FINANCIAL SWAPS

SWAPS Swaps is the agreed exchange of future cash flows with or without any exchange of cash flows at present.
Financial swaps are broadly classified into : Currency Swaps If the terms of agreement also provide for exchange of principal, which normally happens when two currencies are involved. Interest Rate Swaps If the terms provide for exchange of interest payments without involving exchange of principal payments .

Classification on the basis of the time period involved: Short term Medium term Long term : maturity period of less than 3 years : matures between 3-5 years : extending beyond 5 years

UTILITY Swaps can be used to convert liabilities or assets to the benefit of the owner. a floating rate liability ( loan) can be converted into fixed rate liability (loan), thus ensuring that the volatility in the interest rates does not increase the burden of payments or else , convert a fixed rate liability (loan) into a floating rate liability (loan) when the interest rates fall steeply in the market. Similarly , the nature of an asset can be changed to convert a floating rate earning asset into a fixed rate earning asset or vice versa according to the requirements of the holder.

LIMITATIONS It is difficult to identify a counterparty to take the opposite side of the transaction . The swap deal cannot be terminated without the consent of the parties involved in the transaction. Existence of inherent default risk. Under developed markets for swaps , mainly as a result of very slow development of standardized documentation. This clearly shows that swaps are not easily tradable. The swap market is not exchange controlled and it is over the counter market. This calls for extra caution on the part of the parties involved to look into the creditworthiness of the counterparties before entering into the agreement.

SWAP FACILITATORS Swaps are mutual obligations among the swap parties . But it may not be necessary for the counter parties involved in a swap deal to be aware of each other because of the role assumed by a swap dealer (market-maker) or swap broker. Collectively , the swap facilitators are known as `Swap Banks` or simply `Banks`.

Swap Broker : When the swap facilitator : does not take any financial position in a swap arrangement he initiates and he dissociates himself from the deal after making the arrangement between the counter parties who have approached him , then he is called a `swap broker`. He charges a fee (commission) for the services provided He is not a party to the swap contract. He merely acts as a intermediary. Thus a swap broker is an economic agent who helps in identifying the potential counter parties to a swap transaction.

Swap Dealer : Swap dealer bears the financial risk associated with the deal he is arranging in addition to the functions of a swap broker and He becomes an actual party to the transaction He serves as a financial intermediary , earning profits by helping complete the swap transactions . The swap dealers face two main problems (i) pricing of swaps (ii) managing of default risk of the company

IMPORTANT TERMINOLOGY SWAP COUPON The fixed rate of interest on the swap. NOTIONAL PRINCIPAL The principal amount on which the fixed and floating interest calculations are made. It is notional because the parties do not exchange this amount at any time , it is only used to compute sequence payments . In a standard swap the notional principal remains constant through the life of the swap .

TRADE DATE It is the date on which swap is entered into .This is the date on which both the parties have agreed for a swap. EFFECTIVE DATE This is also known as value date .The maturity of the fixed and floating rate is calculated from the effective date. RESET DATE The applicable LIBOR for each period is to be determined before the date of payment .The 1st reset date will generally be 2 days before the first payment date , 2nd reset date will be 2 days before the second payment. MATURITY DATE The date on which the interest accrual stops.

RELEVANCE OF DATES
X Ltd enters into a swap contract on 10 th June 2001.Firm will pay a fixed rate of 10.10% (semi-annually) to bank and in turn it will receive the flexible rate LIBOR+ 0.05% (semi-annually) .
____________________________________________________ 10 June,`01 12 Jun,`01 10 Dec,`01 12 Dec,`01 10Jun,`02 12 Jun`02 Trade Dt. Effective Dt. 1stPay 2nd Pay
1st Reset Dt.

Receipt Dt. 2nd Reset Dt.

Receipt Dt.

