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FINANCIAL SWAPS

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SWAPS

Swaps is the agreed exchange of future cash flows with orwithout any exchange of cash flows at present.

Financial swaps are broadly classified into :

Currency Swaps

If the terms of agreement also provide forexchange of principal, whichnormally happens when two currencies are involved.

Interest Rate Swaps

If the terms provide forexchange of interest payments without involving

exchange of principal payments .

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Classification on the basis of the time period

involved:

Short term : maturity period of less than 3

years

Medium term : matures between 3-5 years

Long term : extending beyond 5 years

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UTILITY

Swaps can be used to convert liabilities or assets to the benefitof the owner.

a floating rate liability ( loan) can be converted into fixedrate liability (loan), thus ensuring that the volatility in theinterest rates does not increase the burden of payments or

else ,

convert a fixed rate liability (loan) into a floating rateliability (loan) when the interest rates fall steeply in themarket.

Similarly ,the nature of an asset can be changed to converta floating rate earning asset into a fixed rate earning assetor vice versa according to the requirements of the holder.

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LIMITATIONS

It is difficult to identify a counterparty to take the oppositeside of the transaction .

The swap deal cannot be terminated without the consent ofthe parties involved in the transaction.

Existence of inherent default risk.

Under developed markets for swaps , mainly as a result of veryslow development of standardized documentation. This clearlyshows 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 ofthe parties involved to look into the creditworthiness of thecounterparties before entering into the agreement.

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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`.

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Swap Broker :

When the swap facilitator : does not take any financial position in a swap arrangement

he initiates and

he dissociates himselffrom the deal after making thearrangement between the counter parties who haveapproached 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 inidentifying the potential counter parties to a swap transaction.

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Swap Dealer :

Swap dealerbears the financial risk associated with the dealhe 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

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IMPORTANTTERMINOLOGY

SWAP COUPON

The fixed rate of interest on the swap.

NOTIONAL PRINCIPAL

The principal amount on which the fixed and floating interestcalculations are made.

It is notionalbecause the parties do not exchange this amountat any time , it is only used to compute sequence payments .

In a standard swap the notional principal remains constantthrough the life of the swap .

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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 andfloating rate is calculated from the effective date.

RESET DATE

The applicable LIBOR for each period is to be determinedbefore the date of payment .The 1st reset date will generally be

2 days before the first payment date , 2nd reset date will be 2days before the second payment.

MATURITY DATE

The date on which the interest accrual stops.

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RELEVANCE OF DATES

X Ltd enters into a swap contract on 10 th June 2001.Firm will paya fixed rate of 10.10% (semi-annually) to bank and in turn it willreceive the flexible rate LIBOR+ 0.05% (semi-annually) .

____________________________________________________10 June,`01 12 Jun,`01 10 Dec,`01 12 Dec,`01 10Jun,`02 12 Jun`02Trade Dt. Effective Dt. - 1stPay - 2nd Pay

1st Reset Dt. Receipt Dt. 2nd Reset Dt. Receipt Dt.

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DAY COUNT CONVENTIONS for the calculation of interests:

Fixed Floating

30 / 360 Actual / 360

Actual / 360 Actual / 365

Actual / 365

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CURRENCY SWAPS

Step 1: Initial exchange of principal

Theprincipal 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 bephysically exchangedon the

commencement date of the swap ormay be notionally

exchangedas with the interest rate swap.

The exchange rate will usuallybe spot

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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 thetype 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 thecontract i.e. at maturity.

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ILLUSTRATION 1 :Assume that there are two firms A and B who are in need ofdollar funds and sterling funds respectively. A wants USD 100million and B wants 65 million Sterling. The exchange rate is0.65 GBP / USD. They have access to the foreign currencymarket at the following rates:

Firms Dollars Sterling

Firm A (BBB rating) 10.5% 11.8%

Firm B (AAA rating) 8.5% 11%

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

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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 payonly 0.8% more in the sterling market ascompared to 2.0% in the dollar market.

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As A wants dollar funds and B wants sterling funds , acurrency 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 spreaddifferent 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 totheir advantage in reducing their effective cost ofborrowing in a number of ways depending on thecreditworthiness of each of them.

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Option I

There is no swap dealerto mediate between the twoparties.

The quality spread is equally shared between A andB.

