SWAPS AND ITS TYPES

PRESENTED BY: ABHINAV GUPTA(01-MBA-11) ADITYA PAUL SHARMA(02-MBA-11) AKHIL GOUR(03-MBA-11) AKHIL GUPTA(04-MBA-11) AMAN TALLA(06-MBA-11)
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SWAP: CONCEPT AND NATURE

In the business world, swaps have been termed as private agreements between the two parties to exchange cash flows in the future according to a prearranged formula. In simple words, a swap is an agreement to exchange payments of two different kinds in the future. It involves exchange of cash flows or payments, hence, it is also called financial swap in global financial markets. The swaps market has had an exceptional growth since its inception in 1979. The swaps volume exceeds $10 trillion today.

 In the context of financial markets, the term swap has two meanings. First, it is a purchase and simultaneous forward sale or viceversa. Second, it is defined as the agreed exchange of future cash flows, possibly, but not necessarily with a spot exchange of cash flows. The second definition of swap is most commonly used stating as an agreement to the future exchange of cash flows. Swaps not only often replace other derivative instruments such as futures and forwards, but also complement those products.
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EVOLUTION OF SWAP MARKET

Most of the financial experts agree that the origin of the swap markets can be traced back to 1970s when many countries imposed foreign exchange regulations and restrictions in order to control cross border capital flows. In 1980s, a few countries liberalized their exchange regulatory measures, as a result, some of the MNCs treasures structured their portfolios and brought out new financial product, known as swaps. The first swap was negotiated in 1981 between Deutsche Bank and an undisclosed counter party. Since then, the swap markets have grown very rapidly.
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 The formation of the International Swap Dealers Association(ISDA) in 1984 was a significant development to speed up the growth in the swaps market by standardizing swap documentation. In 1985 the ISDA published the first standardized swap code, which was revised in 1986 and then in 1987, it published its Standard Form Agreements.

FEATURES OF SWAPS
Counter Parties: All swaps involve the exchange of a series of periodic payments between at least two parties. Facilitators: Swap agreements are arranged mostly, ( known as swap facilitators), through an intermediary which is usually a large international financial institution/ bank having network of its operations in major countries. Swap facilitators can be classified into two categories:
Brokers: They function as agents that identify and bring the counter parties on the table for the swap deal. Swap dealers: They themselves become counter-parties and takeover the risk.

Cash Flows: In the swap deal, two different payment streams in terms of cash flows are estimated to have identical present values at the outset when discounted at the respective cost of funds in the relevant primary markets. 6

 Documentations: Swap transactions may be set up with great speed sine their documentations and formalities are generally much less in comparable to loan deals. Transaction Costs: The transaction costs in swap deals are relatively low in comparison to loan agreements. Benefit to Parties: Swap agreements will be done only when the parties will be benefited by such agreement, otherwise such deals will not be accepted. Termination: The termination requires to be accepted by counter parties. Default Risk: Since most of the swap deals are bilateral agreements, therefore, the problems of potential default by either counter party exists, making them more risky products in comparison to futures and options. 7

MAJOR TYPES OF FINANCIAL SWAPS

The basic objective of a swap deal is to hedge the risk as desired by the counter parties. The major risks that can be changed with the swap transactions, are relating to interest rate, currency, commodity, equity, credit, climate and so on. The major types of financial swaps that will be discussed are as:
Interest-Rate Swaps. Currency Swaps. Equity Swaps.

INTEREST-RATE SWAPS
An interest-rate swap is a financial agreement between the two parties who wish to change the interest payments or receipts in the same currency on assets or liabilities to a different basis. There is no exchange of principal amount in this swap. It is an exchange of interest payment for a specific maturity on a agreed upon notional amount. Maturity ranges from a year to over 15 years, however, most transactions fall within two years to ten years period. The simplest example of interest rate swap is to exchange of fixed for floating rate interest payments between two parties in the same currency.
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FEATURES OF INTEREST-RATE SWAPS

Notional Principal In the interest rate swap agreement, the interest amount whether fixed or floating is calculated on a specified amount borrowed or lent. It is notional because the parties do not exchange this amount at any time. Fixed Rate This is the rate, which is used to calculate the size of fixed payment. Banks or other financial institutions who make market in interest rate swaps quote the fixed rate, they are willing to pay if they are fixed rate payers in swap(bid swap rates) and they are willing to receive if they are floating rate payers in a swap(ask swap rate). Floating Rate It may be defined as one of he market indexes like LIBOR, SIBOR, MIBOR, Treasury bill rate, primary rate etc. on which basis the floating rate is determined in the swap agreements.

