SWAPS
COVERAGE
Understand the different types of swaps available for hedging purpose, with
respect to interest rate /Exchange rate and Risk
CO5: Evaluate how swap market helps in hedging against interest rate risk,
equity market risk
L5 Evaluate End Term
FINANCIAL MARKETS
A mechanism that allows people to
participate in trade.
Consisting of…… INTERRELATED
CAPITAL MARKET
Derivatives
in all Asset
DEBT MARKET
Classes
FOREX MARKET
COMMODITY MARKET
DERIVATIVES IN FINANCIAL MARKETS
Stock: Futures, Options,
CAPITAL MARKET Forwards, SWAP
Interest Rate: Futures, Options,
DEBT MARKET Forwards, SWAP
Currency: Futures, Options, Forwards,
FOREX MARKET SWAP
Commodity: Futures, Options,
COMMODITY MARKET
Forwards, SWAP
SWAP- DEFINITION
An agreement between two parties to exchange a series
of cash flows at specified times in the future, according
to certain specified rules
A B O U T S WA P S
Features:
Derivative
OTC contracts
Unregulated market
Swap of interest rate / Exchange rate obligations
Tailor made to suit two parties
Regular payoff intervals over the life of the IRS
There is no transfer of principal in interest rate swaps (only notional)
Typically floating/fixed swaps are done
SWAP
Swap is the same as a series of forward contracts
Like a forward contract, a swap has no premium, therefore has a
zero value when initiated
The swap market is very large, with trillions of dollars outstanding
TYPES OF SWAPS
Currency Swaps
Interest Rate Swaps
Equity Swaps
Commodity Swaps
SWAP CONTRACT
Swaps are traded over-the-counter and therefore are:
Customized
Subject to Default Risk
Held to Termination
Swap market consists of dealers & End-users
Dealers: Major banks, investment houses, large trading companies
End-users: Usually a party or firm dealing with a specific risk management issue
SWAP PARTICIPANTS
Combinations of participants
MNC & Subsidiary
Two separate entities
Fixed rate payer - make payments based on known factors, the value of
which do not change over the course of the agreement
Floating rate payer – make payments based on a variable factor, the value
of which may change over the course of the agreement
SWAP SETTLEMENT
Settlement Date: are dates on which the parties agree to make
payments
Settlement Period: Is the time between transactions.
Termination Date: Referred to as the tenor of the swap, is the date
of final payment
Fixed rate payer is the buyer of the swap
Floating rate payer is the seller of the swap
SWAP SETTLEMENT
Swaps are settled by netting the amount owed, so only one party
makes a payment (interest rate swaps).
This excludes cases where the settlement are in different
currencies or different underlying assets.
SWAP INITIATION
1. Finding a match is difficult (principal/timing/duration/nature)
2. End-user requests quote from a dealer
3. Dealer makes-a-market by providing a quote
4. The Dealer and End-user initiate a swap agreement
5. Dealer matches transaction with an offsetting position or holding
a position as an at-risk position
SWAP TERMINATION
Swaps may be terminated early if
Both parties agreed to a termination clause inception of the contract
Both parties agree to terminate at any time
If a party defaults on the contract
Each termination scenario bears a cost for each party
CURRENCY SWAPS
CURRENCY SWAP: Two firms initially trade one currency for
another. Subsequently, the two firms exchange interest
payments. Finally, the two firms re-exchange the two
currencies
WHY DO CURRENCY SWAPS?
1. A company may have a better access to capital in one currency market
than in another.
2. This may be due to many factors, such as:
Investor preference
A firm may have a superior credit rating in one country than another
SWAPS & GLOBALIZATION
Swaps give companies extra flexibility to exploit their comparative
advantage in their respective borrowing markets.
Swaps can be arranged for long period of time.
