Table of Contents

S.No. Page#

1. Introduction 1

2. Swaps 1

3. Swap Market 2

4. Types 3

i. Interest rate swap 4

ii. Currency swap 6

iii. Commodity swap 7

iv. Equity swap 7

v. Credit default swap 8

vi. Other variations 8

5. Valuation 9

6. Currency swap V/S Interest rate swap 11

Introduction

The implacable wave of credit crisis casualties has financial institutions scrambling to

protect their bottom line. In these uncertain times, once solid investment vehicles are now

looked upon as carrying great risk. A derivative is a financial instrument that allocates the

risks and price exposures associated with a designated asset between the parties to an

instrument. Derivatives can provide price exposure or price insulation to changes in the

price or level of an open-ended range of assets, including stocks, interest rates,

currencies, bonds, commodities, insured risks, credit risks, investment funds, property,

the weather and more. Derivatives are used in an infinite variety of ways by commercial,

eleemosynary and governmental entities to manage the commercial and financial risks

they confront. As the breadth and complexity of derivatives evolve, so too does the

complexity of associated documentation and legal issues.

Swaps

The first swaps were negotiated in the early 1980s. David Swensen, a Yale Ph.D. at

Salomon Brothers, engineered the first swap transaction according to "When Genius

Failed: The Rise and Fall of Long-Term Capital Management" by Roger Lowenstein.

Today, swaps are among the most heavily traded financial contracts in the world.

In finance, a swap is a derivative in which two counterparties exchange certain benefits

of one party's financial instrument for those of the other party's financial instrument. The

benefits in question depend on the type of financial instruments involved. Specifically,

the two counterparties agree to exchange one stream of cash flows against another

stream. These streams are called the legs of the swap. The swap agreement defines the

dates when the cash flows are to be paid and the way they are calculated. Usually at the

time when the contract is initiated at least one of these series of cash flows is determined

by a random or uncertain variable such as an interest rate, foreign exchange rate, equity

price or commodity price.

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The cash flows are calculated over a notional principal amount, which is usually not

exchanged between counterparties. Consequently, swaps can be used to create unfunded

exposures to an underlying asset, since counterparties can earn the profit or loss from

movements in price without having to post the notional amount in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on

changes in the expected direction of underlying prices. Traditionally, the exchange of one

security for another to change the maturity (bonds), quality of issues (stocks or bonds), or

because investment objectives have changed. If firms in separate countries have

comparative advantages on interest rates, then a swap could benefit both firms. For

example, one firm may have a lower fixed interest rate, while another has access to a

lower floating interest rate. These firms could swap to take advantage of the lower rates

Swap Market

Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties.

Some types of swaps are also exchanged on futures markets such as the Chicago

Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board

Options Exchange, Intercontinental Exchange and Frankfurt-based Eurex AG.

The Bank for International Settlements (BIS) publishes statistics on the notional amounts

outstanding in the OTC derivatives market. At the end of 2006, this was USD 415.2

trillion, more than 8.5 times the 2006 gross world product. However, since the cash flow

generated by a swap is equal to an interest rate times that notional amount, the cash flow

generated from swaps is a substantial fraction of but much less than the gross world

product -- which is also a cash-flow measure. The majority of this (USD 292.0 trillion)

was due to interest rate swaps. These split by currency as:

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The CDS and currency swap markets are dwarfed by the interest rate swap market. All

three markets peaked in mid 2008.

Types of Swaps

The five generic types of swaps, in order of their quantitative importance, are:

i. Interest Rate Swaps

ii. Currency Swaps

iii. Credit Swaps

iv. Commodity Swaps And

v. Equity Swaps..

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i. Interest rate Swaps

An agreement between two parties (known as counterparties) where one stream of future

interest payments is exchanged for another based on a specified principal amount.

