This document provides an introduction and overview of swaps. It defines a swap as an arrangement where two parties exchange cash flows at future dates. Common types of swaps include interest rate swaps, currency swaps, and commodity swaps. Swaps are used to reduce borrowing costs, manage risk from interest rate, exchange rate, or commodity price movements, exploit economies of scale, enter new markets, and create synthetic instruments. The document also provides examples of how interest rate swaps can be used to transform fixed rate liabilities and assets into floating rate ones, and vice versa.
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This document provides an introduction and overview of swaps. It defines a swap as an arrangement where two parties exchange cash flows at future dates. Common types of swaps include interest rate swaps, currency swaps, and commodity swaps. Swaps are used to reduce borrowing costs, manage risk from interest rate, exchange rate, or commodity price movements, exploit economies of scale, enter new markets, and create synthetic instruments. The document also provides examples of how interest rate swaps can be used to transform fixed rate liabilities and assets into floating rate ones, and vice versa.
This document provides an introduction and overview of swaps. It defines a swap as an arrangement where two parties exchange cash flows at future dates. Common types of swaps include interest rate swaps, currency swaps, and commodity swaps. Swaps are used to reduce borrowing costs, manage risk from interest rate, exchange rate, or commodity price movements, exploit economies of scale, enter new markets, and create synthetic instruments. The document also provides examples of how interest rate swaps can be used to transform fixed rate liabilities and assets into floating rate ones, and vice versa.
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online from Scribd
This document provides an introduction and overview of swaps. It defines a swap as an arrangement where two parties exchange cash flows at future dates. Common types of swaps include interest rate swaps, currency swaps, and commodity swaps. Swaps are used to reduce borrowing costs, manage risk from interest rate, exchange rate, or commodity price movements, exploit economies of scale, enter new markets, and create synthetic instruments. The document also provides examples of how interest rate swaps can be used to transform fixed rate liabilities and assets into floating rate ones, and vice versa.
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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%