International Financial Management

P G Apte

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 Introduction
• Financial Swaps are an asset-liability management
technique which permits a borrower (investor) to
access one market and then exchange the liability
(asset) for another type of liability (asset)
• Swaps by themselves are not a funding
instrument; they are a device to obtain the desired
form of financing indirectly which otherwise
might be inaccessible or too expensive
• The growth in the volume and variety of swap
transactions has outpaced the growth in the
analytical literature dealing with theoretical
explanations of swaps, their pricing and valuation

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 Major Types of Swap Structures
• All swaps involve exchange of a series of periodic
payments between two parties, usually through an
intermediary which is normally a large international
financial institution which runs a “swap book”
• The two major types are interest rate swaps (also known
as coupon swaps) and currency swaps. The two are
combined to give a cross-currency interest rate
swap
• Other less common structures are equity swaps,
commodity swaps
– Liability swaps exchange one kind of liability for
another
– Asset swaps exchange incomes from two different types
of assets
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 Major Types of Swap Structures
• Interest Rate Swaps
– A standard fixed-to-floating interest rate swap, known
in the market jargon as a plain vanilla coupon swap
(also referred to as "exchange of borrowings") is an
agreement between two parties in which each contracts
to make payments to the other on particular dates in the
future till a specified termination date
– One party, known as the fixed rate payer, makes fixed
payments all of which are determined at the outset
– The other party known as the floating rate payer will
make payments the size of which depends upon the
future evolution of a specified interest rate index

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 Major Types of Swap Structures
–The key features of an interest rate swap
The Notional Principal; The Fixed Rate; Floating Rate
Trade Date, Effective Date, Reset Dates and Payment
Dates (each floating rate payment has three dates
associated with it as shown in Figure below

D(S), the setting date is the date on which the floating

rate applicable for the next payment is set
D(1) is the date from which the next floating payment
starts to accrue and D(2) is the date on which the
payment is due
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 Major Types of Swap Structures
– Fixed and Floating Payments
Fixed Payment = P × Rfx × Ffx
Floating Payment = P × Rfl × Ffl
• P is the notional principal, Rfx is the fixed rate, Rfl is
the floating rate set on the reset date, Ffx is known as
the "Fixed rate day count fraction" and Ffl is the
"Floating rate day count fraction"
– In an interest rate swap, there is no exchange of
underlying principal; only the streams of
interest payments are exchanged between the
two parties

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A Typical Plain Vanilla Coupon Swap
Party A (Firm) Party B (Bank)
Funding objective Fixed Rate Floating Rate
Fixed Rate Cost 8% 6.5%
Floating Rate Cost Prime+75bp Prime
This is an instance of quality spread differential. Bank
has absolute advantage in both fixed and floating rate
markets but less so in floating rate market. The
structure shown next saves each party 25 bp and nets
the swap bank 25bp.
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 A TYPICAL USD IRS
A FIXED-TO-FLOATING INTEREST RATE SWAP

6.75% Fixed 6.5% fixed

SWAP BANK

Prime-25bp Prime-25bp

XYZ CORP. ABC BANK

Prime+75bp 6.5% Fixed

To Floating to Fixed
Rate Lenders Rate Lenders

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 Major Types of Swap Structures
– A number of variants of the standard structure are
found in practice
• A zero-coupon swap has only one fixed payment at
maturity
• A basis swap involves an exchange of two floating
payments, each tied to a different market index
• In a callable swap the fixed rate payer has the
option to terminate the agreement prior to scheduled
maturity while in a puttable swap the fixed rate
receiver has such an option
• In an extendable swap, one of the parties has the
option to extend the swap beyond the scheduled
termination date

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Major Types of Swap Structures
• In a forward start swap, the effective date is
several months even years after the trade
date so that a borrower with a future funding
need can take advantage of prevailing
favourable swap rates to lock in the terms of
a swap to be entered into at a later date
An indexed principal swap is a variant in
which the principal is not fixed for the life of
the swap but tied to the level of interest rates
- as rates decline, the notional principal rises
according to some formula

