Part-20

Fundamentals of Swaps

Introduction What is a swap?

It is basically an exchange of two payment streams that are different from each other.

Why do parties enter into a swap? To acquire one stream of payments

and to dispose off another stream.

Introduction (Cont…) What is an interest rate swap?

It is a contract where two counterparties commit themselves to exchange, over an agreed time period, two streams of payments, each calculated using a different type of interest rate, but with the same notional principal.

Introduction (Cont…) Are there other types of swaps? Yes

In the case of a currency swap the two streams of payment are denominated in different currencies.

In an equity swap one stream is calculated based on an equity price.

In a commodity swap one stream is calculated based on a commodity price.

Illustration Citibank and HSBC agree to exchange

over a period of two years, two streams of cash flows at six monthly intervals. Citibank will calculate its payments based

on a fixed interest rate of 6% per annum. HSBC will calculate its payments based

on the 6M LIBOR that is prevailing at the start of the six monthly period for which the payment is being computed.

Terms Counterparties: Citibank and HSBC Maturity: 2 Years Interest Rate (1): Fixed 6% per annum

Citibank pays HSBC Frequency of payment: Semi-annual Interest Rate (2): 6M LIBOR

HSBC pays Citibank Frequency of payment: Semi-annual Notional Principal: 100 MM USD

Illustration (Cont…) The interest rate is normally fixed at the

start of the period to which it applies. But the payment calculated using this

rate is made at the end of the period. This is what is meant by `determined in

advance and paid in arrears.’ We can also have a system of

`determined in arrears and paid in arrears.’

Summary of Cash FlowsTime Days in

the 6M interval

Fixed Rate

Amount payable by Citibank

LIBOR Amount payable by HSBC

0 - 6% - 5.75 -6M 181 6% 2975343 6.125% 285137012M 184 6% 3024658 6% 308767118M 181 6% 2975343 5.5% 297534324M 184 - 3024658 - 2772603TOTAL - - 1200000

0- 1168698

7

Sample Calculations Cash Outflow for Citibank after 6

months:0.06 x 100,000,000 x 181

------ =2,975,343

365

Calculations (Cont…) Cash Outflow for HSBC after 12

months:0.06125x100,000,000x184

------=3,087,671

365

Notional Principal In the case of an interest rate swap

only the interest is exchanged. There is no exchange of principal. The principal is specified purely for

the computation of interest. Hence it is termed as a `notional

principal’.

Off-Balance-Sheet Since the principal is not

exchanged the swap does not impact the balance sheets of the counterparties.

Hence interest rate swaps are referred to as off-balance-sheet transactions.

Netting In our illustration the

counterparties were required to make payments to each other on the same date.

Hence the payments are usually netted and only a single amount representing the difference is exchanged.

IllustrationSettlement Date

Amount Payable by Citibank

Amount Payable by HSBC

Net Amount Payable by Citibank

6M 2975343 2851370 12397312M 3024658 3087671 -6301318M 2975343 2975343 024 M 3024658 2772603 252055

12000000 11686987 313013

Netting Netting of payments reduces the

delivery risk. What is delivery risk? It is a default risk that can arise when an

exchange of payments does not occur simultaneously.

Thus a delay exposes the counterparty making the earlier payment to the risk that the other party may not honour its commitment.

Netting (Cont…) In order to facilitate netting, the

frequency and timing of fixed rate payments will usually match the frequency and timing of the floating rate counter payments.

Frequency of Payments The frequency of the floating rate

payments is usually set by the tenor of the benchmark rate that is used in the swap. Thus if 6M LIBOR is used as the

benchmark then the payments will be made semi-annually, whereas if 3M LIBOR were to be used, the payments would be made quarterly.

Terms A swap agreement ought to contain

the following details The names of the counterparties The maturity date of the swap The fixed interest rate The benchmark for the floating rate The notional principal amount And the frequency of payments

Frequency of Payments In our illustration, both fixed as

well as floating rate payments were made on a semi-annual basis. Such a swap is called a semi/semi. Short-term swaps can often be

quarterly/quarterly.

Purpose of a Swap Let us consider the swap between

Citibank and HSBC. What did it achieve?

In the case of Citibank the fixed interest rate payments were known from the outset.

