swaps new

Currency and interest rate swaps

To understand swaps as a hedging techniqueTo create currency and interest rate swapTo evaluate the present scenario

They said• [D]erivatives are financial

weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." —Warren Buffett, Berkshire Hathaway 2002 Annual Report

• "When used properly, derivatives are a valuable risk management tool…" —Kathryn E. Dick, OCC Deputy Comptroller for Risk Evaluation

Derivatives:The ugly, the bad and the

good

Broad AreasTypes of SwapsSize of the Swap MarketThe Swap BankInterest Rate SwapsCurrency Swaps

Specific Areas Swap Market QuotationsVariations of Basic Currency and Interest

Rate SwapsRisks of Interest Rate and Currency

SwapsSwap Market EfficiencyAbout Swaps in General

Definitions In a swap, two counterparties

agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals.▫ For example, a company might

ideally want to borrow in the fixed rate market, but finds it cannot do so at any reasonable rate. It might therefore take out a floating rate loan, and enter into a swap contract under which it pays amounts equivalent to fixed rate interest on a notional principal sum, and receives amount equivalent to floating rate interest on the same notional principal.

Lender

Floating

Bank

Floating

Borrowing Company

Fl

oa

ti

ng

Plain Vanilla Interest Rate Swap

• Plain Vanilla Interest Rate SwapThe 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.

Example• On December 31, 2008, 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, assume the two parties exchange payments annually on December 31, beginning in 2009 and concluding in 2013.

http://www.investopedia.com/terms/l/libor.asp

http://www.investopedia.com/articles/optioninvestor/07/swaps.asp

http://www.investopedia.com/terms/e/eurodollar.asp

Cash flows for a plain vanilla interest rate swap

•Company A

•Company B

• Fixed Rate: 6% • $ 20M*6% = $

1,200,000

• LIBOR +1% = 5.33%+1 * $ 20 M = $1,200,000 = $ 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 to avoid unnecessary payments netted against each other

• 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.

Meaning of types

Two types of interest rate swaps• 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.

CASH FLOWS FOR A PLAIN VANILLA CURRENCY SWAP, STEP 1.

Company C (US – based)

Company D (European-

base)

Principal : $50 million

Principal : $40 million

Company C, a U.S. firm, and Company D, a European firm, enter into a five-year currency swap for $50 million. Assume the exchange rate at the time is $1.25 per euro (i.e., the dollar is worth $0.80 euro). First, the firms will exchange principals. So, Company C pays $50 million, and Company D pays Euros 40 million. This satisfies each company's need for funds denominated in another currency (which is the reason for the swap).

CASH FLOWS FOR A PLAIN VANILLA CURRENCY SWAP, STEP 2



base)

Interest: € 40 M* 3.50%

Interest: $50 M*8.25%

The agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year, Company C pays € 40,000,000 * 3.50% = €1,400,000 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 then-prevailing exchange rate. If, at the one-year mark, the exchange rate is $1.40 per euro, then Company D's payment equals $1,960,000, and Company C would pay the difference ($4,125,000 - $1,960,000 = $2,165,000).

CASH FLOWS FOR A PLAIN VANILLA CURRENCY SWAP, STEP 3



base)

Principal: € 40 M

Principal : $50 M

The agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year, Company C pays € 40,000,000 * 3.50% = €1,400,000 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 then-prevailing exchange rate. If, at the one-year mark, the exchange rate is $1.40 per euro, then Company D's payment equals $1,960,000, and Company C would pay the difference ($4,125,000 - $1,960,000 = $2,165,000).

Size of the Swap Market - 2008• The notional amounts outstanding of over-the-counter

(OTC) derivatives continued to expand in the first half of 2008.

• Notional amounts of all types of OTC contracts stood at $683.7 trillion at the end of June, 15% higher than six months before.

• The average growth rate for outstanding CDS contracts over the last three years has been 45%. In contrast to CDS markets, markets for interest rate derivatives and FX derivatives both recorded significant growth.

