Introduction To Swaps and Their Application in Pakistan

International Financial Management
SWAPS & PAKISTAN
2012
Contents
1. 2. I. II. III. IV. 3. I. 4. I. II. III. IV. V. VI. VII. 5. I. II. III. 6. Introduction:.......................................................................................................................................... 2 Currency Swap: ..................................................................................................................................... 5 Examples:.......................................................................................................................................... 5 World Bank & IBM Currency Swap: ............................................................................................... 6 SBI & HUDCO yen swap deal: .................................................................................................... 8 Pak & China Currency Swap: ....................................................................................................... 9
Interest Rate SWAP: ............................................................................................................................. 9 Example: Citibank, Unilever & Xerox: .......................................................................................... 10 SWAPS in Pakistan: ........................................................................................................................... 11 Lucky Cement, Pakistan: ................................................................................................................ 12 Attock Cement, Pakistan:................................................................................................................ 12 Kohinoor Textile Mills Limited: ................................................................................................. 12 Gadoon Textile Mills Limited: ................................................................................................... 13 Azgard -9: ....................................................................................................................................... 13 Standard Chartered Bank Pakistan Ltd: ...................................................................................... 14 Royal Bank of Scotland: ............................................................................................................. 14
Implementation of Swap System in Pakistan: ..................................................................................... 14 Fixed vs. Floating Cross Currency Swaps ...................................................................................... 15 Pricing and Valuation ..................................................................................................................... 15 Using a Cross Currency Swap to Transform Loans and Assets.................................................. 16
References:.......................................................................................................................................... 17
Submitted & Prepared By Saad Bin Mehmood
MBA Banking & Finance IM Sciences
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Introduction to Swaps and their Application in Pakistan
1. Introduction:
A swap is a financial contract between two parties, where each party pays the other party periodic payments over the life of the contract according to some pre-specified rules based on certain underlying index. In most swaps, one party makes the fixed payments while the other party delivers the floating payments according to the underlying index. The two most common types are the interest rate swaps and currency swaps, where the underlying index is the interest rate and exchange rate, respectively. The payments are calculated based on notional principal, and usually the payments between the parties are netted. For interest rate swaps, there is no exchange of principals at initiation or maturity. However, for currency swaps, principals at the respective currencies are exchanged at both initiation and maturity. At initiation of the swap, the value of the swap is set to be zero to both parties. The fixed rate of the swap is then calculated such that the present value of the fixed payments equals that of the floating payments based on the current information of the underlying index. As time evolves, the underlying index may move upward or downward so that the value of the floating payments changes. Therefore, the value of the swap changes in later times, and its value at each time is given by the difference in the present values of the remaining cash flows from the two parties. For example, consider an interest rate swap and an upward interest move environment, the floating rate payer is expected to pay more in future payments so that swap is expected to be in-the-money to the fixed rate payer.
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In swap contracts, there are two most basic forms of risk: price risk and default risk. The price risk arises due to the movement of the underlying index so that the defaults free present value of the future payments changes. The price risk can be hedged by taking offsetting positions using related derivative instruments, like interest rate futures, currency futures, etc. The default risk is defined to be the exposure to the risk of failure of the other counterparty. Unlike forward contracts, swaps are over-the-counter contracts so they are not backed by the guarantee of a clearing house or an exchange. Swap default may be due to early termination of the swaps contract, or defaulting on some other obligation or filing for bankruptcy. Early termination may be due to the non-performance of obligations under the swap contract, for example, defaulting on a swap payment. The swap may include clauses that trigger early termination, say, the credit rating of either party falling below a certain class, or failure to meet margin payment when required on a marking to market basis. Assessment of termination damages in case of premature termination is based on the replacement cost of the swap. An estimate of the swap value is obtained from quotes from several established swap dealers. The average of these quotes is used as the replacement value. The cost of default is related to the replacement cost of the contract, and this depends on the rule for sharing claims in default. There are two basic rules of settlement. In the full two-way settlement, if the swap has positive value to the defaulting party, the counterparty pays the full replacement value of the swap. However, in the limited two-way settlement, the non-defaulting party is not liable to pay the defaulting party even the swap is in-the-money to the defaulting party based on the rationale that there has been a breach of contract by the defaulting party. In real life, non-defaulting parties have typically settled out of court by paying part of the replacement cost to the defaulting parties.
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The common tools of default risk analysis of swaps use either the structural models or the reduced form models. The structural models (Baz and Pascutti, 1996; Cooper and Mello, 1991; Li, 1998) employ the contingent claim approach where the firm values of the swap parties are assumed to follow some stochastic processes. Default occurs when either firm value cannot meet its liabilities. The payment streams are incorporated as source terms in the governing partial differential equation and the settlement rules are modeled as auxiliary conditions. In the reduced from models (Duffie and Huang, 1996; Huge and Lando, 1999), default arrives suddenly as point process. Valuation of defaultable securities is characterized by an effective discount rate, which is above the default free rate by a premium that is related to the arrival rate of default and recovery rate upon default. All theoretical analyzes on credit risk of swaps show that the difference in swap rates between two counterparties of different credit ratings is much less than the difference in their debt rates. For example, Duffie and Huang (1996) found that for a 5- year interest rate swap between a given party paying LIBOR and another party paying a fixed rate, the replacement of the given fixed-rate counterparty with a lower quality counterparty whose bond yields are 100 basis points higher, increases the swap rate by roughly 1 basis point. For a 5-year currency swap, with volatility on the exchange rate of 15%, their model shows the impact of credit risk asymmetry on the market swap rate to be roughly 10-fold greater than that for interest rate swaps. This is consistent with the actual market practices that swap dealers quote the same rates to all counterparties, irrespective of their credit ratings. The insensitivity of swap rates to credit ratings may be attributed to the very nature of a swap that it can be either an asset or liability to either counter party. Also, the multi-period nature effectively mitigates the impact of default risk. In
