UNIT – 4

Financial Swaps
 
In finance, a SWAP is a derivative in which two counterparties agree to exchange one stream of
cash flow against another stream. These streams are called the legs of the swap. Conventionally
they are the exchange of one security for another to change the maturity (bonds), quality of
issues (stocks or bonds), or because investment objectives have changed.

A swap is an agreement to exchange one stream of cash flows for another. Swaps are most
usually used to:

 Switch financing in one country for financing in another

 To replace a floating interest rate swap with a fixed interest rate (or vice versa)
In August 1981 the World Bank issued $290 million in euro-bonds and swapped the interest and
principal on these bonds with IBM for Swiss francs and German marks. The rapid growth in the
use of interest rate swaps, currency swaps, and swaptions (options on swaps) has been
phenomenal. Currently, the amount of outstanding interest rate and currency swaps is almost $6
trillion. Recently, swaps have grown to include currency swaps and interest rate swaps. It can be
used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected
direction of underlying prices.

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.

Different Types of Swaps

1. Currency Swaps
Cross currency swaps are agreements between counter-parties to exchange interest and principal
payments in different currencies. Like a forward, a cross currency swap consists of the exchange
of principal amounts (based on today’s spot rate) and interest payments between counter-parties.
It is considered to be a foreign exchange transaction and is not required by law to be shown on
the balance sheet.
 In a currency swap, these streams of cash flows consist of a stream of interest and principal
payments in one currency exchanged for a stream, of interest and principal payments of the same
maturity in another currency. Because of the exchange and re-exchange of notional principal
amounts, the currency swap generates a larger credit exposure than the interest rate swap.

Cross-currency swaps can be used to transform the currency denomination of assets and
liabilities. They are effective tools for managing foreign currency risk. They can create currency
match within its portfolio and minimize exposures. Firms can use them to hedge foreign
currency debts and foreign net investments.

Currency swaps give companies extra flexibility to exploit their comparative advantage in their
respective borrowing markets. Currency swaps allow companies to exploit advantages across a
matrix of currencies and maturities.

Currency swaps were originally done to get around exchange controls and hedge the risk on
currency rate movements. It also helps in Reducing costs and risks associated with currency
exchange.

They 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.

2. Credit Default Swap

Credit Default Swap is a financial instrument for swapping the risk of debt default. Credit default
swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and
local government bond.

 The buyer of a credit default swap pays a premium for effectively insuring against a debt default.
He receives a lump sum payment if the debt instrument is defaulted.
 The seller of a credit default swap receives monthly payments from the buyer. If the debt
instrument defaults they have to pay the agreed amount to the buyer of the credit default swap.
The first credit default swap was introduced in 1995 by JP Morgan. By 2007, their total value
has increased to an estimated $45 trillion to $62 trillion. Although since only 0.2% of Investment
Company’s default, the cash flow is much lower than this actual amount. Therefore, this shows
that credit default swaps are being used for speculation and not insuring against actual bonds.

As Warren Buffett calls them “financial weapons of mass destruction”. The credit default swaps
are being blamed for much of the current market meltdown.

Example of Credit Default Swap;

 An investment trust owns £1 million corporation bond issued by a private housing firm.
 If there is a risk the private housing firm may default on repayments, the investment trust may
buy a CDS from a hedge fund. The CDS is worth £1 million.
 The investment trust will pay an interest on this credit default swap of say 3%. This could
involve payments of £30,000 a year for the duration of the contract.
 If the private housing firm doesn’t default. The hedge fund gains the interest from the investment
bank and pays nothing out. It is simple profit.
 If the private housing firm does default, then the hedge fund has to pay compensation to the
investment bank of £1 million – the value of the credit default swap.
 Therefore the hedge fund takes on a larger risk and could end up paying £1million
The higher the perceived risk of the bond, the higher the interest rate the hedge fund will require.

