SWAPS AND ITS TYPES

1
SWAP: CONCEPT AND NATURE

In the business world, swaps have been termed as private agreements between the two
parties to exchange cash flows in the future according to a prearranged formula.

In simple words, a swap is an agreement to exchange payments of two different kinds in

the future.

It involves exchange of cash flows or payments, hence, it is also called financial swap in
global financial markets.

The swaps market has had an exceptional growth since its inception in 1979.
The swaps volume exceeds $10 trillion today.

In the context of financial markets, the term swap has two meanings.

First, it is a purchase and simultaneous forward sale or vice-versa.

Second, it is defined as the agreed exchange of future cash flows, possibly, but not
necessarily with a spot exchange of cash flows.

The second definition of swap is most commonly used stating as an agreement to the
future exchange of cash flows.

Swaps not only often replace other derivative instruments such as futures and forwards,
but also complement those products.

3
EVOLUTION OF SWAP MARKET

Most of the financial experts agree that the origin of the swap markets can be traced back
to 1970s when many countries imposed foreign exchange regulations and restrictions in
order to control cross border capital flows.

In 1980s, a few countries liberalized their exchange regulatory measures, as a result,

some of the MNCs treasures structured their portfolios and brought out new financial
product, known as swaps.

The first swap was negotiated in 1981 between Deutsche Bank and an undisclosed
counter party. Since then, the swap markets have grown very rapidly.

The formation of the International Swap Dealers Association(ISDA) in 1984 was a

significant development to speed up the growth in the swaps market by standardizing
swap documentation.

In 1985 the ISDA published the first standardized swap code, which was revised in 1986
and then in 1987, it published its Standard Form Agreements.

5
FEATURES OF SWAPS

Counter Parties: All swaps involve the exchange of a series of periodic payments
between at least two parties.

Facilitators: Swap agreements are arranged mostly, ( known as swap facilitators),

through an intermediary which is usually a large international financial institution/ bank
having network of its operations in major countries. Swap facilitators can be classified
into two categories:
Brokers: They function as agents that identify and bring the counter parties on the table

for the swap deal.

Swap dealers: They themselves become counter-parties and takeover the risk.

Cash Flows: In the swap deal, two different payment streams in terms of cash flows are
estimated to have identical present values at the outset when discounted at the respective
cost of
funds in the relevant primary markets.
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Documentations: Swap transactions may be set up with great speed sine their
documentations and formalities are generally much less in comparable to loan deals.

Transaction Costs: The transaction costs in swap deals are relatively low in comparison
to loan agreements.

Benefit to Parties: Swap agreements will be done only when the parties will be benefited
by such agreement, otherwise such deals will not be accepted.

Termination: The termination requires to be accepted by counter parties.

Default Risk: Since most of the swap deals are bilateral agreements, therefore, the
problems of potential default by either counter party exists, making them more risky
products in comparison to futures
and options.
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MAJOR TYPES OF FINANCIAL SWAPS

The basic objective of a swap deal is to hedge the risk as desired by the counter parties.

The major risks that can be changed with the swap transactions, are relating to interest
rate, currency, commodity, equity, credit, climate and so on.

The major types of financial swaps that will be discussed are as:
Interest-Rate Swaps.
Currency Swaps.
Equity Swaps.

8
INTEREST-RATE SWAPS

An interest-rate swap is a financial agreement between the two parties who wish to
change the interest payments or receipts in the same currency on assets or liabilities to a
different basis.
There is no exchange of principal amount in this swap.

It is an exchange of interest payment for a specific maturity on a agreed upon notional

amount.

Maturity ranges from a year to over 15 years, however, most transactions fall within two
years to ten years period.

The simplest example of interest rate swap is to exchange of fixed for floating rate
interest payments between two parties in the same currency.

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FEATURES OF INTEREST-RATE SWAPS

Notional Principal

Fixed Rate

In the interest rate swap agreement, the interest amount whether fixed or floating is
calculated on a specified amount borrowed or lent. It is notional because the parties do
not exchange this amount at any time.
This is the rate, which is used to calculate the size of fixed payment.
Banks or other financial institutions who make market in interest rate swaps quote the
fixed rate, they are willing to pay if they are fixed rate payers in swap(bid swap rates) and
they are willing to receive if they are floating rate payers in a swap(ask swap rate).
It may be defined as one of he market indexes like LIBOR, SIBOR, MIBOR, Treasury
bill rate, primary rate etc. on which basis the floating rate is determined in the swap
agreements.

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Example For Fixed Rate

A bank might quote a US dollar floating to fixed 5-year swap rate:

Treasuries + 20 bp/Treasuries + 40bp vs six- month LIBOR

The quote indicates the following:

The said bank is willing to make fixed payment at a rate equal to the current yield on 5-

Floa

year treasury notes plus 20 basis points (0.20 percent) in return for receiving floating
payments, say at six-month LIBOR.
The bank has offered to accept at a rate equal to 5-year treasury notes plus 40 basis
points in return for payment of six month LIBOR.