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Example For Fixed Rate

A bank might quote a US dollar floating to fixed 5-year swap rate:
Treasuries + 20 bp/Treasuries + 40bp vs six- month LIBOR

The quote indicates the following:

The said bank is willing to make fixed payment at a rate equal to the current yield on 5-year treasury notes plus 20 basis points (0.20 percent) in return for receiving floating payments, say at six-month LIBOR. The bank has offered to accept at a rate equal to 5-year treasury notes plus 40 basis points in return for payment of six month LIBOR.

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Trade Date: It may be defined as such date on which the swap deal is concluded.

Effective Date: It is the date from which the first fixed and floating payment start to accrue.

Relevant dates for the floating payment: D(S) is the setting date on which the floating rate applicable for next payment is set, D(1) is that date from which the next floating payment starts to accrue and D(2) is such date on which the payment is due.

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 Fixed and Floating payments: In a standard swap deal the fixed and floating payments are calculated as follows:
Fixed payment= (P)*(Rfx)*(Ffx) Floating payment= (P)*(Rfe)*(Ffe)

where P is the notional payment, Rfx is the fixed price, Rfe is the floating rate set on the reset date, Ffx is the fixed rate day count fraction and Ffe is the floating rate day count fraction. The last two are time periods over which the interest is to be calculated.

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EXAMPLE OF INTEREST RATE SWAP

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SITUATION OF A AND B FIRMS BEFORE THE SWAP

MORTGAGE PORTFOLIO

$100 (M) PORTFOLIO 5-YEAR AVERAGE MATURITY

LOAN PORTFOLIO

$100 (M) PORTFOLIO 5-YEAR AVERAGE MATURITY

8.50% YIELD

LIBOR+ 0.75% (YIELD)

FIRM A

FIRM B

LIBOR + 0.5%

6% $100(M) 5-YEAR MATURITY

FLOATING RATE LENDERS

EURO BONDS
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 In order to eliminate the interest rate risk. Firm A may enter into interest rate swap deal with any Big Bank. Assume that 6.50 percent will be paid by Firm A to Big Bank for 5 years with payments calculated by multiplying the rate by $100(M) notional principal amount. In return for this payment, Big Bank agrees to pay the Firm A six-month LIBOR over five years, with reset dates matching the reset on its floating rate loan. This is shown in the figure in the next slide relating to Firm A. The net result to A is a follows: Receipt on portfolio
Pay big bank Receive from big bank Pay on loan Cost of fund Locked in Spread 8.50% 6.50% LIBOR (LIBOR + 50bp) (6.50 + .50)= 7.00% 1.50%
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FIRM A INTEREST RATE SWAP AGREEMENT WITH BIG BANK

MORTGAGE PORTFOLIO

8.50%

6.50%

FIRM A

LIBOR

Big Bank

NOTIONAL $100(M) FOR 5 YEARS

LIBOR + 0.5%

FLOATING RATE LENDERS

$100 (M) LOAN 5-YEAR MATURITY

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 Similarly, Firm B enters into portfolio with the Big Bank where it agrees to pay six-month LIBOR to Big Bank on an notional principal amount of $100(M) for 5 years for receiving payments of 6.40%. The net result to B and swap are shown in the figure in next slide. The net result to B is as follows:
Receipt on portfolio
Pay big bank Receive from big bank Pay on euro bond Cost of fund Locked in Spread LIBOR + 0.75% LIBOR 6.40% 6.00% LIBOR 0.40% 0.75% + 0.40%= 1.15%
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FIRM B INTEREST RATE SWAP AGREEMENT WITH BIG BANK

$100(M) FOR 5 YEARS

LOAN PORTFOLIO

LIBOR+ 0.75%

NOTIONAL $100(M) FOR 5 YEARS

6.40%

Big Bank

LIBOR

FIRM B

6%

$100 (M) FOR 5-YEAR MATURITY

EURO BONDS
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 It is evident from the example that the cost of funds of FIRM B has been reduced to LIBOR less 40 basis points resulting FIRM B has been locked in spread on its portfolio of 115 basis points. In this swap deal, the interest of Big Bank is to be assessed. The net result in each of these transactions is that the risk of loss due to interest rate fluctuations has been transferred from the counter party to Big Bank. The Big Bank will only be interested to enter into such deals with Firm A and B if it will also be in beneficial position. As a financial intermediary, the Big Bank puts together both transactions, the risks net out is left with a speed of 10 basis points. This is shown in the figure in next slide.
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SWAP STRUCTURE
MORTGAGE PORTFOLIO
$100 (M) PORTFOLIO 5-YEAR MATURITY $100 (M) FOR 5-YEAR MATURITY

LOAN PORTFOLIO
LIBOR+ 0.75%

8.50%

FIRM A

6.50%

6.40%

Big Bank
LIBOR LIBOR

FIRM B

LIBOR + 0.5%

6%

FLOATING RATE LENDERS

$100 (M) FOR 5-YEAR MATURITY

EURO BONDS
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 Thus, Big Bank receives compensation equal to $1 lac annually for the next five years on $100(M) swap deal. Swap profit to Big Bank
0.001(10 basis points) * 1 million= $ 1 lac

