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Forex Swaps IRS An Introduction VRK100 04102009
Forex Swaps IRS An Introduction VRK100 04102009
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The articles discusses the world of Swaps Interest Rate Swap (IRS), Overnight Index Swaps (OIS), mechanism of OIS, currency swaps, equity swap, CDS and others in the Indian context. An example of OIS is also given to help the readers.
DEFINITION OF SWAP
A simple definition of a swap is an exchange, trade or barter. In the financial world, a swap is a financial transaction involving simultaneous exchange of assets (the swap) of comparable value by the counterparties. The assets may be commodities or financial instruments involving interest rates, cash flows, foreign exchange, debts or equities. A swap has also been defined as a financial transaction in which two counterparties agree to exchange streams of payments, or cash flows, over time on the basis agreed at the time of inception of the arrangement. A swap is like a series of forward contracts. Swaps are basically financial derivative instruments traded over the counter (OTC).
TYPES OF SWAPS: There are mainly two types of swapsone is interest rate swap
and the other currency swap. However, commodity swaps and tax rate swaps too are being introduced and finding acceptance.
B. Basis, or floating to floating, swaps: the exchange of one benchmark for another under floating rates (e.g., LIBOR for T-bill rate)
CURRENCY SWAP
Under a currency swap, the two counterparties agree to exchange interest and principal in one currency for interest and principal in another currency. These exchanges are generally done at the spot exchange rate ruling, when the swap was entered into, and would involve:
A.
B. exchange of interest and repayment obligations (in instalments or in the form for re-exchange of the principal amount, i.e., bullet repayment); or C. debt servicing obligations alone (i.e., B)
The interest rates for the two currencies would differ, and may be fixed or floating. MERITS OF SWAPS: Swaps are essentially used as a devise for: Reducing the cost of borrowing Exploit a view on the market Hedge against a risk Arbitrage between markets
GENESIS: Currency swaps became famous worldwide with a swap transaction entered
into between the World Bank and IBM in 1981. This year also saw the birth of interest rate swaps in London. ADVANTAGES OF IRS: In general, in the international capital markets, fixed rate lenders are individuals or institutions like insurance companies or pension funds. When they raise funds, the cost of funds would depend on their credit rating given by rating agencies and other factors. On the other hand, in the floating rate markets (say LIBORlinked), the lender are international banks who study the commercial and political risks relevant to a given loan and price it accordingly. (Their view does not always correspond to that of rating agencies). As such, companies will try to exploit the differences in interest rates in fixed and floating markets and enter into swaps with a view to reducing their cost of borrowing. BANK INTERMEDIATION: In practice, it is difficult for a corporate to locate a counterparty for a swap because the structure of swaps is such that the counterparties need to have not only differing but mutually complementary needs, but also identical amounts and maturities. Counterpartys financial strength (over the period of the swap) to meet the obligation also needs to be known. Swaps suffer from counter party risk. Therefore, major international banks step in and make two separate swaps with the two counterparties. While banks/financial institutions initially entered the swap market as brokers or intermediaries, their role widened quickly. Soon, major banks started warehousing transactions without the ready availability of a matching counterparty, and hedged the exposure in the interim in other markets until another counterparty with opposite requirements could be located. In other words, banks started running swap books. BASIS SWAP: Basis swaps are swaps where the two sides pay each other rates determined by different benchmarks. In the case of a basis swap, instead of exchanging LIBOR for a fixed rate, the swap could be LIBOR for T-bill rate (or the CD rate).
Company A has an advantage in both markets but has a better advantage in Floating Rate Market. Company A can borrow in the floating rate market at the given rate of Mibor +1 and Company B can borrow fixed at 9% Both Companies can enter into a swap Company A can receive Mibor+2 from Company B and pay 8.25 fixed interest to Company B. Consider cost to both companies Com. A Borrow Swap Receive Swap Pay Net Cost Net Cost Gain -(Mibor+1) +(Mibor+2) -8.25% -8.25+1 -7.25% 0.75% Com. B -9% +8.25% -(Mibor+2) -(Mibor+2)-.75 -(Mibor+2.75) 0.25
The difference to be shared is 1%. This could be shared in any combination desired. Usually the company with relative advantage in both markets will take away a larger share of the gain. Note that the swap would work only if A wants to borrow Fixed and B Floating.
