Swaps

swapsswaps
 -- swap means exchange-- swap means exchange
 -- exchange of future cash flows between two-- exchange of future cash flows between two
parties on a predetermined basisparties on a predetermined basis
 -- a nseries of forward contracts-- a nseries of forward contracts
 -- types-- types
 I Interest rate swapI Interest rate swap
 -- coupon swap-- coupon swap
 -- basis swap-- basis swap
 -- cross – currency swap-- cross – currency swap

COUPON SWAP A FLOWCOUPON SWAP A FLOW
CHARTCHART
Abc requires 7 year fixed rate funding
Abc raises a 7 year floating rate debt at
0.50% over libor (i.e. in the market where
it has a comparative advantage)
Abc locatesxyz , a company which needs 7
year floating rate funds

Interest rate swapsInterest rate swaps
Coupon swapCoupon swap
OrOr
Plain vanilla coupon swapPlain vanilla coupon swap

Interest rate swapInterest rate swap
I coupon swapI coupon swap
-- there is an exchange (swap) of interest payment streams of-- there is an exchange (swap) of interest payment streams of
differing character exchanged according to predetermined rules.differing character exchanged according to predetermined rules.
-- principal is not exchanged (neither initially nor at maturity)-- principal is not exchanged (neither initially nor at maturity)
-- one party pays a strem of fixed rate interest payments and-- one party pays a strem of fixed rate interest payments and
receives a strem of floating rate payments, both denominated inreceives a strem of floating rate payments, both denominated in
the same currencythe same currency
-- the counterparty receives ‘ fixed’ and pays ‘floating’-- the counterparty receives ‘ fixed’ and pays ‘floating’
-- economic rationale: comparative advantage-- economic rationale: comparative advantage

 Some companies have a comparative advantage in the fixed rateSome companies have a comparative advantage in the fixed rate
market, while other companies have a comparative advantage inmarket, while other companies have a comparative advantage in
floating rate market. Hence companies having comparativefloating rate market. Hence companies having comparative
advantage in the fixed rate market might borrow fixed even thoughadvantage in the fixed rate market might borrow fixed even though
even though it is desirous of a floating rate loan.Using a couponeven though it is desirous of a floating rate loan.Using a coupon
swap, the company can convert fixed interest payments to floatingswap, the company can convert fixed interest payments to floating
interest payments.interest payments.
 Benchmark interest ratesBenchmark interest rates
 Fixed -- yield on government bondsFixed -- yield on government bonds
 FLOTING -- LIBORFLOTING -- LIBOR
Coupon swap results in reduction in borowing costs for both partiesCoupon swap results in reduction in borowing costs for both parties

Mechanism of aMechanism of a
coupon swapcoupon swap
COMPANYCOMPANY ABC LTD.ABC LTD. XYZ LTD.XYZ LTD.
FLOTINGFLOTING
RATERATE
LIBOR + 0.5%LIBOR + 0.5% LIBOR +LIBOR +
0.125%0.125%
FIXEDRATEFIXEDRATE 9.5% P.A9.5% P.A 8% P.A8% P.A
RATINGRATING ‘‘AA’AA’ ‘‘AAA’AAA’

 CURRENT LIBOR - 8% p.aCURRENT LIBOR - 8% p.a
 XYZ has an advantage of 1.5 % andXYZ has an advantage of 1.5 % and
0.375% over ABC in the fixed rate and0.375% over ABC in the fixed rate and
floating rate market respectivelyfloating rate market respectively
 So , XYZ will borrow fixed and ABC willSo , XYZ will borrow fixed and ABC will
borrow floatingborrow floating

Abc raises floating money pays 0.5% overAbc raises floating money pays 0.5% over
libor to lenders receives libor from xyzlibor to lenders receives libor from xyz
pays 8.5% fixed to xyzpays 8.5% fixed to xyz
Xyz raises fixed rate pays 8% to lendersXyz raises fixed rate pays 8% to lenders
pays libor to abc. Receives fixed 8.5%pays libor to abc. Receives fixed 8.5%
from abcfrom abc