Interest rate swaps often exchange a fixed payment for a floating payment that is linked

to an interest rate (most often the LIBOR). Interest rate swaps are simply the exchange of

one set of cash flows (based on interest rate specifications) for another. Because they

trade OTC, they are really just contracts set up between two or more parties, and thus can

be customized in any number of ways. A company will typically use interest rate swaps

to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally

lower interest rate than it would have been able to get without the swap. Swaps are

sought by firms that desire a type of interest rate structure that another firm can provide

less expensively.

Example:

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but

wants to pay floating. By entering into a interest rate swap, the net result is that each

party can 'swap' their existing obligation for their desired obligation. Normally the parties

do not swap payments directly, but rather, each sets up a separate swap with a financial

intermediary such as a bank. In return for matching the two parties together, the bank

takes a spread from the swap payments.

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Plain Vanilla; a type:

The most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange

of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to

over 15 years. The reason for this exchange is to take benefit from comparative

advantage. Some companies may have comparative advantage in fixed rate markets while

other companies have a comparative advantage in floating rate markets. When companies

want to borrow they look for cheap borrowing i.e. from the market where they have

comparative advantage. However this may lead to a company borrowing fixed when it

wants floating or borrowing floating when it wants fixed. This is where a swap comes in.

A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice

versa.

Example:

For example, party B makes periodic interest payments to party A based on a variable

interest rate of LIBOR +70 basis points. Party A in turn makes periodic interest payments

based on a fixed rate of 8.65%. The payments are calculated over the notional amount.

The first rate is called variable, because it is reset at the beginning of each interest

calculation period to the then current reference rate, such as LIBOR. In reality, the actual

rate received by A and B is slightly lower due to a bank taking a spread.

Notional Amount:

The notional amount (or notional principal amount or notional value) on a financial

instrument is the nominal or face amount that is used to calculate payments made on that

instrument. This amount generally does not change hands and is thus referred to as

notional.

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ii. Currency S waps

It is a swap that involves the exchange of principal and interest in one currency for the

same in another currency. It is considered to be a foreign exchange transaction and is not

required by law to be shown on the balance sheet. Just like interest rate swaps, the

currency swaps also are motivated by comparative advantage.

Example

Suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based

company needs to acquire U.S. dollars. These two companies could arrange to swap

currencies by establishing an interest rate, an agreed upon amount and a common

maturity date for the exchange. Currency swap maturities are negotiable for at least 10

years, making them a very flexible method of foreign exchange.

Working

A currency swap agreement specifies the principal amount to be swapped, a common

maturity period and the interest and exchange rates determined at the commencement of

the contract. The two parties would continue to exchange the interest payment at the

predetermined rate until the maturity period is reached. On the date of maturity, the two

parties swap the principal amount specified in the contract.

The equivalent amount of the loan value in another currency is calculated by using the

net present value (NPV). This implies that the exchange of the principal amount is carried

out at market rates during the inception and maturity periods of the agreement.

Benefits of Currency Swap

The benefits of currency swaps are:

Help portfolio managers regulate their exposure to interest rates.

Speculators can benefit from a favorable change in interest rates.

Reduce uncertainty associated with future cash flows as it enables companies to

modify their debt conditions.

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Reduce costs and risks associated with currency exchange.

Companies having fixed rate liabilities can capitalize on floating-rate swaps and

vise versa, based on the prevailing economic scenario.

Currency swaps can be used to exploit inefficiencies in international debt markets.

Limitations of Currency Swap

The drawbacks of currency swaps are:

Exposed to credit risk as either one or both the parties could default on interest

and principal payments.

Vulnerable to the central government’s intervention in the exchange markets.

This happens when the government of a country acquires huge foreign debts to

temporarily support a declining currency. This leads to a huge downturn in the

value of the domestic currency.

iii. Commodity Swap

A commodity swap is an agreement whereby a floating (or market or spot) price is

exchanged for a fixed price over a specified period. It is a swap where exchanged cash

flows are dependent on the price of an underlying commodity. This is usually used to

hedge against the price of a commodity. In this swap, the user of a commodity would

secure a maximum price and agree to pay a financial institution this fixed price. Then in

return, the user would get payments based on the market price for the commodity

involved. The vast majority of commodity swaps involve oil.

iv. Equity Swap

It is basically a strategy in which an investor sells a bond and at the same time purchases

a different bond with the proceeds from the sale. There are several reasons why people

use a bond swap: to seek tax benefits, to change investment objectives, to upgrade a

portfolio's credit quality or to speculate on the performance of a particular bond.