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 Major Types of Swap Structures
• Currency Swaps
– In a currency swap, the two payment streams being
exchanged are denominated in two different currencies
– Fixed-to-fixed currency swap
– A fixed-to-floating currency swap also known as
cross-currency coupon swap will have one payment
calculated at a floating interest rate while the other is at
a fixed interest rate

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 A typical currency swap situation
is illustrated by this example :
Alpha Corp. Beta Bank
Requirement: Fixed rate USD Fixed rate CHF
Funding Funding

Cost of $
Funding: 12.5% 11%
Cost of CHF
Funding: 6.5% 6%
Beta bank should borrow USD, Alpha Corp. CHF and they
should swap.
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 A CURRENCY SWAP

12.3% USD 12%USD

SWAP BANK

6.5% CHF 6.5% CHF

CHF
ALPHA
COMPANY BETA BANK

USD

USD

CHF

6.5% TO CHF LENDERS 11% TO USD LENDERS

INITIAL EXCHANGE OF PRINCIPALS

FINAL RE-EXCHANGE OF PRINCIPALS

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 Motivations Underlying Swaps
• Why would a firm want to exchange one kind of
liability or asset for another?
• Capital market imperfection or factors like
differences in investor attitudes, informational
asymmetries, differing financial norms,
peculiarities of national regulatory and tax
structures and so forth explain why investors and
borrowers use swaps.
• Swaps enable users to exploit these imperfections
to reduce funding costs or increase return while
obtaining a preferred structure in terms of
currency, interest rate basis etc.
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 Motivations Underlying Swaps
• Swaps help borrowers and investors overcome the
difficulties posed by market access and/or provide
opportunities for arbitraging some market
imperfection
– Quality Spread Differential
• Absolute advantage
• Comparative advantage
– Market Saturation
– Differing Financial Norms
– Hedging Price Risks
– Other Considerations
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 Evolution of Swap Markets
• Origins of the swap markets can be traced back to
1970s when many countries imposed exchange
regulations and restrictions on cross-border capital
flows
• Early precursors of swaps are seen in the so-called
back-to-back and parallel loans
• As exchange controls were liberalised in the
eighties, currency swaps with the same functional
structure replaced parallel and back-to-back loans

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 Evolution of Swap Markets
• Further impetus to the growth of swaps was given
by the realization that swaps enable the
participants to lower financing costs by
arbitraging a number of capital market
imperfections, regulatory and tax differences
• In the early years, banks only acted as brokers to
match the two counterparties with complementary
requirements and market access

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 Evolution of Swap Markets
• With the increase in the use of swaps as an active
asset/liability management tool, banks became
market makers i.e. the bank would "take a swap on
its own books" by itself becoming a counterparty
• When a bank takes the swap onto its books, it
subjects itself to a variety of risks. It assumes the
credit risk of the counterparty, exchange rate risk,
interest rate risk, basis risk and so forth

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Application of Swaps:Some Illustrations

• Locking in a Low Fixed Rate

– Plain vanilla coupon swap is used to exploit the quality
spread differential to reduce the cost of funding
• The World bank-IBM Currency Swap
– This particular swap deal is said to have really launched
the swap market
– In the summer of 1981, the World Bank wished to raise
CHF and DEM funding for its lending programme and
instead of tapping these markets directly via fixed rate
bond issues, it achieved the same objective by means of
a currency swap with IBM

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Application of Swaps:Some Illustrations
• A Multi-Party Swap
– How the three main types of swaps - interest rate,
currency and cross-currency interest rate - can be
combined into a single structure to simultaneously
serve the needs of several parties
• A Basis Swap Coupled with A Plain Vanilla
Interest Rate Swap

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 Further Innovations
• Several innovative products during the last five or
so years
• Originated as a response to specific needs of
investors and borrowers to achieve customized
risk profiles or to enable them to speculate on
interest rates or exchange rates when their views
regarding future movements in these prices
differed from the market