Credit default swaps are used not only by investment banks, but also by other financial
institutions. Corporate entities use credit default swaps either for protection purposes, to hedge or
to sell. Investment banks are primarily affected by the buyers. If a number of major corporate
entities have bought protection from the same investment bank, and all of them fail
simultaneously, this will put pressure on the investment bank to pay out. Moreover, the credit
risk caused by the above failure may lead to other risks, such as liquidity risk, market
risk and operational risk. Therefore, most of the investment banks re-sell the sold protection on
the market to other market participants. The derivatives do not reduce credit risk, but rather
transfer it from banks to other banks or entities. Therefore, most of the investment banks re-sell
the sold protection on the market to other market participants.

3. 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. The vast majority of commodity swaps involve oil. A swap
where exchanged cash flows are dependent on the price of an underlying commodity. This swap
is usually used to hedge against the price of a commodity. Commodities are physical assets such
as precious metals, base metals, energy stores (such as natural gas or crude oil) and food
(including wheat, pork bellies, cattle, etc.).

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.

They are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads
between final product and raw material prices.

A company that uses commodities as input may find its profits becoming very volatile if the
commodity prices become volatile. This is particularly so when the output prices may not change
as frequently as the commodity prices change. In such cases, the company would enter into a
swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange.
There are two kinds of agents participating in the commodity markets: end-users (hedgers) and
investors (speculators).
 Commodity swaps are becoming increasingly common in the energy and agricultural industries,
where demand and supply are both subject to considerable uncertainty. For example, heavy users
of oil, such as airlines, will often enter into contracts in which they agree to make a series of
fixed payments, say every six months for two years, and receive payments on those same dates
as determined by an oil price index. Computations are often based on a specific number of tons
of oil in order to lock in the price the airline pays for a specific quantity of oil, purchased at
regular intervals over the two-year period. However, the airline will typically buy the actual oil it
needs from the spot market.

4. Equity Swap
The outstanding performance of equity markets in the 1980s and the 1990s, have brought in
some technological innovations that have made widespread participation in the equity market
more feasible and more marketable and the demographic imperative of baby-boomer saving has
generated significant interest in equity derivatives. In addition to the listed equity options on
individual stocks and individual indices, a burgeoning over-the-counter (OTC) market has
evolved in the distribution and utilization of equity swaps.

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. An exchange of the potential appreciation of equity’s value
and dividends for a guaranteed return plus any decrease in the value of the equity. An equity
swap permits an equity holder a guaranteed return but demands the holder give up all rights to
appreciation and dividend income. 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.

Equity swaps make the index trading strategy even easier. Besides diversification and tax
benefits, equity swaps also allow large institutions to hedge specific assets or positions in their
portfolios

The equity swap is the best swap amongst all the other swaps as it being an over-the-counter
derivatives transaction; they have the attractive feature of being customizable for a particular
user’s situation. Investors may have specific time horizons, portfolio compositions, or other
terms and conditions that are not matched by exchange-listed derivatives. They are private
transactions that are not directly reportable to any regulatory authority.

A derivatives dealer can, through a foreign subsidiary in the particular country, invest in the
foreign securities without the withholding tax and enter into a swap with the parent dealer
company, which can then enter a swap with the American investor, effectively passing on the
dividends without the withholding tax

5. Interest Rate Swap

An interest rate swap, or simply a rate swap, is an agreement between two parties to exchange a
sequence of interest payments without exchanging the underlying debt. In a typical fixed/floating
rate swap, the first party promises to pay to the second at designated intervals a stipulated
amount of interest calculated at a fixed rate on the “notional principal”; the second party
promises to pay to the first at the same intervals a floating amount of interest on the notional
principle calculated according to a floating-rate index.

The interest rate swap is essentially a strip of forward contracts exchanging interest payments.
Thus, interest rate swaps, like interest rate futures or interest rate forward contracts, offer a
mechanism for restructuring cash flows and, if properly used, provide a financial instrument for
hedging against interest rate risk.

The reason for the exchange of the interest obligation 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. In an interest rate swap they
consist of streams of interest payments of one type (fixed or floating) exchanged for streams of
interest payments of the other-type in the same currency.

Interest rate swaps are voluntary market transactions by two parties. In an interest swap, as in all
economic transactions, it is presumed that both parties obtain economic benefits. The economic
benefits in an interest rate swap are a result of the principle of comparative advantage. Further, in
the absence of national and international money and capital market imperfections and in the
absence of comparative advantages among different borrowers in these markets, there would be
no economic incentive for any firm to engage in an interest rate swap.

