rate obligation into
synthetic floating-rate financing. But these observations raise an obvious question. Why would
a firm issue short-term debt only to swap its interest payments into a longer-term, fixed-rate

44
obligation rather than just issue long-term, fixed-rate debt at the outset? Conversely, why would
a firm issue long-term debt and swap it into synthetic floating-rate debt rather than simply
issuing floating-rate debt at the outset? The next two sections explore the rationales that have
been offered to explain the widespread use of interest rate swaps.

The period t cost of synthetic fixed-rate financing in this case is just rs+q(t),the
swap fixed rate plus the short-term credit-quality spread q(t).Now consider the other side to
this transaction. Suppose a firm with out-standing fixed-rate debt on which it pays an interest
rate of rb enters into a swap as a floating-rate payer so as to convert its fixed-rate obligation to
a synthetic floating-rate note. The net period t cost of this synthetic note is just the cost of its
fixed-rate obligation plus the net cost of the swap : Period t cost of synthetic floating rate
note=rs(t)+(rb−rs).The cost of synthetic floating-rate financing just equals the floating rate on
the interest rate swap plus the difference between the interest rate the firm pays on its
outstanding fixed-rate debt and the fixed interest rate it receives from its swap counterparty
.Thus, interest rate swaps can be used to change the characteristics of a firm’s outstanding debt
obligations. Using interest rate swaps, firms can change floating-rate debt into synthetic fixed-
rate financing or, alternatively, a fixed-rate obligation into synthetic floating-rate financing.

45
TYPES OF INTEREST RATE SWAP.

Plain vanilla swap.

The most common and simplest swap is a "plain vanilla" interest rate swap. In this
swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional
principal on specific dates for a specified period of time. Concurrently, Party B agrees to make
payments based on a floating interest rate to Party A on that same notional principal on the
same specified dates for the same specified time period. In a plain vanilla swap, the two cash
flows are paid in the same currency. The specified payment dates are called settlement dates,
and the time between are called settlement periods.

A plain vanilla interest rate swap is often done to hedge a floating rate exposure,
although it can also be done to take advantage of a declining rate environment by moving from
a fixed to a floating rate. Both legs of the swap are denominated in the same currency, and
interest payments are netted. The notional principal does not change during the life of the swap,
and there are no embedded options.

Example In a plain vanilla interest rate swap, Company A and Company B choose a
maturity, principal amount, currency, fixed interest rate, floating interest rate index, and rate
reset and payment dates. On the specified payment dates for the life of the swap, Company A
pays Company B an amount of interest calculated by applying the fixed rate to the principal
amount, and Company B pays Company A the amount derived from applying the floating
interest rate to the principal amount. Only the netted difference between the interest payments
changes hands.

Amortizing swap.

An exchange of cash flows, one of which pays a fixed rate of interest and one of which
pays a floating rate of interest, and both of which are based on a notional principal amount that
decreases. In an amortizing swap, the notional principal decreases periodically because it is
tied to an underlying financial instrument with a declining (amortizing) principal balance, such
as a mortgage. The notional principal in an amortizing swap may decline at the same rate as
the underlying or at a different rate which is based on the market interest rate of a benchmark
like mortgage interest rates or the London Interbank Offered Rate. The opposite of an
amortizing swap is an accreting principal swap - its notional principal increases over the life of

46
the swap. In most swaps, the amount of notional principal remains the same over the life of the
swap.

Accreting swap.

A derivative where counterparties exchange financial instrument benefits, involving

a growing notional principal amount. An accreting principal swap, is an interest rate or cross-
currency swap where the notional principal grows as it reaches maturity. This type of swap
may be used in instances where the borrower anticipates the need to draw down funds over a
certain period of time but wants to fix the cost of the funds in advance. Also called accreting
swap, accumulation swap, construction loan swap, drawdown swap and step-up swap. An
example of a situation where an accreting principal swap might be sought, is to fix the costs in
response to a project's funding requirements. An accreting principal swap is priced by
determining the cost of deferring the various trances of the principal along with the legs of the
swap itself.

Notional swap.

The notional principal amount, in an interest rate swap, is the predetermined dollar
amounts on which the exchanged interest payments are based. The notional principal never
changes hands in the transaction, which is why it is considered notional, or theoretical. Neither
party pays nor receives the notional principal amount at any time; only interest rate payments
change hands.

For example, two companies might enter into an interest rate swap contract as follows:
For three years, Company A pays Company B 5% interest per year on a notional principal
amount of $10 million. For the same three years, Company B pays Company A the one-year
LIBOR rate on the same notional principal amount of $10 million. This would be considered a
plain vanilla interest rate swap because one party pays interest at a fixed rate on the notional
principal amount and the other party pays interest at a floating rate on the same notional
principal amount.

Extension swap.

An extension swap is an agreement designed to extend the tenor of existing swap.as

such ,an extension swap is a special type of forward swap.In the middle of the tenor of an

47
interest rate swap in which one party pays LIBOR and receives a fixed rate, the parties might
agree to extend the tenor of the swap by an additional three years.If the agreement is initiated
based on the forward rates for the date of inception i.e. ate the termination of the current
agreement there should be no payment at the time the agreement is made.

Inflation swap:
An inflation swap is a fixed-for-floating swap where the floating reference rate is a
published measure of the rate of inflation .The value of an interest rate swap to a fixed rate
payer will increase if expectations about the applicable measure of inflation rise, and decrease
if expectations about the applicable measure of inflation fall. The converse is true for a floating
rate payer under an inflation swap. The terms of the inflation swap will specify whether the
floating payment will be based solely on the initial publication of the relevant inflation measure
or whether it will be subject to adjustment if the relevant inflation measure is revised. If the
relevant inflation measure is discontinued or is not published on a date of determination, the
calculation agent (which may be us) may be required to select a substitute inflation measure or
to calculate the relevant inflation level pursuant to an alternative methodology, which in either
case may adversely affect the Transaction Economics from your perspective. The particular
inflation measure underlying an inflation swap may exclude various categories of prices from
the measure of inflation, which may have a significant effect on the measure of inflation. If
your objective in entering into an inflation swap is to hedge other exposure that you have, you
should consider carefully how well the particular inflation measure represents your other
exposure. For purposes of valuing an inflation swap, observed market prices may be adjusted
for seasonality, which may increase the level of uncertainty of the valuation. When we calculate
the value of an inflation swap for any purpose, including in the event of early termination of
an inflation swap, our interests will be adverse to yours. – “Conflicts of Interest and Material
Incentives – Our financial market activities may adversely impact Transactions – Act as
calculation agent, valuation agent, collateral agent, or determining party” – of the General
Disclosure Statement. Inflation swaps often have floors or caps or other option-like features.
See “Options / Swaptions” below for a discussion of certain risks relating to such option-like
features.

