Swaps: Terminologies used in Swaps; Types of Swaps - Interest Rate Swaps - Caps and Floors,

Equity Swaps, Commodity Swaps, Currency Swaps and Credit Derivatives.

Introduction

The forward, future and option contracts are generally short-term contracts and help individuals
and institutions to hedge risk in the short term. They can be used to hedge long-term risk by
rolling over the contracts from one short term to another, but this strategy can result in losses
if the underlying asset prices move against the hedger. Therefore, there was a need for
developing an instrument that could be useful in hedging over a long term. Th e instrument
created for this purpose was the swap contract.

Meaning of Swaps

Swaps are private agreements between two parties to exchange one stream of future cash flows
for another stream of cash flows in accordance with a pre-arranged formula. Th e agreement
provides details of how the cash flows will be calculated and the dates on which the cash flows
will be exchanged. At the time the contract is entered into, at least one of these cash flows will
be determined on the basis of an uncertain variable such as interest rate, exchange rate, equity
price, or commodity price, while the other could either be a fixed payment or be determined on
the basis of another uncertain variable.

Similarity of Swaps and Forward Contracts

A swap is a periodic exchange of cash flows under specified rules. A forward contract can be
viewed as a simple example of a swap. Suppose it is March 1, 2022, and a company enters into
a forward contract to buy 100 ounces of gold for $1,700 per ounce in one year. The company
can sell the gold in one year as soon as it is received. The forward contract is therefore
equivalent to a swap where the company agrees that on March 1, 2023, it will pay $170,000
and receive 100S, where S is the market price of one ounce of gold on that date. Whereas a
forward contract is equivalent to the exchange of cash flows on just one future date, swaps
typically lead to cash-flow exchanges taking place on several future dates.
Features of Swaps

Swaps are the combination of forwards by two counterparties. It is arranged to reap the benefits
arising from the fluctuations in the market (either currency market or interest rate market or
any other market for that matter).

The following are the important features of swaps.

Terminologies in Swaps

Swap: An agreement between two parties to exchange cash flows over a fixed period of time.

Counterparties: The two participants in the swap

Notional Principal: A monetary figure that is used as a part of the calculation to determine the
payment amounts.

Tenor: The length of time for which these payments will be exchanged is known as the tenor,
term, maturity, or expiration of the swap.

Swap Facilitators: They are specialists in the swap market who help clients find ways, via the
swap market, to alter or avoid unwanted risks. They are like financial engineers who design
swaps to solve client problems.

Swap Brokers: Swap brokers bring swap counterparties together so that a swap can be
arranged between them

Swap Dealers: Swap dealers, in addition to acting as facilitators or brokers, also enter into
swaps on their own behalf as one of the parties to the swap.

Swap facilitators and swap brokers receive commission or fees for their services. Swap
dealers become parties to the swap, and they stand ready to take the risks associated with the
swap. Facilitators can also be brokers and/or dealers. Swap dealers typically engage in an
offsetting swap so that their net risk exposure is kept at a minimum level. Dealers price the
swaps in which they are principals so as to earn a bid–asked spread on their overall book of
business, so that they earn a positive income even if their net position is zero. They also manage
their portfolio so that they earn a positive income by accepting a net exposure when they
consider the potential returns to outweigh the risks.

Trade Date: The date the transaction is closed.

Termination Date: Maturity date. The date when the obligations of the counterparties cease.

Effective Date: Also known as Value Date. This is usually 2 business days after the trade date
and from that date either regular or irregular periods are computed. It is the date from which
accrued and payment obligations for both parts arise in a swap.

INTEREST RATE SWAPS

An interest rate swap is a forward contract in which one stream of future interest payments is
exchanged for another based on a specified principal amount. Interest rate swaps usually
involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or
increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate
than would have been possible without the swap.

The cash flows at a fixed rate of interest are exchanged for those referenced to a floating rate.
An interest rate swap is a contractual agreement to exchange a series of cash flows. One leg of
cash flow is based on a fixed interest rate and the other leg is based on a floating interest rate
over a period of time. There is no exchange of principal. The size of the swap is referred to as
the notional amount and is the basis for calculating the cash flows.