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 Further Innovations
• A Callable Coupon Swap is a coupon swap in
which the fixed rate payer has the option to
terminate the swap at a specified point in time
before maturity and a Puttable Swap can be
terminated by the fixed rate receiver
– Application of callable swap
– Transforming Callable Debt into Straight Debt
• Swaptions, as the name indicates are options to
enter into a swap at a specified future date, the
terms of the swap being fixed at the time the
swaption is transacted

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 Further Innovations
• A cross currency swaption (also known as circus
option) is an option to enter into a cross-currency
swap with any combination of fixed and floating
rates
• Switch LIBOR swaps, also known as currency
protected swaps(CUPS) and differential swaps
(Diffs) is a cross-currency basis swap without
currency conversion

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 Further Innovations
• A Yield Curve Swap is, like a basis swap, a
floating-to-floating interest rate swap in which one
party pays at a rate indexed to a short rate such as
3 or 6 month LIBOR while the counterparty
makes floating payments indexed to a longer
maturity rate such as 10-year treasury yield
• In a fixed-to-floating commodity swap one party
makes a series of fixed payments and receives
floating payments tied to a commodity price index
or the price of a particular commodity

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 Further Innovations

• In an equity swap, one party pays the total

return on an equity index 500 and receives
payments tied to a money market rate

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 Interest Rate Swaps in the Indian
Market
• Banks and financial institutions are permitted to
make a market in interest rate swaps without any
restrictions on the size of the notional principal
and the tenor of the agreement
• Corporates are allowed to enter into IRS
agreements only to hedge underlying exposures
and market making banks are required to obtain
evidence to that effect before making a deal with a
corporate client

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 Interest Rate Swaps in the Indian
Market
• Limits on these positions in different maturity
buckets should be evolved by the bank's top
management board and vetted by RBI
• The guidelines state that the benchmark rate for
the floating side of the swap can be any domestic
money or debt market rate which is market
determined provided the methodology for
computing it is objective and transparent
• In practice, since term money markets are not very
deep or liquid, most deals have used the overnight
MIBOR as the benchmark

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 Valuation of Swaps
• A swap is equivalent to a borrowing plus an
investment and the value of a swap
therefore is the difference between the
present values of all inflows and all
outflows
• The market valuation of a series of cash
flows depends upon the discount rate used
and this in turn incorporates risk-free
interest rate and a risk premium.

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 Valuation of Swaps
• The pricing problem for swaps is to
determine what rate should be quoted for
one leg of the swap, for a specified
sequence of counter payments, so that the
two sequences have equal present values
• A par swap is a swap which values to zero

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 Valuation of Swaps
• Value of an existing interest rate swap
• Valuation of a Cross-Currency Interest Rate
Swap
• Pricing an Off-Market Cross-Currency
Interest Rate Swap
• It has been observed that the swap rates
quoted in the market do not reflect
differences in borrowing costs between
different counterparties

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Valuation Issues for Interest Rate Swaps
One can view interest rate swaps as:
Long position in bond with a short position in another bond or as a
portfolio of forward contracts.
The value of the swap (for the institution paying floating and
receiving fixed), denoted V, is (assume that the financial institution
receives fixed payments of C dollars at times s and make floating
payments at the same times):
V ( t ) = b ( t ) – b*(t)
b( t ): value of fixed-rate bond underlying swap.
b*( t ): value of floating-rate bond underlying swap.

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The discount rates used in the valuation reflect the riskiness of the
cash flows. Note that: [r(n) is the discount rate at date n]:
b = Σ C × e-r(s) s + Q × e-r(T) T
where Q is the notional principal underlying the interest rate swap,
C is the fixed payment and the summation goes from s=1 to s=T the
termination date of the swap
b* = C* × e-r(t1) t1 + Q × e-r(t1) t1
where the floating rate bond, b* must have, after the payment at
time t1 value equal to the notional principal , Q , and C* is the
floating rate payment due at time t1 .