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Relevant da

floating paym

the setting da
Trade Date: It may be

Effective Date: It is the

the floating rat

defined as such date on

date from which the first

for next paym

which the swap deal is

fixed and floating payment

D(1) is that

concluded.

start to accrue.

which the ne

payment star

and D(2) is s

which the pay

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Fixed and Floating payments: In a standard swap deal the fixed and floating payments
are calculated as follows:
Fixed payment= (P)*(Rfx)*(Ffx)
Floating payment= (P)*(Rfe)*(Ffe)
where P is the notional payment, Rfx is the fixed price, Rfe is the floating rate set on the
reset date, Ffx is the fixed rate day count fraction and Ffe is the floating rate day count
fraction.
The last two are time periods over which the interest is to be calculated.

13
EXAMPLE OF INTEREST RATE SWAP

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SITUATION OF A AND B FIRMS BEFORE THE SWAP

MORTGAGE
PORTFOLIO

$100 (M) PORTFOLIO

5-YEAR AVERAGE
MATURITY

8.50% YIELD

FIRM A

LIBOR + 0.5%

FLOATING RATE
LENDERS

LOAN
PORTFOLIO

$100 (M) PORTFOLIO

5-YEAR AVERAGE
MATURITY

LIBOR+ 0.75% (YIELD)

FIRM B

6% $100(M) 5-YEAR MATURITY

EURO BONDS
15

In order to eliminate the interest rate risk. Firm A may enter into interest rate swap deal
with any Big Bank. Assume that 6.50 percent will be paid by Firm A to Big Bank for 5
years with payments calculated by multiplying the rate by $100(M) notional principal
amount. In return for this payment, Big Bank agrees to pay the Firm A six-month LIBOR
over five years, with reset dates matching the reset on its floating rate loan.
This is shown in the figure in the next slide relating to Firm A.

The net result to A is a follows:

Receipt on portfolio

8.50%

Pay big bank

6.50%

Receive from big bank

LIBOR

Pay on loan

(LIBOR + 50bp)

Cost of fund

(6.50 + .50)= 7.00%

Locked in Spread

1.50%

FIRM A INTEREST RATE SWAP AGREEMENT WITH BIG BANK

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MORTGAGE
PORTFOLIO

8.50%

6.50%
FIRM A
LIBOR

Big Bank

LIBOR + 0.5%

FLOATING RATE
LENDERS

$100 (M) LOAN

5-YEAR
MATURITY

NOTIONAL $100(M) FOR

5 YEARS
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Similarly, Firm B enters into portfolio with the Big Bank where it agrees to pay sixmonth LIBOR to Big Bank on an notional principal amount of $100(M) for 5 years for
receiving payments of 6.40%. The net result to B and swap are shown in the figure in
next slide.

The net result to B is as follows:

Receipt on portfolio

LIBOR + 0.75%

Pay big bank

LIBOR

Receive from big bank

6.40%

Pay on euro bond

6.00%

Cost of fund

LIBOR 0.40%

Locked in Spread

0.75% + 0.40%= 1.15%

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FIRM B INTEREST RATE SWAP AGREEMENT WITH BIG BANK

NOTIONAL
$100(M) FOR 5 YEARS

$100(M) FOR
5 YEARS

LIBOR+ 0.75%

6.40%
Big Bank

FIRM B
LIBOR

6%

$100 (M) FOR 5-YEAR MATURITY

EURO BONDS
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It is evident from the example that the cost of funds of FIRM B has been reduced to

LIBOR less 40 basis points resulting FIRM B has been locked in spread on its portfolio
of 115 basis points.

In this swap deal, the interest of Big Bank is to be assessed. The net result in each of
these transactions is that the risk of loss due to interest rate fluctuations has been
transferred from the counter party to Big Bank.

The Big Bank will only be interested to enter into such deals with Firm A and B if it will
also be in beneficial position.

As a financial intermediary, the Big Bank puts together both transactions, the risks net out
is left with a speed of 10 basis points.
This is shown in the figure in next slide.

