Swaps

Prof Mahesh Kumar

Amity Business School
profmaheshkumar@rediffmail.com
Introduction- Definition and Uses
 A swap is an arrangement between two
companies to exchange cash flows at one or
more future dates.
 Swaps are used:
1. To reduce the cost of capital
2. Manage risk (interest rate, exchange rate,
commodity price movement)
3. Exploit economies of scale
4. Enter new markets
5. Create synthetic instruments
Introduction-Swap Variants
 ‘Vanilla Swaps’ can be used in three different
settings:
1. An interest rate swap to convert a fixed rate
obligation to a floating rate obligation
2. A currency swap to convert an obligation in
one currency to an obligation in another
currency
3. A commodity swap to convert a floating price
to fixed price
Introduction
 A forward contract can be viewed as simple
example of swap.
 A forward contract leads to the exchange of
cash flows on just one future date, swaps
typically lead to cash flow exchanges taking
place on several future dates.
 Interest rate and currency swaps are often
discussed together and are collectively called
rate swaps.
Structure of Swap
 All swaps have basically the same structure.
 Two parties, called counterparties, agree to one
or more exchanges of specified quantities of
underlying assets.
 These underlying assets are known as notional.
 A swap may involve one exchange of notional,
two exchange of notional, a series of exchange
of notional or no exchange of notional.
 The notional exchanged in the swap may be
same or different.
Structure of Swap
 Between the exchange of notional counter party make
payments to each other for using the underlying
assets. The first counterparty makes periodic payment
at a fixed price for using second counter party’s
assets. The fixed price is the swap coupon. At the
same time, the second counter party makes periodic
payment at a floating rate for using the first
counterparty’s assets.
 Usually we have an intermediary that serves as a
counterparty to both end user and is called swap
dealer or market maker or swap bank. The swap
dealer profits from bid-ask spread it imposes on the
swap coupon.
Interest Rate Swap
 A standardized fixed-to-floating interest rate swap,
known in the market jargon as plain vanilla coupon
swap (also referred to as ‘exchange of borrowings’) is
an agreement between two parties in which each
contracts to make payment to the other on a particular
dates in the future till a specified termination date.
 The party which makes fixed payments and which are
fixed at outset are known as fixed rate payer.
 The party which makes payments the size of which
depends upon the future evolution of a specified
interest rate index e.g. LIBOR is known as floating rate
payer.
Interest Rate Swap
 Interest rate swaps are used to reduce the cost
of financing.
 In these cases, one party has access to
comparatively cheap fixed rate funding but
desires floating rate of interest while another
party has access to comparatively cheap
floating rate funding but desires fixed rate of
funding.
Using the Swap to Transform a Liability
 The swap could be used to transform a floating rate loan
into a fixed rate loan. Suppose that Infosys arranged to
borrow Rs.100 cr at LIBOR plus 10 basis points and
Wipro has a three year Rs.100 cr loan outstanding on
which it pay 5.2%. The swap between two companies
can be shown as
5.2% 5%
Wipro Infosys
LIBOR LIBOR+0.1%
Using the Swap to Transform a Liability
 After Infosys has entered into the swap it has three
cash flows:
1. It pays LIBOR plus 0.10 to its outside lenders.
2. It receives LIBOR under the terms of the swap.
3. It pays 5% under the term of the swap.
 These three sets of cash flows net out to an interest
rate payment of 5.1%. Thus for Infosys the swap could
have the effect of transforming borrowings at a floating
rate of LIBOR plus 10 basis point into a borrowings at a
fixed rate of 5.1%
Using the Swap to Transform a Liability
 For WIPRO the swap has following three set of cash
flows:
1. It pays 5.2% to its outside lenders
2. It pays LIBOR under the terms of the swap.
3. It receives 5% under the terms of the swap.
 These three cash flows net out to an interest payment
of LIBOR plus 0.2% . Thus for WIPRO the swap has the
effect of transforming borrowings at a fixed rate of
5.2% into a borrowings at a floating rate of LIBOR plus
20 basis points.
Using the Swap to Transform an Asset
 Swaps can be used to transform the nature of an asset.
Suppose that Infosys owns Rs.100cr in bonds which
provide an interest of 4.7% over next three year and
Wipro has an investment of similar amount that yields
LIBOR minus 25 basis points. The swap between two
companies can be shown as
LIBOR-0.25% 5%
Wipro Infosys
LIBOR 4.7%
Using the Swap to Transform an Asset
 After Infosys has entered into the swap it has three
cash flows:
1. It receives 4.7% on the bonds.
2. It receives LIBOR under the terms of the swap.
3. It pays 5% under the terms of the swap.
 These three sets of cash flows net out to an interest
rate inflow of LIBOR minus 30 basis points. Thus
Infosys has transformed an asset earning 4.7% into an
asset earning LIBOR minus 30 basis points.
Using the Swap to Transform an Asset
 After Wipro has entered into the swap it has three set
of cash flows:
1. It receives LIBOR minus 25 basis points on investment.
2. It pays LIBOR under the terms of the swap.
3. It receives 5% under the terms of the swap.
 These three cash flows net out to an interest rate inflow
of 4.75%. Thus Wipro has transformed an asset earning
LIBOR minus 25 basis points into an asset earning
4.75%
Role of a Swap Dealer
 Usually two non-financial companies such as
Infosys and Wipro do not get in touch directly
to arrange a swap. They each deal with a
financial intermediary such as bank or other
financial institutions.
 ‘Plain vanilla’ fixed for floating swaps are
usually structures so that financial institution
earns 3-4 basis points on the pair of offsetting
transactions.
Role of a Swap Dealer

