NAME: SHIVANGI PATEL

SUBJECT: FD
TOPIC: ANALYZE THE INFLUENCE OF THE
DIFFERENCES AMONG INTERNATIONAL
MARKET ON SWAPS.
Introduction to Swaps:
A swap is a derivative instrument allowing counterparties to exchange (or
"swap") a series of cash flows based on a specified time horizon.
Typically, one series of cash flows is considered the “fixed leg” of the
agreement, while the less predictable “floating leg” includes cash flows
based on interest rate benchmarks or foreign exchange rates. The swap
contract, which is agreed on by both parties, specifies the terms of the
swap, including the underlying values of the legs, plus payment
frequency and dates. People typically enter swaps either to hedge against
other positions or to speculate on the future value of the floating leg's
underlying index/currency/etc.
For speculators like hedge fund managers looking to place bets on the
direction of interest rates, interest rate swaps are an ideal instrument.
While one traditionally trades bonds to make such bets, entering into
either side of an interest rate swap agreement gives immediate exposure
to interest rate movements with virtually no initial cash outlay.
Counterparty risk is a major consideration for swap investors. Since any
gains over the course of a swap agreement are considered unrealized until
the next settlement date, timely payment from the counterparty
determines profit. A counterparty’s failure to meet their obligation could
make it difficult for swap investors to collect rightful payments.
The Swap Market
Since swaps are highly customized and not easily standardized, the swap
market is considered an over-the-counter (OTC) market, meaning that
swap contracts cannot typically be easily traded on an exchange. But that
does not necessarily mean swaps are illiquid instruments. The swap
market is one of the largest and most liquid global marketplaces, with
many willing participants eager to take either side of a contract.
According to the Bank for International Settlements, the notional amount
outstanding in over-the-counter interest rate swaps was more than $341
trillion in 2019.
Types of Swaps

1) Plain Vanilla Swaps

Plain vanilla interest rate swaps are the most common swap instrument.
They are widely used by governments, corporations, institutional
investors, hedge funds, and numerous other financial entities.
In a plain vanilla swap, Party X agrees to pay Party Y a fixed amount
based upon a fixed interest rate and a notional dollar amount. In the
exchange, Party Y will pay Party X an amount based upon that same
notional amount as well as a floating interest rate, typically based upon a
short-term benchmark rate like the Fed Funds Rate or LIBOR.
The notional amount, however, is never exchanged between parties, as
the next effect would be equal. At the start, the value of the swap to either
party is zero. However, as interest rates fluctuate, the value of the swap
fluctuates as well, with either Party X or Party Y having an equivalent
unrealized gain to the other party's unrealized loss. Upon each settlement
date, if the floating rate has appreciated relative to the fixed, the floating
rate payer will owe a net payment to the fixed payer.
Take the following scenario: Party X has agreed to pay a fixed rate of 4%
while receiving a floating rate of LIBOR+50 bps from Party Y, on a
notional amount of 1,000,000. At the time of the first settlement date,
LIBOR is 4.25%, meaning that the floating rate is now 4.75% and Party
Y must make a payment to Party X. The net payment would, therefore, be
the difference between the two rates multiplied by the notional amount
[4.75% - 4% *(1,000,000)], or $7,500.
2) Currency Swap
In a currency swap, two counterparties aim to exchange principal
amounts and pay interest in their respective currencies. Such swap
agreements let the counterparties gain both interest rate exposure and
foreign exchange exposure, as all payments are made in the
counterparty's currency.
For example, say a U.S.-based firm wishes to hedge a future liability it
has in the U.K., while a U.K.-based business wishes to do the same for a
deal expected to close in the U.S. By entering into a currency swap, the
parties can exchange an equivalent notional amount (based on the spot
exchange rate) and agree to make periodic interest payments based on
their domestic rates. The currency swap forces both sides to exchange
payments based upon fluctuations in both domestic rates and the
exchange rate between the U.S. dollar and the British pound over the life
of the agreement.

3) Equity Swap
An equity swap is similar to an interest rate swap, but rather than one leg
being the "fixed" side, it is based on the return of an equity index. For
example, one party will pay the floating leg (typically linked to LIBOR)
and receive the returns on a pre-agreed-upon index of stocks relative to
the notional amount of the contract.
If the index traded at a value of 500 at inception on a notional amount of
$1,000,000, and after three months the index is now valued at 550, the
value of the swap to the index receiving party has increased by 10%
(assuming LIBOR has not changed). Equity swaps can be based upon
popular global indexes such as the S&P 500 or Russell 2000 or can be
made up of a customized basket of securities decided upon by the
counterparties.
4) Credit Default Swaps
A credit default swap, or CDS, acts differently than other types of swaps.
A CDS can be viewed almost as a type of insurance policy, by which the
purchaser makes periodic payments to the issuer in exchange for
the assurance that if the underlying fixed income security goes into
default, the purchaser will be reimbursed for the loss. The payments, or
premiums, are based upon the default swap spread for the underlying
security (also referred to as the default swap premium).
Say a portfolio manager holds a $1 million bond (par value) and wishes
to protect their portfolio from a possible default. They can seek a
counterparty willing to issue them a credit default swap (typically an
insurance company) and pay the annual 50 basis point swap premium to
enter into the contract.
So, every year, the portfolio manager will pay the insurance company
$5,000 ($1,000,000 x 0.50%) as part of the CDS agreement, for the life of
the swap. If in one year the issuer of the bond defaults on its obligations
and the bond's value falls 50%, the CDS issuer is obligated to pay the
portfolio manager the difference between the bond's notional par value
and its current market value, $500,000.
The Bottom Line
Swap agreements and the swap market can be easy to understand once
you know the fundamentals. Swaps are a popular derivative instrument
utilized by parties of all types to meet their specific investment strategies.