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AGENDA
Swaps and its evolutionEvolution of IRS IRS Why IRSTypes Mechanism Examples Pros and cons IRS in India. Why failed Future of IRS in India
DEFINITION
A contract which involves two counter parties to exchange over an agreed
Since there are no movements of principal, these are off balance sheet
instruments and the capital requirements on these instruments are minimal.
Characteristics
Contractual agreement Over a period of time Exchange a series of interest cash flows Only net cash flows exchanged on the maturity date The size of the swap is referred to as the notional amount and is the basis for calculation Actual principal of the swap NOT exchanged
Generic swap
A plain vanilla swap is a generic swap. It contain the simple characteristics, such as a constant notional principal amount, exchange of fixed against floating interest (coupon swap), an immediate start (i.e., on the spot date).
Asset Swap
If in an interest rate swap, one of the streams of payments being exchanged is funded with interest received on an asset, the whole mechanism is called the asset swap. i.e. it is an interest rate swap, which is attached to an asset. Asset swaps are used by investors. If an investor anticipates a change in interest rates, he can maximize his interest inflow by swapping the fixed interest paid on the asset for floating interest, in order to profit from an expected rise in interest rates.
Term Swaps
A swap with an original tenor of more than two years is referred to as a term swap.
Basis Swap
Two streams of payments can be calculated using different floating rate indices. These are also called as floating-against-floating swaps. It is possible to enter into a swap with a 3-month Libor against a 6 months LIBOR It is also possible to enter into a swap with a 91-Day T-Bill Yield against a 6-Month Libor.
Counterparties to a basis swap: In a basis swap, each counter party is described in terms of both the interest stream it pays and the interest stream it receives.
Participants 5. Scheduled commercial banks (excluding Regional Rural Banks), primary dealers (PDs) and all-India financial institutions (FIs) are free to undertake FRAs/IRS as a product for their own balance sheet management or for market making. Banks/Fls/PDs can also offer these products to corporates for hedging their (corporates) own balance sheet exposures. No specific permission from Reserve Bank would be required to undertake FRAs/IRS. However, participants when they start undertaking such transactions, will be required to inform Monetary Policy Department (MPD), Reserve Bank of India and abide by such reporting requirements as prescribed by the Reserve Bank from time to time. 6. Participants undertaking FRAs/IRS are, however, advised that before undertaking market making activity in FRAs/IRS, they should ensure that appropriate infrastructure and risk management systems such as ability to price the product and mark to market their positions, monitor and limit exposures on an ongoing basis, etc., are put in place. Types of FRAs/IRS 7. Banks/PDs/FIs can undertake different types of plain vanilla FRAs/IRS. Swaps having
explicit/implicit option features such as caps/floors/collars are not permitted. Bench Mark Rate 8. The benchmark rate should necessarily evolve on its own in the market and require market acceptance. The parties are therefore, free to use any domestic money or debt market rate as benchmark rate for entering into FRAs/IRS, provided methodology of computing the rate is objective, transparent and mutually acceptable to counterparties. Size 9. There will be no restriction on the minimum or maximum size of 'notional principal' amounts of FRAs/IRS. Norms with regard to size are expected to emerge in the market with the development of the product. Tenor 10. There will be no restriction on the minimum or maximum tenor of the FRAs/ IRS. Capital Adequacy 11. Banks and financial institutions are required to maintain capital for FRAs/IRS, as per the stipulations contained in An-nexure 1. Primary dealers should follow the norms as indicated in Annexure 2.
USES
Originally created to allow multi-national companies to evade exchange controls.
Hedging To alter exposure to interest-rate fluctuations. Swapping fixed-rate obligations for floating rate obligations, or vice versa.
Speculation Used by hedge funds to change in interest rates or the relationship between them. Arbitrage opportunities. Insurers with long term assets and shorter term liabilities can enter a swap in which they pay a fixed rate and receive a floating rate This swap provides cash inflows if interest rates rise
Risk Involved
Interest Rate Risk - Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position. Basis Risk - If the floating rates of the two counterparties are not pegged to the same index. Tax Risk -The risk created by potential tax events that could affect the relationship of the swap index with the interest rate on our variable rate bonds. Counterparty Risk -The failure of the counterparty to make required payments or otherwise comply with the terms of the swap agreement.
Termination Risk
- The risk that there will be a mandatory termination of the swap. A termination will almost always result in our either owing or being due to receive a termination payment.
Rollover Risk
- The mismatch of the maturity of the swap and the maturity of the underlying bonds
Liquidity Risk
- The risk that liquidity is unavailable when needed for future renewals or that the price for the liquidity is unattractive at that time.
Credit Risk - The occurrence of an event modifying the credit quality or credit rating of the swap provider or its credit support provider.
Effective date/ : The date on which the swap Value date becomes effective i.e. when the interest obligations start to accrue
Maturity date : The date on which the swap stops accruing interest and terminates
All participants are allowed to enter into these transactions only for the purposes of hedging an underlying exposure.
Assume a quarterly settlement At the first settlement date (in three months), the floating rate is (current) spot 3-month LIBOR For future periods, the floating side is determined by the future level of LIBOR At settlement, the payment is based on the difference of LIBOR and the fixed rate times the notional principal
NP*Rfix
NP*Rfix
NP*Rfix
NP*Rfix
Time 0 1 2 T-1 T
NP*Rfloat
NP*Rfloat
NP*Rfloat
NP*Rfloat
Trade Date
Maturity Date
Notional principal = amount on which interest is computed Cash settlement = payment of loss by one counterparty to the other Start Date = date on which the first floating rate is set (usually the Trade Date or Contract Date except for forward start IRS) Value (Effective) Date = date on which the interest rate payments start to accrue; could be start date Reset Date = date on which the floating rate is reset (includes the first set date at start date) Reset Frequency = number of times per year floating rate is reset e.g. quarterly or semi-annually Reset period = 1/(reset frequency) year Maturity Date = date when swap matures, the last day on which interest accrues for usual swap in-fine where settlement takes place at the end of the accruing period Tenor* = total period in years from value date to maturity date Front stub period = time from value date to first payment
Note:* For interest rate caps, tenor sometimes refer to the reset period, i.e. time length between two adjacent payments.
24
Interest Rate SWAP between Alfa Corp. and Strong Financial Corp.
Terms: Fixed rate payer: Alfa Corp Fixed rate: 5 percent, semiannual Floating rate payer: Strong Financial Corp Floating rate: 3-month USD Libor Notional amount: US$ 100 million Maturity: 5 years
Alfa Corp agrees to pay 5.0% of $100 million on a semiannual basis to Strong Financial for the next five years That is, Alfa will pay 2.5% of $100 million, or $2.5 million, twice a year Strong Financial agrees to pay 3-month Libor (as a percent of the notional amount) on a quarterly basis to Alfa Corp for the next five years That is, Strong will pay the 3-month Libor rate, divided by four and multiplied by the notional amount, four times per year
Advantages
Asset-Liability Mismatch Correction Opens up Diverse Avenues of Funding Hedging Floating Rate Risks Taking advantage of low floating rate borrowings Low Credit Risk Decouple Funding and Duration Decisions Can be CustomizedFlexibility in the Management of Interest Rates Improve Funding Cost
Lack of credible term money benchmark Lack of participation large players with interest rate risk - PSU Banks, MFs and Insurance companies Absence of cash market for floating rate products Legality of OTC derivatives Transparency availability of price and volume data MTM and valuation framework
Remedies
Measurement and management of credit risk in OTC derivative transactions Robust mark-to-market and valuation framework Accounting and disclosure guidelines (IAS 39)