Differential information and institutional restrictions are the major factors that contribute to the
differences in transactions costs in both the fixed-rate and the floating-rate markets across
national boundaries which, in turn, provide economic incentive to engage in an interest rate
swap.

Interest rate swaps have become one of the most popular vehicles utilized by many companies
and financial institutions to hedge against interest rate risk. The growing popularity of interest
rate swaps is due, in part, to the fact that the technique is simple and easy to execute. The most
widely used swap is a fixed/floating interest rate swap.

Managing Interest Rate Exposure

 
Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s
financial condition.  The management of Interest Rate Risk should be one of the critical
components of market risk management in banks. The regulatory restrictions in the past had
greatly reduced many of the risks in the banking system. Deregulation of interest rates has,
however, exposed them to the adverse impacts of interest rate risk.

What is the Impact of IRR:

 The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long
term impact of changing interest rates is on the bank’s networth since the economic value of a
bank’s assets, liabilities and off-balance sheet positions get affected due to variation in market
interest rates.

The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the
movements of interest rates.  Any mismatches in the cash flows (fixed assets or liabilities) or
repricing dates (floating assets or liabilities), expose bank’s NII or NIM to variations.  The
earning of assets and the cost of liabilities are closely related to market interest rate volatility.

The interest rate risk when viewed from these two perspectives is known as ‘earnings
perspective’ and ‘economic value’ perspective, respectively.

Management of interest rate risk aims at capturing the risks arising from the maturity and
repricing mismatches and is measured both from the earnings and economic value perspective.

(a) Earnings perspective involves analysing the impact of changes in interest rates on accrual or
reported earnings in the near term. This is measured by measuring the changes in the Net Interest
Income (NII) or Net Interest Margin (NIM) i.e. the difference between the total interest income
and the total interest expense.

 (b) Economic Value perspective involves analysing the changes of impact og interest on the
expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows
on off-balance sheet items. It focuses on the risk to networth arising from all repricing
mismatches and other interest rate sensitive positions. The economic value perspective identifies
risk arising from long-term interest rate gaps.

Board and senior management oversight of interest rate risk

Principle 1: In order to carry out its responsibilities, the board of directors in a bank should
approve strategies and policies with respect to interest rate risk management and ensure that
senior management takes the steps necessary to monitor and control these risks. The board of
directors should be informed regularly of the interest rate risk exposure of the bank in order to
assess the monitoring and controlling of such risk.

Principle 2: Senior management must ensure that the structure of the bank’s business and the
level of interest rate risk it assumes are effectively managed, that appropriate policies and
procedures are established to control and limit these risks, and that resources are available for
evaluating and controlling interest rate risk.
Principle 3: Banks should clearly define the individuals and/or committees responsible for
managing interest rate risk and should ensure that there is adequate separation of duties in key
elements of the risk management process to avoid potential conflicts of interest. Banks should
have risk measurement, monitoring and control functions with clearly defined duties that are
sufficiently independent from position-taking functions of the bank and which report risk
exposures directly to senior management and the board of directors. Larger or more complex
banks should have a designated independent unit responsible for the design and administration of
the bank’s interest rate risk measurement, monitoring and control functions.

Adequate Risk Management Policies and Procedures

Principle 4: It is essential that banks’ interest rate risk policies and procedures are clearly defined
and consistent with the nature and complexity of their activities. These policies should be applied
on a consolidated basis and, as appropriate, at the level of individual affiliates, especially when
recognising legal distinctions and possible obstacles to cash movements among affiliates.

Principle 5: It is important that banks identify the risks inherent in new products and activities
and ensure these are subject to adequate procedures and controls before being introduced or
undertaken. Major hedging or risk management initiatives should be approved in advance by the
board or its appropriate delegated committee.

Risk Measurement, Monitoring and Control Functions

Principle 6: It is essential that banks have interest rate risk measurement systems that capture all
material sources of interest rate risk and that assess the effect of interest rate changes in ways
that are consistent with the scope of their activities. The assumptions underlying the system
should be clearly understood by risk managers and bank management.