20
SWAP STRUCTURE

MORTGAGE

$100 (M) FOR

$100 (M) PORTFOLIO

PORTFOLIO

5-YEAR MATURITY
5-YEAR MATURITY

8.50%

6.50%
FIRM A

6.40%
Big Bank

LIBOR
LIBOR

LIBOR + 0.5%

FLOATING RATE
LENDERS

$100 (M) FOR

5-YEAR MATURITY

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Thus, Big Bank receives compensation equal to $1 lac annually for the next five years on
$100(M) swap deal.
Swap profit to Big Bank
0.001(10 basis points) * 1 million= $ 1 lac

Receive

6.50%

Pay

6.40%

Receive

LIBOR

Pay

LIBOR

Net

(6.50- 6.40)= 10 basis points

22
TYPES OF INTEREST RATE SWAPS

Plain Vanilla
Swap

Zero coupon to floating

Alternative floating rate

It is also known as fixed-for-floating swap. In this swap, one party with a floating interest
rate liability is exchanged with fixed rate liability. Usually
swap period ranges from 2 years to over 15 years for a pre-determined notional
principal amount. Most of the deals occur within 4 year period.

The holders of zero coupon bonds get the full amount of loan and interest accrued at the
maturity of the bond. The fixed rate player makes a bullet
payment at the end and floating rate player makes the periodic payment throughout
the swap period.

The floating reference can be switched to other alternatives as per the requirement of the
counter party. These alternatives include three month
LIBOR, One month CP, T-Bill rate, etc. In other words, alternative floating rates are
charged in order to meet the exposure of other party.

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Floating-tofloating

Forward
swap

Rate-capped
swap

In this swap, one counter party pays one floating rate, say, LIBOR while the other counter
party pays another, say, prime for a specified time period.
These swap deals are mainly used by the non-US banks to manage their dollar
exposure.

This swap involves an exchange of interest payment that does not begin until a specified
future point in time. It is also kind of swap involving fixed
for floating interest rate.

There is exchange of fixed rate payments for floating rate payments, whereby the floating
rate payments are capped. An upfront fee is paid by
floating rate party for the cap.

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Swaptions

Extendable
swap

These are combination of the features of two derivative instruments, i.e., option and
swap. The buyer of the Swaptions has the right to enter into an interest rate
swap agreement by some specified date in future. Swaptions can be of two types: Call
Swaptions or callable swap and put Swaptions or puttable swap.

It contains an extendable feature, which allows fixed for floating counter party to extend
the swap period.

It involves the exchange of interest payment linked to the change in the stock index. For
example, an equity swap agreement may allow a company to swap a
fixed interest rate of 6% in exchange for the rate of appreciation on a particular
index, say, BSE or NSE index, each year over the next four years.
Equity swap

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EXAMPLE OF PLAIN VANILLA SWAP

Let us consider a simple example of plain vanilla swap to show the net cash flow arisen
in the swap. Let us assume Party X on a semi annual basis, pays 7%of interest rate on the
notional amount and receives from the Party Y LIBOR + 30 basis points. The current sixmonth LIBOR rate is 6.30% per annum. The notional principal is $35 million.

7.00%
Party X pays fixed, receives

Pa

floating
LIBOR + 30 bp

FIG. : STRUCTURE OF PLAIN VANILLA SWAP

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Amount to be paid as per fixed rate: The fixed rate in a swap is usually quoted on a
semi-annual bond equivalent yield basis. Therefore, the interest is paid every six months
is:
Notional principal(Days in period/365)(Interest rate /100)
= $35,00,00,000(182/365)(7.00/100)= $12,21,643.83
It is assumed that there are 182 days in a particular period.

Amount to be paid as per floating rate: The floating side is quoted on a money market
yield basis. The difference between the two-rate computation is the number of days in a
year conversion employed. Therefore, the payment is:
Notional principal(Days in period/360)(Interest rate/100)
=$35,00,00,000(182/360)(7.00/100)= $11,67,833.33
In a swap, the payments are netted. In this case, Party X pays Party
Y the net difference. : $12,21,643.83-$11,67,833.33 = $53,810

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VALUATION OF INTEREST RATE SWAP

Assuming no default risk, an interest swap can be valued either as a long position in one
bond combined with short in another bond or as portfolio of forward contracts.

Interest rate swap can be valued by treating the fixed rate payments as being equivalent to
the cash flows on a conventional bond and the floating rate payments as being equivalent
to a floating rate note(FRN).

The principal amount is not exchanged and further amount is paid in the same currency.
Thus, the value of swap could be expressed as the value of fixed rate bond and value of
the floating rate underlying the swap.
It may be expressed as: V= B1 B2
where V is the value of swap, B1 is the value of fixed rate bond underlying the swap and
B2 is the value of floating rate bond underlying the swap.

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In the previous equation, valuation of swap depends upon the valuation of fixed rate bond
and floating rate bond. To find out valuation, the discount rate used should reflect the
riskness of the
cash flows. Therefore, it is appropriate to use the same discount rate for both the
bonds B1 and B2.

Value of the bond B1 =

+
Q
=1
where K is the periodic fixed payment in the swap, is the discount rate
corresponding to maturity t, Q is the principal sum and is length of the time to
corresponding maturity.
No, Value of the bond B2 = Q 1 1 + K* 1 1
where K* is the floating rate payment, Q is the principal sum, r 1 is the discount
rate and t1 is length of the time to the next interest payment.