The effective cost of borrowing for each of them willget reduced by 0.6 % in the respective markets inwhich they wish to borrow.

FirmA

- Net Borrowing Cost :10.5 0.6 = 9.9 %

Firm B - Net Borrowing Cost :

11 0.6 = 10.4 %

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B borrows dollar funds at 8.5 % and lends it to A at9.9 %.

A borrows sterling funds at 11.8 % and lends it to Bat 11.8 %.

B is gaining 1.4 % on dollar payments from A whichcan 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 , aswap dealer arranges the swap agreement betweenthe two potential parties.

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Firm A Firm B

9.9 %9.9 %

11.8 %11.8 %

Borrows Dollars at 8.5 %Borrows Sterlings at 11.8 %

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Firms Receipts Payments NetBorrowingCost

Savings

A

(BBB)

11.8 on 11.8 on

9.9 on $

9.9 10.5 (-)9.9

= 0.6

B

(AAA)

9.9 on $ 8.5 on $

11.8 on

11.8 -1.4

= 10.4

11(-)10.4

= 0.6

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ILLUSTRATION 1 :Assume that there are two firms A and B who are in need ofdollar funds and sterling funds respectively. A wants USD 100million and B wants 65 million Sterling. The exchange rate is0.65 GBP / USD. They have access to the foreign currencymarket at the following rates:

Firms Dollars Sterling

Firm A (BBB rating) 10.5% 11.8%

Firm B (AAA rating) 8.5% 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 financialintermediary as a swap dealer and are ready to pay 0.2% of theswap benefit to him and will share the remaining profit equally.

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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 at10.5 %.

Here the swap dealer is exposed to exchange risk due to theoffset of gain in one currency with the loss in another .Thisrisk can be avoided if the dealer can hedge with forwards orfutures each year during the life of swap.

The exchange risk can be shifted to A or B also .The spreadneed not be shared equally always .The dealer can chargemore from the party he considers to be more risky.

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SWAP

BANK

Firm A Firm B

8.5 %

$10 % $

10.5% 11.8 %

Borrows Sterlings at 11.8 %

Borrows Dollars at 8.5 %

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Firms Receipts Payments NetBorrowing

Cost

Savings

A 11.8 11.8

10 $

10 $ 10.5 10

= 0.5

B 8.50 $ 8.50 $

10.5

0.5 11-10.5

= 0.5

SwapBank

B: 10.5 A :10 $

A :11.8 B :8.5 $

20.5 20.3

= 0.2

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TYPES OF SWAPSTYPES 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 differentmarket index.

CALLABLE SWAPThe fixed rate payer has the option to terminate the agreement prior to thescheduled maturity .

PUTTABLE SWAP

The fixed rate receiver has the option to terminate the agreement prior to thescheduled maturity .

EXTENDABLE SWAP

One of the parties has the option to extend the swap beyond the scheduledtermination date.

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INTEREST RATES SWAPS

Interest rate swap is an agreement between two ormore 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.

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PLAIN VANILLA SWAPS:

These are the swaps where the fixed rate obligationare exchanged for floating rate obligations over a

specific period of time on notional principals.

They are also called Coupon Swaps orGeneric

Swaps.

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Firms Requirement Fixed

Rate

FloatingRate

XYZ

Ltd.

Fixed Rate

USD

11% Prime+

0.75%

ABC

Ltd.

Floating Rate

US

D

9.5% Prime

Illustration 2: Interest Rate Swap

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The firm XYZ Ltd. and ABC Ltd. decide to enter intoan interest rate swap and decide to appoint HDFCBank 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: 1Show how all the three parties yield benefit byentering into an interest rate swap?

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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 .

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Net Borrowing Cost for :

ABC Ltd : Prime - 0.25% = Prime - 0.25%

XYZ

Ltd : 11% - 0.25% = 10.75%

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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 itto ABC through the swap bank at (Prime-0.25).

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Firms Receipts Payments NetBorrowing

Cost

Savings

XYZ Prime+0.75 10.75Prime+0.75 = 10.75

11 10.75

= 0.25

ABC 9.50 9.50Prime-0.25

= Prime-0.25

Prime (prime-0.25)

= 0.25

SwapBank

XYZ:10.75

ABC:prime-0.25

ABC:9.50

XYZ:prime+

0.75

Income: 0.25

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Thank you