48
Currency swap.

49
 A currency swap involves two parties that exchange a notional principal with one
another in order to gain exposure to a desired currency. A currency swap is an agreement in
which two parties exchange the principal amount of a loan and the interest in one currency for
the principal and interest in another currency.

At the inception of the swap, the equivalent principal amounts are exchanged at the
spot rate.

During the length of the swap each party pays the interest on the swapped principal
loan amount.

At the end of the swap the principal amounts are swapped back at either the prevailing
spot rate, or at a pre-agreed rate such as the rate of the original exchange of principals. Using
the original rate would remove transaction risk on the swap.

Currency swaps are used to obtain foreign currency loans at a better interest rate than
a company could obtain by borrowing directly in a foreign market or as a method of hedging
transaction risk on foreign currency loans which it has already taken out.

50
Purpose of Currency Swaps.
An American multinational company (Company A) may wish to expand its operations into
Brazil. Simultaneously, a Brazilian company (Company B) is seeking entrance into the U.S.
market. Financial problems that Company A will typically face stem from Brazilian banks'
unwillingness to extend loans to international corporations. Therefore, in order to take out a
loan in Brazil, Company A might be subject to a high interest rate of 10%. Likewise, Company
B will not be able to attain a loan with a favorable interest rate in the U.S. market. The Brazilian
Company may only be able to obtain credit at 9%.

While the cost of borrowing in the international market is unreasonably high, both of
these companies have a competitive advantage for taking out loans from their domestic banks.
Company A could hypothetically take out a loan from an American bank at 4% and Company
B can borrow from its local institutions at 5%. The reason for this discrepancy in lending rates
is due to the partnerships and ongoing relations that domestic companies usually have with
their local lending authorities.

Setting up the Currency Swap.

Based on the companies' competitive advantages of borrowing in their domestic

markets, Company A will borrow the funds that Company B needs from an American bank
while Company B borrows the funds that Company A will need through a Brazilian Bank. Both
companies have effectively taken out a loan for the other company. The loans are then swapped.
Assuming that the exchange rate between Brazil (BRL) and the U.S (USD) is 1.60BRL/1.00
USD and that both Company’s require the same equivalent amount of funding, the Brazilian
company receives $100 million from its American counterpart in exchange for 160 million
real; these notional amounts are swapped.

Company A now holds the funds it required in real while Company B is in possession
of USD. However, both companies have to pay interest on the loans to their respective domestic
banks in the original borrowed currency. Basically, although Company B swapped BRL for
USD, it still must satisfy its obligation to the Brazilian bank in real. Company A faces a similar
situation with its domestic bank. As a result, both companies will incur interest payments
equivalent to the other party's cost of borrowing. This last point forms the basis of the
advantages that a currency swap provides. (Learn which tools you need to manage the risk that
comes with changing rates, check out Managing Interest Rate Risk.)

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 Currency swaps can also involve exchanging two variable rate loans, or fixed rate
borrowing for variable rate borrowing. Let’s consider a case where a company exchanges fixed
rate borrowing for variable rate borrowing.

Barrow Co, a company based in the USA, wants to borrow €500m over five years to
finance an investment in the Eurozone .Today’s spot exchange rate between the Euro and US
$ is €1·1200 = $1.Barrow Co’s bank can arrange a currency swap with Greening Co. The swap
would be for the principal amount of €500m, with a swap of principal immediately and in five
years’ time, with both these exchanges being at today’s spot rate. Barrow Co’s bank would
charge an annual fee of 0.4% in € for arranging the swap. The benefit of the swap will be split
equally between the two parties.

The relevant borrowing rates for each party are as follows:

There are a few basic considerations that differentiate plain vanilla currency swaps
from other types of swaps. In contrast to plain vanilla interest rate swaps and return based
swaps, currency based instruments include an immediate and terminal exchange of notional
principal. In the above example, the US$100 million and 160 million reals are exchanged at
initiation of the contract. At termination, the notional principals are returned to the appropriate
party. Company A would have to return the notional principal in reals back to Company B, and
vice versa. The terminal exchange, however, exposes both companies to foreign exchange risk
as the exchange rate will likely not remain stable at original 1.60BRL/1.00USD level. Currency
moves are unpredictable and can have an adverse effect on portfolio returns.

Additionally, most swaps involve a net payment. In a total return swap, for example,
the return on an index can be swapped for the return on a particular stock. Every settlement
date, the return of one party is netted against the return of the other and only one payment is
made. Contrastingly, because the periodic payments associated with currency swaps are not
denominated in the same currency, payments are not netted. Every settlement period, both
parties are obligated to make payments to the counterparty.

As its name implies, a currency swap is the exchange of currencies between two parties.

While the idea of a swap by definition normally refers to a simple exchange of

property or assets between parties, a currency swap also involves the conditions determining

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the relative value of the assets involved. That includes the exchange rate value of each currency
and the interest rate environment of the countries that have issued them.

A Two-way Exchange

In a currency swap operation, also known as a cross currency swap, the parties
involved agree under contract to exchange the following: the principal amount of a loan in one
currency and the interest applicable on it during a specified period of time for a corresponding
amount and applicable interest in a second currency.

