Swaps meaning, evolution and

types II sem M Com

Dr Manju S Associate Professor

SWAPS

-SWAPS are the most versatile of derivative products

-The dev of swap market was an imp milestone in the growth of international capital markets

-swaps have enhanced funding choices for financiers or bankers.

-while futures are single period price fixing contracts

Swaps are multi-period price fixing contracts

developed as OTC products; but now traded at exchanges.

Swaps very essential due to varied access to financial markets and different needs

For ex some may need fixed rate funds, some may need variable interest rate funds

Currency and interest rate SWAPS are techniques that transform the characteristics of a liability or assets

Meaning of swaps:

means exchange

a financial swap may be defined as a contract whereby two parties,

- exchange two streams of cash flows over a defined period of time;

-usually through an intermediary like a financial institution.

Evolution of swaps:

History of SWAP is much debated and disputed

The concept originated from British pounds and US Dollars loans arranged between British and American entities in 1970s

In 1970, with the introduction of exchange controls in UK that parallel and back-to-back loans began to be arranged.

Throughout the 1970s the British govt imposed taxes on foreign exchange transactions involving its own currency.

the objective was to stop outflow of GBP

- to encourage domestic investment

-to make foreign invst less attractive

parallel and back-to-back loans used to avoid taxes

Parallel loans involve two entities with headquarters in diff countries each having subsidiary in the other country.

For ex A US based parent co with a subsidiary in Britain has USD or access to USD loan

its British(UK) subsidiary needs GBP

Similarly a British parent having a US subsidiary, may have surplus GBP

its US subsidiary needs USD

A parallel loan from US co to British subsidiary in US

And loan from British parent to US subsidiary in Britain.

For ex ABC Ltd, a US parent company has a

subsidiary in UK called BUK co and

A British parent company MNP having a subsidiary in US called BUS company

BUK Ltd needs GBP and BUS Co needs USD, Now ABC Ltd gives loan to BUS Co and MNP Ltd gives loan to BUK Ltd.

The first currency swap was executed in Aug 1981 between the World bank and IBM

The world bank swapped a USD 290 million bond issue into deutche mark and swiss francs

Swaps considered to be cost-reducing and risk management tool

It is widely accepted as a routine requirement to consider swap with traditional alternative.

Swaps are used to hedge interest rate risk exchange rate risk, commodity price risk, and equity return risk

Types of swaps:

1.Interest rate swaps 2) currency swaps

An IRS is a contractual agreement between counter-parties to exchange a series of interest payments for a stated period of time

An IRS involves exchanging fixed and floating interest payments in the same currency

The important points are: 1.there is no exchange of principal at the

initiation of swap contract 2.only interest payments exchanged; -netted on settlement dates and only the

net value is exchanged between counterparties.

-It reduces credit risk in an IRS 3.any underlying loan or deposit is not

affected by the swap.

CURRENCY SWAP:

It is a contractual agreement

One makes payment in one currency and the other makes in diff currency

Features

1.it usually involves an exchange of currencies at the time of agreement and expiry date

2. if no exchange of currency at the time of agreement then at the time of expiry

3.int payments are usually paid in full

- int payments on two currencies calculated on a fixed or floating basis for both currencies

Or payments for one currency can be on a fixed basis and other on a floating basis

C. due to the exchange of principal as also the exchange of interest payments in full, the credit risk in a currency swap is higher

terminologies:

1. counterparties:

refers to parties to swap

the counter party who pays fixed rate cash flows is known as buyer of swap and

who receives fixed rate cash flows is known as seller

Swap dealer;

Is the intermediary between two counterparties

He stands to match clients’ requirements

He acts as counter party also

Effective/Value date:

It refers to the date on which the swap commences,

The date from which interest starts accruing.

The start date is normally a spot date ie 2 days after the transaction date.

It may also have a corporate start date –swap effective from a date ie, a week later.

Termination/Maturity date: date on which the swap terminates

Swap tenor/Maturity: period between the effective and termination dates.

Swap coupon: it is the fixed rate or fixed price which does not change over the tenor of a swap

Also known as SWAP PRICE, SWAP RATE, OR SWAP STRIKE

REFERENCE RATE:

It indicates the rate on which the floating leg is based.

The most common reference rate is LIBOR

RESET DATES;

Dates on which the floating leg is re-priced on the basis of reference rate.

Usually it is semi annual

NOTIONAL PRINCIPAL AMOUNT:

It is the amount involved in swap

It is used purely on a notional basis.

Used for calculating the periodic payments between the counter parties.

Basic structure of swaps;

relatively simple

Same for IRS CS & ES

the counterparties agree to make payments on the basis of quantities of underlying assets

The underlying assets may or may not be exchanged

They are referred to as notional, if not exchanged.

In case exchanged called actuals Swap commences on effective date and

terminates on its maturity date. Swap payments made at periodic

intervals as specified in the swap agreement

Payments may be annual, semi-annual or quarterly or monthly

The swap payments begin to accrue on the effective date and stop on the termination date

The swap payments of the first counter party are made at a fixed rate/price for the use of second counter party’s notional assets.

The fixed price is called the swap coupon

The swap payments of the second party are made at a floating rate for the use of first counter party’s notional assets.

Generally swap involves a financial intermediary ie swap dealer or market maker or swap bank

It serves as counterparty to the end-users

The swap dealer profits from bid-offer spread imposed on the swap coupon

It is the basic or generic or plain vannila swap structure.

INTEREST RATE SWAP: Most common type of a financial swap is a

int rate swap. In this one party agrees to pay to the

other party cash flows equal to fixed rate int on a notional principal for a number of years.

At the same time other party agrees to pay cash flows equal to int at a floating rate

on the same notional principal for the same period of time.

Life of the swaps may range from 2 to 15 years.

LIBOR/MIBOR:

LIBOR – an imp benchmark rate in international finance

Established by the British bankers association

Represents the average of rate of int offered by banks on deposit from other banks in Eurocurrency markets.

One-month LIBOR rate is the rate offered for one month deposits

3 month for rate offered on 3 months deposits.

It is the reference rate of interest for loans in international financial markets.

Designing and IRS:

The borrowing rates:

FIXED FLOATING

COMPANY A 10% 6 MONTH LIBOR+0.40%

COMPNAY B 12% 6MONTH LIBOR+1.60%

COMPANY A and B need Rs.10Million for 5 years assume that co B wants to borrow at fixed rate Co A wants at floating rate linked to LIBOR. CO A has comparative advantage in fixed rate

markets as the rate spread is 2%` and 1.20% as compared to B in floating rate.

In both the markets, Co B pays higher rates Yet it has comparative advantage in floating

market. Because compared to fixed rate diff 2%,

floating rate diff 1.2%. Hence better B co borrow floating rate.

This difference in rates allow the companies to negotiate SWAP;

CO A BORROWS FIXED RATE LOAN(BUT ACTUALLY NEEDS FLOATING RATE) AT10%

Co B borrows at floating rate though needs fixed rate loan

Then enter into SWAP

SO THAT B co pays int at fixed rate and A pays at floating rate.

The gain is measured as difference between the interest rates

The gain =a-b

a=diff in the fixed rate

b=diff in the variable rate

The gain =2-1.2=0.8

Usually swap agreement is made through banks.

The gain is split between 3 parties

It could be= bank= 0.2 company A=0.3 co B=0.3

Effective floating rate for firm A is

Mibor 0.4%

Less share of gain 0.3

effective Floating Rate 0.1%

Effective fixed interest rate for B

Effective int rate 12.00%

Less gain 0.3

eff fixed rate 11.70%