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real market environment, several non-price devices to control default risk are commonly used in swap markets to limit the ability of bad firms to shift risk via swaps. Some of these common techniques include credit trigger, collateral, netting and markingtomarket.
2. Currency Swap:
Before 1981 companies were involved in back-to-back loans where they agreed to borrow in their domestic currency and lend to each other these currencies. The long-term currency swap transactions started in August, 1981.The World Bank issued $290mln in bonds and used the dollar proceeds in currency swaps with IBM for German marks and Swiss francs. A currency swap is an agreement to exchange principal and fixed interest in one currency for principal and fixed interest in another currency. We may also say that a simple type of currency swap would be an agreement between two parties to exchange fixed rate interest payments and the principal on a loan in one currency for fixed rate interest payments and the principal on a loan in another currency. Whereas, the uncertainty in the cash flow is due to uncertainty in the currency exchange rate. A currency swap gives the parties to the contract the right of offset that is the right to offset any nonpayment of principal or interest with a comparative nonpayment. A currency swap is not a loan and therefore does not change the liability structure of the parties balance sheets.
I.
Examples:
For example a US company may receive the Euro payments of the swap while a German company might receive the dollar payments. Whereas the value of the swap to each party will
Submitted & Prepared By Saad Bin Mehmood MBA Banking & Finance IM Sciences Page 5
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vary as the USD/Euro exchange rate varies. As a result, the companies are exposed to foreign exchange risk but if necessary this risk can be hedged by trading in the forward foreign exchange market. Why might the US and German companies enter such a transaction? A possible explanation might be that the US company wishes to invest in the Euro zone while the German country wishes to invest in the U.S. Each company therefore needs foreign currency. However, they may have a comparative advantage borrowing in their domestic currency at home as opposed to borrowing in a foreign currency abroad. If this is the case, it makes sense to borrow domestic currency at home and use a swap to convert it into the foreign currency.
II.
World Bank & IBM Currency Swap:
The first currency swap seems to be a 1981 transaction between the World Bank and IBM. Its details are instructive. The World Bank wanted to raise additional capital and to denominate the liabilities in Swiss francs because of a low interest rate in that currency. The US market, though, was more receptive to World Bank bonds than the Swiss market, since the World Bank had already saturated the Swiss market for its bonds, and US investors regarded World Bank bonds to have much less credit risk than Swiss investors did. But the US investors wanted to invest in bonds denominated in US dollars. IBM had financed before by issuing Swiss franc debt, but had since developed the view that the Swiss franc was going to appreciate relative to the US dollar. It wanted to replace its Swiss franc debt with US dollar debt. But of course IBM would incur the transactions costs of issuing new US dollar debt and retiring the Swiss franc debt. A major global bank observed that both parties could benefit if they made a private deal, termed a currency swap. The swap let IBM receive cash flows of Swiss francs from the World Bank, and the World Bank to receive US dollars from IBM. The World Bank could then go ahead and borrow in US dollars from US investors in the
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favorable US market, planning to use its US dollar receipts from the currency swap with IBM to make the US dollar bond payments. This way, the Swiss franc swap payments to IBM represented the net effective liability for the World Bank. Similarly, IBM could use the Swiss francs received from the currency swap with the World Bank to meet its Swiss franc debt obligations, while its US dollar payments to the World Bank represented its new effective liability in US dollars.
World Bank-IBM Swap (1981) IBMs motivation was clear. IBM had issued Swiss franc bonds but subsequently wanted to change that liability into a US dollar liability, as it feared an appreciation of the Swiss franc. IBM used the currency swap as an expeditious way to convert Swiss franc debt into US dollar debt, without having to retire its Swiss franc debt and reissue new US dollar debt (avoiding transaction costs). This was money-saving and time-saving. The World Bank used the currency swap as a capital raising strategy. You might ask why the World Bank didnt simply issue Swiss franc bonds in the first place, if it wanted its liabilities to be denominated in Swiss francs? The
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answer is that the World Bank was able to get a lower effective Swiss franc interest rate than it could by issuing Swiss franc bonds directly. There was more appetite for World Bank bonds among US investors than among Swiss investors, and US investors thought the World Bank to be a better credit risk than Swiss investors thought. But the US investors wanted bonds denominated in US dollars, so the World Bank took advantage of the financing opportunity in the US market. It achieved its preferred liability denomination of Swiss francs through the swap deal. We describe the positions in currency swaps like positions in forward FX contracts. IBM had a long Swiss franc position and a short US dollar position in the swap since it received Swiss francs and paid US dollars. The World Bank had a short Swiss franc position and a long US dollar position in the swap since it paid Swiss francs and received US dollars.
III.
SBI & HUDCO yen swap deal:
In 1998, State Bank of India entered into a long-term Rupee-Japanese Yen swap with Housing and Urban Development Corporation (HUDCO).HUDCO swapped its foreign currency liability of Yen 2.89 billion for equivalent Rupee resources with SBI for a tenor of 10 years. Under the arrangement, HUDCO deposited its Yen with SBI on the day of transaction and SBI in return paid the equivalent Rupee resources to HUDCO. The swap was done at the prevailing exchange rate on the day of the transaction. HUDCO used the Rupee resources for lending to their projects in India. The overseas branches of SBI in Japan, to fund their own assets used the Yen. As per the swap agreement, SBI provided the long-term hedge to HUDCO for a period of 10 years to cover the exchange risk of the foreign liability. As a result of this, the swap neutralized both the exchange rate risk and interest rate risk of HUDCO on Yen loan by converting the Yen flows into risk neutral fixed interest rate Rupee
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flows for the firm. At the end of 10 years, HUDCO will take back the Yen by giving the Rupee equivalent to SBI.
Rupee
SBI
Yen
HUD
IV.
Pak & China Currency Swap:
In 2011, Pakistan and China signed a bilateral currency swap agreement to promote trade between the two countries and also further strengthening their economic ties, According to State Bank, The bilateral currency swap agreement is of 10 billion yuan Chinese yuan ($1.58 billion) 140 billion Pakistani rupees ($1.57 billion) and would end in three years. The purpose of this agreement is promoting bilateral trade and investment and strengthening financial cooperation.
3. Interest Rate SWAP:

Since the early 1980's, interest rate swaps have become one of the most popular vehicles utilized by many companies and financial institutions to hedge against interest rate risk. The growing popularity of interest rate swaps is due, in part, to the fact that the technique is simple and easy to execute. An interest rate swap, or simply a rate swap, is an agreement between two parties to exchange a series of interest payments without exchanging the underlying debt. In a typical fixed/floating rate swap, the first party promises to pay to the second at designated intervals a stipulated amount of interest calculated at a fixed rate on the "notional principal"; the second party promises to pay to the first at the same intervals a floating amount of interest on the notional principle calculated according to a floatingrate index. The first party in a fixed/floating rate swap, that which pays the fixed amount of interest, is
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known as the fixed rate payer, while the second party, that which pays the floating amount of interest, is known as the floating-rate payer'. Interest rate swaps are voluntary market transactions by two parties. In an interest swap, as in all economic transactions, it is presumed that both parties obtain economic benefits. The economic benefits in an interest rate swap are a result of the principle of comparative advantage. Further, in the absence of national and international money and capital market imperfections and in the absence of comparative advantages among different borrowers in these markets, there would be no economic incentive for any firm to engage in an interest rate swap. The Interest rate Swaps are somewhat complex, innovative financing arrangement for corporations that can reduce borrowing costs and increase control over interest rate risk and foreign exchange exposure.Relatively new market, due to financial deregulation, integration of world financial markets, and currency and interest rate volatility. Market has grown significantly.Interest Rate Swap financing involves two parties (MNCs) who agree to exchange CFs, results in benefits for both parties. Singlecurrency interest rate swap is usually just called an Interest Rate Swap.
I.
Example: Citibank, Unilever & Xerox:
Following Figure shows the structure of an interest rate Swap of Citibank, Unilever & Xerox:
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In the given figure Unilever borrows at 7% p.a., and then enters into interest rate swap with Citibank and agrees to pay Citibank a floating rate of interest and to receive one-year LIBOR. Whereas Xerox borrows at LIBOR+3/4%, and then swaps the payments with Citibank and (Xerox) agrees to pay Citibank 7.875% p.a. interest and to receive LIBOR+3/4%. So Net borrowing cost are: LIBOR for Unilever (saving of % p.a.) 7.875% p.a. for Xerox (saving of 1/8% p.a.)
4. SWAPS in Pakistan:
Pakistani banks participation in Swaps has risen sharply in recent years. The total amount of interest rate, currency, commodity, and equity contracts at PAKISTANI commercial and savings banks soared from Rs 6.8 trillion in 2003 to Rs 11.9 trillion in 2006, an increase of 75 percent. A major concern facing policymakers and bank regulators today is the possibility that the rising use of Swaps has increased the riskiness of individual banks and of the banking system as a whole. Banks have long used one type of swaps instrument, namely interest rate futures, to manage interest rate risk. However, the development of newer instruments, such as swaps, caps, collars, and floors has greatly expanded the menu of financial technologies available to banks for assetliability management. In particular, interest rate swaps have become the preferred tool. According to a recent market survey of swaps users, 92 percent of responding financial
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institutions report using interest rate swaps to manage the interest rate risk of their lending portfolios.
I.
Lucky Cement, Pakistan:
Lucky Cement, Pakistans largest cement manufacturer has entered into a combination of interest rate and currency swaps to finance its expansion projects. Under the current interest rate swap the company receives a floating rate equivalent to 6-month T-Bill or KIBOR in exchange for the fixed payment from 7% to 9.3%. Lucky is likely to benefit in an environment which expects interest rates to increase.
II.
Attock Cement, Pakistan:
Attock Cement has also entered into an interest rate swap arrangement to finance its expansion project. The company receives a fixed mark-up above a floating KIBOR rate against fixed payments.
III.