Currency swaps are often used to exchange fixed-interest rate payments on debt for
floating-rate payments; that is, debt in which payments can vary with the upward or downward
movement of interest rates. However, they can also be used for fixed rate-for-fixed rate and
floating rate-for-floating rate transactions.1)

Each side in the exchange is known as a counterparty.

In a typical currency swap transaction, the first party borrows a specified amount of
foreign currency from the counterparty at the foreign exchange rate in effect. At the same time,
it lends a corresponding amount to the counterparty in the currency that it holds. For the
duration of the contract, each participant pays interest to the other in the currency of the
principal that it received. Upon the expiration of the contract at a later date, both parties make
repayment of the principal to one another.

An example of a cross currency swap for a EUR/USD transaction between a

European and an American company follows:

In a cross currency basis swap, the European company would borrow US$1 billion
and lend €500 million to the American company assuming a spot exchange rate of US$2 per
EUR for an operation indexed to the London Interbank Rate (Libor), when the contract is
initiated. Throughout the length of the contract, the European company would periodically
receive an interest payment in euros from its counterparty at Libor plus a basis swap price, and
it would pay the American company in dollars at the Libor rate. When the contract comes to
maturity, the European company would pay US$1 billion in principal back to the American
company and would receive its initial €500 million in exchange.

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 A cross-currency basis swap (CCBS) is a floating-for-floating exchange of interest
rate payments in two different currencies. Unlike other basis swaps, CCBS also exchange
notional principals. The floating reference for each leg is based on the associated reference
rate, typically a three-month deposit rate, in the respective currency. Market convention is to
quote the spread against the non-USD leg. Thus, in a standard CCBS, an investor would pay
(receive) 3m USD LIBOR and receive (pay) the relevant 3m deposit rate in the other currency
plus a spread. The basis spread partly reflects the difference in credit risks implied by the two
reference rates. CCBS spreads are driven by supply and demand for the products as investors
swap liabilities to the desired currency or swap issuance after using foreign debt markets to
avail more favorable funding. The spreads are also driven by market perception of relative
funding stresses in the two currencies, as became acutely clear during the recent financial crisis
when the demand for USD funds drove most CCBS spreads lower (Exhibit 1).

A cross-currency basis swap (CCBS) is a floating-for-floating exchange of interest

rate payments and notional amounts in two different currencies. The floating reference for each
leg is based on the associated reference rate, a three-month deposit rate, in the respective
currency. For example in a standard EURUSD basis swap, an investor might pay 3m USD
LIBOR and receive 3m EURIBOR plus a spread. CCBS exchange payments on a quarterly
basis similar to most other basis swaps. However, unlike other basis swaps, CCBS also swap
notional principals. CCBS exchange floating rates that contain innate credit risk; therefore, the
basis spread partly reflects the difference in credit risks of the two reference rates. For example,
in a USDCAD basis swap, the USD LIBOR is an unsecured deposit rate while CDOR is a
secured rate. This potentially would tend to cause CDOR to trade below LIBOR all else being
equal, which requires a positive spread on the CDOR leg to make the basis swap fair. A
common use of CCBS is to exchange floating liabilities in one currency for another. With the
growth of international markets, cross-currency basis swaps are used to match assets and
liabilities of corporations that have exposure to foreign exchange fluctuations from
international operations. Basis swaps are used extensively to swap issuance back to the
currency of choice after availing more favorable funding in a foreign market. Additionally,
firms that need foreign-denominated cash can raise the funds using a cross-currency basis
swap. The supply and demand for CCBS based on firms swapping issuance or raising foreign
funds drives the cross-currency basis spreads. Funding stresses and/or concerns over the credit
risk of banks in one currency versus another can cause severe dislocations in CCBS spreads. A
good illustration of this phenomenon was at the peak of the financial crisis when the demand

54
for USD relative to all other currencies soared. During this time, dollar funding in the interbank
cash market became extremely limited as banks’ became reluctant to lend to other banks. As a
result, the basis swap markets, as an alternative to acquire USD funds, saw increased demand
to receive USD funds in exchange for EUR, among other currencies. This excess demand drove
the EURUSD basis swap spreads down to highly negative levels as counterparties were willing
to receive lower interest payments in return for US dollar funds (Exhibit 2).

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Commodity Swap.
Commodities are physical assets such as precious metals, base metals, energy stores
(such as natural gas or crude oil) and food (including wheat, pork bellies, cattle, etc.).
Commodity swaps were first traded in the mid-1970's, and enable producers and consumers
to hedge commodity prices. Swaps involving oil prices are probably the most common;
however, swaps involving weather derivatives are increasingly popular. The floating leg of a
commodity swap is tied to the price of a commodity or a commodity index, while the fixed leg
payments are stipulated in the contract as in an interest rate swap. It is common for a commodity
swap to be settled in cash, although physical delivery is becoming increasingly common. The
floating leg is typically held by a commodity consumer, who is willing to pay a fixed rate for
a commodity to guarantee its price. The fixed leg is typically held by a commodity producer
who agrees to pay a floating rate which is set by the market price of the underlying commodity,
thereby hedging against falls in the price of the commodity. In most cases, swap rates are fixed
either by commodity futures, or by estimating the commodity forward price.

In commodity swaps, the cash flows to be exchanged are linked to commodity prices.
Commodities are physical assets such as metals, energy and agriculture.

For example: In a commodity swap, a party may agree to exchange cash flows linked
to prices of oil for a fixed cash flow.

Commodity swaps are used for hedging against Fluctuations in commodity prices or
Fluctuations in spreads between final product and raw material prices (For example: Cracking
spread which indicates the spread between crude prices and refined product prices significantly
affect the margins of oil refineries)

A company that uses commodities as input may find its profits becoming very volatile
if the commodity prices become volatile.

This is particularly so when the output prices may not change as frequently as the
commodity prices change. In such cases, the company would enter into a swap whereby it
receives payment linked to commodity prices and pays a fixed rate in exchange.