Features of Interest Rate Swaps

➢ Forward Contracts
Interest rate swaps are forward contracts where one stream of future interest payments is
exchanged for another based on a specified principal amount.
➢ Exchange and Exposure
Interest rate swaps can exchange fixed or floating rates in order to reduce or increase
exposure to fluctuations in interest rates.
➢ Simple Swap Instruments
Interest rate swaps are sometimes called plain vanilla swaps, since they were the original
and often the simplest such swap instruments.
➢ Over the Counter (OTC) and Customization
Because the interest rate swaps traded over-the-counter (OTC), the contracts are between
two or more parties according to their desired specifications and can be customized in many
different ways.
➢ No Exchange of Principle
There is no exchange of principal. The size of the swap is referred to as the notional amount
and is the basis for calculating the cash flows.
➢ Reference Rate
The floating rate is tied to a reference rate LIBOR i.e. London Interbank Offered Rate.

Example to Understand Interest Rate Swap

Let’s assume that Charlie owns a $1,000,000 investment that pays him LIBOR + 1% every

month. As LIBOR goes up and down, the payment Charlie receives changes.

Now assume that Sandy owns a $1,000,000 investment that pays her 1.5% every month.

The payment she receives never changes.

Charlie decides that that he would rather lock in a constant payment and Sandy decides that

she'd rather take a chance on receiving higher payments. So Charlie and Sandy agree to

enter into an interest rate swap contract.

Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on

a $1,000,000 principal amount (called the "notional principal" or "notional amount").

Sandy agrees to pay Charlie 1.5% per month on the $1,000,000 notional amount.
Scenario-A: LIBOR = 0.25%

❖ Under initial investment,

o Charlie receives a monthly payment of $12,500 from his investment
($1,000,000 x (0.25% + 1%)).
o Sandy receives a monthly payment of $15,000 from her investment ($1,000,000
x 1.5%).

❖ Now, under the terms of swap agreement,

o Charlie owes Sandy $12,500 ($1,000,000 x LIBOR+1%) and
o Sandy owes Charlie $15,000 ($1,000,000 x 1.5%).

Scenario-B: LIBOR = 1.00%

❖ Under initial investment,

o Charlie receives a monthly payment of $20,000 from his investment ($1,00,000
x (1% + 1%)).
o Sandy still receives a monthly payment of $15,000 from her investment
($1,000,000 x 1.5%).

❖ Now, under the terms of swap agreement,

o Charlie owes Sandy $20,000 ($1,000,000 x LIBOR+1%) and
o Sandy owes Charlie $15,000 ($1,000,000 x 1.5%).
o Two transactions partially offset each other and now Charlie owes Sandy $5000
i.e. difference between swap interest payments
Observations in this example:
- Note that the interest rate swap has allowed Charlie to guarantee himself a $15,000 pay
out; if LIBOR is low, Sandy will owe him under the swap, but if LIBOR is higher, he
will owe Sandy money. Either way, he has locked in a 1.5% monthly return on his
investment.
- Sandy has exposed herself to variation in her monthly returns. Under Scenario A, she
made 1.25% after paying Charlie $2,500, but under Scenario B she made 2% after
Charlie paid her an additional $5,000. Charlie was able to transfer the risk of interest
rate fluctuations to Sandy, who agreed to assume that risk for the potential for higher
returns.
- One more thing to note is that in an interest rate swap, the parties never exchange the
principal amounts. On the payment date, it is only the difference between the fixed and
variable interest amounts that is paid; there is no exchange of the full interest amounts.
Procedure of Interest Rate Swaps
Interest rate swaps involves two parties agreeing to exchange interest payments over an agreed
period of at least one year end typically longer. A swap may be arranged with a bank, or a
counter party may be found through a bank or other financial intermediary. Fees will be payable
in bank is used. A Bank may be able to find a counterparty in more markets than if the company
seeking the swap tried to find the counterparty itself.

Advantages of Interest Rate Swaps

The interest rate swaps are beneficial for both banks and their commercial borrowers. Banks

often look for ways to educate their commercial borrowers about interest rate swaps.