Restructure a companies capital structure
I N T E R E S T R AT E S WA P
Receives Floating
Rate
BORROWER BANK
GUS BOA
Pays Fixed Rate
Pays Floating
Rate
LENDER
GRETA
Arrangers progressed to Dealers
EXAMPLE: INTEREST RATE SWAP
PRESENT SITUATION
Plain Vanilla Swap
Gus Borrows
$10 million from Greta for one year.
Rate is LIBOR/SOFR plus 50 basis points
Interests will be paid every 90 days in a 360 day year
LIBOR is now called SOFR (Secured overnight Financing Rate)
FLOATING RATE LOAN
PRESENT SITUATION
Q1 Q2 Q3 Q4
LIBOR 2.0% 2.0% 2.5% 2.5%
Notional Principal Floating Rate 2.5% 2.5% 3.0% 3.0%
$ 10,000,000 Quarterly Rate 0.625% 0.625% 0.750% 0.750%
Gus Pays Greta (Floating) Payment $ 62,500 $ 62,500 $ 75,000 $ 75,000
G U S E N T E R S I N TO A N I N T E R E S T R AT E S WA P W I T H B O A
I N T E R E S T R AT E S WA P E X A M P L E
Gus fears interest rates will rise so he enters an interest rate
swap with Bank of America
BOA Quotes a Fixed for Floating swap
Gus will pay
Fixed Rate is 2.6%
Interests will be paid every 90 days in a 365 day year
Bank of America will Pay
Variable at LIBOR/SOFR plus 50 basis points
Interests will be paid every 90 days in a 360 day year
S WA P S E T T L E M E N T
Q1 Q2 Q3 Q4
LIBOR 2.0% 2.0% 2.5% 2.5%
Notional Principal Floating Rate 2.5% 2.5% 3.0% 3.0%
$ 10,000,000 Quarterly Rate 0.625% 0.625% 0.750% 0.750%
BoA Pays Gus (Floating) Payment $ 62,500 $ 62,500 $ 75,000 $ 75,000
Fixed Rate 2.6% 2.6% 2.6% 2.6%
Quarterly Rate 0.64% 0.64% 0.64% 0.64%
Gus Pays BoA (Fixed) Payment $ 64,110 $ 64,110 $ 64,110 $ 64,110
Gus Pays BoA (Net) Payment $ 1,610 $ 1,610 $ (10,890) $ (10,890)
I N T E R E S T R AT E S WA P
Receives Floating
Rate
BORROWER BANK
Pays Fixed Rate
Pays Floating
Rate IRS
LENDER
The Borrower has hedged his loan effectively, servicing it on a
Fixed Rate basis
T H E L O A N P L U S T H E S WA P
Gus Pays Greta (Floating) Payment $ 62,500 $ 62,500 $ 75,000 $ 75,000
With only the loan
Gus Pays Greta (Floating) Payment $ 62,500 $ 62,500 $ 75,000 $ 75,000
BoA Pays Gus (Floating) Payment $ 62,500 $ 62,500 $ 75,000 $ 75,000
Gus Pays BoA (Fixed) Payment $ 64,110 $ 64,110 $ 64,110 $ 64,110
Including the Swap – Floating Payments cancel
Gus Pays less on average – Good Move!
How Much Less? 18560
S WA P S U M M A RY
1. Converting a liability from
fixed rate to floating rate
floating rate to fixed rate
2. Converting an investment from
fixed rate to floating rate
floating rate to fixed rate
3. In an interest rate swap the principal is not exchanged
4. In a currency swap the principal is exchanged at the beginning and the end
of the swap
W H Y S WA P ?
1. MNC with Subsidiaries
Avoid regulatory controls imposed by government legally
Avoid unnecessary conversion cost
2. Two separate entities
Benefit from comparative advantage
Back to Back Loan
OTHER FINER POINTS
Hedging
Role of Intermediary:
Banks double up as market makers
Offer 2 way quotes
Valuation: Quote SWAP rates
Warehouse cost
Mid-term termination cost
S WA P I N E X A M I N AT I O N
ONLY THEORY QUESTION
THANK YOU
QUESTION / ANSWER SESSION
