USE OF SWAPS IN INDIA

As the organizations are becoming increasing globalized, firms are finding it necessary to pay special attention to foreign exchange risk and accordingly, design and implement suitable hedging strategies. Various tools are available to manage foreign exchange risk like options, futures, forward market, swaps etc. There is good scope of each of these instruments at international level. This research project is an attempt to how effectively Indians are using Swaps as the risk hedging tool and identifying the reasons for the slow growth of swap market in India. It has been identified that the knowledge of swaps among Indian is not good as the swap market here is at its infancy stage. Generally swap deal is entered into for less than a year. The main constraints which creates impediment for the growth of the swap market in India are as follows: Non-availability of an acceptable Benchmark rate Lack of A Developed Term-Money Market Lack of Active Market for Floating Rate Loans Non-availability of a variety of acceptable Yield Curves Participants Inertia At the end recommendations to overcome these obstacles has been suggested.

The role of treasury has come about in response to the changing economic and financial environment. If there is one word to describe how business is today versus half a century ago, the word would be risky. The treasurer as a facilitator of transactions faces many daunting responsibilities. Among these responsibilities are the use of financial products which have appeared in response to the growth of uncertainty. Borrowers in todays markets have a variety of ways of raising money. Some borrow in foreign currency because they have revenues in that currency which was used to service debt. Others borrow in another currency because they believe that the currency being borrowed will weaken, thereby reducing the overall cost of borrowing. They will fully hedge their foreign borrowings by means of a foreign exchange swap transaction Alternatively, one partys comparative advantage over the other allows them to borrow funds at minimal cost either through fixed or floating rates. Similarly the weaker borrowers have access to floating fixed rates at a higher cost. By exchanging their payment obligations through a swap, both parties are able to obtain a lower cost of funds. So, the study is an attempt to determine how interest rate and foreign exchange exposure can be hedged through an innovative financial product called swaps.

SWAPS
What is a swap? A swap is nothing but a barter or exchange but it plays a very important role in international finance. A swap is the exchange of one set of cash flows for another. A swap is a contract between two parties in which the first party promises to make a payment to the second and the second party promises to make a payment to the first. Both

payments take place on specified dates. Different formulas are used to determine what the two sets of payments will be. Classification of swaps is done on the basis of what the payments are based on. The different types of swaps are as follows. Interest rate swaps Currency Swaps Commodity swaps Equity swaps

Interest rate swaps The interest rate swap is the most frequently used swap. An interest rate swap generally involves one set of payments determined by the Eurodollar (LIBOR) rate. Although, it can be pegged to other rates. The other set is fixed at an agreed-upon rate. This other agreed upon rate usually corresponds to the yield on a Treasury Note with a comparable maturity. Although, this can also be variable. Additionally, there will be a spread of a pre-determined amount of basis points. This is just one type of interest rate swap. Sometimes payments tied to floating rates are used for interest rate swaps. The notional principal is the exchange of interest payments based on face value. The notional principal itself is not exchanged. On the day of each payment, the party who owes more to the other makes a net payment. Only one party makes a payment. Currency swaps A currency swap is an agreement between two parties in which one party promises to make payments in one currency and the other promises to make payments in another currency. Currency swaps are similar yet notably different from interest rate swaps and are often combined with interest rate swaps. Currency swaps help eliminate the differences between international capital markets. Interest rates swaps help eliminate barriers caused by regulatory structures. While currency swaps result in exchange of one currency with another, interest rate swaps help exchange a fixed rate of interest with a variable rate. The needs of the parties in a swap transaction are diametrically different. Swaps are not traded or listed on exchange but they do have an informal market and are traded among dealers. A swap is a contract, which can be effectively combined with other type of derivative instruments. An option on a swap gives the party the right, but not the obligation to enter into a swap at a later date. Commodity swaps In commodity swaps, the cash flows to be exchanged are linked to commodity prices. Commodities are physical assets such as metals, energy stores and food including cattle. E.g. in a commodity swap, a party may agree to exchange cash flows linked to prices of oil for a fixed cash flow. Commodity swaps are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads between final product and raw material prices (E.g. Cracking spread which indicates the spread between crude prices and refined product prices significantly affect the margins of oil refineries)

A Company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. A producer of a commodity may want to reduce the variability of his revenues by being a receiver of a fixed rate in exchange for a rate linked to the commodity prices.

Equity swaps Under an equity swap, the shareholder effectively sells his holdings to a bank, promising to buy it back at market price at a future date. However, he retains a voting right on the shares.
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COMPONENTS OF SWAP PRICE What are the components of a swap price? There are four major components of a swap price. Benchmark price Liquidity (availability of counter parties to offset the swap). Transaction cost Credit risk

Benchmark price: Swap rates are based on a series of benchmark instruments. They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP rates and PLR rates. Liquidity: Liquidity, which is function of supply and demand, plays an important role in swaps pricing. This is also affected by the swap duration. It may be difficult to have counterparties for long duration swaps, especially so in India. Transaction Costs: Transaction costs include the cost of hedging a swap. Say in case of a bank, which has a floating obligation of 91 day T. Bill. Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The transaction cost would thus involve such a difference. Yield on 91 day T. Bill - 9.5% Cost of fund (e.g.- Repo rate) 10% The transaction cost in this case would involve 0.5% Credit Risk: Credit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an AAA rating.