Particularly on how swaps work in conjunction with loans and, perhaps more importantly, what

the advantages of swaps are, relative to traditional fixed-rate lending. Swaps make sense not

only for community and regional banks but also for commercial borrowers.

➢ Benefits for Banks on Offering Interest Rate Swaps

o Flexibility
▪ The interest rate swaps gives the bank flexibility, providing another tool to
help manage its interest rate risk, not only at the loan-by-loan level, but also
at the macro or balance sheet level.

o Prepayment Discipline
▪ The interest rate swaps creates prepayment discipline by differing from
fixed-rate loan prepayment where penalties are often waived, costing the
bank in lost economic value of equity.

o Economic Benefit
▪ The interest rate swaps offers economic benefit. Executing a swap will
generate non-interest income for the bank. This fee income is recognized in
the period the swap is executed and is NOT amortized over the life of the
loan.
 o Competitive Advantage
▪ The interest rate swaps provide competitive advantage. Separating the
funding of a loan from the management of interest rate risk through
derivatives provides pricing flexibility, usually allowing the bank to be more
competitive.

Note: It is the rare borrower who walks into a bank and says, “I want to
do a swap!” More often than not, a borrower will say he or she wants a
long-term fixed rate. As the bank will likely not be keen on extending a
fixed-rate loan for beyond seven years, the banker will probably suggest
a swap.

➢ Benefits of Interest Rate Swaps for Borrowers

o Flexibility
▪ Swaps gives the borrowers flexibility. Separating the borrower’s funding
source from the interest rate risk allows the borrower to secure funding to
meet its needs and gives the borrower the ability to create a swap structure
to meet its specific goals. For example, if there is a construction component
or a stabilization period, the swap can match it with a forward starting swap
or with an initial interest only period.

o Prepayment Benefits
▪ Interest rate swaps provide prepayment benefits for borrowers. Resulting in
the event of a prepayment, the borrower has bilateral make whole with the
swap, meaning the swap might be an asset and the borrower would receive
the value of that asset on the way out.

o Lowest Rate
▪ The swap usually leads to the lowest rate. Coupling a floating-rate loan with
a swap often results in the lowest possible rate for the borrower.
Disadvantages of Interest Rate Swaps

Interest rate swaps are a financial mechanism used by investors to manage risk and speculate
on future market performance. In a rate swap, one investor group pledges to pay a fixed interest
rate on an investment to another in return for a variable interest rate on the same amount of
money. This allows speculators to help other investors solidify their investments.

- Rate Increases for Investigators

o Because the return on investments with floating interest rates fluctuates with the
market, they’re more difficult to manage than fixed-rate investments. Money
managers frequently swap floating rates for fixed rates in a rate swap in order
to lock in a rate and allow for planning. If the floating interest rate rises after
terms of the rate swap are negotiated, the original interest-stream owner loses
out on the increased interest revenue from boosted rates, but only in the
difference between the rate agreed upon with the other party in the swap and
the floating one. For example, if a rate-swap is negotiated at 6.7 percent interest,
and the floating rate rises to 6.9 percent, the original investor doesn’t accrue
interest for the 0.2 percent difference in rates.
- Rate Drops for Speculators
o Speculative investors trade the predictability and security of fixed interest rate
revenue streams for the volatility of floating rate streams predicting interest
rates will rise, making the floating rate more lucrative and the investment worth
more than the initial outlay. If the floating rate falls, the value of the speculator’s
investment decreases, and the investor loses money. For example, trading a
$1,000 at 6.5 percent interest rate revenue stream (worth $65 annually) for a
$1,000 floating rate stream that drops to 6 percent (worth $60 annually) results
in a net loss of $5 annually for the speculator.
- Currency Fluctuations
o More complicated forms of rate swap mechanisms trade value in two currencies
or a combination of interest rates and currencies. These strategies pose the same
risks to investigators and speculators--either losing out on additional revenue
when the value of one currency rises or losing money when it falls--the
combination of currency exchange and interest rate prediction makes
international rate swaps a complicated proposition.
Types of Interest Rate Swaps