Principle 7: Banks must establish and enforce operating limits and other practices that maintain
exposures within levels consistent with their internal policies.

Principle 8: Banks should measure their vulnerability to loss under stressful market conditions –
including the breakdown of key assumptions – and consider those results when establishing and
reviewing their policies and limits for interest rate risk.

Principle 9: Banks must have adequate information systems for measuring, monitoring,
controlling and reporting interest rate exposures. Reports must be provided on a timely basis to
the bank’s board of directors, senior management and, where appropriate, individual business
line managers.

Internal controls

Principle 10: Banks must have an adequate system of internal controls over their interest rate
risk management process. A fundamental component of the internal control system involves
regular independent reviews and evaluations of the effectiveness of the system and, where
necessary, ensuring that appropriate revisions or enhancements to internal controls are made. The
results of such reviews should be available to the relevant supervisory authorities.

Information for supervisory authorities

Principle 11: Supervisory authorities should obtain from banks sufficient and timely information
with which to evaluate their level of interest rate risk. This information should take appropriate
account of the range of maturities and currencies in each bank’s portfolio, including off-balance
sheet items, as well as other relevant factors, such as the distinction between trading and non-
trading activities.

Capital adequacy

Principle 12: Banks must hold capital commensurate with the level of interest rate risk they
undertake.

Disclosure of interest rate risk

Principle 13: Banks should release to the public information on the level of interest rate risk and
their policies for its management.

Sources, effects and measurement of interest rate risk

Interest rate risk is the exposure of a bank’s financial condition to adverse movements in interest
rates. Accepting this risk is a normal part of banking and can be an important source of
profitability and shareholder value. However, excessive interest rate risk can pose a significant
threat to a bank’s earnings and capital base. Changes in interest rates affect a bank’s earnings by
changing its net interest income and the level of other interest-sensitive income and operating
expenses. Changes in interest rates also affect the underlying value of the bank’s assets,
liabilities and off-balance sheet instruments because the present value of future cash flows (and
in some cases, the cash flows themselves) change when interest rates change.

Sources of Interest Rate Risk

Repricing risk: As financial intermediaries, banks encounter interest rate risk in several ways.
The primary and most often discussed form of interest rate risk arises from timing differences in
the maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-
balance-sheet (OBS) positions. While such repricing mismatches are fundamental to the business
of banking, they can expose a bank’s income and underlying economic value to unanticipated
fluctuations as interest rates vary. For instance, a bank that funded a long-term fixed rate loan
with a short-term deposit could face a decline in both the future income arising from the position
and its underlying value if interest rates increase. These declines arise because the cash flows on
the loan are fixed over its lifetime, while the interest paid on the funding is variable, and
increases after the short-term deposit matures.
Yield curve risk: Repricing mismatches can also expose a bank to changes in the slope and
shape of the yield curve. Yield curve risk arises when unanticipated shifts of the yield curve have
adverse effects on a bank’s income or underlying economic value. For instance, the underlying
economic value of a long position in 10-year government bonds hedged by a short position in 5-
year government notes could decline sharply if the yield curve steepens, even if the position is
hedged against parallel movements in the yield curve.

Basis risk: Another important source of interest rate risk (commonly referred to as basis risk)
arises from imperfect correlation in the adjustment of the rates earned and paid on different
instruments with otherwise similar repricing characteristics. When interest rates change, these
differences can give rise to unexpected changes in the cash flows and earnings spread between
assets, liabilities and OBS instruments of similar maturities or repricing frequencies.

