Swaps

A Presentation
on
SWAPS
By:
Poojitha k

Synopsis:
 An Introduction to Swaps.
 History of Swaps.
 Meaning and Definitions of Swaps.
 characteristics of Swaps.
 Types of Swaps.
 Valuation of Swaps.
 Advantages and Disadvantages of Swaps
 Economic Motives for Swaps.

An Introduction to Swaps
 The word ‘Swap’ literally means an Exchange.
 In the language of Finance, Swap is a derivative
contract in which two counterparties exchange
certain benefits.
 It is a customized contract in the form of Over The
Counter (OTC) derivative. Thus, swaps are non-
standardized contracts that are traded Over The
Counter (OTC).
 A Swap contract is a type of derivative based on
forward claims which can be understood from the
following figure:

A Derivative Contract
Based on
Contingent Claims Forward Claims
*Options *Exchange Traded Futures
* forwards
* swaps

A Swap is a derivative whose value is derived from a
specific underlying may be financial or commodity.
Underlying Contract type
1. Equity Equity Swap
2. Interest Rate Interest Rate Swap
3. Credit Credit Default Swap
4. Foreign Exchange Currency Swap
5. Commodity Commodity Swap

The counterparties agree to exchange one stream
of cashflow against another stream. These streams
are called The Legs of the swap.
(a) Timing of Cashflow: The dates when the cashflows are to
be made.
(b) Methods of Calculation of Cashflow Amount: The Swap
agreement clearly specifies the way the cashflows are to
be calculated.
Because Swaps derivatives are OTC derivatives,
there is always the risk of default of counterparty. So the
corporations and financial institutions are the primary
users of swaps and dominate the swap market Globally.

History of swaps
 The first interest rate swap occurred between IBM
and World bank in 1981.
 Swaps have exploded popularity in 1987.
 In 1987, the International Swaps and
Derivatives Association reported that the swap
market had a total notional value of $865.6 billion.
 By mid 2006, this figure exceeded $250 trillion,
according to the Bank For International
Settlements. That’s more than the 15 times the size
of the U.S. public equities market.

Meaning of Swaps
Private Agreement or a contract between
two parties to exchange a series or streams of
future cash flows according to pre-arranged
formula where;
• One party makes a payment based on a random
outcome such as LIBOR (variable payment) and
• Other party makes a fixed payment.

LIBOR (London interbank Offered Rate) is
considered as the banchmark rate Globally. It is the
average of interest rates estimated by each of the
leading banks in London that it would be charged
were it to borrow from other banks.In India, the
following rates are considered as benchmark.
 MIBOR – Mumbai Interbank Offer Rate.
 MIFOR – Mumbai Interbank Forward Offered Rate.
 MITOR – Mumbai Interbank Tomarrow Offered
Rate.

Definitions of Swaps
 Swap means an exchange, something which is exchanged
or offered in exchange, an exchange ( a sum of money) at
different rates.
- The Chambers Dictionary.
 Private agreement between counterparties to exchange
cashflows in the future according to pre-arranged formula.
 Agreement to exchange sequences of cashflows for a set
period of time.

 Agreement between two companies or financial
institutions to exchange cashflow in the future.
 parties
(a) promise to make payments to one another on
scheduled dates in the future, and
(b) use different criteria or formulas to determine
their respective payments (cash flows).

characteristics of Swaps
 Swap Rate
 Fixed Rate Payer
 Floating Rate Payer
 Settlement dates
 Netting
 Termination date
 Tenor

Indian Swap Market
 At present only swaps are the only types
of rupee derivatives which can be traded in
India.
 Three main types of Swap instruments
having specific criteria.
(1) Plain Vanilla Interest Rate swaps
(2) Currency Swaps
(3) G-see linked swaps

Features of Swap Market
 Custom Instruments
 OTC Market
 Intermediary facilitators (Banks, Investment
banks)
 Unregulated
 Credit (default) risk.
 Dual co-incidence of counterparties.
 Generally long term contracts.
 Termination.

Types of Swaps
Interest Rate swaps
Currency Swaps
Equity Swaps
Credit Default Swaps
Commodity Swaps

Currency Swap
“ A Currency Swap is an Over-The-Counter
derivative. It is a foreign exchange
agreement. It involves the exchange of
principal and interest payment on a loan or an
asset in one currency for principal and interest
payment on an equivalent loan or an asset in
another currency”.

Features of Currency Swaps
1) Foreign Exchange Agreement.
2) Over-The-Counter derivatives.
3) Exchange of Principal amounts at the
beginning and at the end of the Swap
Contract.

Example;
A US Company Target, wants to expand
in Germany and needs Euro. Target is not
known in Germany so the cost of
borrowing is high.

Types of Currency Swaps
 Fixed Rate Currency Swap – Interest rates are
fixed for both the parties.
 Cross Currency swap – Interest rate on one leg
Is based on a floating rate and interest rate on
other leg is based on fixed rate.
1. Fixed to Float
2. Float to Fixed
 Currency Basis Swap – Interest rate on both
legs are based on floating rates.

