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INTEREST RATE AND CURRENCY SWAPS

CONTENTS

Introduction
Swap and its Terminology

Interest Rate Swaps

Fixed to Floating Floating to Fixed Basis Swap Features of Interest Rate Swap Rationale for Swap Role of Intermediary
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CONTENTS

Reducing Financing Cost through Currency Swap Distinguishing Features of Currency Swaps Valuing and Interpreting Swap

As Pair of Bonds
As Series of Forward Contracts

Swap Quotes and Initial Pricing Counter party Risk and Swaps Pricing Currency Swap
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E VOLUTION

Swap as financial instrument came into existence due to presence of exchange controls restricting movement of capital from one country to another.

When multinational corporations operating in various countries could not remit funds back and forth among their subsidiaries due to exchange controls exercised by various governments on the capital flows, they came out with innovations of back-to-back or parallel loans among themselves.

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E VOLUTION

Swaps overcame the operational difficulties faced in parallel loans and developed into an instrument independent of the underlying loan transaction Parallel loans involve four parties - two multinational corporations and two subsidiaries in two different countries
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W HAT I S A S WAP

Swap is defined as an exchange of future cash flows between two parties according to the terms of the contract.
If the basis of future cash flow is exchange rate for currency it is called financial or currency swap. If basis of exchange of cash flows is interest rates it is known as interest rate swap (IRS).

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F EATURES O F I RS
Under plain vanilla swaps

the exchange of interest payments is done on a notional principal amount. The cash flows for the principal amount is not exchanged, and even the cash flow for the interest is also done for the differential amount only

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T YPES O F I RS

Fixed to Floating Floating to Fixed Basis Swap

Fixed-to-floating: In the fixed-to-floating rate swaps the party pays fixed rate of interest to the bank or swap dealer and in exchange receives a floating rate interest determined on the basis of a reference/ benchmark rate at predetermined intervals of time
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T YPES O F I RS

Floating-to-fixed: In this kind of swap the party pays floating rate of interest to the bank or swap dealer and in exchange receives a fixed rate interest at predetermined intervals of time Basis swap: in contrast to the fixed-to-floating or floating-to-fixed where one leg is based on fixed rate of interest the basis swaps involve both the legs on floating rate basis

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I NTEREST R ATE S WAP A S CHEMATIC V IEW

CHANGING FIXED RATE LIABILITY INTO FLOATING AND VICE VERSA

MIBOR+3% 12% A 13% Cash Flow for SWAP PARTY A 1. Payment to investors 12% 2. Payment to counter party MIBOR + 3% 3. Receipt from counter party 13% Effective interest rate (1+2-3) MIBOR + 2% PARTY B MIBOR + 2% 13% MIBOR + 3% 12% B MIBOR+2%

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I NTEREST R ATE S WAP I MPACT

PARTY A 1. Payment to investors 2. Payment to counter party 3. Receipt from counter party Effective interest rate (1+2-3) 12% MIBOR + 3% 13%

PARTY B
MIBOR + 2% 13% MIBOR + 3%

MIBOR + 2%
Fixed rate liability (12%) changed to variable rate liability (MIBOR + 2%)

12%
Variable rate liability (MIBOR+2%) changed to fixed rate liability (12%)
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IMPACT

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R EDUCING C OST O F F UNDS U SING S WAP

SCHEMATIC VIEW: REDUCING COST OF FUNDS 10% MIBOR+2%
AAA A

11.5% Cost of funds for Firms 1. Payment to investors 2. Payment to counter party 3. Receipt from counter party Cost of borrowing (1+2-3) AAA 10% MIBOR+2% 11.5% MIBOR+50 bp

MIBOR+2%

A MIBOR+2% 11.5% MIBOR+2% 11.5%

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R EDUCING C OST O F F UNDS U SING S WAP

AAA
1. Payment to investors 2. Payment to counter party 10% MIBOR+2%

A
MIBOR+2% 11.5%

3. Receipt from counter party

Cost of borrowing (1+2-3)

11.5%
MIBOR+50 bp

MIBOR+2%
11.5%

IMPACT

Firm can raise funds at MIBOR+50 bp as against MIBOR+100 bp without the swap; gaining 50 bp

Firm can raise funds at 11.5% as against 12% without the swap; gaining 50 bp
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R OLE O F I NTERMEDIARY
1.