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An equity swap is a special type of total return swap, where the underlying asset is a

stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this

case you do not have to pay anything up front, but you do not have any voting or other

rights that stock holders do have.

v. Credit default Swap

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a

series of payments to the seller and, in exchange, receives a payoff if a credit instrument -

typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event

that triggers the payoff can be a company undergoing restructuring, bankruptcy or even

just having its credit rating downgraded. CDS contracts have been compared with

insurance, because the buyer pays a premium and, in return, receives a sum of money if

one of the events specified in the contract occur It is a swap designed to transfer the

credit exposure of fixed income products between parties. The buyer of a credit swap

receives credit protection, whereas the seller of the swap guarantees the credit worthiness

of the product. By doing this, the risk of default is transferred from the holder of the fixed

income security to the seller of the swap.

For example, the buyer of a credit swap will be entitled to the par value of the bond by

the seller of the swap, should the bond default in its coupon payments.

vi. Other variations

There are myriad different variations on the vanilla swap structure, which are limited

only by the imagination of financial engineers and the desire of corporate treasurers and

fund managers for exotic structures.[1]

A total return swap is a swap in which party A pays the total return of an asset,

and party B makes periodic interest payments. The total return is the capital gain

or loss, plus any interest or dividend payments. Note that if the total return is

negative, then party A receives this amount from party B. The parties have

exposure to the return of the underlying stock or index, without having to hold the

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underlying assets. The profit or loss of party B is the same for him as actually

owning the underlying asset.

An option on a swap is called a swaption. These provide one party with the right

but not the obligation at a future time to enter into a swap.

A variance swap is an over-the-counter instrument that allows one to speculate

on or hedge risks associated with the magnitude of movement, i.e. volatility, of

some underlying product, like an exchange rate, interest rate, or stock index.

A constant maturity swap, also known as a CMS, is a swap that allows the

purchaser to fix the duration of received flows on a swap.

An Amortising swap is usually an interest rate swap in which the notional

principal for the interest payments declines during the life of the swap, perhaps at

a rate tied to the prepayment of a mortgage or to an interest rate benchmark such

LIBOR.

Valuation

The value of a swap is the net present value (NPV) of all estimated future cash flows. A

swap is worth zero when it is first initiated, however after this time its value may become

positive or negative. There are two ways to value swaps: in terms of bond prices, or as a

portfolio of forward contracts.

a) Using bond prices

While principal payments are not exchanged in an interest rate swap, assuming that these

are received and paid at the end of the swap does not change its value. Thus, from the

point of view of the floating-rate payer, a swap can be regarded as a long position in a

fixed-rate bond (i.e. receiving fixed interest payments), and a short position in a floating

rate note (i.e. making floating interest payments):

Vswap = Bfixed − Bfloating

From the point of view of the fixed-rate payer, the swap can be viewed as having the

opposite positions. That is,

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Vswap = Bfloating − Bfixed

Similarly, currency swaps can be regarded as having positions in bonds whose cash flows

correspond to those in the swap. Thus, the home currency value is:

Vswap = Bdomestic − S0Bforeign, where Bdomestic is the domestic cash flows of the swap,

Bforeign is the foreign cash flows of the swap, and S0 is the spot exchange rate.

b) Using forward rate agreements

Consider a three year interest rate swap with semiannual payments. The first cash flow is

known at the time the swap is initiated, however the other five exchanges can be regarded

as forward rate agreements. The payment for these other exchanges is the 6 month rate

observed in the market 6 months earlier. Assuming that forward interest rates are

realised, this method values the swap by firstly calculating the required forward rates

using the LIBOR/swap curve, then calculating the swap cash flows using these rates, and

then finally discounting these cash flows back to today.