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EXAMPLE

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CURRENCY SWAPS

A swap deal can also be arranged across currencies. It is an oldest technique in the swap
market.

The two payment streams being exchanged are denominated in two different currencies.

For example , a firm which has borrowed Japanese yen at a fixed interest rate can swap
away the exchange rate risk by setting up a contract whereby it receives yen at a fixed
rate in return for dollars at either a fixed or a floating interest rate.

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The currency swap is, like interest rate swap, also two party transaction, involving two
counter parties with different but complimentary needs being bought by a bank.
Normally three basic steps are involved which are as under:
Initial exchange of principal amount.
On-going exchange of interest.
Re-exchange of principal amounts in maturity.

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EXAMPLE OF CURRENCY SWAP

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Step III Exchange of Final Contract

Swiss franc forward contract

Firm A
Dollar forward contract

Swiss franc principal

to bond holders.

Do
Fig.: Transaction under currency swap

From the example, it is noted that exchange of principal amounts, both at the beginning
and at the end of swap contract is notional and not real. Then cash flows resulting from
the interest rates are real. The benefits arising out of such swap to counter parties depend
upon the movements in underlying currency exchange rates and interest rates there on.
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TYPES OF CURRENCY SWAPS

The structure of currency swaps differs from interest rate swaps in a variety of ways.

The major difference is that in a currency swap, there is always an exchange of principal
amounts at maturity at a predetermined exchange rate.

The swap contract, behaves like a long dated forward, is foreign exchange contract,

to b

where forward is the current spot rate.

The currency swaps can be of different types based on their term structure; these are
namely fixed-to-fixed currency swap, floating-to-floating currency swap and fixed to
floating currency swap.

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Fixed-to-fixed
The currencies are exchanged at
fixed rate. One firm raises a fixed
rate liability in currency X, say
USD while the other firm raises
fixed rate funding in currency Y,
say, Pound. The principal
amounts are equivalent at the
current market rate of exchange.
In swap deal, first party will get
Pound whereas the second party
will get Dollars. Subsequently,
the first party will make periodic
(pound) payments to the second,
in turn gets dollars computed at
interest at a fixed rate on the
respective principal amount of
both currencies.
At maturity, the dollar and
pound principal are reexchanged.

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EXAMPLE

Floating-to-floating
The counter parties will have
payments at floating rate in
different currencies.

Fixe

It is a combin
fixed curren
swap.
One party m
fixed rate in
the other par
payment at a
currency Y.
Contracts wi
and re-excha
not exist.

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ALTERNATIVE STRATEGY FOR CURRENCY SWAP

There can be different alternative arrangements depending upon the firms considerations.

An alternative arrangement in the previous example is shown as follows:

The firm X borrows FRF@ 9% and lends to the bank, who in turn transfers the same to
firm Y @9% p.a.

On the other hand, firm Y borrows DEM@ 6.4% in its market and lends to the bank, who
transfers the same to firm X@6% p.a.

In this figure, firm Y bears some foreign exchange risk because it pays 10% in FRF and
6.4% in DEM.

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VALUATION OF CURRENCY SWAP

The swap can be valued as the difference between he current values of two conventional
bonds.

The technique used for valuation of currency swap is just synonymous to valuation of
interest rate swap.

The value of foreign currency bond, and the corresponding value of a domestic currency
bond would be taken considered which are as under:
V= SBF BD
where V is the value of the swap, S is the current exchange rate , BF is the value in
foreign currency of the foreign currency bond and BD is the value of local
currency bond underlying the swap.

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Calculation of BF : The bond equivalent to the foreign currency interest flows has
the value as shown in the following equation:
B
=

+ Q
F
=1
where is constant foreign currency interest payment, is the foreign currency
discount rate, is corresponding periods to the interest payments and Q is the
principal sum in foreign currency.
Calculation of BD : The bond equivalent to the foreign currency interest flows has the
value as shown in the following equation:
B
=

+ SQ
D
=1
where is the constant foreign currency interest payment, is discount rates for
various periods to cash flows, is length of those periods to cash flows, S is
exchange rate at the time that swap was agreed and Q is foreign currency
principal sum converted into the equivalent domestic currency principal sum

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EXAMPLE

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DEBT-EQUITY SWAP

In debt-equity swap, a firm buys a countrys debt on the secondary loan market at a
discount and swaps it into local equity.
Debts are exchanged for equity by one firm with the other.

A market for less developed countries (LDC) debt-equity swap has developed that enable
the investors to purchase the external debts of such under-developed countries to acquire
equity or domestic currencies in those same countries.

This market was developed in 1985 and by 1988, the same market reached to $15 billion
in size and further it is on rising trend.

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THANK YOU AND HAVE

A NICE DAY J

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