DAY COUNT CONVENTIONS for the calculation of interests:

Fixed 30 / 360 Actual / 360 Actual / 365

Floating Actual / 360 Actual / 365

CURRENCY SWAPS
Step 1: Initial exchange of principal The principal amount is agreed at the outset. The principal amount is agreed in one currency along with the exchange rate which will be used to determine the equivalent amount in the other currency. The principal amounts may be physically exchanged on the commencement date of the swap or may be notionally exchanged as with the interest rate swap. The exchange rate will usually be spot

Step 2: Exchange of Interest Rate Interest rate obligations have been swapped, resulting in interest payments and receipts on agreed dates based upon the swapped principal amounts . Interest will be either fixed or floating as appropriate to the type of swap and each counterpartys obligations. Naturally the two interest rate flows will be in different currencies. Step 3: Re- exchange of the principal at the end of the contract i.e. at maturity.

ILLUSTRATION 1 : Assume that there are two firms A and B who are in need of dollar funds and sterling funds respectively. A wants USD 100 million and B wants 65 million Sterling. The exchange rate is 0.65 GBP / USD. They have access to the foreign currency market at the following rates: Firms Firm A (BBB rating) Firm B (AAA rating) Dollars 10.5% 8.5% Sterling 11.8% 11%

How can A and B make use of financial swap to reduce their borrowing cost incase they wish to share the benefit equally?

 B has absolute advantage in both dollar and sterling markets. A has a comparative advantage in sterling market in relation to the dollar , as it has to pay only 0.8% more in the sterling market as compared to 2.0% in the dollar market.

 As A wants dollar funds and B wants sterling funds , a currency swap can be arranged between them using the comparative principle. So that A and B can reduce their effective cost of borrowing to the extent of the available spread different currency market . Spread in Dollar market : 10.5 8.5 = 2 % Spread in Sterling market : 11.8 11 = 0.8 % Effective Swap Spread / Quality Spread Differential = 2 0.8 = 1.2 % The two parties i.e. A and B can share this spread to their advantage in reducing their effective cost of borrowing in a number of ways depending on the creditworthiness of each of them.

Option I There is no swap dealer to mediate between the two parties. The quality spread is equally shared between A and B. The effective cost of borrowing for each of them will get reduced by 0.6 % in the respective markets in which they wish to borrow. Firm A - Net Borrowing Cost : 10.5 0.6 = 9.9 % Firm B - Net Borrowing Cost : 11 0.6 = 10.4 %

B borrows dollar funds at 8.5 % and lends it to A at 9.9 %. A borrows sterling funds at 11.8 % and lends it to B at 11.8 %. B is gaining 1.4 % on dollar payments from A which can be used to pay the sterling borrowings to A and hence the effective cost of B works out to be 10.4 % [11.8 1.40]. Note :The above example assumes that there is no intermediary, i.e. a swap dealer. But in practice , a swap dealer arranges the swap agreement between the two potential parties.

9.9 % 11.8 % 11.8 %

9.9 %

Firm A

Firm B

Borrows Sterlings at 11.8 %

Borrows Dollars at 8.5 %

Firms

Receipts

Payments

Savings Net Borrowing Cost 9.9 10.5 (-)9.9 = 0.6

A (BBB)

11.8 on

11.8 on 9.9 on $

B (AAA)

9.9 on $

8.5 on $ 11.8 on

11.8 -1.4 = 10.4

11(-)10.4 = 0.6

ILLUSTRATION 1 : Assume that there are two firms A and B who are in need of dollar funds and sterling funds respectively. A wants USD 100 million and B wants 65 million Sterling. The exchange rate is 0.65 GBP / USD. They have access to the foreign currency market at the following rates: Firms Firm A (BBB rating) Firm B (AAA rating) Dollars 10.5% 8.5% Sterling 11.8% 11%

How can A and B make use of financial swap to reduce their borrowing cost incase they wish to share the benefit equally? Assume that both the companies decide to appoint a financial intermediary as a swap dealer and are ready to pay 0.2% of the swap benefit to him and will share the remaining profit equally.