MECHANISM OF OIS: The mechanism is best described with the following example. Example: Bank A is a fixed rate receiver for INR 5 crores for a period of one week at 10% (which is the OIS rate) and a floating rate payer (FIMMDA-NSE MIBOR). Bank B is a receiver of floating rate linked to the Overnight index (i.e., FIMMDA-NSE MIBOR) and a fixed rate receiver (OIS RATE). The FIMMDA-NSE MIBOR rates for the seven days are taken and settled at the end of the swap period. At the end of the period of one week, i.e., the 8th day, Bank B will have to pay to Bank A Rs. 95,890/- (being interest on Rs. 5 crores for 7 days at 10%) and has to receive from A Rs. 97,508/-. The payments are netted and the only payment that takes place is a payment by A of Rs. 1,608 (97508 95890) to B. Please note that FIMMDA-NSE MIBOR rates are compounded daily.
NSE Mibor Index 1st day 10.25% 2nd day 10.00% 3rd day 9.75% 4th day 10.125% 5 & 6 day 10.25% 7th day 10.50%
Notional Principal Interest for Amount One day 500,00,000 14,041 500,14,041 13,702 13,363 500,27,743 13,881 500,41,107 500,54,988 28,113 14,407 500,83,101 500,97,508 97,508
In case of a 1-year OIS, this settlement goes on for one year. Coming to the volumes, OIS volumes outnumber spot volumes. Minimum lot in OIS is Rs 25 crores whereas in spot it is Rs 5 crores.
CURRENCY SWAPS:
RBI has given general permission to authorized dealers to deal in currency swaps with one currency leg being the Indian rupee. The circular of RBI guidelines was dated January 19, 2000. In terms of the provisions, authorized dealers can offer the following products: interest rate swaps, currency swaps, coupon swaps, interest caps/collars (purchase) and Forward Rate Agreements. The circular contains other provisions concerning corporate requirements for swaps, reporting of the deals to RBI, premium payment, etc. Two important limitations placed by RBI on the use of derivatives are that the notional principal should not exceed the amount of the loan, nor should the maturity of the derivative extend beyond the maturity of the underlying. EQUITY SWAP: This is an equity derivative. An equity swap is a swap transaction whereby the underlying will be linked to an index of the stock market. These are not available in India. CREDIT DEFAULT SWAP (CDS): This is an example of a credit derivative. A credit derivative is an arrangement whereby the credit risk of an asset is transferred from the buyer to the seller of protection. A CDS is a contract where the protection seller receives premium or interest related payments in return for contracting to make payments to the protection buyer upon a defined credit event. Credit events normally include bankruptcy, payment default and rating downgrades. RBI had considered introduction of CDS in India during 2007, but had later decided not to introduce them in India in view of the global financial crisis. (CDS has earned immense notoriety of late due to the sub-prime crisis in the US). REGULATORS: The regulators for swaps in India are SEBI, ICAI and RBI. ICAI has issued guidelines for accounting of derivative instruments. ICAI has issued Accounting Standard 30 (AS-30) norms for recognition and measurement of all financial derivative instruments. However, AS-30 will come into effect from April 1, 2009 and will be recommendatory in nature until 2011. RBI also has various norms for the regulation of swaps.
ISDA AGREEMENT: All swap transactions involve signing of an agreement between the parties. The standard document is known as ISDA (International Swaps and Derivatives Association) Master Agreement. SWAPTIONS: A swaption or a swap option is an option on an interest rate swap. It gives the buyer of the swaption the right (but not the obligation) to enter into an interest rate swap of specified parameters (maturity of the option, notional principal, strike rate, and period of the swap). Swaptions are traded over the counter. CAPITAL ADEQUACY: RBIs capital adequacy norms are applicable to banks and financial institutions for undertaking interest rate swaps.
ABBREVIATIONS USED:
BSE CCIL FEMA FIMMDA ICAI INR IRS ISDA LIBOR MCX-SX MIBID MIBOR MIFOR MIOCS NDS-CALL NSE OIS OTC SEBI USD Bombay Stock Exchange The Clearing Corporation of India Limited Foreign Exchange Management Act Fixed Income Money Market and Derivatives Association of India The Institute of Chartered Accountants of India Indian Rupee Interest Rate Swaps International Swaps and Derivatives Association London Inter-Bank Offer Rate MCX Stock Exchange Mumbai Inter-Bank Bid Rate Mumbai Inter-Bank Offer Rate Mumbai Inter-Bank Forward Offer Rate Mumbai Inter-Bank Offered Currency Swaps Call money platform on the NDS (Negotiated Dealing System) National Stock Exchange of India Overnight Indexed Swaps Over the counter Securities and Exchange Board of India US Dollar
References: 1. Foreign Exchange International Finance & Risk Management by A V Rajwade 2. CCIL 3. FIMMDA 4. NSE 5. Inputs from Mr. Manoj Kumar, SBI, Hong Kong
SWAPS IN GRAPHICS