But in the case of HSBC since LIBOR is variable, the cash outflows were subject to uncertainty, except for the first six months.

Purpose (Cont…) Citibank is paying fixed and receiving

floating. Hence it is subject to the risk that the

LIBOR will fall during the life of the Swap. HSBC is paying floating and receiving

fixed. It is therefore exposed to the risk that the

LIBOR will rise during the life of the swap.

Purpose (Cont…) Thus an interest rate swap exposes

both the counterparties to interest rate risk. Such swaps may therefore be used for

speculation or for profiting from an expected interest rate change by deliberately taking risk.

Citibank is anticipating a rate hike HSBC is expecting a decline in rates

Purpose (Cont…) Or they may be used for hedging

against another source of interest rate risk.

What is a hedge? It is an equal and opposite risk to the

risk being hedged.

Speculation Assume that Citibank is

anticipating rates to rise whereas HSBC is expecting that rates will fall. Thus a swap which requires Citibank

to pay fixed and HSBC to pay floating, can be used as a speculative mechanism by both the parties.

Hedging Assume that Citibank has already

borrowed on a floating rate basis. It can use the swap with HSBC to

hedge interest rate risk. If rates rise it will have to pay more

interest on its original borrowings, but will receive a net cash inflow from the swap.

Hedging (Cont…) Assume that HSBC has already

made a loan on floating rate basis. If so it can use the swap to hedge.

If interest rates were to fall it would receive less on its original investment but will receive a cash inflow from the swap.

Advantages Before swaps became available

interest rate risk had to be managed using assets and liabilities in the form of cash instruments. For instance assume that a bank

anticipates a fall in interest rates. It could make a medium term fixed

rate loan and fund it by taking a series of consecutive short term deposits.

Advantages (Cont…) If it were to rollover a series of short

term deposits, it would be effectively borrowing at a floating rate and lending at a fixed rate. If rates were to fall as expected it would

pay a lower rate of interest on its deposits but would continue to receive a fixed rate of interest from its loan.

Advantages (Cont…) An interest rate swap where the

bank receives fixed and pays floating can be used to achieve the same result. The swap would yield the same profit

but would there would be no transfer of principal and consequently no impact on the balance sheet.

Advantages (Cont…) Since a swap is an off-balance-sheet

transaction as opposed to the alternative entailing the use of assets and liabilities, it offers several advantages. There is less credit risk.

Only interest payments are at risk whereas in the case of assets and liabilities the full principal is at risk.

Advantages (Cont…) Swaps are subject to lower capital

adequacy requirements because they involve less credit risk.

Swaps involve lower transaction costs because less money is being transferred and funded.

They offer greater flexibility.

Types of Interest Rate Swaps Coupon swaps

What we have just seen is a coupon swap. It entails the exchange of a payment based on a

fixed rate in return for a payment based on a floating rate.

Basis swaps In these swaps both streams of payment are

calculated using a floating rate index. For instance one stream could be based on the

LIBOR whereas the other could be based on the prevailing commercial paper rate.

Types (Cont…) Asset swaps

If one of the payment streams is funded with interest received from an asset, the swap and the asset as a whole are called an asset swap.

There is no change in the swap mechanism per se.

Strictly speaking we could also have liability swaps.

But this term is rarely used. Thus swaps used in conjunction with a liability

are merely referred to as interest rate swaps.

Types (Cont…) Currency swap

It is a swap where each stream on interest is denominated in a different currency.

These swaps also involve an exchange of principal.

Terminology The counterparties to a swap are

called payers or receivers. In the case of a coupon swap, the party

paying on a fixed rate basis is said to be the `payer in the swap’ and the other counterparty is the `receiver in the swap’.

In the case of a basis swap we cannot use this convention since both the cash flow streams are based on floating rates.

Terminology (Cont…) Thus it is a good practice in the case of

basis swaps to describe each counterparty in terms of both the rate it pays as well as the rate it receives.

In the inter-bank swap market the terms buyer and seller are used in the case of coupon swaps. Buyers are payers and sellers are

receivers.

