Swaps: Prof Mahesh Kumar Amity Business School

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Swaps

Prof Mahesh Kumar


Amity Business School
profmaheshkumar@rediffmail.com
Introduction- Definition and Uses
 A swap is an arrangement between two
companies to exchange cash flows at one or
more future dates.
 Swaps are used:
1. To reduce the cost of capital
2. Manage risk (interest rate, exchange rate,
commodity price movement)
3. Exploit economies of scale
4. Enter new markets
5. Create synthetic instruments
Introduction-Swap Variants
 ‘Vanilla Swaps’ can be used in three different
settings:
1. An interest rate swap to convert a fixed rate
obligation to a floating rate obligation
2. A currency swap to convert an obligation in
one currency to an obligation in another
currency
3. A commodity swap to convert a floating price
to fixed price
Introduction
 A forward contract can be viewed as simple
example of swap.
 A forward contract leads to the exchange of
cash flows on just one future date, swaps
typically lead to cash flow exchanges taking
place on several future dates.
 Interest rate and currency swaps are often
discussed together and are collectively called
rate swaps.
Introduction-LIBOR
 The floating side has most often been tied to the
London Inter bank Offer Rate abbreviated as LIBOR.
 LIBOR is the rate of interest offered by the banks
on deposits of other banks in Eurocurrency
markets.
 One month LIBOR is the rate offered on one month
deposit, three month LIBOR is the rate offered on three
month deposit and so on.
 LIBOR rates are determined by trading between banks
and change frequently so that the supply of funds in
inter bank market equals the demand for funds in that
market.
Introduction-LIBOR
 A five year loan with a rate of interest specified as
6 month LIBOR plus 0.5% p.a. In this life of loan
is divided into ten periods each six months in
length. For each period the rate of interest is set
at 0.5% p.a. above the six month LIBOR rate at
the beginning of the period. Interest is paid at the
end of the period.
 LIBOR rates are quoted on annual basis and by
convention is stated as though year has 360 days,
but the interest is actually paid everyday. This
results in increase in effective rate of interest.
Introduction-LIBOR Example
 If 6-month LIBOR is quoted at 8% we would
expect that six month periodic rate is 4% But in
fact one could earn 182/360*8%=4.0444% for
first half and 183/360*8=4.0667 for second
half.
 The second complication is that compound
raises the effective annual rate of interest.
ER=[(1.040444*1.040667)-1=8.276%
Thus we see that effective annual rate
corresponding to 6M LIBOR quote of 8% is
about 8.276%
Introduction-LIBOR Example
 Fixed rate side of a rate swap, called the swap coupon,
is most often quoted as Bond Equivalent Yield (BEY).
Bond Equivalent Yields are calculated on the basis of a
365 day year. This differing treatment implies that
LIBOR rate differential and swap coupon differentials
are not comparable.
 To make rates comparable, either the six month LIBOR
rate must be multiplied by 365/360 or the fixed rate
must be multiplied by 360/365. This adjustment is
only correct, however, if the payment frequencies on
the two sides (legs) of the swap are the same i.e.
either they are both quarterly or semi-annual or
annual.
Structure of Swap
 All swaps have basically the same structure.
 Two parties, called counterparties, agree to one
or more exchanges of specified quantities of
underlying assets.
 These underlying assets are known as notional.
 A swap may involve one exchange of notional,
two exchange of notional, a series of exchange
of notional or no exchange of notional.
 The notional exchanged in the swap may be
same or different.
Structure of Swap
 Between the exchange of notional counter party make
payments to each other for using the underlying
assets. The first counterparty makes periodic payment
at a fixed price for using second counter party’s
assets. The fixed price is the swap coupon. At the
same time, the second counter party makes periodic
payment at a floating rate for using the first
counterparty’s assets.
 Usually we have an intermediary that serves as a
counterparty to both end user and is called swap
dealer or market maker or swap bank. The swap
dealer profits from bid-ask spread it imposes on the
swap coupon.
Interest Rate Swap
 A standardized fixed-to-floating interest rate swap,
known in the market jargon as plain vanilla coupon
swap (also referred to as ‘exchange of borrowings’) is
an agreement between two parties in which each
contracts to make payment to the other on a particular
dates in the future till a specified termination date.