A commodity swap helps producers manage their exposure to fluctuations in their

products’ prices, and although they can be risky, these swaps are important for energy,

56
chemical and agricultural companies. The speculators who buy and sell these commodities
through various types of swaps are a crucial part of the market and play a key role in pricing
these commodities.

Commodities are physical assets such as precious and base metals, energy stores
(natural gas or crude oil) and food (including wheat, pork bellies and cattle). These can be
swapped for cash flows under what’s called a commodity swap, through markets that involve
two kinds of agents: end-users (hedgers) and investors (speculators).

Commodity swaps A Commodity Swap is an agreement involving the exchange of a

series of commodity price payments (fixed amount) against variable commodity price
payments (market price) resulting exclusively in a cash settlement (settlement amount). The
buyer of a Commodity Swap acquires the right to be paid a settlement amount (compensation)
if the market price rises above the fixed amount. In contract, the buyer of a Commodity Swap
is obliged to pay the settlement amount if the market price falls below the fixed amount. The
buyer of a commodity Swap acquires the right to be paid a settlement amount, if the market
price rises above the fixed amount. In contract, the seller of a commodity Swap is obligated to
pay the settlement amount if the market price falls below the fixed amount. Both streams of
payment (fixed/variable) are in the same currency and based on the same nominal amount.
While the fixed side of the swap is of the benchmark nature (it is constant), the variable side is
related to the trading price of the relevant commodities quoted on a stock exchange or otherwise
published on the commodities futures market on the relevant fixing date or to a commodity
price index.

How do Commodity Swaps work?

For example, consider a commodity swap involving a notional principal of 1, 00,000 barrels of
crude oil. One party agrees to make fixed semi-annual payments at a fixed price of ₹2,500/bbl,
and receive floating payments.

 On the first settlement date, if the spot price of crude oil is ₹2,400/bbl, the pay-fixed
party must pay (₹ 2,500/bbl)*(1, 00,000 bbl) = ₹ 2,50,000,000.
 The pay-fixed party also receives (₹ 2,400/bbl)*(1, 00,000 bbl) =₹ 2, 40,000,000.

57
  The net payment made (cash out flow for the pay-fixed party) is then ₹ 10,000,000.
 In a different scenario, if the price per barrel will have increased to ₹ 2,550/bbl than the
pay-fixed party would have received a net inflow of ₹ 5,000,000.

Commodity swaps are derivatives; the value of a swap is tied to the underlying value
of the commodity that it represents. Commodity swap contracts allow the two parties to hedge
pricing by fixing the effective price of the asset being traded. Many commodity swaps are run
through financial service companies that don't actually swap commodities -- they just tie the
security to the price of the commodity. Swaps may be behind the stable performance of the
stock of a commodity-producing or commodity-using company that you own, or they could be
a way for you to invest in the commodities market.

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Credit default swap.

59
 Credit Default Swaps (CDS) are a bilateral OTC contracts that transfer a credit
exposure on a specific (“reference”) entity across market participants. In very general terms,
the buyer of a CDS makes periodic payments in exchange for a positive payoff when a credit
event is deemed to have occurred. These contracts are linked to either a specific reference
entity (“single name CDS”) or a portfolio of reference entities (“index” or “basket” CDS).
Selling protection through a CDS contract replicates a leveraged long position in bonds of the
underlying reference entity, exposing protection sellers to risks similar to those of a creditor.
Buying protection through CDS replicates instead a short position on bonds of the underlying
reference entity (with proceeds reinvested at the riskless rate). Buyers of protection through a
CDS contract can hedge a credit exposure on the underlying reference entity or effectively take
a short position on credit risk. This is the case when the CDS buyer has no credit exposure on
the reference entity (so called “naked” CDS position) or has an exposure lower than the value
of the CDS contract (so called “over-insured” position). While it is possible for a protection
buyer to replicate the economic payoff of a CDS contract by shorting bonds of the underlying
reference entity and reinvesting the proceeds at the riskless rate, CDS may be an attractive
alternative to short selling because of their ability to eliminate the risk associated with rolling
over short positions. When a credit event occurs, the contract is terminated. In this case, if
“physical delivery” is the specified settlement method, the CDS seller must pay to the buyer
the nominal contract value and the CDS buyer must deliver bonds of the reference entity (of a
pre-specified type). Alternatively, if “cash settlement” is the agreed settlement method, the
seller must pay to the buyer the difference between the notional contract value and the market
value of the bonds

While most of the discussion has been focused on holding a CDS contract to
expiration, these contracts are regularly traded. The value of a contract fluctuates based on the
increasing or decreasing probability that a reference entity will have a credit event. Increased
probability of such an event would make the contract worth more for the buyer of protection,
and worth less for the seller. The opposite occurs if the probability of a credit event decreases.
A trader in the market might speculate that the credit quality of a reference entity will
deteriorate some, time in the future and will buy protection for the very short term in the hope
of profiting from the transaction. An investor can exit a contract by selling his or her interest

60
to another party, offsetting the contract by entering another contract on the other side with
another party, or offsetting the terms with the original counterparty. Because CDSs are traded
over the counter (OTC), involve intricate knowledge of the market and the underlying assets
and are valued using industry computer programs, they are better suited for institutional rather
than retail investors.