Receive
Pay Receive Pay Net

6.50%
6.40% LIBOR LIBOR (6.50- 6.40)= 10 basis points

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TYPES OF INTEREST RATE SWAPS

It is also known as fixed-for-floating swap. In this swap, one party with a floating interest rate liability is exchanged with fixed rate liability. Usually swap period ranges from 2 years to over 15 years for a pre-determined Plain Vanilla notional principal amount. Most of the deals occur within 4 year period. Swap The holders of zero coupon bonds get the full amount of loan and interest accrued at the maturity of the bond. The fixed rate player makes a bullet payment at the end and floating rate player makes the periodic payment Zero coupon throughout the swap period. to floating The floating reference can be switched to other alternatives as per the requirement of the counter party. These alternatives include three month LIBOR, One month CP, T-Bill rate, etc. In other words, alternative floating Alternative rates are charged in order to meet the exposure of other party. floating rate

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 In this swap, one counter party pays one floating rate, say, LIBOR while the other counter party pays another, say, prime for a specified time period. These swap deals are mainly used by the non-US banks to manage their Floating-todollar exposure. floating

Forward swap

This swap involves an exchange of interest payment that does not begin until a specified future point in time. It is also kind of swap involving fixed for floating interest rate.

There is exchange of fixed rate payments for floating rate payments, whereby the floating rate payments are capped. An upfront fee is paid by Rate-capped floating rate party for the cap. swap

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Swaptions

These are combination of the features of two derivative instruments, i.e., option and swap. The buyer of the Swaptions has the right to enter into an interest rate swap agreement by some specified date in future. Swaptions can be of two types: Call Swaptions or callable swap and put Swaptions or puttable swap.

Extendable swap

It contains an extendable feature, which allows fixed for floating counter party to extend the swap period.

It involves the exchange of interest payment linked to the change in the stock index. For example, an equity swap agreement may allow a company to swap a fixed interest rate of 6% in exchange for the rate of appreciation on a particular Equity swap index, say, BSE or NSE index, each year over the next four years.

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EXAMPLE OF PLAIN VANILLA SWAP

Let us consider a simple example of plain vanilla swap to show the net cash flow arisen in the swap. Let us assume Party X on a semi annual basis, pays 7%of interest rate on the notional amount and receives from the Party Y LIBOR + 30 basis points. The current six-month LIBOR rate is 6.30% per annum. The notional principal is $35 million.

7.00% Party X pays fixed, receives floating LIBOR + 30 bp FIG. : STRUCTURE OF PLAIN VANILLA SWAP Party Y received fixed, pays floating

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 Amount to be paid as per fixed rate: The fixed rate in a swap is usually quoted on a semi-annual bond equivalent yield basis. Therefore, the interest is paid every six months is:
Notional principal(Days in period/365)(Interest rate /100) = $35,00,00,000(182/365)(7.00/100)= $12,21,643.83 It is assumed that there are 182 days in a particular period.

Amount to be paid as per floating rate: The floating side is quoted on a money market yield basis. The difference between the two-rate computation is the number of days in a year conversion employed. Therefore, the payment is:
Notional principal(Days in period/360)(Interest rate/100) =$35,00,00,000(182/360)(7.00/100)= $11,67,833.33

In a swap, the payments are netted. In this case, Party X pays Party Y the net difference. : $12,21,643.83-$11,67,833.33 = $53,810
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VALUATION OF INTEREST RATE SWAP

Assuming no default risk, an interest swap can be valued either as a long position in one bond combined with short in another bond or as portfolio of forward contracts. Interest rate swap can be valued by treating the fixed rate payments as being equivalent to the cash flows on a conventional bond and the floating rate payments as being equivalent to a floating rate note(FRN). The principal amount is not exchanged and further amount is paid in the same currency. Thus, the value of swap could be expressed as the value of fixed rate bond and value of the floating rate underlying the swap. It may be expressed as: V= B1 B2 where V is the value of swap, B1 is the value of fixed rate bond underlying the swap and B2 is the value of floating rate bond underlying the swap.
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 In the previous equation, valuation of swap depends upon the valuation of fixed rate bond and floating rate bond. To find out valuation, the discount rate used should reflect the riskness of the cash flows. Therefore, it is appropriate to use the same discount rate for both the bonds B1 and B2.

Value of the bond B1 = + Q =1 where K is the periodic fixed payment in the swap, is the discount rate corresponding to maturity t, Q is the principal sum and is length of the time to corresponding maturity. No, Value of the bond B2 = Q 1 1 + K* 1 1 where K* is the floating rate payment, Q is the principal sum, r1 is the discount rate and t1 is length of the time to the next interest payment.

