SWAP AgreementsUSMAN ALI

SWAPS

Basic meaning of SWAP is “something that is exchanged”

An exchange of streams of payments over time according to specified terms.

A contract between two parties in which the 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.

Currency swaps were originally conceived in late 1970s b/w World Bank and IBM in London arranged by Salomon Brothers for obtaining Swiss Francs and Deutschmarks.

Currency interest rate swaps were introduced in 1981.

The Swaps Market:

Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments.

Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties.

Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating.

Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap.

Volume of swaps exceedes $250 trillion,

Currency SWAP:

The currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency.

Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap.

The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated.

Currency SWAPS Example

Problem in taking loans from Parent Company

1. Two time conversation (Commission charges)

2. Increase & decrease in exchange rate (Exchange rate Exposure)

3. If in case subsidiary defaults payments will be made by parent companies.

After SWAP

Features Here in SWAP

No conversions required (Just Interest Amount).

No commission to be charged (Just Interest Amount).

Interest payment would be made by the parent companies to each other.

Another Example: (Currency SWAP)

For example, Company C, a U.S. firm, and Company D, a European firm, enter into a five-year currency swap for $50 million.

Let's assume the exchange rate at the time is $1.25 per euro (e.g. the dollar is worth 0.80 euro).

First, the firms will exchange principals. So, Company C pays $50 million, and Company D pays 40 million euros. This

satisfies each company's need for funds denominated in another currency (which is the reason for the swap).

Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts.

Because Company C has borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, will pay interest in dollars, based on a dollar interest rate.

For this example, let's say the agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%.

Thus, each year, Company C pays 40,000,000 euros * 3.50% = 1,400,000 euros to Company D.

Company D will pay Company C $50,000,000 * 8.25% = $4,125,000.

Finally, at the end of the swap the parties re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time.

Interest Rate Swaps

A contract in which two parties agree to exchange periodic interest payments, especially when a one payment is at a fixed rate and the other varies according to the performance of a reference rate.

In interest rate swap Party A agrees to pay Party B a predetermined, fixed rate of interest on a principal on specific dates for a specified period of time.

Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same principal on the same specified dates for the same specified time period.

The two cash flows are paid in the same currency.

The specified payment dates are called settlement dates, and the time between are called settlement periods.

Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties.

Example of Interest Rate SWAP

After Interest Rate SWAP

Another Example: (Interest Rate SWAP)

For example, on Dec. 31, 2006, Company A and Company B enter into a five-year swap with the following terms: Company A pays Company B an amount equal to 6% per annum on a notional

principal of $20 million.

Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million.

For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011.

At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000.

On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000.

Why 2006 ?

Because. Normally in a interest rate swap, the floating rate is usually determined at the beginning of the settlement period.

Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing.

At no point does the principal change hands, which is why it is referred to as a "notional" amount.

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