For index or basket CDS a credit event on one of the component reference entities
will not cause the contract to be terminated and the buyer of protection will receive a
compensation proportional to the weight of the reference entity on the index (see next §3.1 for
more details).There are a number of ways to “terminate” or change the economic exposure
associated with a CDS contract other than those related to the occurrence of a credit event. The
first is referred to as “novation”, which entails the replacement of one of the two original
counterparties to the contract with a new one. A novation is executed by identifying a market
participant that is willing to assume the obligations of one of the original counterparties at
prevailing market prices. There are however two quite different kinds of novation: the first is
the one in which a new party replaces one of the parties of the original trade and the second in
which both parties give up the trade to a central counterparty (so called “CCP novation” –see
next §3.3), though in this latter case there is no change or termination in the economic exposure
for the original counterparties. Other changes may be related to early termination clauses or to
contract terminations due to “compression” mechanisms designed to cancel redundant
contracts due to offsetting positions. For example, if the same counterparties have entered into
offsetting positions on contracts with the same economic terms, a compression trade cancels
these contracts and creates a new contract with the same net exposure as the original contracts.
It is also possible to terminate a position by entering into a transaction of opposite sign
(“offsetting transaction”) with other market participants. The difference between an offsetting
transaction and a novation is that in the first case the original contract is not cancelled and
remains a legal obligation. Though offsetting transactions are the most common way to
terminate the economic exposure related to the reference entity underlying the CDS contract,
they create a network of exposures that results in increased counterparty risk

The market for credit default swaps (“CDS”) is going through rapid change. Over the
last several years, CDS contracts have become more standardized, and electronic processing
and central clearing of trades have increased. Large amounts of CDS data have become publicly
available, and abundant research has been conducted to assess the role that CDSs play in global
financial markets .This report discusses those recent changes and current trends in the CDS

61
markets, and provides information from recent literature about the trading, pricing and clearing
of CDS. The report is meant to inform the ongoing regulatory debate and highlight some key
policy issues. However, policy recommendations are left for other reports. In summary, the
amount of CDS trading has continued to increase even after the onset of the financial crisis
while standardization and risk management practices have significantly expanded. Trade
compression has reduced CDS contracts by tens of trillions dollars. A non-negligible amount
of CDS trades are currently being cleared by several central counterparties (CCP) around the
world and the number of cleared CDS contracts is expanding. Because of its highly
concentrated and interconnected nature, and given the evidence of possible under-
collateralization of CDS positions, one of the main sources of risk in the CDS market is
counterparty risk generated by the default of large protection sellers .The use of central
counterparties has been seen as a way of mitigating counterparty risk and preventing default
contagion. Though the amount of public information on CDS has increased over the recent
years, the CDS market is still quite opaque. Regulators would benefit from better access to
information on trade and position data, which is necessary for financial stability supervision,
for improving the assessment of counterparty risk by CCP and for the detection of market
abuse. CDS markets have come to play an informational role in credit markets, where CDS
spreads are widely regarded as a market consensus on the creditworthiness of the underlying –
corporate or sovereign-entity. This is also reflected in the market practice of computing the
implied default probability of an entity from its CDS spreads and using such default
probabilities for the pricing of credit derivatives. A study indicates implied survival
probabilities for Lehman Brothers implied from CDS quotes on September 8, 2008, shortly
before Lehman’s default. The Lehman Brother’s case should temper any wild claims as to the
“forward-looking” nature of the CDS spreads. Moreover, the implied default probabilities and
hazard rates depend on the assumption used for recovery rates, which are themselves subject
to a large uncertainty. Nevertheless, CDS spreads are useful indicators of credit risk, especially
in contexts where the underlying debt markets are less liquid. The volatility of CDS premia
during the crisis has affected risk assessment on other markets. As for transparency towards
market participants (disclosure of pre- and post-trade information), results from theoretical
research and empirical work on the OTC bond market in the US for the time being suggest that
greater transparency may reduce information a symmetries and transaction costs, but it may
also discourage dealers from providing liquidity. IOSCO will continue to examine these issues
in order to provide a sound basis for possible future policy proposals on how to best improve
the functioning of the CDS markets. Available research shows that CDS have an important role
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in the price discovery process on credit risk and that the inception of CDS trading has a negative
impact on the cost of funding for entities of lower credit quality. To date, there is no conclusive
evidence on whether taking short positions on credit risk through naked CDS is harmful for
distressed firms or high-yield sovereign bonds. IOSCO will continue to monitor market
developments on this issue, however, going forward

Since the financial crisis and, even more, since the recent sovereign debt crisis, the
role of credit default swap (CDS) has been subject to growing attention by policy makers and
regulators, because of fears that transactions of a speculative nature on the CDS market may
amplify tensions on the bond markets. The link between CDS and bond markets is complex
and it is deeply affected by their different degree of liquidity and by market imperfections
exacerbated by the financial crisis .The recent turmoil has impacted on the feasibility of
arbitrage strategies between the two markets, increasing the gap between CDS prices and
underlying bonds rates; CDS prices tend however to have a leading role in the price discovery
process when the market for the underlying bonds is less liquid. Having regard to the European
government bonds market, there is no clear evidence that speculation through CDS has affected
the prices of the underlying bonds, nor that it is possible to manipulate the price of CDS in
order to generate destabilizing informative signals on the credit risk of sovereign issuers.
Regulatory responses to such concerns based on constraints or restrictions on CDS transactions
must be assessed with extreme caution, because they might not have the desired effects and
might have an adverse impact on the orderly functioning of the government bond market. Post-
trade transparency obligations may instead mitigate the potential destabilizing effects of CDS
speculative trading.

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Types of Credit default swap.

Total Return Swaps.

A total return swap is a means to transfer the total economic exposure, including
both market and credit risk, of the underlying asset. The payer of a total return swap can
confidentially remove all the economic exposure of the asset without having to sell it. The
receiver of a total return swap, on the other hand, can access the economic exposure of the asset
without having to buy the asset. Typical reference assets of total return swaps are corporate
bonds, loans and equities.

Credit-Linked Notes.

A credit-linked note, also known as a credit default note, is a fixed or floating rate
note where the principal and/or coupon payments are referenced to a credit or a basket of
credits. If there is no credit event of the reference credit(s), all the coupons and principals will
be paid in full. However, if there is a credit event, the payments of the principal and, possibly,
also the coupon of the note will be reduced.

Credit Default Swap Options.

A credit default swap option is also known as a credit default swaption. It is an

option on a credit default swap (CDS). A CDS option gives its holder the right, but not the
obligation, to buy (call) or sell (put) protection on a specified reference entity for a specified
future time period for a certain spread. The option is knocked out if the reference entity defaults
during the life of the option. This knock-out feature marks the fundamental difference between
a CDS option and a vanilla option. Most commonly traded CDS options are European style
options.