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Interest Rate Swaps
Example: Financial institution pays 6-month LIBOR and receives
8% per annum (with semiannual compounding) on a notional
principal of $100 Million. The swap has a remaining life of 1.25
years. The relevant discount rates are 10%, 10.5%, and 11% for 3
months, 9 months, and 15 months. The 6 month LIBOR rate at the
last payment date was 10.2% (and the reset frequency is 3
months).
Note For s= 3/12 = 0.25; r = 0.10 For s = 9/12 = 0.75; r=0.105
For s = 1.25; r = 0.11
t1 = 3 months = 0.25
r ( t1 = 1) = 0.10 [reset frequency discount rate]
C = ½ × 0.08 ×100 = 4 Million [coupon for fixed]
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C* = ½ × 0.102 ×100 = 5.1 Million [coupon for floating].
Interest Rate Swaps
Example: Financial institution pays 6-month LIBOR and receives
8% per annum (with semiannual compounding) on a notional
principal of $100 Million. The swap has a remaining life of 1.25
years. The relevant discount rates are 10%, 10.5%, and 11% for 3
months, 9 months, and 15 months. The 6 month LIBOR rate at the
last payment date was 10.2% (and the reset frequency is 3
months).
Note For s= 3/12 ,r = 0.10 For s = 9/12 , r=0.105 For s = 1.25;
r = 0.11 ; t1 = 3 months = 0.25
r ( t1 = 1) = 0.10 [reset frequency discount rate]
C = ½ × 0.08 ×100 = 4 Million [coupon for fixed]
C* = ½ × 0.102 ×100 = 5.1 Million [coupon for floating].
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Interest Rate Swaps .. Example of Valuation of a
swap
Then
b = 4 (e-0.25 × 0.1 + e-0.75 × 0.105) + 104 (e-1.25 × 0.1) = 98.24 million
b* = 5.1 (e-0.25 × 0.10) + 100 e-0.25 × 0.10 = 102.51
The value of the swap to the fixed rate receiver is
98.24 – 102.51 = -4.27 million.
The value to the fixed rate payer is obviously + 4.27million

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Valuation Formula for Currency Swaps
Let V be the value of the swap to the party paying U.S. dollar
interest rates.
Then V ( t ) = S ( t ) b*( t; T ) – b(t, T)
S(t): exchange rate, USD per unit of FC
b*( t; T ): is the value of foreign currency denominated bond
underlying the swap.
b ( t; T ): value of the U.S. dollar underlying the swap.
Example : Let the term structure be flat in the U.S. and Japan and
is respectively 9% and 4%. A financial institution has entered into
a currency swap where it receives 5% in yen and pays 8% in
dollars once every year.
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The principals are 10m USD and 1,200m JPY. The swap will last
for another 3 years and the current exchange rate is 110 yen = 1$.
In this case:
b ( t; T ) = 0.8e-0.09 + 0.8e-0.18 + (10.8)e-0.27 = 9.64m USD
And
b*(t, T) = 60e-0.04 + 60e-0.08 + 1260e-0.12 = 1230.55m JPY
The value of the swap is:
V ( t ) = (1/110)(1230.55) – 9.64 = 1.55m USD
If the financial institution had been paying yen and receiving
USD, the value of the swap would have been –1.55m USD

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 16.9 Summary

• Financial swaps have transformed asset liability

management into a complex and interesting area
• Swaps by themselves and in combination with
other derivatives permit borrowers, investors and
treasurers to achieve unbundling of various risks
and achieve the desired currency, interest rate and
maturity mix of assets and liabilities at minimum
cost or optimum returns

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 16.9 Summary (contd.)

• The swap market has grown by leaps and

bounds so that the notional principal
underlying outstanding coupon and
currency swaps now stands at several
trillion dollars
• Interest rate swaps were introduced in the
Indian money and debt markets in July
1999 and the market has seen some activity
in short-tenor deals
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