Source: http://www.bis.org/publ/otc_hy0811.htm

Size of the Swap Market - 2008• A Credit Default Swap (CDS) is

like an insurance contract. • In principle, it lets someone

who wants to own a company's bonds but doesn't want to risk the company defaulting buy insurance from someone else, who is willing to pay the buyer of CDS protection the face value of the bond if a default happens.

• http://db.riskwaters.com/public/showPage.html?page=11383

http://db.riskwaters.com/public/showPage.html?page=11383


Swap and forex operations in India

• The Indian foreign exchange market has grown significantly in the last several years.

• The daily average turnover has gone up from about USD 5 billion per day in 1998 to more than USD 50 billion per day in 2008.

• There is also evidence of growing merchant turnover reflecting the huge increase in external transactions.

• The Total Turnover forex operation between April ‘08 – Dec ‘08 was $9621billion

• The Swap operation is estimated to be $3146 billion

Spot/Total Turnover (%)

Forward /Total Turnover (%)

SWAP/Total Turnover (%)

0 10 20 30 40 50

45.9

21.5

32.7

April '08 -Dec '08

Currencies of the Swap Market• The most popular

currencies are:– U.S. dollar– Japanese yen– Euro– Swiss franc– British pound sterling

The Swap Bank

The Swap Bank• A swap bank is a

general term to describe a financial institution that facilitates swaps between counterparties.

• They are the market-makers in most cases

• The swap bank can serve as either a broker or a dealer.– As a broker, the swap bank

matches counterparties but does not assume any of the risks of the swap.

– As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.

An Example of an Interest Rate Swap

“Plain Vanilla” Interest Rate Swap.• Bank A is a AAA-rated international bank located

in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans.– Bank A is considering issuing 5-year fixed-rate

Eurodollar bonds at 10 percent.– It would make more sense to for the bank to issue

floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.


• Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life.– Firm B is considering issuing 5-year fixed-rate Eurodollar bonds

at 11.75 percent.– Alternatively, firm B can raise the money by issuing 5-year

floating-rate notes at LIBOR + ½ percent.– Firm B would prefer to borrow at a fixed rate.


The borrowing opportunities of the two firms are:

COMPANY B BANK A

Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR


The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years

COMPANY B BANK A



Bank A Swap Bank

103/8%

LIBOR -1/8%

COMPANY B BANK A




Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of -10 3/8 + 10 + (LIBOR – 1/8) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap.

½% of $10,000,000 = $50,000. That is quite a cost savings per year for 5 years.

Bank A Swap Bank

103/8%

LIBOR -1/8%

10.0%


The swap bank makes this offer to company B: You pay us 10½% per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years.

COMPANY B BANK A



Swap Bank Company B

10½%

LIBOR - ¼%

COMPANY B BANK A



They can borrow externally at LIBOR + ½ % and have a net borrowing position of 10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow floating.

Here’s what’s in it for B:

½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years.

Swap Bank Company B

10½%

LIBOR - ¼%

+½%


The swap bank makes money too.

¼% of $10 million = $25,000 per year for 5 years.

LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8

10 ½ - 10 3/8 = 1/8

¼

COMPANY B BANK A



Swap Bank Company B

10½%

LIBOR - ¼%

Bank A103/8%

LIBOR -1/8%


B saves ½%A saves ½%

The swap bank makes ¼%

COMPANY B BANK A



Swap Bank Company B

10½%

LIBOR - ¼%

Bank A103/8%

LIBOR -1/8%

An Example of a Currency Swap• Suppose a U.S. MNC wants to finance a

£10,000,000 expansion of a British plant.• They could borrow dollars in the U.S. where

they are well known and exchange for dollars for pounds.– This will give them exchange rate risk: financing

a sterling project with dollars.• They could borrow pounds in the

international bond market, but pay a premium since they are not as well known abroad.

An Example of a Currency Swap

• If they can find a British MNC with a mirror-image financing need they may both benefit from a swap.

• If the spot exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.