Similar to the credit default swaps, CDS options can be: CDS options on a single
entity with a regular payoff for the default leg; CDS options on a single entity with a binary
payoff for the default leg; CDS options on a basket of entities with regular payoff for the default
leg; and CDS options on a basket of entities with a binary payoff for the default leg.

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Credit Default Index Swap Options.

A credit default index swap option (CD index swap option, or CD index swaption,
or CDS index option) is an option to buy or sell the underlying CDIS at a specified date. A
payer swaption gives the holder of the option the right to buy protection (pay premium) and a
receiver swaption gives the holder of the option the right to sell protection (receive premium).
Unlike a CD index swap, which is a natural extension of a CDS on a single-entity to a CDS on
a portfolio of entities, a CD index swaption is significantly different from a CDS option, an
option on a single-entity CDS. In the case of an option on a single-entity, if the reference entity
defaults before the option's expiry, the option will be knocked out and become worthless. For
an option on a CDIS, when a reference entity defaults before the option's expiry, the loss will
be paid by the protection seller to the protection buyer when the option is exercised. Even if
there is only one entity in the portfolio, a CD index swaption is still different from a single-
entity CDS option: if the entity defaults before expiry, the option's seller will pay to the
protection buyer the lost amount at expiry. Clearly, a CD index swaption is always more
valuable than a single-entity CDS option.

Credit Spread Options and Forwards.

Credit spread options are options where the payoffs are dependent on changes to
credit spreads. The transaction may be either based on changes in a credit spread relative to a
risk-free benchmark (e.g. LIBOR or US Treasury) or changes in the relative spread between
two credit instruments. A credit spread option may be a vanilla option or an exotic option, such
as an Asian option, a look back option, etc. The option style may be European or American.
Valuation of credit spread options can be based on modeling the two underlying instruments
or modeling the credit spread only.

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Asset swap.
Asset swaps combine an interest-rate swap with a bond and are seen as both cash
market instruments and also as credit derivatives. They are used to alter the cash flow profile
of a bond. The asset swap market is an important segment of the credit derivatives market since
it explicitly sets out the price of credit as a spread over Libor. Pricing a bond by reference to
Libor is commonly used and the spread over Libor is a measure of credit risk in the cash flow
of the underlying bond. Asset swaps can be used to transform the cash flow characteristics of
reference assets, so that investors can hedge the currency, credit and interest rate risks to create
synthetic investments with more suitable cash flow characteristics. An asset swap package
involves transactions in which the investor acquires a bond position and then enters into an
interest rate swap with the bank that sold him the bond. The investor pays fixed and receives
floating. This transforms the fixed coupon of the bond into a Libor based floating coupon.

As an example, consider an entity that wishes to insure against loss to due to credit
events such as default or bankruptcy of the issuer of a bond it is holding. As a protection buyer
holding this risky bond, it wishes to hedge the credit risk of this position. By means of an asset
swap the protection seller will agree to pay the protection buyer Libor +/- a spread in return for
the cash flows of the risky bond (there is no exchange of notional at any point). In the event of
default the protection buyer will continue to receive the Libor +/- a spread from the protection
seller. In this way the protection buyer has transformed its original risk profile by changing
both its interest rate and credit risk exposure.

The generic structure of an asset swap is shown at Figure 1

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Asset swaps example.

Assume that an investor holds a bond and enters into an asset swap with a bank. Then
the value of an asset swap is the spread the bank pays over or under Libor .This is based on the
following components: (i) value of the coupons of the underlying asset compared to the market
swap rate; (ii) the accrued interest and the clean price premium or discount compared to par
value. Thus when pricing the asset swap it is necessary to compare the par value and to the
underlying bond price; the spread above or below Libor reflects the credit spread difference
between the bond and the swap rate

Product Briefing – Asset Swaps

An asset swap is a combination investment package where an investor buys a fixed

rate bond and simultaneously enters into a ‘pay fixed’ interest rate swap. Although asset swaps
can be structured in one of two ways the most popular format is the ‘par in, par out’ (or just
‘par-par’) structure. Here the investor pays 100% of the face value of the bond (i.e. its par
value) at the start of the transaction, holds the bond to maturity and then receives par from the
issuer at maturity. If the market value of the asset is anything other than par at the point of
purchase this will create an advantage to either the buyer or seller. If the bond is trading below
par this means the investor will be disadvantaged as he will ‘overpay’ for the bond. For bonds
that are trading at a price greater than their face value this bestows a cash flow advantage on
the investor (i.e. if the bond is trading at 120 the investor only pays 100).

The second element of the asset swap structure is that the fixed rate on the swap is
set equal to the coupon on the bond. Again, since it is unlikely that these two parameters will
be exactly equal, it will create an advantage for the one of the parties.

Figure 1Asset swap package

Figure 1 shows the cash flows associated with an asset swap and gives a visual
depiction of the rationale for entering into this type of transaction. Since the fixed coupon on
the bond and the fixed rate on the swap are equal and opposite to each other (and have the
same maturity), the cash flows have no net economic impact on the investor. As a result, the
investor owns a structure that pays them LIBOR plus or minus a spread, which makes the
structure economically equal to a floating rate note.

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 In the asset swap package the spread to LIBOR acts as a balancing mechanism to
ensure that any advantage or disadvantage incurred as a result of the investor paying par and
entering into an off-market swap is returned over the life of the deal. In this way the entire
package will then become an equitable exchange of cash flows.

An asset swap structure has more credit than interest rate exposure. Suppose that
interest rates were to rise. The bond element of the structure would lose money but since the
investor is paying fixed on a swap, this deal now becomes a more attractive transaction and
will therefore increase in value. As a result the two elements more or less cancel each other
out. The same effect in the opposite direction would happen for a fall in interest rates. However,
if interest rates remain unchanged but there is a perception that the issuer is more likely to
default, then the bond element will lose value with no offsetting profit on the swap. Overall
there will be a net loss.

