UNDERSTANDING the swaps

8/7/2019 UNDERSTANDING the swaps

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UNDERSTANDING

SW

A

PS

SW

A

PS

03


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MEANINGGENERAL

Give something in exchange for something else.(Oxford Advanced Learners Dictionary)

FINANCEExchange of Risk/Return

(ALAN McDOUGALL, Mastering Swaps Market, Prentice Hall)


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EXAMPLE


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DEFINITION

A derivative in which two parties agree

To exchange one stream of cash flows against another.

To exchange their risk.

R


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TYPES Interest Rate Swap

Bond Swap

Commodity Swap

Credit Default Swap

Non-Deliverable Swap

Total Return Swap

Currency Swap


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C D S

$45 TRILLION

INSURANCE MARKET

TO

GAMBLING MARKET

The buyer of a credit swap receives credit protection, whereas the

seller of the swap guarantees the credit worthiness of the

product. By doing this, the risk of default is transferred from

the holder of the fixed income security to the seller of the swap.


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EXAMPLE

50,00,000

PRABHU CEMENT HOUSE

2,00,000

X

5

=

10,00,000


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PARALLEL SITUATION

BOND


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COMMON IN AIG&

EXAMPLE

50,00,000$400 BILLION


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CDS (USES)

SPECULATION

HEDGING

ARBITRAGE

Risk


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INTEREST RATE

SWAPS(IRS)An agreement between two parties in which theycontracts to make payments of interest amount ontheir outstanding debt to the other in future till aspecified termination date.

Generally involve fixed-to-floating rates of interest

Two Parties:

Also called Plain Vanilla Swaps

Fixed Rate Payer

Floating Rate Payer


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TERMINOLOGY

NOTIONAL PRINCIPAL

BASIS POINTS

SWAP COUPON

FIXED RATE

FLOATING RATE

LIBOR

DATES

TRADE

EFFECTIVE

RESET

PAYMENT


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USES & USERSUSES

To,

Lower Cost ofFunding

Hedge Interest Rate Exposure

Obtain HigherYielding InvestmentAssets Speculate

USERS

Commercial Banks

Investment Banks

Investment Companies

Mortgage Companies

GOVTAgencies etc


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EXAMPLEFixed Rate Bond Floating Rate Bond

Quality Co 9% LIBOR+1/2%

Risky Co 10.5% LIBOR+1%

QUALIT

YCORISKY

CO

INVESTOR

S

INVESTOR

S

Fixed

Paymentsat 9%

Variable

Paymentsat LIBOR+1%

Variable Payments at LIBOR+1/2%

Fixed Payments at 9.5 %


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CONSIDERING NOTIONAL

PRINCIPAL

Year LIBOR Quality Co Payment Risky Co Payment Net Payment

1 8 8.5%*$50m=$4.25 9.5%*$50m= $4.75m Risky pays $0.5m

2 7 7.5%*$50m=$3.75 9.5%*$50m= $4.75m Risky pays $0.5m

35.5 6

%*$50

m=

$3m 9.5%*$

50m

=$4.7

5m Risky pays $

0.5

m

4 9 9.5%*$50m=$4.75m 9.5%*$50m= $4.75m Risky pays $0.5m

5 10 10.5%*$50m=$5.25m 9.5%*$50m= $4.75m Risky pays $0.5m

In the previous example if we consider Notional Principal as

$50m, then


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CURRENCY SWAP (CS)

A swap that involves the exchange ofprincipal and interest in one currency for thesame in another currency.

Like,

Sell

Repurchase

SWAP RATE


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TYPES

FX SWAP

BACK TOBACKLOAN

CROSSCURRENCY

SWAP

CURRENCY SWAPS


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EXAMPLE

A Canadian company wants to borrow 10 million.

The company, however, believes that it can get better

terms if it issues $-denominated bonds in Canada where

it is well known, and then swap the $ for with aGerman company that wants to borrow $ but for the

same reasons finds it easier to borrow in Europe


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SOLUTION

Ca a ia

Com a yCan$ Coupon rincipalp

Ca a ia

I vestors

o

Can$ap

ayments

DMap

ayments

q

Germa

Com a yDM Coupon rincipalp

Germa

I vestots


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EXAMPLE

If the $ depreciates relative to the , denominatedassets and liabilities will be worth more $.

Because the bank has more denominated liabilities

than denominated assets, it will suffer losses.

Assets Amount Liabilities Amount

$-Denominated

-Denominated

$188m

$12

m

$-Denominated

-Denominated

$50m

$30 m

#(7.5 m @ $1.6/)

(18.75 m @ $1.6/)

*Net worth =$120 m


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Now, if the $/ exchange rate increases to $1.7, then the bank

will have a capital loss of $1.05 m, as can be seen:

To reduce its exposure to the $/ exchange rate risk, the bank could swap$18 million of its denominated liabilities for$ denominated liabilities.

This would leave the bank with $12 million in denominated liabilities,which matches its $12 million of denominated assets.

With denominated assets = denominated liabilities, a change in $/exchange rate does not change the banks net worth.

Assets Amount Liabilities Amount

$-Denominated

-Denominated

Total

$88 m

$112.75

$200.75

$-Denominated

-Denominated

Net worth

Total

$50m

$31.8

$118.95

$200.75

#(7.5 m @ $1.7/)

(18.75 m @ $1.7/)


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LIMITATIONS

Exposed to credit risk as either one or both the

parties could default

V

ulnerable to the central governments interventionin the exchange markets.


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CS (USES)

To secure cheaper debt

To hedge against exchange rate

fluctuations


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UNDERSTANDING the swaps

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