c) London Interbank Offered Rate (LIBOR)

LIBOR is the rate of interest offered by banks on deposit from other banks in the

eurocurrency market. One-month LIBOR is the rate offered for 1-month deposits, 3-

month LIBOR for three months deposits, etc. LIBOR rates are determined by trading

between banks and change continuously as economic conditions change. Just like the

prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest

in the International Market.

d) Arbitrage arguments

To be arbitrage free, the terms of a swap contract are such that, initially, the NPV of these

future cash flows is equal to zero. Where this is not the case, arbitrage would be possible.

For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A

pays a fixed rate and Party B pays a floating rate. In such an agreement the fixed rate

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would be such that the present value of future fixed rate payments by Party A are equal to

the present value of the expected future floating rate payments (i.e. the NPV is zero).

Where this is not the case, an Arbitrageur, C, could:

1. assume the position with the lower present value of payments, and borrow funds

equal to this present value

2. meet the cash flow obligations on the position by using the borrowed funds, and

receive the corresponding payments - which have a higher present value

3. use the received payments to repay the debt on the borrowed funds

4. pocket the difference - where the difference between the present value of the loan

and the present value of the inflows is the arbitrage profit.

Subsequently, once traded, the price of the Swap must equate to the price of the various

corresponding instruments as mentioned above. Where this is not true, an arbitrageur

could similarly short sell the overpriced instrument, and use the proceeds to purchase the

correctly priced instrument, pocket the difference, and then use payments generated to

service the instrument which he is short.

Currency Swap versus Interest Rate Swap

Currency swaps are often combined with interest rate swaps. For example, one company

would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a

floating-rate debt denominated in Euro. This is especially common in Europe where

companies shop for the cheapest debt regardless of its denomination and then seek to

exchange it for the debt in desired currency.

For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-

based company needs to acquire U.S. dollars. These two companies could arrange to

swap currencies by establishing an interest rate, an agreed upon amount and a common

maturity date for the exchange. Currency swap maturities are negotiable for at least ten

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years, making them a very flexible method of foreign exchange. Currency swaps were

originally done to get around exchange controls.

During the global financial crisis of 2008 the United States Federal Reserve System

offered swaps to the Reserve Bank of Australia, the Bank of Canada, Danmarks

Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the

Reserve Bank of New Zealand, the Norges Bank, the Sveriges Riksbank, and the Swiss

National Bank and also stable emerging economies such as South Korea, Singapore,

Brazil, and Mexico.

A currency swap is exactly the same thing except, with an interest rate swap, the cash

flow streams are in the same currency. With a currency swap, they are in different

currencies.

That difference has a practical consequence. With an interest rate swap, cash flows

occurring on concurrent dates are netted. With a currency swap, the cash flows are in

different currencies, so they can't net. Full principal and interest payments are exchanged

without any form of netting.

Suppose the spot JPY/USD exchange rate is 109 JPY per USD. Two firms might enter

into a currency swap to exchange the cash flows associated with

a five-year USD 100MM loan at 6-month USD Libor, and

a five year JPY 10,900MM loan at a fixed 3.15% semiannual rate.

All cash flows associated with those loans are paid:

initial receipt/payment of loaned principal,

payment/receipt of interest (in the same currency) on that loan,

ultimate return/recovery of the principal at the end of the loan.

Notional Amounts:

For credit default swaps, notional amount refers to the par amount of credit protection

bought or sold, equivalent to debt or bond amounts, and is used to derive the premium

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payment calculations for each payment period and the recovery amounts in the event of a

default.

The reason for using notional amount is that it is relatively simple to identify and gather,

as well as similar to measures of underlying cash markets. In addition, it is consistent

over time; that is, the notional for a deal does not change except in limited cases that are

not likely to have a significant effect on the overall measure.

For most OTC derivatives, cash flow obligations are normally a small percent of notional

amounts and so are mark-to-market exposures.

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