SWAPS

PRESENTED BYPugazh, Nithya, Melroy

SWAPS In SWAPS two counter parties agree to

enter into a contractual agreement wherein they agree to exchange cash flows at periodic intervals.

Most SWAPS are traded ‘Over the counter’.

Some are also traded on futures exchange market.

TYPES OF SWAPSThere are two main types of SWAPS:

Plain Vannila fixed for floating SWAPS or simply interest rate swaps.

Fixed for fixed currency SWAPS or simply currency swaps.

An interest rate swap (IRS) is a liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another.

Types:

Floating for fixed Fixed for floating Floating for floating (basis swap)

No exchange of principal; coupon flows only.

Example:

FIXED RATE FLOATING RATE

COMPANY A 11% LIBOR – 1%

COMPANY B 10% LIBOR + 0.5%

BANK

B

LENDER

A

GAIN = 0.1%

9.7%

10%LIBOR + 1 %

LIBOR

9.8% LIBOR

After swap A - 9.8% +1% B - LIBOR + 0.3%

USES OF INTEREST RATE SWAPS

HedgingSpeculation

FOREX SWAPSA FOREX swap is an agreement to

exchange currencies now at the prevailing spot rate and also to exchange the currencies back in the future at the prevailing forward rate.

Two types of FOREX swap:• Current to forward • Forward to forward

A currency swap is a foreign exchange agreement between two institute to exchange aspects of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency.

A currency swap should be distinguished from a central bank liquidity swap.

USES OF CURRENCY SWAPS

Two main uses : To secure cheaper debt To hedge against exchange rate

fluctuations

HEDGE• Instead of forward contracts, the

swap bank also could hedge it’s swap position by using a money market position.

• For example:On it’s first sterling liability of £50000 due in one year, the bank would need to credit a sterling asset worth £50000 one year later and a dollar liability worth $ 764524.

TYPICAL USES OF CURRENCY SWAPS

• To convert a liability in one currency into a liability in another currency.

• To convert an investment (asset) in one currency to an investment in another currency.

CREDIT RISK• Note that there is greater credit risk

with a currency swap when there will be a final exchange of principal.

• This means that there is a higher probability of a large build-up in value, giving one of the counter-parties (the losing party) the incentive to default.

• NO credit risk exists when a swap is first created.

• The credit risk in a swap is greater when there is an exchange of principle amounts at termination.

• Only the winning party ( for whom the swap is an asset) faces credit risk. This risk is the risk that the counter-party will default.

The vehicles exist to manage credit risk :

• Collateral or collateral triggers.• Getting agreements.• Credit derivatives.• Making to market.

ADVANTAGES OF SWAPSSwap is generally cheaper. There is no

upfront premium and it reduces transactions costs.

Swap can be used to hedge risk, and long time period hedge is possible.

It provides flexible and maintains informational advantages.

It has longer term than futures or options. Swaps will run for years, whereas forwards and futures are for the relatively short term.

Using swaps can give companies a better match between their liabilities and revenues.

DISADVANTAGES OF SWAPS

☺Early termination of swap before maturity may incur a breakage cost.

☺Lack of liquidity.☺ It is subject to default risk.

THANK YOU