Terminology (Cont…) In most coupon swaps the 6M LIBOR is

the standard index for the floating rate. Thus these swaps can be defined purely in

terms of the fixed rate of interest. For example in the case of the Citibank-

HSBC swap, the price of the swap would have been quoted as 6% per annum, which is nothing but the fixed rate. The price of a coupon swap is also called

the swap rate.

Terminology (Cont…) In most markets swap rates are quoted

as full percentage figures. Example in our case the rate was 6%. This is called an all-in price.

Terminology (Cont…) However in certain inter-bank

swap markets, particularly the US dollar market the convention of quoting the price on

an all-in basis has been replaced by the convention of quoting the differential between the all-in rate and an accepted benchmark rate.

Terminology (Cont…) The benchmark rate is usually the rate on

the government bond with a remaining period to maturity closest to that of the swap. The difference between the all-in price and

the benchmark rate is called the swap spread. For instance assume that the all-in price is

5.5% for a 5 year swap and that 5 year T-notes are yielding 5.3% per annum.

The swap price will be quoted as 20 basis points.

Terminology (Cont…) The trade date or the fixing date is the date

on which the terms are agreed upon. The following terms have to be agreed upon

The maturity The swap rate The floating rate index The payment frequency The notional principal

On this date the counterparties contractually commit themselves to the transaction.

Terminology (Cont…) The value date is the date on which

the interest payments start to accrue. For swaps involving only the domestic

currency the value date is usually the same as the trade date.

For foreign currency swaps the value date is usually two days after the trade date.

Terminology (Cont…) The date on which the floating rate is re-

fixed for the next period is called The re-fixing or re-pricing or reset date.

The date on which the interest is paid for the preceding period is called the effective date. The effective dates are calculated from the

value date. For domestic currency swaps the effective dates are

the same as the re-fixing dates. For currency swaps the effective date is two business

days after the re-fixing date.

Swaps versus Other Derivatives Swaps are traded on a bilateral

basis in decentralized markets. Thus swaps are OTC instruments.

In contrast futures contracts and listed options are exchange traded instruments.

Swaps vs. Others (Cont…) On an exchange the clearinghouse

becomes the buyer for every seller and the seller for every buyer. This takes care of counterparty risk.

Both the parties have to provide daily collateral called margins.

Swaps vs. Others (Cont…) The role of the clearinghouse and

the margining mechanism minimizes the risk of default. In OTC markets there is no

clearinghouse, and margining is not compulsory.

So default risk is a major concern.

Swaps vs. Others (Cont…) Futures contracts and listed options are

standardized instruments. Standardization reduces transactions costs

and provides greater liquidity. OTC contracts are however customized.

Activity in exchange traded products is limited to certain instruments.

However OTC products like swaps are available for any currency and for any tenor provided a counterparty can be found.

Swaps vs. Others (Cont…) Futures and listed options are

usually available only for short to medium terms.

Swaps on the other hand can extend as far as 20 years into the future.

Illustration of All-in Prices New Zealand Dollar Swaps

Maturity Semi-annual Rate1 year 8.00-7.852 years 8.25-8.053 years 8.50-8.304 years 8.85-8.655 years 9.05-8.857 years 9.25-9.05

Illustration of Swap Spreads

US Dollars Spread Annual InterestA/360

2 years 21/25 5.70-5.753 years 40/45 6.23-6.285 years 46/51 7.01-7.057 years 46/51 7.46-7.5110 years 47/52 7.93-7.97

Two-way Prices As can be seen, two swap rates are

quoted for each maturity. Such prices are quoted between

professional dealers and consist of a buying and selling price for the instrument.

However the terms buying and selling can be ambiguous in the case of swaps.

So we use the terms paying and receiving.

Two-way Prices (Cont…) When you have two prices, which is

being paid and which is received? The logic is that the dealer hopes to

make a profit if he undertakes a fixed-floating swap with one party and a floating-fixed swap with the other.

Thus he would like to pay the lower fixed rate and receive the higher fixed rate.

Two-way Prices (Cont…) For instance the all-in prices for

the 5 year NZ Dollar swap is 9.05-8.85.

Thus the dealer will demand 9.05% if he is receiving the fixed rate and will part with 8.85% if he is paying the fixed rate.