COSTCOST ABCABC XYZXYZ
PRE- SWAP(A)PRE- SWAP(A) 9.5%9.5% LIBOR +LIBOR +
0.125%0.125%
i.e.8.125i.e.8.125
POST-POST-
SWAP(B)SWAP(B)
9%9% LIBOR - 0.5%LIBOR - 0.5%
i.e 7.50%i.e 7.50%
SAVINGS(A-B)SAVINGS(A-B) 0.5%0.5% 0.625%0.625%

 TOTAL GAIN TO ALL PARTIES FROM THETOTAL GAIN TO ALL PARTIES FROM THE
SWAPSWAP
 EQALS THE DIFFERENCE BETWEEN THEEQALS THE DIFFERENCE BETWEEN THE
INTEREST RATES AVAILABLE FOR THEINTEREST RATES AVAILABLE FOR THE
TWO COMPANIES IN THE FIXED MARKETSTWO COMPANIES IN THE FIXED MARKETS
MINUS THE DIFFERENCE BETWEEN THEMINUS THE DIFFERENCE BETWEEN THE
INTEREST RATES AVAILABLE TO THE TWOINTEREST RATES AVAILABLE TO THE TWO
COMPANIES IN THE FLOATING RATE MKTSCOMPANIES IN THE FLOATING RATE MKTS
 I.E (9.50% - 8.0%) – (8.50% -8.125%)I.E (9.50% - 8.0%) – (8.50% -8.125%)
 =1.1250%=0.5% TO ABC =0.625% TO XYZ=1.1250%=0.5% TO ABC =0.625% TO XYZ

Coupon swap – a flowCoupon swap – a flow
chartchart
 Abc requires 7 year fixed rate fundingAbc requires 7 year fixed rate funding
 Abc raises a 7 ear floating rate debt at 0.5%Abc raises a 7 ear floating rate debt at 0.5%
over LIBOR9(i.e in the market where it has aover LIBOR9(i.e in the market where it has a
comparative advantage,or a lowercomparative advantage,or a lower
disadvantagedisadvantage
 Abc locates Xyz, a company which needs 7Abc locates Xyz, a company which needs 7
year floating rate funds(same amount andyear floating rate funds(same amount and
parallel repayment), and has a comparativeparallel repayment), and has a comparative
advantage over Abc in the fixed rate market.advantage over Abc in the fixed rate market.

 Xyz raises a 7year fixed rate debt at 8%p.aXyz raises a 7year fixed rate debt at 8%p.a
 Xyz and Abc swap interest liabilities.XyzXyz and Abc swap interest liabilities.Xyz
agrees to pay interest at say Libor to Abc , andagrees to pay interest at say Libor to Abc , and
Abc agrees to pay interest at say 8.5% to Xyz.Abc agrees to pay interest at say 8.5% to Xyz.
 Xyz has now got floating rate funds at anXyz has now got floating rate funds at an
effective cost of Libor to Abc but makes a profiteffective cost of Libor to Abc but makes a profit
of 0.5% on the fixed side , or 0.625% belowof 0.5% on the fixed side , or 0.625% below
what it would have otherwise paid for floatingwhat it would have otherwise paid for floating
rate funds.rate funds.

 Abc has now got fixed rate funds at anAbc has now got fixed rate funds at an
effective cost of 9%p.a (it pays 8.55 toeffective cost of 9%p.a (it pays 8.55 to
Xyz and makes a loss of 0.5% on theXyz and makes a loss of 0.5% on the
floating side or below what it would havefloating side or below what it would have
otherwise paid for fixed rate fundsotherwise paid for fixed rate funds

Swap constraintsSwap constraints
 I Counterparties should have differing andI Counterparties should have differing and
mutually complementary needs.mutually complementary needs.
 II The principal amount borrowed by theII The principal amount borrowed by the
counterparties should be of identical amountcounterparties should be of identical amount
and maturity.and maturity.
 III Counterparty riskIII Counterparty risk
 -- in practice, major international banks step-- in practice, major international banks step
in and run their own swap bookin and run their own swap book
 -- a bank would enter into a separate swap-- a bank would enter into a separate swap
transaction with each partytransaction with each party