There are a number of reasons why an investor may wish to enter into an asset swap
package:

•They may wish to reduce the market risk of holding a fixed rate bond •Since floating rate
notes offer an investor credit exposure rather than interest rate exposure the investor may
wish take a view on how this component will evolve
•The corporate entity to which the asset swap is linked does not have any floating rate debt
in issue and so the investor may have to create this synthetically using the asset swap
•If the fixed rate bond is trading cheap to its fair value, then asset swapping the asset will
create an attractively priced
•It is possible to buy a fixed rate bond say in USD and asset swap it using a currency swap,
where the fixed rate is also USD but the LIBOR cash flows are denominated in say, EUR.

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ADVANTAGES AND DISADVANTAGES.

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Advantage.

1. Borrowing at Lower Cost:

Swap facilitates borrowings at lower cost. It works on the principle of the theory of
comparative cost as propounded by Ricardo. One borrower exchanges the comparative
advantage possessed by him with the comparative advantage possessed by the other borrower.
The net result is that both the parties are able to get funds at cheaper rates.

2. Access to New Financial Markets:

Swap is used to have access to new financial markets for funds by exploring the
comparative advantage possessed by the other party in that market. Thus, the comparative
advantage possessed by parties is fully exploited through swap. Hence, funds can be obtained
from the best possible source at cheaper rates.

3. Hedging of Risk:

Swap call also be used to hedge risk. For instance, a company has issued fixed rate
bonds. It strongly feels that the interest rate will decline in future due to some changes in the
economic scene. So, to get the benefit in future from the fall in interest rate, it has to exchange
the fixed rate obligation with floating rate obligation. That is to say, the company has to enter
into swap agreement with a counterparty, whereby, it has to receive fixed rate interest and pay
floating rate interest. The net result is that the company will have to pay only floating rate of
interest. The fixed rate it has to pay is compensated by the fixed rate it receives from the
counterparty. Thus, risks due to fluctuations in interest rate can be overcome through swap
agreements. Similar, agreements can be entered into for currencies also.

4. Tool to correct Asset-Liability Mismatch:

Swap can be profitably used to manage asset-liability mismatch. For example, a bank
has acquired a fixed rate bearing asset on the one hand and a floating rate of interest bearing
liability on the other hand. In case the interest rate goes up, the bank would be much affected
because with the increase in interest rate, the bank has to pay more interest. This is so because,
the interest payment is based on the floating rate. But, the interest receipt will not go up, since,
the receipt is based on the fixed rate. Now, the asset- liability mismatch emerges. This can be

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conveniently managed by swap. If the bank feels that the interest rate would go up, it has to
simply swap the fixed rate with the floating rate of interest. It means that the bank should find
a counterparty who is willing to receive a fixed rate interest in exchange for a floating rate.
Now, the receipt of fixed rate of interest by the bank is exactly matched with the payment of
fixed rate interest to swap counterparty. Similarly, the receipt of floating rate of interest from
the swap counterparty is exactly matched with the payment of floating interest rate on
liabilities. Thus, swap is used as a tool to correct any asset- liability mismatch in interest rates
in future.

5. Additional Income: By arranging swaps, financial intermediaries can earn additional

income in the form of brokerage.

Currency swap.

The main advantage of using a currency swap is to lower the risk given by currency
pairs moving too aggressively in a specific direction. For example, the US dollar being the
world’s reserve currency, all the US dollar pairs may react aggressively to a US economic
news. Managing the risk of the dollar moving too aggressively one-sided can be done via a
currency swap.

These operations are also called cross-currency swaps and they deal with the exchange
of interest in one currency for the same in another currency, and it is supposed to be a foreign
exchange transaction. Together with other hedging strategies, currency swaps are main trading
tools especially in the B-booking activities when the broker is taking the opposite side of their
customer’s trades.

Another advantage of currency swaps is that they can be done in multiple ways. If the
amount that is being exchanged is fully exchanged when the transaction is initiated, at the
maturity date the exchange is being reversed. The idea behind this is that in the meantime, until
the maturity date, the market may reverse, thus the brokerage house managed the risk.

These maturity dates are very flexible, stretching for a long period, several years in
most of the cases, and are negotiable. One other thing to be considered is the fact that interest
rates that govern a currency swap agreement can be either fixed or floating on the market.

Interest rate swap.

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 Swaps offer three key advantages over conventional financing.

First, they offer added flexibility and diversity. For instance, you could use a swap to
split a single loan into both fixed and floating rate tranches, rather than having the entire debt
load as one or the other. In addition, if you have, for example, a long-term loan on a floating
rate basis, a swap could allow you to shift to a fixed rate for just a portion of that time. Through
these techniques, swaps allow you to separate the funding decision itself from the funding risk
management.

Swaps also allow for a bilateral make whole provision. If you pay off your loan early,
you could potentially face a pre-payment penalty if rates have fallen, as with traditional
financing. But unlike traditional financing, you might also benefit if rates have risen.

Finally, swaps can allow you to lock in a fixed rate today for funding that will occur
later. This lets you take advantage of a favorable rate environment even before you're prepared
to take out the actual loan.

Swap is an instrument used for the exchange of stream of cash flows to reduce risk.
1) Swap is generally cheaper. There is no upfront premium and it reduces transactions costs.
2) Swap can be used to hedge risk, and long time period hedge is possible.
3) It provides flexible and maintains informational advantages.
4) It has longer term than futures or options. Swaps will run for years, whereas forwards
and futures are for the relatively short term.
5) Using swaps can give companies a better match between their liabilities and revenues.

 Illegal Money which is stored as cash will totally be turned as useless money, unless
they ready to submit to government
 All fraud notes across nation will be a scrap
 Every people will know about the banking process

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Disadvantage.

Rate Increases for Investigators.

Because the return on investments with floating interest rates fluctuates with the
market, they’re more difficult to manage than fixed-rate investments. Money managers
frequently swap floating rates for fixed rates in a rate swap in order to lock in a rate and allow
for planning. If the floating interest rate rises after terms of the rate swap are negotiated, the
original interest-stream owner loses out on the increased interest revenue from boosted rates,
but only in the difference between the rate agreed upon with the other party in the swap and
the floating one. For example, if a rate-swap is negotiated at 6.7 percent interest, and the
floating rate rises to 6.9 percent, the original investor doesn’t accrue interest for the 0.2 percent
difference in rates.