Kohinoor Textile Mills Limited:

Nature of Option: Cross Currency Swap (CCS) Particulars: KTML entered into a CCS of notional amount of PKR
1.852BN for its local currency loans to hedge the possible adverse movement in interest rates.
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Under the terms of the agreement KTML pays LIBOR plus Bank spread @ 0.95% to the arranging Bank on the local currency loan denominated in USD for the purpose of CCS and receives KIBOR.
The derivative Cross Currency interest rate swap that are outstanding as at June 30, 2008 have been mark to market and the effective unrealized gain aggregating to PKR 206mn has been recognized in accordance with the provision of IAS 39.
IV.

Gadoon Textile Mills Limited:

Nature of Option: Cross Currency Swap (CCS) Particulars: The Company has entered into a Cross Currency interest rate swap arrangement amounting to PKR 155mn with banks. Under the arrangement the principal amount is swapped with UD$ component. The Company pay six month US$ LIBOR and receive six month KIBOR minus spread as per the arrangement. Settlements are made on semi-annual basis. The Company has terminated the contracts after the balance sheet date. (Source: Annual report 2008)
V.

Azgard -9:
Nature of Option: Cross Currency Interest rate swap Particulars: The Company has entered into a Cross Currency interest rate swap arrangement amounting to PKR 1,500mn with Citibank to cover various short term facilities. The Company is liable to pay interest at 6 months LIBOR.
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(Source: Annual report 2007) Azgard-9 was one of the first ones to undertake Cross Currency Swap in Pakistan. Azgard9 benefited to a large extent in the initial years from this arrangement however now due to significant devaluation of PKR this arrangement has exposed them to losses.
VI.