 -- a bank would do a swap without the-- a bank would do a swap without the
ready availability of a matchingready availability of a matching
counterparty and hedge its exposures incounterparty and hedge its exposures in
the market, until another counterpartythe market, until another counterparty
with opposite requirement is located.with opposite requirement is located.
 -- Thus with an intermediary, the-- Thus with an intermediary, the
comparative advantage gets slit threecomparative advantage gets slit three
ways 9between the bank and the twoways 9between the bank and the two
counterpartiescounterparties

Curency swapsCurency swaps
 1. Exchange of cash flows1. Exchange of cash flows
 2. On NPV basis, identical to covering on2. On NPV basis, identical to covering on
forward basis.forward basis.
 3. Optimise liability profile3. Optimise liability profile
 4. Use as hedge against economic exposures4. Use as hedge against economic exposures
 5. Timing – when temptation to do something5. Timing – when temptation to do something
is leastis least
 6. Accounting/tax implications6. Accounting/tax implications

Mechanics of aMechanics of a
currency swapcurrency swap
companycompany usdusd pdspds
AA 6.5%6.5% 8.5%8.5%
BB 8.5%8.5% 9.5%9.5%
-- ‘ A’ has an advantage of 2% and 1%
over
‘B’ in borrowing dollars and sterling
respectively.

Currency swapCurrency swap
 -- $/£ = $ 1.6 per £.
 -- ‘A’ is desirous to swap dollar borrowing
into sterling and vice-versa for ‘B’
 A financial contract for exchange ofA financial contract for exchange of
principal and fixed payments on a loan inprincipal and fixed payments on a loan in
one currency for principal and fixed rateone currency for principal and fixed rate
interest payments on a loan in anotherinterest payments on a loan in another
currency.currency.

 The exchange rate at which the principal andThe exchange rate at which the principal and
interest payments are to be exchanged in theinterest payments are to be exchanged in the
two currencies during the life of the swap is thetwo currencies during the life of the swap is the
one ruling in the spot market on the day theone ruling in the spot market on the day the
currency swap is entered into.currency swap is entered into.
 Like interest rate swaps , currency swaps areLike interest rate swaps , currency swaps are
also motivated by comparative advantages.also motivated by comparative advantages.
 Currency swaps facilitate a corporate to alterCurrency swaps facilitate a corporate to alter
its existing currency flows and risk:rewardits existing currency flows and risk:reward
strategy.strategy.

 Exchange of principal takes place at theExchange of principal takes place at the
beginning and at the end whereasbeginning and at the end whereas
interest payments occur during the life ofinterest payments occur during the life of
the swap.the swap.
 usually banks act as intermediariesusually banks act as intermediaries
thereby eliminating couterparty risk.thereby eliminating couterparty risk.

Basis swapBasis swap
A swap in which a stream of floatingA swap in which a stream of floating
interest rates are exchanged for anotherinterest rates are exchanged for another
stream of floating interest rates is knownstream of floating interest rates is known
as basis swap.Such type of swap isas basis swap.Such type of swap is
possible when:possible when:
Both the floating rate streams are based onBoth the floating rate streams are based on
the same structure, but differentthe same structure, but different
instruments.E:xample: a promise to payinstruments.E:xample: a promise to pay
B and B promises to pay A 3 monthB and B promises to pay A 3 month
LIBOR to 3 month treasury bill yield.LIBOR to 3 month treasury bill yield.

 Interest base :money market9actual /360Interest base :money market9actual /360
or 365) or Bond (30 days month and 360or 365) or Bond (30 days month and 360
days year)days year)
 Periodicity annually, semiPeriodicity annually, semi
annually,quarterlyannually,quarterly

Swaps

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Editor's Notes