There are two categories and three different types of interest rate swaps
1. Coupon Swaps
Coupon swaps convert fixed-rate debt into floating-rate debt (or vice versa).
a. Fixed-to-Floating Interest Rate Swap
b. Floating-to-Fixed Interest Rate Swap
2. Basis Swaps
Basis swap converts one type of floating-rate debt into another type of
floating-rate debt.
a. Float-to-Float Interest Rate Swaps

A. Fixed-to-Floating Interest Rate Swaps

For example, consider a company named TSI that can issue a bond at a very attractive fixed
interest rate to its investors. The company's management feels that it can get a better cash
flow from a floating rate. In this case, TSI can enter into a swap with a counterparty bank
in which the company receives a fixed rate and pays a floating rate.

The swap is structured to match the maturity and cash flow of the fixed-rate bond and the
two fixed-rate payment streams are netted. TSI and the bank choose the preferred floating-
rate index, which is usually LIBOR for a one-, three-, or six-month maturity. TSI then
receives LIBOR plus or minus a spread that reflects both interest rate conditions in the
market and its credit rating.

B. Floating-to-Fixed Interest Rate Swaps

A company that does not have access to a fixed-rate loan may borrow at a floating rate and
enter into a swap to achieve a fixed rate. The floating-rate tenor, reset, and payment dates
on the loan are mirrored on the swap and netted. The fixed-rate leg of the swap becomes
the company's borrowing rate.

C. Float-to Float Interest Rate Swap

Companies sometimes enter into a swap to change the type or tenor of the floating rate
index that they pay; this is known as a basis swap. A company can swap from three-month
LIBOR to six-month LIBOR, for example, either because the rate is more attractive or it
matches other payment flows. A company can a also switch to a different index, such as
the federal funds rate, commercial paper, or the Treasury bill rate.
Interest Rate Swaps – Caps and Floors

Interest Rate Caps, Floors and Collars are option-based Interest Rate Risk Management
products. These option products can be used to establish maximum (cap) or minimum (floor)
rates or a combination of the two which is referred to as a collar structure. These products are
used by investors and borrowers alike to hedge against adverse interest rate movements.

➢ INTEREST RATE CAPS

o Meaning

▪ A Cap provides variable rate borrowers with protection against rising

interest rates while also retaining the advantages of lower or falling interest
rates.

o Users of Caps

▪ Variable rate borrowers are the typical users of Interest Rate Caps.
▪ They use Caps to obtain certainty for their business and budgeting process
by setting the maximum interest rate they will pay on their borrowings.
▪ By implementing this type of financial management, variable rate borrowers
obtain peace of mind from rising interest rates but retain the ability to benefit
from any favourable interest rate movements.

o Working of Caps

▪ An Interest Rate Cap ensures that you will not pay any more than a pre-
determined level of interest on your loan.
▪ An Interest Rate Cap enables variable rate borrowers to retain the
advantages of their variable rate facility while obtaining the additional
benefits of a maximum interest rate.

o Cost of Interest Rate Caps

▪ The cost of the Cap is referred to as the premium. The premium for an
Interest Rate Cap depends on the Cap rate you want to achieve when
compared to current market interest rates.
▪ For example, if current market rates are 6%, you would pay more for a Cap
at 7% than a Cap at 8.5%. The premium for an Interest Rate Cap also
depends on the rollover frequency and how you make your premium
payments. We will endeavour to structure the payments to suit your cash
flows.
 o Duration (or) Tenure of Interest Rate Caps

▪ An Interest Rate Cap can be purchased for a minimum term of 90 days and
a maximum term of five years.
▪ When the Actual Interest Rate rises above the Cap Strike Rate the Bank will
reimburse the extra interest to the customer.

o Association of Risks with Interest Rate Caps

▪ There are no risks associated with an Interest Rate Cap. It is important to

understand that if interest rates do not rise above the Cap rate, you have not
obtained any benefit from the purchase of the Cap.