 The party which makes fixed payments and which are
fixed at outset are known as fixed rate payer.
 The party which makes payments the size of which
depends upon the future evolution of a specified
interest rate index e.g. LIBOR is known as floating rate
payer.
Interest Rate Swap
 Interest rate swaps are used to reduce the cost
of financing.
 In these cases, one party has access to
comparatively cheap fixed rate funding but
desires floating rate of interest while another
party has access to comparatively cheap
floating rate funding but desires fixed rate of
funding.
Interest Rate Swap-Example
 Consider a three year swap initiated on March 15,2005,
between Infosys and Wipro. We assume Infosys agrees
to pay to Wipro an interest rate of 5% p.a. on a notional
principal of 100 crores and in return Wipro agrees to pay
Infosys six month LIBOR rate on the same notional
principal. We assume that agreement specifies that
payments are exchanged every six months, and the 5%
rate is quoted with semi annual compounding.
The swap can be diagrammatically depicted as:
5%
Wipro Infosys
LIBOR
Interest Rate Swap-Example
Cash flows to Infosys in a Rs100 cr three year interest rate swap
when a fixed rate is paid and LIBOR is received
Date 6 mth LIBOR Floating cash Fixed cash Net cash flow
rate (%) flow rcvd flow paid
Mar 15,’05 4.20
Sep 15,’05 4.80 +2.10 -2.50 -0.40
Mar 15,’06 5.30 +2.40 -2.50 -0.10
Sep 15,’06 5.50 +2.65 -2.50 +0.15
Mar 15,’07 5.60 +2.75 -2.50 +0.25
Sep 15,’07 5.90 +2.80 -2.50 +0.30
Mar 15,’08 6.40 +2.95 -2.50 +0.45
Interest Rate Swap-Example
 From above table we can enunciate the cash flows
in the third column of the table are the cash flows
from a long position in a floating rate bond. The
cash flows in the fourth column of the table are
the cash flows from the short position in a fixed
rate bond. The exchange can be regarded as the
exchange of fixed rate bond for a floating rate
bond. Infosys whose position is described in the
table is long a floating rate bond and short a fixed
rate bond. Wipro is similarly long a fixed rate
bond and short a floating rate bond.
Using the Swap to Transform a Liability
 The swap could be used to transform a floating rate loan
into a fixed rate loan. Suppose that Infosys arranged to
borrow Rs.100 cr at LIBOR plus 10 basis points and
Wipro has a three year Rs.100 cr loan outstanding on
which it pay 5.2%. The swap between two companies
can be shown as
5.2% 5%
Wipro Infosys
LIBOR LIBOR+0.1%
Using the Swap to Transform a Liability
 After Infosys has entered into the swap it has three
cash flows:
1. It pays LIBOR plus 0.10 to its outside lenders.
2. It receives LIBOR under the terms of the swap.
3. It pays 5% under the term of the swap.
 These three sets of cash flows net out to an interest
rate payment of 5.1%. Thus for Infosys the swap could
have the effect of transforming borrowings at a floating
rate of LIBOR plus 10 basis point into a borrowings at a
fixed rate of 5.1%
Using the Swap to Transform a Liability
 For WIPRO the swap has following three set of cash
flows:
1. It pays 5.2% to its outside lenders
2. It pays LIBOR under the terms of the swap.
3. It receives 5% under the terms of the swap.
 These three cash flows net out to an interest payment
of LIBOR plus 0.2% . Thus for WIPRO the swap has the
effect of transforming borrowings at a fixed rate of
5.2% into a borrowings at a floating rate of LIBOR plus
20 basis points.
Using the Swap to Transform an Asset
 Swaps can be used to transform the nature of an asset.
Suppose that Infosys owns Rs.100cr in bonds which
provide an interest of 4.7% over next three year and
Wipro has an investment of similar amount that yields
LIBOR minus 25 basis points. The swap between two
companies can be shown as
LIBOR-0.25% 5%
Wipro Infosys
LIBOR 4.7%
Using the Swap to Transform an Asset
 After Infosys has entered into the swap it has three
cash flows:
1. It receives 4.7% on the bonds.
2. It receives LIBOR under the terms of the swap.
3. It pays 5% under the terms of the swap.
 These three sets of cash flows net out to an interest
rate inflow of LIBOR minus 30 basis points. Thus
Infosys has transformed an asset earning 4.7% into an
asset earning LIBOR minus 30 basis points.
Using the Swap to Transform an Asset
 After Wipro has entered into the swap it has three set
of cash flows:
1. It receives LIBOR minus 25 basis points on investment.
2. It pays LIBOR under the terms of the swap.
3. It receives 5% under the terms of the swap.
 These three cash flows net out to an interest rate inflow
of 4.75%. Thus Wipro has transformed an asset earning
LIBOR minus 25 basis points into an asset earning
4.75%

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