Firm A Net Borrowing Cost: 10.5 0.5 = 10 % Firm B Net Borrowing Cost: 11 0.5 = 10.5 % Steps involved in Swap will be: B borrows dollar funds at 8.5 % and lends it to A at 10 %. A borrows sterling funds at 11.8 % and lends it to B at 10.5 %. Here the swap dealer is exposed to exchange risk due to the offset of gain in one currency with the loss in another .This risk can be avoided if the dealer can hedge with forwards or futures each year during the life of swap. The exchange risk can be shifted to A or B also .The spread need not be shared equally always .The dealer can charge more from the party he considers to be more risky.

SWAP BANK
10 % $
11.8 %

8.5 % $ 10.5%

Firm A

Firm B

Borrows Sterlings at 11.8 %

Borrows Dollars at 8.5 %

Firms

Receipts

Payments

Savings Net Borrowing Cost

11.8

11.8 10 $ 8.50 $ 10.5 A :11.8 B :8.5 $

10 $

10.5 10 = 0.5 11-10.5 = 0.5 20.5 20.3 = 0.2

8.50 $

0.5

Swap Bank

B: 10.5 A :10 $

TYPES OF SWAPS ZERO COUPON SWAP It has only one fixed payment at maturity. BASIS SWAP It involves an exchange of two floating payments , each tied to a different market index. CALLABLE SWAP The fixed rate payer has the option to terminate the agreement prior to the scheduled maturity . PUTTABLE SWAP The fixed rate receiver has the option to terminate the agreement prior to the scheduled maturity . EXTENDABLE SWAP One of the parties has the option to extend the swap beyond the scheduled termination date.

INTEREST RATES SWAPS Interest rate swap is an agreement between two or more parties who agree to exchange interest payments over a specific time period on agreed terms. The interest rates agreed may be fixed or floating. LIABILITY SWAP: If there is an exchange of interest rate obligation. ASSET SWAP: If there is an exchange of interest rate income.

 PLAIN VANILLA SWAPS: These are the swaps where the fixed rate obligation are exchanged for floating rate obligations over a specific period of time on notional principals. They are also called Coupon Swaps or Generic Swaps.

Illustration 2:

Interest Rate Swap

Firms XYZ Ltd.

Requirement Fixed Rate USD

Fixed Rate 11%

Floating Rate Prime+ 0.75% Prime

ABC Ltd.

Floating Rate USD

9.5%

The firm XYZ Ltd. and ABC Ltd. decide to enter into an interest rate swap and decide to appoint HDFC Bank as the facilitator. If all the three parties mutually agree to share the benefit arising out of swap deal in the ratio of 1: 1: 1 Show how all the three parties yield benefit by entering into an interest rate swap?

ABC Ltd. : Absolute advantage XYZ Ltd. : Comparative advantage in floating rate Fixed Rate Spread : 11-9.5 = 1.5 Floating Rate Spread : (prime+0.75) prime = 0.75 Quality Spread = 1.5 0.75 = 0.75 To be shared by ABC ltd , XYZ ltd and swap bank equally i.e. each party gets 0.25 .

Net Borrowing Cost for : ABC Ltd : Prime - 0.25% = Prime - 0.25% XYZ Ltd : 11% - 0.25% = 10.75%

ABC borrows USD at 9.5% and lends it to XYZ through a swap bank at 10.75% . XYZ borrows USD at floating (Prime+0.75) and lends it to ABC through the swap bank at (Prime-0.25).

Firms

Receipts

Payments

Net Borrowing Cost

Savings

XYZ

Prime+0.75 10.75 Prime+0.75 = 10.75

11 10.75 = 0.25

ABC

9.50

9.50 Prime-0.25

= Prime0.25

Prime (prime0.25) = 0.25 Income : 0.25

Swap XYZ:10.75 ABC:9.50 Bank ABC:prime- XYZ:

0.25 prime+ 0.75

 Thank you