➢ INTEREST RATE FLOORS

o Meaning
▪ An interest rate floor is the lowest interest rate you can receive on a loan
product that has a variable rate. These floors are often used in derivative
agreements so the investor knows the rate of return will never fall below a
certain limit

o Users of Floors
▪ Variable rate investors are the typical users of Interest Rate Floors. They use
Floors to obtain certainty for their investments and budgeting process by
setting the minimum interest rate they will receive on their investments.
▪ By implementing this type of financial management, variable rate investors
obtain peace of mind from falling interest rates and the freedom to
concentrate on other aspects of their business/investments.

o Working of Floors
▪ An Interest Rate Floor ensures that you will not receive any less than a pre-
determined level of interest on your investment.
▪ The Bank will reimburse you the extra interest incurred if interest rates fall
below the level of the Floor.
▪ An Interest Rate Floor enables variable rate investors to retain the upside
advantages of their variable rate investment while obtaining the comfort of
a known minimum interest rate.

o Cost of Floors
▪ The cost of the Floor is referred to as the premium. The premium for an
Interest Rate Floor depends on the Floor rate you want to achieve when
compared to current market interest rates.
▪ For example, if current markets rates are 6%, you would pay more for a
Floor at 5% than a Floor at 4.5%.
▪ The premium for an Interest Rate Floor also depends on the rollover
frequency and how you make your premium payments.
 o Duration (or) Tenure of Interest Rate Floor
▪ An Interest Rate Floor can be purchased for a minimum term of 90 days and
a maximum term of five years.
▪ When the actual Interest Rate falls below the Floor Strike Rate the Bank will
reimburse the extra interest to the customer.

o Association of Risks with Interest Rate Floor

▪ There are no risks associated with an Interest Rate Floor. It is important to
understand that if interest rates do not fall below the Floor rate, you have
not obtained any benefit from the purchase of the Floor.

EQUITY SWAPS

An equity swap is an exchange of future cash flows between two parties that allows each party
to diversify its income for a specified period of time while still holding its original assets. 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. The two sets of nominally equal cash flows are
exchanged as per the terms of the swap, which may involve an equity-based cash flow (such
as from a stock asset called the reference equity) that is traded for fixed-income cash flow (such
as a benchmark interest rate).

An equity swap contract is a derivative contract between two parties that involves the exchange
of one stream (leg) of equity-based cash flows linked to the performance of a stock or an equity
index with another stream (leg) of fixed-income cash flows.

In equity swap contracts, the cash flows are based on a predetermined notional amount.
However, unlike currency swaps, equity swaps do not imply the exchange of principal
amounts. The exchange of cash flows occurs on fixed dates.
Equity swap contracts offer a great degree of flexibility; they can be customized to suit the
needs of the parties participating in the swap contract. Essentially, equity swaps provide
synthetic exposure to equities.

Example to Understand Equity Swaps

Consider two parties – Party A and Party B. The two parties enter into an equity swap. Party A
agrees to pay Party B (LIBOR + 1%) on USD 1 million notional principal, and in exchange,
Party B will pay Party A returns on the S&P index on USD 1 million notional principal. The
cash flows will be exchanged every 180 days.

Assume a LIBOR rate of 5% per annum in the above example and appreciation of the S&P
index by 10% at the end of 180 days from the commencement of the swap contract.

At the end of 180 days, Party A will pay USD 1,000,000 * (0.05 + 0.01) * 180 / 360 = USD
30,000 to Party B. Party B would pay Party A return of 10% on the S&P index i.e. 10% * USD
1,000,000 = USD 100,000.

The two payments will be netted off, and in net, Party B would pay USD 100,000 – USD
30,000 = USD 70,000 to Party A. It should be noted that the notional principal is not exchanged
in the above example and is only used to calculate cash flows at the exchange dates.

Stock returns experience negative returns very frequently, and in case of negative equity
returns, the equity return payer receives the negative equity return instead of paying the return
to its counterparty.
In the above example, if the returns of stocks were negative, say -2% for the reference period,
then Party B would receive USD 30,000 from Party A (LIBOR + 1% on notional) and in
addition would receive 2% * USD 1,000,000 = USD 20,000 for the negative equity returns.
This would make a total payment of USD 50,000 from Party A to Party B after 180 days from
the start of an equity swap contract.