5.2% 4.985% 5.015%

Swap Infosys
Wipro
Dealer

LIBOR LIBOR LIBOR+0.1%

Role of a Swap Dealer

4.985% 5.015% 4.7%

Swap Infosys
Wipro
Dealer

LIBOR LIBOR LIBOR

-0.25%
The Comparative Advantage Argument
 The popularity of swaps concerns comparative
advantages. Some companies have
comparative advantage when borrowing in
fixed rates whereas others have a comparative
advantage in floating rate markets.
 To obtain a new loan, it makes sense for a
company to go to the market it has a
comparative advantage.
Currency Swap
 In simplest form currency swap involves
exchanging principal and interest payment in
one currency for principal and interest
payments in another currency.
 A currency swap agreement requires the
principal to be specified in each of the two
currencies and they are exchanged at the
beginning and at the end of the life of the
swap. The principal amounts are chosen to be
approximately equivalent using the exchange
rate at the swap’s initiation.
Currency Swap- Example
 Consider a hypothetical five year currency swap between
IBM (a US based Co) and British Petroleum (a UK based
Co) into on Feb 1, 2002. Suppose IBM pays a fixed rate
of interest of 11% in sterling and receives a fixed rate of
interest of 8% in dollars from British Petroleum. Interest
payments are made once a year and principal amounts
are $15 million and GBP 10 million. The swap for this
deal can be depicted as :
11%
IBM British Petroleum
8%
Currency Swap- Example
 This type of swap is known as fixed currency swap
because interest rates in both the currencies are fixed.
 Initially the principal amounts flow in opposite direction
to the arrows.
 Thus at the outset IBM receives GBP 10 million and pays
$15 million.
 Each year during the life of the swap contract , IBM
receives $ 1.20 million (8% of $15million) and pays GBP
1.10 million ( 11% of GBP 10 million)
 At the end of the life of the swap, it pays a principal of
GBP 10 million and receives a principal of $15 million.
The Cash Flows
Dollars Pounds
$ £
Year ------millions------
2001 –15.00 +10.00
2002 +1.20 -1.10
2003 +1.20 –1.10
2004 +1.20 –1.10
2005 +16.20 –11.10
Currency Swap
 A currency swap can transform borrowings in
one currency to borrowings in another
currency.
 The swap can also be used to transform the
nature of asset. Suppose that IBM can invest
GBP10 million in UK to yield 11% pa for the
next five years, but feels that US dollar will
strengthen against sterling and prefers US
denominated investment. The swap has the
effect of transforming the UK investment into a
$15 million investment in the US yielding 8%.
Comparative Advantage
 Currency swap can be motivated by comparative
advantage.
 Suppose the five year fixed rate borrowing cost to
General Motors and Jet Airways in USD and INR is given
below:
USD INR
General Motors 5.0% 12.6%
Jet Airways 7.0% 13%
1. INR rates are higher than US interest rates.
2. General motors is more creditworthy than Jet Airways
because it is offered a more favorable rate of interest in
both the currencies.
3. Since spreads are different in different currencies, swaps
can be negotiated.
Comparative Advantage
 Here a=2, b=0.4. This may be on account of
comparative tax advantage of two companies.
General Motors position might be such that
USD borrowing lead to lower taxes on its
worldwide income than INR borrowings and
may be vice versa for Jet Airways.
 We now suppose that General Motors wants to
borrow in INR and Jet Airways in USD.
 Total gain to all parties on account of this swap
deal is 2-0.4=1.6% pa
 The deal can be depicted as;
Comparative Advantage
USD 5.0% USD 6.3%
GM Swap Dealer Jet Airways
USD 5.0% INR 11.9% INR 13% INR 13%

USD 5.0% USD 5.2%

GM Swap Dealer Quantas Air
USD 5.0% INR 11.9% INR 11.9% INR 13%
Jet Airways some foreign risk

USD 6.1% USD 6.3%

GM Swap Dealer Quantas Air
USD 5.0% INR 13% INR 13% INR 13%
GM bears some foreign risk
Credit Risk in Swaps
 Since swaps are tailor made private arrangement between two
parties, therefore they entail credit risk.
 If neither party defaults, the financial institution remains fully
hedged.
 A financial institution has credit exposure from a swap only
when the value of swap to the financial institution is positive
and there will be no effect on the financial institution’s position
if the value of swap is negative.
 Potential losses from default on a swap are much less than the
potential losses from default on loan with the same principal.
This is because the value of the swap is usually only a small
fraction of the value of the loan.
 Potential losses from defaults on a currency swap are greater
than on an interest rate swap. The reason being principal
amount in two different currencies are exchanged at the end of
the life of a currency swap, a currency swap has greater value
than an interest rate swap.