Two-way Prices (Cont…) What about quotations in terms of spreads? For instance a 5 year USD swap is quoted

as 46/51. This means that when the dealer is paying

fixed he will give 46 basis points over the yield on the most liquid 5 year T-note.

If he is receiving fixed he will demand 51 basis points over the 5 year T-note yield.

The equivalent all-in rates are 7.01% and 7.05%.

Swap Documentation What is a contract?

It is evidence of an agreement between the counterparties to a transaction.

It should provide a detailed definition of a transaction in respect of:

Documentation (Cont…) Financial terms and conditions

That is the rights that the parties enjoy or the obligations that they have accepted.

The legal framework

Documentation (Cont…) The legal framework should be

clearly spelt out. What are the rights of enforcement

according to law if there is a default by a counterparty.

In this context the definition of default must be clearly spelt out

The methods of computing damages should be clearly stated

Documentation (Cont…) In the early days, swap

documentation was extremely complex because the instrument was new and there was a need to provide adequate financial and legal definitions. There was a lack of legal precedent and

little in the way of `custom and usage’. Contracts therefore contained extensive

legal opinion.

Documentation (Cont…) Contracts were long winded and often

took months to finalize. An attempt has been made

subsequently to standardize the documentation. Initial efforts were on a bilateral basis

between active market players. Subsequently multilateral initiatives were

launched by market associations.

Documentation (Cont…) The two principal multilateral

initiatives have originated from: The British Bankers’ Association (BBA) The International Swap Dealers’

Association (ISDA)

BBA Documentation (Cont…) The BBA terms have now been

largely superseded by the more comprehensive documentation drafted by ISDA. But the mechanism for fixing LIBOR

which was devised as a part of BBAIRS Terms continues to play a central role in the settlement of swaps.

BBAIRS Interest Settlement Rate The BBA arranged for Telerate to

calculate and publish on a daily basis a list of BBAIRS Interest Settlement Rates for each monthly maturity between one and twelve months for 9 currencies.

ISDA Documentation In 1985 ISDA published a Code of

Standard Wording, Assumptions and Provisions for Swaps known as the ISDA Swaps Code. This was a menu from which

counterparties could draw when drafting a contract for US Dollar swaps.

ISDA Documentation (Cont…) The Code dealt mainly with

financial terms and conditions such as calculation of interest and termination payments. It was subsequently revised and

expanded to address rights of enforcement and credit provisions.

ISDA Documentation (Cont…) In 1987 ISDA published two master

contracts. For USD interest rate swaps – The Interest

Rate Swap Agreement (Rate Swap Master Agreement)

For interest rate and currency swaps in or between a variety of currencies – the Interest Rate and Currency Exchange Agreement (Rate and Currency Swap Master agreement)

ISDA Documentation (Cont…) Once an ISDA Master Contract is in

place between two counterparties, the details of new swaps are simply added as appendices. Thus there will always be a single

contract in place between two counterparties regardless of the number of swaps transacted.

ISDA Documentation (Cont…)

A master agreement is designed to net the profits and losses being made on all the swaps outstanding between the same two counterparties.

Netting reduces exposure to default risk.

The Primary Market: The Role of Banks In the early days of the swap market,

the intermediaries were investment banks with fairly limited resources. They tried to avoid exposure to default risk

by assuming the role of an agent rather than a principal in swap transactions.

Hence they merely helped arrange such transactions between the counterparties, for which they were paid a fee.

The Role of Banks (Cont…) As the market developed it became

necessary for swap intermediaries to assume the role of principals.

There were two reasons for this. End users desired anonymity Secondly they were reluctant to deal

with non-bank counterparties because of the default risk.

The Role of Banks (Cont…) Intermediaries initially began to

maintain matched books. That is, they would arrange a swap

only if there was a more or less equal and opposite swap that was immediately available as a hedge.

Such a matching swap is known as a reversal.

The Role of Banks (Cont…) While running a matched book, the

intermediary is exposed to default risk from both sides. Consequently they would charge a

risk-related dealing spread in the form of a difference between the fixed interest rate paid to one user and that received from the other user.

The Role of Banks (Cont…) Due to competition, arrangement fees

have become rare unless the swap structure is unusual and complex.

Swaps have now become an active tool for asset-liability management.