Rate Drops for Speculators.

Speculative investors trade the predictability and security of fixed interest rate revenue
streams for the volatility of floating rate streams predicting interest rates will rise, making the
floating rate more lucrative and the investment worth more than the initial outlay. If the floating
rate falls, the value of the speculator’s investment decreases, and the investor loses money. For
example, trading a $1,000 at 6.5 percent interest rate revenue stream (worth $65 annually) for
a $1,000 floating rate stream that drops to 6 percent (worth $60 annually) results in a net loss
of $5 annually for the speculator.

Currency Fluctuations.

More complicated forms of rate swap mechanisms trade value in two currencies or a
combination of interest rates and currencies. These strategies pose the same risks to
investigators and speculators--either losing out on additional revenue when the value of one
currency rises or losing money when it falls--the combination of currency exchange and interest
rate prediction makes international rate swaps a complicated proposition.

Currency Swaps Con’s.

There is one main disadvantage to currency swaps, and this is related to their original
purpose. At first, they were agreements to get around exchange controls, but then after these

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barriers were eliminated, they are being used mainly to hedge investments. The risk when using
a currency swap is that at the time the maturity is being reached, the floating interest rate would
represent a bigger cost than the whole purpose of the swap. To mitigate this downside, longer
term periods are favored.

All in all, currency swaps present more advantages than disadvantages and forex
brokers are using them as a valuable risk management tool. Used together with other risk
management tools like hedging, they help forex brokers navigate through difficult financial
periods.

Other.

It is difficult to identify a counter-party to take the opposite side of the transaction. So suppose
one company wants to swap $100000 it is not necessary that other company will also be willing
to swap the same amount with same maturity and hence it is a shortcoming of swap market.

The swap deal cannot be terminated without the mutual agreement of the parties involved in
the transactions, also it has significant amount of default risk in it and hence it is risky
instrument to use.

Secondary market for swap is still not fully developed like that of equity or currency market
and hence swaps are illiquid and cannot be easily traded like equities or currencies.

Since swap market is an over the counter market and not exchange controlled the parties have
to look carefully into the creditworthiness of the counter-party because there is no exchange
to guarantee about fulfilling of the obligations of the parties involved in swap.

Early termination of the swap contract can cause breakage cost to both or either side of the
contract if one of the counterparties decides to terminate the IRS before its term is up, the
price of the swap at the time of the early termination will have to be exchanged. If interest
rates have risen, the fixed counterparty makes payment to the floating, i.e. the floating
counterparty is the winner. The reverse is true for falling interest rates. The amount
exchanged is the net present value of the remaining netted cash flows.

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Conclusion.
Swaps seem set to be a permanent feature of the financial landscape, although the
exponential growth seen in recent years is unlikely to continue. Warren buffet has once said
that,” Swap contracts are weapons of mass destruction to financial market”. There are two
possible responses to the decline in profit margins caused by increased competition. First, there
may be a tendency towards increasingly complex swaps related to more exotic underlying
instruments, and the spread of the swap technique into new markets. More complex hedging
techniques are also likely to emerge. The second response, somewhat paradoxically, is likely
to be continued efforts to standardize products and moves to increase the tradability of swaps.
Moves to increase the tradability of swaps might include a swap futures contract, or some type
of 'swap clearing house' with which swap dealers could write contracts and net their positions.
The fastest growing sector of the swap market, dollar interest rate swaps, owes much
of its success to the relative efficiency of hedging techniques and the existence of the Treasury
bond repo market, although end-user demand has also contributed. The volume of interest rate
swaps in currencies such as sterling is only likely to grow rapidly if there is demand for the
product, and if the current difficulties involved in hedging the swap are removed. In this context
Big Bang may be expected to stimulate activity in the sterling market by increasing the number
of gilt-edged market makers, although there has been little evidence of this so far
To continue on this topic in the next project we will discuss about detail study of
mixed swaps, regulation in swap market, and valuation in swaps, comparative study of swap
market, special contract studies & case study of crisis of 2008.

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BIBLOGRAPHY / WEBLIOGRAPHY.

Swaps and other derivative [second edition] Richard Flavell.

Derivative product and pricing: The swap and financial derivative library
Third edition revised, satyajit das

http://www.cfapubs.org/doi/pdf/10.2470/rf.v1995.n4.4453.1 overview swaps

https://en.wikipedia.org/wiki/Swap_(finance) understanding swaps

http://www.bankofengland.co.uk/archive/Documents/historicpubs/qb/1987/qb87q16679.
pdf Basis of swap

https://sites.duke.edu/djepapers/files/2016/08/schiffrin.pdf History of swap

http://www.finsia.com/docs/default-source/jassa-new/jassa-1987/the-evolution-of-the-
market-for-swap-financing.pdf?sfvrsn=56a9b393_2
Evolution of swap market

https://global.pimco.com/en-gbl/resources/education/understanding-interest-rate-swaps
Interest rate swap

https://pdfs.semanticscholar.org/5ff2/fe0b3fd45c275191cfaadb0ce7fe6965b6f2.pdf
Fundamentals uses interest rate swap

http://www.financestrokes.com/wp-content/uploads/2012/12/Swaps.pdf
Commodity swap

https://www.fxcm.com/insights/how-do-currency-swaps-work/
How currency swap works

https://researchdoc.creditsuisse.com/docView?language=ENG&format=PDF&source_id=csp
lusresearchcp&document_id=1014795411&serialid=mW557HA4UbeT5Mrww553YSwfqEw
ZsxUA4zqNSkp5JUg%3D
cross currency swap

https://www.mnb.hu/letoltes/op-90.pdf

http://people.stern.nyu.edu/msubrahm/papers/ARFE.pdf
Overview on credit default swap

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