Optionality: An additional and increasingly important source of interest rate risk arises from the
options embedded in many bank assets, liabilities and OBS portfolios. Formally, an option
provides the holder the right, but not the obligation, to buy, sell, or in some manner alter the cash
flow of an instrument or financial contract. Options may be stand alone instruments such as
exchange-traded options and over-the-counter (OTC) contracts, or they may be embedded within
otherwise standard instruments. While banks use exchange-traded and OTC-options in both
trading and non-trading accounts, instruments with embedded options are generally most
important in non-trading activities. They include various types of bonds and notes with call or
put provisions, loans which give borrowers the right to prepay balances, and various types of
non-maturity deposit instruments which give depositors the right to withdraw funds at any time,
often without any penalties. If not adequately managed, the asymmetrical payoff characteristics
of instruments with optionality features can pose significant risk particularly to those who sell
them, since the options held, both explicit and embedded, are generally exercised to the
advantage of the holder and the disadvantage of the seller. Moreover, an increasing array of
options can involve significant leverage which can magnify the influences (both negative and
positive) of option positions on the financial condition of the firm.

Effects of Interest Rate Risk

As the discussion above suggests, changes in interest rates can have adverse effects both on a
bank’s earnings and its economic value. This has given rise to two separate, but complementary,
perspectives for assessing a bank’s interest rate risk exposure.

Earnings perspective: In the earnings perspective, the focus of analysis is the impact of changes
in interest rates on accrual or reported earnings. This is the traditional approach to interest rate
risk assessment taken by many banks. Variation in earnings is an important focal point for
interest rate risk analysis because reduced earnings or outright losses can threaten the financial
stability of an institution by undermining its capital adequacy and by reducing market
confidence. In this regard, the component of earnings that has traditionally received the most
attention is net interest income (i.e. the difference between total interest income and total interest
expense). This focus reflects both the importance of net interest income in banks’ overall
earnings and its direct and easily understood link to changes in interest rates. However, as banks
have expanded increasingly into activities that generate fee-based and other non-interest income,
a broader focus on overall net income – incorporating both interest and non-interest income and
expenses – has become more common. The non-interest income arising from many activities,
such as loan servicing and various asset securitisation programs, can be highly sensitive to
market interest rates. For example, some banks provide the servicing and loan administration
function for mortgage loan pools in return for a fee based on the volume of assets it administers.
When interest rates fall, the servicing bank may experience a decline in its fee income as the
underlying mortgages prepay. In addition, even traditional sources of non-interest income such
as transaction processing fees are becoming more interest rate sensitive. This increased
sensitivity has led both bank management and supervisors to take a broader view of the potential
effects of changes in market interest rates on bank earnings and to factor these broader effects
into their estimated earnings under different interest rate environments.

Economic value perspective: Variation in market interest rates can also affect the economic
value of a bank’s assets, liabilities and OBS positions. Thus, the sensitivity of a bank’s economic
value to fluctuations in interest rates is a particularly important consideration of shareholders,
management and supervisors alike. The economic value of an instrument represents an
assessment of the present value of its expected net cash flows, discounted to reflect market rates.
By extension, the economic value of a bank can be viewed as the present value of bank’s
expected net cash flows, defined as the expected cash flows on assets minus the expected cash
flows on liabilities plus the expected net cash flows on OBS positions. In this sense, the
economic value perspective reflects one view of the sensitivity of the net worth of the bank to
fluctuations in interest rates. Since the economic value perspective considers the potential impact
of interest rate changes on the present value of all future cash flows, it provides a more
comprehensive view of the potential long-term effects of changes in interest rates than is offered
by the earnings perspective. This comprehensive view is important since changes in near-term
earnings – the typical focus of the earnings perspective – may not provide an accurate indication
of the impact of interest rate movements on the bank’s overall positions.

Embedded losses: The earnings and economic value perspectives discussed thus far focus on
how future changes in interest rates may affect a bank’s financial performance. When evaluating
the level of interest rate risk it is willing and able to assume, a bank should also consider the
impact that past interest rates may have on future performance. In particular, instruments that are
not marked to market may already contain embedded gains or losses due to past rate movements.
These gains or losses may be reflected over time in the bank’s earnings. For example, a long
term fixed rate loan entered into when interest rates were low and refunded more recently with
liabilities bearing a higher rate of interest will, over its remaining life, represent a drain on the
bank’s resources.

