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%