Example: a Currency SwapConsider two firms A and B: firm A is a U.S.–based multinational and

firm B is a U.K.–based multinational.Both firms wish to finance a project in each other’s country of the

same size. Their borrowing opportunities are given in the table below.

$ £

Company A 8.0% 11.6%

Company B 10.0% 12.0%

A Currency Swap

Swap Bank

$8

£11

$9.4

£12

$8 £12Firm A Firm B

$ £


Company B 10.0% 12.0%

A Currency Swap

Swap Bank

$8

£11

$9.4

£12


$ £


Company B 10.0% 12.0%

A’s net position is to borrow at £11%

A saves £.6%

11.6%

A Currency Swap

Swap Bank

$8

£11

$9.4

£12


$ £


Company B 10.0% 12.0%

B’s net position is to borrow at $9.4%

B saves $.6%

10.0%

A Currency Swap

Swap Bank

$8

£11

$9.4

£12


$ £


Company B 10.0% 12.0%

The swap bank makes money too:

1.4% of $16 million financed with 1% of £10 million per year for 5 years

At S0($/£) = $1.60/£, that is a gain of $124,000 per year for 5 years.

The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap).

The QSD• The Quality Spread Differential represents the

potential gains from the swap that can be shared between the counterparties and the swap bank.

• There is no reason to presume that the gains will be shared equally.

• In the above example, company B is less credit-worthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.

Comparative Advantage as the Basis for Swaps

A is the more credit-worthy of the two firms.

$ £


Company B 10.0% 12.0%

A has a comparative advantage in borrowing in dollars.

B has a comparative advantage in borrowing in pounds.

A pays 2% less to borrow in dollars than B

A pays .4% less to borrow in pounds than B:


B has a comparative advantage in borrowing in £.

$ £


Company B 10.0% 12.0%

B pays 2% more to borrow in dollars than A

B pays only 0.4% more to borrow in pounds than A:


A has a comparative advantage in borrowing in dollars.B has a comparative advantage in borrowing in pounds.

If they borrow according to their comparative advantage and then swap, there will be gains for both parties.

Swap Market Quotations• Swap banks will tailor the terms of interest rate and

currency swaps to customers’ needs• They also make a market in “plain vanilla” swaps and

provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.

• For example, 6.60 — 6.85 means the swap bank will pay fixed-rate Euro at 6.60% against receiving dollar LIBOR or it will receive fixed-rate Euro payments at 6.85% against receiving dollar LIBOR.

Variations of Basic Currency and Interest Rate Swaps

• Currency Swaps– fixed for fixed – fixed for floating– floating for floating– amortizing

• Interest Rate Swaps – zero-for floating– floating for floating

• For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit.

Risks of Interest Rate and Currency Swaps

• 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.• Exchange rate Risk

– In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

Risks of Interest Rate and Currency Swaps (continued)

Credit Risk– This is the major risk faced by a swap dealer—the risk

that a counter party will default on its end of the swap. Mismatch Risk

– It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.

Sovereign Risk– The risk that a country will impose exchange rate

restrictions that will interfere with performance on the swap.

Pricing a Swap A swap is a derivative security so it can

be priced in terms of the underlying assets:

How to:– Plain vanilla fixed for floating swap gets

valued just like a bond.– Currency swap gets valued just like a nest of

currency futures.

Swap Market Efficiency Swaps offer market completeness and that has

accounted for their existence and growth. Swaps assist in tailoring financing to the type

desired by a particular borrower. Since not all types of debt instruments are available to all types of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures.

Concluding Remarks The growth of the swap market has been

astounding. Swaps are off-the-books transactions. Swaps have become an important

source of revenue and risk for banks

Thank you

Web sites and Books Used:International Financial Management: Eun and Resnick

http://www. investopedia.comhttp://www.bba.org.uk/public/libor/

http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?http://db.riskwaters.com/public/showPage.html?page=11383

http://www.bba.org.uk/public/libor/

http://www.rbi.org.in/scripts/BS_SpeechesView.aspx


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