Interest Rate Swap (IRS) :
 Also known as coupon swap.
 Exchange of two sets of interest flows based on
different interest rates in same currency, with no
exchange of underlying notional principal.
 They often exchange a fixed payment for a
floating payment that is linked to an interest rate.
 These are very popular highly liquid instruments
and used to hedge interest rate risks.

The most common type of interest rate swap is plain
vanilla interest rate swap.
A plain vanilla interest rate swap is an interest
rate swap in which one party pays a floating rate with
both sets of payments in the same currency.
Example;
Party A borrows $100000 from party B for 3 years at a
floating rate (LIBOR) and party B borrows $100000
from party A for 3 years at a fixed rate @5%. Show the
cashflows for first year assuming LIBOR @5% at
0.6% at the end of first settlement date and 7% at the
end of second settlement period.

Features of Interest Rate Swaps
I. Notional (Theoritical) principal
amount.
II. Interest rates.
III. Set of dates of swap transactions.

Types of Interest Rate Swaps
a. Fixed-for-Floating rate swap, same currency.
( To Convert fixed rate asset or liability to a fixed rate asset or
liability or vice-versa)
b. Fixed-for-Floating rate swap, different currencies.
(To convert fixed rate asset or liability in one currency to a
floating rate asset or liability in a different currency or vice-
versa)
c. Floating-for-Floating rate swap, same currency.
(Receiving and paying floating interest rate in the same
currency on notional amount for tenure of certain years)
.

d. Floating-for-Floating rate swap, same currencies.
( pays or receives floating interest rate in one currency and
receives or pays floating rate in another currency at an initial
exchange rate of foreign exchange for a tenure of certain
years)
e. Fixed-for-fixed rate swap, different currencies.
( One party pays or receives fixed interest in one currency
and counterparty receives or pays the fixed interest in
another currency)
f. Other Interest rate Swaps
( Designed to meet the objective of a swap trader)

Equity Swaps
In an equity swap atleast one party pays the
equity return (return on a stock, stock portfolio
or an index); the counterparty could pay an
equity return, a fixed interest rate or a floating
interest rate.
• Floating leg - Usually pegged to a floating rate.
• Equity leg – Based on performance of either a
share of a stock or a stock market index.

Applications of Equity swaps
 To Avoid Transaction cost and security transaction
taxes.
 Passing of negative returns on equity position without
loosing the position of shares and voting rights .
 Facilitates investor to receive the return on a stock
which is listed in such a market where he cannot
invest due to certain legal restriction .
 Vanishing investment barriers .
 Help investors to create leverage

Credit Default swaps (CDS)- Blythe Masters
1994
It is a financial swap agreement between
two counter parties. The buyer of a CDS is known
Protection buyer and seller of a CDS is known as
Protection seller. The seller of the CDS will
compensate the buyer in the event of a loan default
or other credit event. That is, the seller of the CDS
insures the buyer against some reference loan
defaulting.

Features of CDS
 Bilateral contract.
 Reference Entity.
 Regular premium payments by the
protection buyer.
 Termination of contract on default.
 Settlement – Physical and cash
settlement.
 Risk.

Commodity Swaps
Agreement between two counterparties
to exchange cash flows depending upon the
price of a given commodity. Floating price is
exchanged for a fixed price. One party pays
fixed price while the other pay floating price
for the same commodity on the settlement
date. Commodity swaps are used to lock-in
the price of a commodity.

Types of Commodity Swaps
 Fixed-for-Floating commodity Swap
( similar to Fixed-for-floating interest swap).
Example:
GSCI – Golden snacks Commodity exchange.
CRBI – Commodities Research Board Index.
 Commodity-for-Interest Swap ( similar to
equity swap).

Valuation of Swaps
The value of a swap is the Net present value
(NPV) of all estimated future cash flows. A
swap is worth Zero when it is first initiated,
however after this time its value may become
positive or negative.
There are two ways to value swaps :
 Using bond prices
 Portfolio of forward contracts

Termination of Swaps
A party might want to terminate a swap before its formal
expiration; this could be done in several ways:
 One party pays swap value to other party.
 Offsetting contract.
 Resale.
 Swaption: option to enter into a swap. ( when swap is
initiated a party could also purchase the option to enter
into an offsetting swap).

Advantages of Swaps
• Highly flexible and can be customised to
the parties.
• Cost of transacting in the market is fairly
low.
• Private transaction between two parties.

Disadvantages of Swaps
• It requires to find a counterparty with opposite
and matching need and willing to accept the
terms.
• Swap market is an illiquid market and it
requires the consent of counterparty to
terminate.
• It is highly unregulated and suffers from
unlimited potential credit risks.

Risks Associated with Swaps
 Interest rate risk
 Market risk
 Foreign currency exchange risk
 Default or Credit risk
 Settlement risk and so on.

Economic Motives for Swaps
01
• To hedge Various types of risks.
02
• To convert Asset/liability of one currency to other.
03
• To reduce funding cost by multinational firms.
04
• To lock-in the price of a commodity.
05
• To get a designed return on equity Investment.
06
• To access legally restricted Investment opportunities.

Swaps

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