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EXAMPLE

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CURRENCY SWAPS
A swap deal can also be arranged across currencies. It is an oldest technique in the swap market. The two payment streams being exchanged are denominated in two different currencies. For example , a firm which has borrowed Japanese yen at a fixed interest rate can swap away the exchange rate risk by setting up a contract whereby it receives yen at a fixed rate in return for dollars at either a fixed or a floating interest rate.

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 The currency swap is, like interest rate swap, also two party transaction, involving two counter parties with different but complimentary needs being bought by a bank. Normally three basic steps are involved which are as under:
Initial exchange of principal amount. On-going exchange of interest. Re-exchange of principal amounts in maturity.

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EXAMPLE OF CURRENCY SWAP

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Step III Exchange of Final Contract Swiss franc forward contract Dollar forward contract

Firm A

Firm B

Swiss franc principal to bond holders.

Fig.: Transaction under currency swap

Dollar principal to bond holders

From the example, it is noted that exchange of principal amounts, both at the beginning and at the end of swap contract is notional and not real. Then cash flows resulting from the interest rates are real. The benefits arising out of such swap to counter parties depend upon the movements in underlying currency exchange rates and interest rates there on.
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TYPES OF CURRENCY SWAPS

The structure of currency swaps differs from interest rate swaps in a variety of ways. The major difference is that in a currency swap, there is always an exchange of principal amounts at maturity at a predetermined exchange rate. The swap contract, behaves like a long dated forward, is foreign exchange contract, where forward is the current spot rate. The currency swaps can be of different types based on their term structure; these are namely fixed-to-fixed currency swap, floatingto-floating currency swap and fixed to floating currency swap.

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Fixed-to-fixed

Floating-to-floating

Fixed-to-floating

The currencies are exchanged at fixed rate. One firm raises a fixed rate liability in currency X, say USD while the other firm raises fixed rate funding in currency Y, say, Pound. The principal amounts are equivalent at the current market rate of exchange. In swap deal, first party will get Pound whereas the second party will get Dollars. Subsequently, the first party will make periodic (pound) payments to the second, in turn gets dollars computed at interest at a fixed rate on the respective principal amount of both currencies. At maturity, the dollar and pound principal are reexchanged.

The counter parties will have payments at floating rate in different currencies.

It is a combination of fixed-tofixed currency swap and floating swap. One party makes payment at fixed rate in currency X, while the other party makes the payment at a floating rate in currency Y. Contracts without the exchange and re-exchange of principals do not exist.

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EXAMPLE

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ALTERNATIVE STRATEGY FOR CURRENCY SWAP

There can be different alternative arrangements depending upon the firms considerations. An alternative arrangement in the previous example is shown as follows:

The firm X borrows FRF@ 9% and lends to the bank, who in turn transfers the same to firm Y @9% p.a. On the other hand, firm Y borrows DEM@ 6.4% in its market and lends to the bank, who transfers the same to firm X@6% p.a. In this figure, firm Y bears some foreign exchange risk because it pays 10% in FRF and 6.4% in DEM.
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VALUATION OF CURRENCY SWAP

The swap can be valued as the difference between he current values of two conventional bonds. The technique used for valuation of currency swap is just synonymous to valuation of interest rate swap. The value of foreign currency bond, and the corresponding value of a domestic currency bond would be taken considered which are as under:
V= SBF BD where V is the value of the swap, S is the current exchange rate , BF is the value in foreign currency of the foreign currency bond and BD is the value of local currency bond underlying the swap.

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 Calculation of BF : The bond equivalent to the foreign currency interest flows has the value as shown in the following equation:
BF = + Q =1 where is constant foreign currency interest payment, is the foreign currency discount rate, is corresponding periods to the interest payments and Q is the principal sum in foreign currency.

Calculation of BD : The bond equivalent to the foreign currency interest flows has the value as shown in the following equation:
BD = + SQ =1 where is the constant foreign currency interest payment, is discount rates for various periods to cash flows, is length of those periods to cash flows, S is exchange rate at the time that swap was agreed and Q is foreign currency principal sum converted into the equivalent domestic currency principal sum

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EXAMPLE

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DEBT-EQUITY SWAP
In debt-equity swap, a firm buys a countrys debt on the secondary loan market at a discount and swaps it into local equity. Debts are exchanged for equity by one firm with the other. A market for less developed countries (LDC) debt-equity swap has developed that enable the investors to purchase the external debts of such under-developed countries to acquire equity or domestic currencies in those same countries. This market was developed in 1985 and by 1988, the same market reached to $15 billion in size and further it is on rising trend.
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THANK YOU AND HAVE A NICE DAY

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