Intermediaries have now become market makers, that is, they provide continuous two-way quotes.

The Role of Banks (Cont…) Such market makers stand ready to

accept temporary exposures to a position, until they are able to find a matching swap.

Currency Swaps What is a currency swap?

It is a contract which commits two counterparties to an exchange, over an agreed period, two streams of payments in different currencies, each calculated using a different interest rate.

And an exchange, at the end of the period, of the corresponding principal amounts, at an exchange rate agreed at the start of the contract.

Example Barclays Bank London agrees to pay

Citibank New York over a period of two years a stream of interest on 17MM USD. The interest rate is fixed at the outset. Citibank in return agrees to pay interest on

10MM GBP at a rate agreed upon at the outset. They also commit to exchange at the end of

the two-year period the principal amounts of 17MM USD and 10MM GBP.

Differences Between Currency Swaps and IRS Currency swaps involve an exchange

of payments in two currencies. Not only is interest exchanged, there is

also an exchange of principal. In this case the exchange of principal

takes place only at maturity. Thus the impact on the balance sheet is

only at maturity.

Differences (Cont…) Thus this kind of a swap is termed

an off balance sheet (OBS) transaction.

The interest payments being exchanged may be computed on a: Fixed versus floating basis Floating versus floating basis Or a Fixed-Fixed basis

Motivation Why may Barclays and Citibank

want to enter into such a swap? At maturity Barclays may have an

amount in USD that it wishes to exchange for GBP.

Citibank on the contrary may have an amount in GBP that it wishes to exchange for USD.

Motivation (Cont…) In a currency swap the rate for the

exchange of principal will be fixed at the outset. This rate is usually the spot exchange

rate prevailing at that time. But is subject to negotiations. By fixing the exchange rate the two

banks hedge each other against exchange rate risk.

Exchange of Principal at Inception? By definition a currency swap only

requires the exchange of principal at maturity. However it can so be structured so

that there is an exchange of currencies at the outset as well.

This kind of deal is also called a currency swap but is something more than just a swap.

Exchange (Cont…) A swap with an initial exchange of

principal is a combination of a risk and a hedge. This is because to exchange currencies

at the outset the two parties must have either borrowed or else accrued income in the respective currencies.

This is a source of risk. The actual swap itself is a hedging

device.

Mechanics Let us assume that Citibank and

Barclays were to exchange principal amounts at the outset. Barclays would sell 10MM GBP to

Citibank in exchange for 17MM USD. The sterling sold by Barclays and the

dollars sold by Citi would be borrowed by these banks specifically for the purpose of the swap.

Mechanics (Cont…) At maturity this exchange of

principal would be reversed. The re-exchange of principals at

maturity would be at the original exchange rate.

Such swaps are therefore termed as par swaps.

The sterling received by Barclays at expiration from Citi would be used to payoff its original borrowing.

Mechanics (Cont…) The periodic interest payments

received from Citi would be used by Barclays to service its sterling loan.

The dollars received by Citi at maturity would be used by it to retire its original borrowing.

The periodic interest payments received from Barclays would be used by Citi to service its dollar loan.

Mechanics (Cont…) Thus, through a currency swap, each

counterparty effectively services the debt of the other.

Terminology The term currency swap is generally

used to describe swaps involving two different currencies. But strictly speaking the term applies only

to those swaps in which both the interest streams are calculated using fixed rates.

A currency swap in which at least one of the interest streams is calculated using a floating rate is called a cross-currency swap.

Terminology (Cont…) There are two types of cross-

currency swaps. Coupon swaps involve a fixed-floating

swap. Basis swaps involve a floating-floating

swap. Currency swaps where there is an

initial exchange of principal are sometimes referred to as Cash Swaps.

Counterparties In the case of single currency

swaps, counterparties are distinguished on the basis of who pays fixed and who receives fixed. However in the case of currency or

cross-currency swaps the relationship is complicated by the exchange of currencies.

Counterparties (Cont…) Thus there is a need to describe

each counterparty in terms of the interest rate and the currency that it pays, and the interest rate and the currency that it receives.

Credit Risk In the case of Interest Rate Swaps,

the risk is with respect to interest only. However in the case of currency

swaps credit risk is with respect to both interest as well as principal.