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pril 18 2012| Filed Under Derivatives, Futures, Options Derivatives contracts can be divided into two general families: 1. Contingent claims, e.g. options 2. Forward claims, which include exchange-traded futures, forward contracts and swaps SEE: Options Basics A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond. This article will discuss the two most common and most basic types of swaps: the plain vanilla interest rate and currency swaps. The Swaps Market Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap. SEE: Futures Fundamentals The first interest rate swap occurred between IBM and the World Bank in 1981. However, despite their relative youth, swaps have exploded in popularity. In 1987, the International Swaps and Derivatives Association reported that the swaps market had a total notional value of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International Settlements. That's more than 15 times the size of the U.S. public equities market. Plain Vanilla Interest Rate Swap The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest

rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties. SEE: How do companies benefit from interest rate and currency swaps? For example, on Dec. 31, 2006, Company A and Company B enter into a five-year swap with the following terms:

Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million. Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million.

LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by other banks in the eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011. At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a "notional" amount. Figure 1 shows the cash flows between the parties, which occur annually (in this example). SEE: Corporate Use Of Derivatives For Hedging

Figure 1: Cash flows for a plain vanilla interest rate swap

Plain Vanilla Foreign Currency Swap The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an

interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated. For example, Company C, a U.S. firm, and Company D, a European firm, enter into a five-year currency swap for $50 million. Let's assume the exchange rate at the time is $1.25 per euro (e.g. the dollar is worth 0.80 euro). First, the firms will exchange principals. So, Company C pays $50 million, and Company D pays 40 million euros. This satisfies each company's need for funds denominated in another currency (which is the reason for the swap).

Figure 2: Cash flows for a plain vanilla currency swap, Step 1.

Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. To keep things simple, let's say they make these payments annually, beginning one year from the exchange of principal. Because Company C has borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, will pay interest in dollars, based on a dollar interest rate. For this example, let's say the agreed-upon dollardenominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year, Company C pays 40,000,000 euros * 3.50% = 1,400,000 euros to Company D. Company D will pay Company C $50,000,000 * 8.25% = $4,125,000. As with interest rate swaps, the parties will actually net the payments against each other at the thenprevailing exchange rate. If, at the one-year mark, the exchange rate is $1.40 per euro, then Company C's payment equals $1,960,000, and Company D's payment would be $4,125,000. In practice, Company D would pay the net difference of $2,165,000 ($4,125,000 - $1,960,000) to Company C.

Figure 3: Cash flows for a plain vanilla currency swap, Step 2

Finally, at the end of the swap (usually also the date of the final interest payment), the parties re-

exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time.

Figure 4: Cash flows for a plain vanilla currency swap, Step 3

Who Would Use a Swap? The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of interest on deposits (e.g. liabilities) and earns a fixed rate of interest on loans (e.g. assets). This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixedpay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets, which would match up well with its floating-rate liabilities. Some companies have a comparative advantage in acquiring certain types of financing. However, this comparative advantage may not be for the type of financing desired. In this case, the company may acquire the financing for which it has a comparative advantage, then use a swap to convert it to the desired type of financing. For example, consider a well-known U.S. firm that wants to expand its operations into Europe, where it is less known. It will likely receive more favorable financing terms in the U.S. By then using a currency swap, the firm ends with the euros it needs to fund its expansion. Exiting a Swap Agreement Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This is similar to an investor selling an exchange-traded futures or option contract before expiration. There are four basic ways to do this: 1. Buy Out the Counterparty: Just like an option or futures contract, a swap has a calculable market value, so one party may terminate the contract by paying the other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance, or the party who wants out must secure the counterparty's consent. 2. Enter an Offsetting Swap: For example, Company A from the interest rate swap example above could enter into a second swap, this time receiving a fixed rate and paying a floating rate.

3. Sell the Swap to Someone Else: Because swaps have calculable value, one party may sell the contract to a third party. As with Strategy 1, this requires the permission of the counterparty. 4. Use a Swaption: A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks associated with Strategy 2. The Bottom Line Swaps can be a very confusing topic at first, but this financial tool, if used properly, can provide many firms with a method of receiving a type of financing that would otherwise be unavailable. This introduction to the concept of plain vanilla swaps and currency swaps should be regarded as the groundwork needed for further study. You now know the basics of this growing area and how swaps are one available avenue that can give many firms the comparative advantage they are looking for. Read more: http://www.investopedia.com/articles/optioninvestor/07/swaps.asp#ixzz2C4lsnR8i