Finding counter-party and default risk associated with it Matching of needs in terms of principal amount of borrowing, its timing, periodicity of payment of interest and final redemption of the borrowing. Assuming counter party risk Warehousing
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2.

3. 4.

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C URRENCY S WAPS

Currency swaps also called financial swaps, have

the series of exchange of cash flows in

different currencies
decided on the basis of exchange rates.

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U SES O F C URRENCY S WAPS

Currency swap are useful in

1. 2.

hedging the exchange rate risk transforming asset/liability from one currency to another and reducing the financing cost for each of the counter party in the deal.

3.

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C URRENCY S WAP A S CHEMATIC V IEW

Converting Asset/Liability from one currency to another
US Asset $ income Swap Transaction

Rupee Liability Firm Liability Rupee Interest Interest

Indian

$ Interest

US Firm

$ $

Rupee Interest

Rupee Income Indian Asset

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R ATIONALE F OR S WAP

Like interest rate swaps, currency swaps can also be used to reduce funding cost for multinational firms needing funds in different currencies Again the guiding principle is theory of comparative advantage.
Greater spread in credit quality increases the comparative advantage. Increased comparative advantage opens up more avenues for currency swaps.
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C OMPARATIVE A DVANTAGE
Indian Market
Rupee Market Indian Firm 10%

British Market
Market 6%

British Firm

14%

4%
2%

Advantage British Firm- 4%

The comparative advantage here is 6%

Both the firms can benefit by 6% in aggregate if they enter into a swap
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S WAP TO R EDUCE C OST

Both the firms can benefit by 6% in aggregate if they enter into a swap arrangement wherein
1. 2. 3. 4. 5. 6.

Indian firm mobilises funds in rupees in the Indian market at 10%, They lend the rupee funds to British firm at 11%, British firm raises funds in the British market in at 4%,

They lend the same funds to the Indian firm at 5%,

Exchange the interest payment periodically, and Finally, exchange the principal at upon redemption.
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R EDUCING C OST T HRU S WAP

A SCHEMATIC VIEW: REDUCING COST OF FUNDS
Rs Principal Rs 10% Rs. 11%
Indian Firm British Firm

4%

5% Principal Cost of funds for Firms Indian Firm 1. Payment to investors Rupee 10% 2. Payment to counter party Pound 5% 3. Receipt from counter party Rupee 11% Cost of borrowing (1+2-3) Pound 4%
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British Firm Pound 4% Rupee 11% Pound 5% Rupee 10%

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T YPES O F C URRENCY S WAPS

Fixed-to-fixed: In a fixed-to-fixed currency swap the interest rates in the two currencies involved are fixed.
Fixed-to-floating: In a fixed-to-floating currency swap the interest rate in one of the currencies is fixed while other is floating. Floating-to-floating: In a floating-to-floating currency swap the both the interest rates are floating but in different currencies.

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VALUING A ND I NTERPRETING S WAP

Swap as pair of bonds:

Swap seen as pair of bond helps in finding the value of the swap subsequent to its initiation. The value of swap is zero when it is set up.
Swap as Pair of Bond Fixed 7% Issue of bond with coupon of 7%
FIRM A

Floating MIBOR+1% Own a floating rate bond with MIBOR+1%

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VALUING A ND I NTERPRETING S WAP

Swap as series of forward contracts:

Interest Rate Swap may also be viewed as series of forward contracts where the floating rate cash flows are equivalent to expected interest rates implied by the term structure of interest rates.

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P RICING C URRENCY S WAP

Vs = S x Vf - Vd

Where Vf and Vd are the present values of the cash flows in foreign currency and domestic currency respectively and S is the spot exchange rate.

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