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Interest Rate Swaps
Interest Rate Swaps
Introduction: Interest rate swaps are used to hedge interest rate risks as well as to take on interest rate risks. If a treasurer is of the view that interest rates will be falling in the future, he may convert his fixed interest liability into floating interest liability; and also his floating rate assets into fixed rate assets. If he expects the interest rates to go up in the future, he may do vice versa. Since there are no movements of principal, these are off balance sheet instruments and the capital requirements on these instruments are minimal. Definition: A contract which involves two counter parties to exchange over an agreed period, two streams of interest payments, each based on a different kind of interest rate, for a particular notional amount. Mechanism of an Interest Rate Swap: Take the case of an interest rate swap, in which Counter Party A and Counter Party B agree to exchange over a period of say, five years, two streams of semi-annual payments. The payments made by A are calculated at a fixed rate of 6% (Fixed rate) per annum while the payments to be made by B are to be calculated using periodic fixings of 6-month Libor (floating). The swap is for a notional principal amount of USD 10 million. The above swap is called the "plain vanilla" or the "coupon swap". Interest rates are normally fixed at the beginning of the contract period, but settled at the end of the period. The contract can be simplified as follows. Counter parties:: A and B Maturity:: 5 years A pays to B : 6% fixed p.a. B pays to A : 6-month LIBOR Payment terms : semi-annual Notional Principal amount: USD 10 million. Diagram: Cash flows in the above swap are represented as follows: Payments at the end Half year period 1 2 3 4 5 Floating rate Payments 6m Libor 337500 337500 337500 325000 325000 Net Cash From A to B -37500 -37500 -37500 -25000 -25000
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Floating Fixed Net cash rate rate paid by payments payments Co. 122500 122500 122500 120000 120000 120000 117500 117500 962500 120000 120000 120000 120000 120000 120000 120000 120000 960000 -2500 -2500 -2500 0 0 0 2500 2500 -2500
Getting comparative advantage in different markets: Various segments of the capital markets differ in terms of how sensitive they are to differences in the creditworthiness of the issuers. Particularly, in bond markets, where retail investors play an important role and tend to be averse to default risk, disproportionately higher yields are offered to them to invest in less creditworthy bonds. Issuers with a lower rating find themselves paying more than the issuers enjoying a stronger rating. Often, we find that cost of funds is higher in the bond markets than in the credit markets. Whenever, these differences occur in different markets, it would be possible
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Cost of Funds to AAA and BBB Fixed rate bonds AAA BBB Differential 10.00% p.a. 12.00% pa 200 bps Floating rate loans< Libor+100bp Libor+160bp 60bps
Assume now that AAA wants to raise floating rate money and BBB wants to raise fixed rate money. It will be realized that the advantage (200 basis points) of AAA raising fixed rate money in the bond market as against BBB, which is, is greater than the disadvantage (60 basis points) of letting BBB raise floating rate money in the credit market. There is a comparative advantage of 140(200-60) basis points. Both the parties can share the difference and reduce their borrowing costs. A Banker normally acts as an intermediary and arranges most of these deals. A share of the advantage is passed on to the banker. In this case, if the three parties agree to share the difference as 80:40:20 basis points, then AAA will receive 9.80% fixed from the bank in exchange for Libor, while paying 10.00% on his bonds. The net outcome for AAA is a floating rate liability at Libor+20 bps. This represents a gain of 80 basis points, than if he had borrowed at Libor+100 bp. Similarly Borrower BBB receives Libor in lieu of 10.00% fixed while paying Libor+160 bp to his creditor. The net effect is equivalent to paying 11.60% fixed, which represents a 40 basis points gain over fixed rate borrowing at 12.00%. The intermediary bank receives 10.00% fixed from BBB and pays 9.80% fixed to AAA in effect gaining 20 basis points on this transaction. The following diagram illustrates the transaction. Interest Rate Swaps in India: With a view to deepening the money market and also to enable banks; primary dealers and all-India financial institutions to hedge interest rate
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10.25%
50000000
14041
10.00%
50014041
13702
9.75%
50027743
13363
10.125% 10.25%
50041107 50054988
13881 28113
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10.50%
50083101 50097508
14407
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