Measuring Interest Rate Risk

The techniques available for measuring interest rate risk range from calculations that rely on
simple maturity and repricing tables, to static simulations based on current on- and off-balance
sheet positions, to highly sophisticated dynamic modelling techniques that incorporate
assumptions about the behaviour of the bank and its customers in response to changes in the
interest rate environment. Some of these general approaches can be used to measure interest rate
risk exposure from both an earnings and an economic value perspective, while others are more
typically associated with only one of these two perspectives. In addition, the methods vary in
their ability to capture the different forms of interest rate exposure: the simplest methods are
intended primarily to capture the risks arising from maturity and repricing mismatches, while the
more sophisticated methods can more easily capture the full range of risk exposures.

Interest Rate Swaps

 
An interest rate swap is a type of a derivative contract through which two counterparties agree to
exchange one stream of future interest payments for another, based on a specified principal
amount. In most cases, interest rate swaps include the exchange of a fixed interest rate for a
floating rate.

Similar to other types of swaps, interest rate swaps are not traded on public exchanges – only
over-the-counter (OTC).

Basically, interest rate swaps occur when two parties – one of which is receiving fixed rate
interest payments and the other of which is receiving floating rate payments – mutually agree
that they would prefer the other party’s loan arrangement over their own. The party being paid
based on a floating rate decides that they would prefer to have a guaranteed fixed rate, while the
party that is receiving fixed rate payments believes that interest rates may rise, and to take
advantage of that situation if it occurs – to earn higher interest payments – they would prefer to
have a floating rate, one that will rise if and when there is a general uptrend in interest rates.

In an interest rate swap, the only things that actually get swapped are the interest payments. An
interest rate swap, as previously noted, is a derivative contract. The parties do not take ownership
of the other party’s debt. Instead, they merely make a contract to pay each other the difference in
loan payments as specified in the contract. They do not exchange debt assets, nor pay the full
amount of interest due on each interest payment date – only the difference due as a result of the
swap contract.

A good interest rate swap contract clearly states the terms of the agreement, including the
respective interest rates each party is to be paid by the other party, and the payment schedule
(e.g., monthly, quarterly, or annually). In addition, the contract states both the start date and
maturity date of the swap agreement, and that both parties are bound by the terms of the
agreement until the maturity date.

Note that while both parties to an interest rate swap get what they want – one party gets the risk
protection of a fixed rate, while the other gets the exposure to potential profit from a floating rate
– ultimately, one party will reap a financial reward while the other sustains a financial loss. If
interest rates rise during the term of the swap agreement, then the party receiving the floating
rate will profit and the party receiving the fixed rate will incur a loss. Conversely, if interest rates
decline, then the party getting paid the guaranteed fixed rate return will benefit, while the party
receiving payments based on a floating rate will see the amount of the interest payments it
receives go down.

Currency Swaps, Interest

Rate Futures
 
Currency Swaps
A currency swap is a “contract to exchange at an agreed future date principal amounts in
two different currencies at a conversion rate agreed at the outset”.

During the term of the contract the parties exchange interest, on an agreed basis, calculated on
the principal amounts.

A currency swap is a legal agreement between two parties to exchange the principal and interest
rate obligations, or receipts, in different currencies.

The transaction involves two counter-parties who exchange specific amounts of two currencies at
the outset, and repay them over time according to a predetermined rule that reflects both the
interest payment and the amortisation of the principal amount.

A currency swap is an agreement to exchange fixed or floating rate payments in one currency for
fixed or floating payments in a second currency plus an exchange of the principal currency
amounts.

Currency swap allows a customer to re-denominate a loan from one currency to another.

The re-denomination from one currency to another currency is done to lower the borrowing cost
for debt and to hedge exchange risk.

The concept behind is to match the difference between the spot and forward rate of any currency
over a specified period of time.

Usually, banks with a global presence act as intermediaries in swap transactions, helping to being
together the two parties. Sometimes, banks themselves may become counter-parties to the swap
deal, and try to offset the risk they take by entering into an offsetting swap deal.

Alternatively, banks can hedge themselves by taking positions in the futures markets.
Interest Rate Futures
An interest rate futures contract is a futures contract, based on an underlying financial instrument
that pays interest. It is used to hedge against adverse changes in interest rates. Such a contract is
conceptually similar to a forward contract, except that it is traded on an exchange, which means
that it is for a standard amount and duration. The standard size of a futures contract is $1 million,
so multiple contracts may need to be purchased to create a hedge for a specific loan or
investment amount. The pricing for futures contracts starts at a baseline figure of 100, and
declines based on the implied interest rate in a contract.