Standard Chartered Bank Pakistan Ltd:

Nature of Option: Interest rate and Currency Swap Particulars: The Bank made an income of PKR 13.713 bn in CY08, out of this PKR 1.05bn is through income on interest rate swap and other derivatives. (Source: Annual report 2008)
VII.

Royal Bank of Scotland:

Nature of Option: Interest rate and Currency Swap Particulars: The Bank made an income of PKR 6.00 bn in CY08, out of this PKR 1.22bn is through income on interest rate swap and other derivatives. (Source: Annual report 2008)
5. Implementation of Swap System in Pakistan:
As we know that the banks are the basic indicators of every economy as they are directly related with the finance and related services, as much the banks are involve directly with financial services it means bank has to face more risks and more risks means more chance of default. As
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stated above there are so many companies in Pakistan which are dealing in SWAP system since 2008 which means the financial sector of Pakistan is developing new and innovative ways of investments and risk management.
I.
Fixed vs. Floating Cross Currency Swaps
In Pakistan many banks favor the use of cross-currency swaps because, as over the counter instruments, they are easy to customize. In addition to the frequency of interest exchanges, the reference interest rates used to determine the interest payments can be customized to reflect the specific needs of the user. Although the interest rates must correspond to the currencies involved in the principal exchange, the actual benchmark rates used are up to the parties entering into the swap. This means that banks can match the reference rates for these instruments to those of their specific liabilities/assets, whose interest flows may be tied rates other than, say, KIBOR rates1.
II.
Pricing and Valuation
This type of Swap is practiced rarely in Pakistan. At inception, the value of a typical, vanilla swap is zero. This implies that the two back-to-back bonds (i.e., cash flows in a single currency) being exchanged have equivalent NPVs, when valued in a common currency at the spot exchange rate. Floating-for floating swaps are akin to a bundle of two floating rate coupon bonds, whereas fix-for-fix swaps are akin to a bundle of two fixed coupon bonds. In terms of quoting convention, whereas the pricing of forwards contracts are expressed in terms of points, CCS is expressed in terms of spreads to the benchmark rates.
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III.
Using a Cross Currency Swap to Transform Loans and Assets
This is the most commonly type of SWAP used in Pakistani banks. Fundamentally, because CCS changes the currency denomination of assets and liabilities, they can be used to alter the expected interest earnings/costs and foreign currency risk associated with those assets and liabilities. For example, suppose that a bank has a USD denominated bond. To reduce its expected borrowing cost (and, for the moment, ignoring risk considerations), the bank may wish to access the lower interest rate JPY market. To do this, it can use a CCS to create synthetic JPY-denominated debt. This is widely practiced by MCB in Pakistan that the initial exchange converts the USD bond proceeds to yen, and the subsequent cash-flows (i.e., the JPY payments to and USD receipts from the swap counterparty) convert the interest and principal payments from dollars to yen.
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6. References:
Baz, Jamil and Michael J. Pascutti, Alternative swap contracts: Analysis and pricing, Journal of Derivatives (Winter, 1996): 7-21. Cooper, Ian A. and Antonio S. Mello, The default risk of swap, Journal of Finance, 46 (1991): 597-620. Alam.F.Muhammad.2008.Workshop on AKD Securities Limited.Akd Securities Ltd Duffie, Darrell and Ming Huang, Swap rates and credit quality, Journal of Finance, 51 (1996): 921-949. Huge, Brian and David Lando, Swap pricing with two-sided default risk in a rating based model, European Finance Review, 3 (1999): 239-268. Li, Haitao, Pricing of swaps with default risk, Review of Derivatives Research, 2 (1998): 231-250. Litzenberger, Robert H., Swaps: Plain and fanciful, Journal of Finance, 47 (1992): 831850. Mozumdar, Abon, Corporate hedging and speculative incentives: Implications for swap market default risk, Journal of Financial and Quantitative Analysis, 36 (2001): 221-250. Sorensen, Eric H. and Thierry F. Bollier, Pricing swap default risk, Financial Analysts Journal (May-June, 1994): 23-33. Directory of Human Resource Management e-Publications June (2011) Vol.1, Issue 1 http://tribune.com.pk/story/311206/pakistan-china-sign-currency-swap-agreement/
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Introduction To Swaps and Their Application in Pakistan

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International Financial Management

SWAPS & PAKISTAN

Submitted & Prepared By Saad Bin Mehmood

MBA Banking & Finance IM Sciences

International Financial Management

SWAPS & PAKISTAN