For example, if a futures contract has an implied interest rate of 5.00%, the price of that contract
will be 95.00. The calculation of the profit or loss on a futures contract is derived as follows:

Notional contract amount × Contract duration/360 Days × (Ending price – Beginning

price)

Most trading in interest rate futures is in Eurodollars (U.S. dollars held outside of the United
States), and are traded on the Chicago Mercantile Exchange.

Hedging is not perfect, since the notional amount of a contract may vary from the actual amount
of funding that a company wants to hedge, resulting in a modest amount of either over- or under-
hedging. For example, hedging a $15.4 million position will require the purchase of either 15 or
16 $1 million contracts. There may also be differences between the time period required for a
hedge and the actual hedge period as stated in a futures contract. For example, if there is a seven
month exposure to be hedged, a treasurer could acquire two consecutive three-month contracts,
and elect to have the seventh month be unhedged.

When the buyer purchases a futures contract, a minimum amount must initially be posted in a
margin account to ensure performance under the contract terms. It may be necessary to fund the
margin account with additional cash (a margin call) if the market value of the contract declines
 over time (margin accounts are revised daily, based on the market closing price). If the buyer
cannot provide additional funding in the event of a contract decline, the futures exchange closes
out the contract prior to its normal termination date. Conversely, if the market value of the
contract increases, the net gain is credited to the buyer’s margin account. On the last day of the
contract, the exchange marks the contract to market and settles the accounts of the buyer and
seller. Thus, transfers between buyers and sellers over the life of a contract are essentially a zero-
sum game, where one party directly benefits at the expense of the other.

It is also possible to enter into a bond futures contract, which can be used to hedge interest rate
risk. For example, a business that has borrowed funds can hedge against rising interest rates by
selling a bond futures contract. Then, if interest rates do in fact rise, the resulting gain on the
contract will offset the higher interest rate that the borrower is paying. Conversely, if interest
rates subsequently fall, the borrower will experience a loss on the contract, which will offset the
lower interest rate now being paid. Thus, the net effect of the contract is that the borrower locks
in the beginning interest rate through the period of the contract.

When a purchased futures contract expires, it is customary to settle it by selling a futures contract
that has the same delivery date. Conversely, if the original contract was sold to a counterparty,
then the seller can settle the contract by buying a futures contract that has the same delivery date.

Forward Rate Agreement

 
A Forward Rate Agreement, or FRA, is an agreement between two parties who want to protect
themselves against future movements in interest rates. By entering into an FRA, the parties lock
in an interest rate for a stated period of time starting on a future settlement date, based on a
specified notional principal amount. The buyer of the FRA enters into the contract to protect
itself from a future increase in interest rates. This occurs when a company believes that interest
rates may rise and wants to fix its borrowing cost today. The seller of the FRA wants to protect
itself from a future decline in interest rates. This strategy is used by investors who want to hedge
the return obtained on a future deposit.

FRAs are settled using cash on the settlement date. This is the start date of the notional loan or
deposit. The exposure to each counterparty is determined by the interest rate differential between
the market rate on settlement date and the rate specified in the FRA contract. There are no
principal flows.

The FRA is a very flexible instrument and can be tailored to meet the needs of both the buyer
and seller to protect themselves against the volatility of interest rates which affect their future
borrowings or investments. The principle advantages of FRAs are:

 Contracts can be structured to meet the specific needs of the user;

 Counterparty exposure is limited to the interest rate differential between the market rate and the
contract rate;
 Administration costs are minimized as there is only one cash flow on the settlement date as
opposed to daily futures settlement;
 They are off-balance sheet items; and
 They can easily be reversed or closed out using an offsetting FRA at a new price.
Technical Details

where

rc = FRA contract rate

rm = market rate

npa = notional principal amount

dt = maturity date of underlying FRA contract

de = settlement date of FRA contract

year_basis = number of days in year for particular accrual method

S = settlement amount