Advantages of Equity Swaps

➢ Synthetic Exposure to Stock or Equity Index

o Equity swaps can be used to gain exposure to stock or an equity index without
actually owning the stock. Forex. If an investor who has an investment in bonds can
enter into an equity swap to take temporary advantage of market movement without
liquidating his bond portfolio and investing the bond proceeds in the equities or
index fund.

➢ Avoiding Transaction Costs

o An investor can avoid transaction costs of equities’ trade by entering into an equity
swap and gaining exposure to stocks or equity index.

➢ Hedging Instrument
o They can be used to hedge equity risk exposures. They can be used to forgo short-
term negative returns of stocks without forging possession of the stocks. During the
period of negative stock return, an investor can forgo the negative returns and also
earn a positive return from the other leg of the swap (LIBOR, fixed rate of return,
or some other reference rate).

➢ Access to a Wider Range of Securities

o Equity swaps can allow investors exposure to a wider range of securities than that
is generally unavailable to an investor. For example – by entering into an equity
swap, an investor can gain exposure to overseas stocks or equity indices without
actually investing in the overseas country and can avoid complex legal procedures
and restrictions.
Disadvantages of Equity Swaps

➢ Unregulated
o Like most of the other otc derivatives instruments, equity swaps are largely
unregulated.

➢ No Open-Ended Exposure to Equities

o Equity swaps, like any other derivatives contract , have termination/expiration
dates. Thus, they don’t provide open-ended exposure to equities.

➢ Credit-Risk
o Equity swaps are also exposed to credit risk , which doesn’t exist if an investor
invests directly into stocks or equity index. There is always a risk that the
counterparty may default on its payment obligation.

Equity swaps are used to exchange returns on a stock or equity index with some other cash
flow (fixed rate of interest/ reference rates like labor/ or return on some other index or stock).
It can be used to gain exposure to a stock or an index without actually possessing the stock. It
can also be used to hedge the equity risk in times of negative return environments and are also
used by investors to invest in a wider range of securities

Features of Equity Swaps

➢ Identical to Interest-Rate Swap

o An equity swap is quite identical to an interest rate swap, but unlike an interest rate
swap in which one leg is being the fixed side, equity swaps are based on the return
of the equity index.
➢ Large Financial Firms
o Equity swaps are usually exchanged between large financial firms.
➢ Exposure to Equity Index
o It provides exposure to the equity index or the stock exchange without having
possession of that stock.
➢ Hedge of Exposure Risk
o Equity swaps hedge equity swaps exposure risk.
➢ No Transaction Costs
o There are no transaction costs in equity swaps.
Types of Equity Swaps

Fixed interest rate swap: In this type of contract, you pay on the basis of fixed interest rate
and receive the returns on equity.

Floating interest rate swap: In such type of equity swap contract, you pay on the basis of
floating interest rate and receive the returns on equity.

Equity vs equity: In such equity swap contracts, you pay returns on one particular equity and
receive returns on some another equity.

COMMODITY SWAPS

A commodity swap is a type of derivative contract where two parties agree to exchange cash
flows dependent on the price of an underlying commodity. A commodity swap is usually used
to hedge against price swings in the market for a commodity, such as oil and livestock.
Commodity swaps allow for the producers of a commodity and consumers to lock in a set price
for a given commodity.

Commodity swaps are not traded on exchanges. Rather, they are customized deals that are
executed outside of formal exchanges and without the oversight of an exchange regulator. Most
often, the deals are created by financial services companies.

Working of Commodity Swaps

A commodity swap consists of a floating-leg component and a fixed-leg component. The

floating-leg component is tied to the market price of the underlying commodity or agreed-upon
commodity index, while the fixed-leg component is specified in the contract.

Most commodity swaps are based on oil, though any type of commodity may be underlying
the swap, such as precious metals, industrial metals, natural gas, livestock, or grains. Because
of the nature and sizes of the contracts, typically only large financial institutions engage in
commodity swaps, not individual investors.
Generally, the floating-leg component of the swap is held by the consumer of the commodity
in question, or the institution willing to pay a fixed price for the commodity. The fixed-leg
component is generally held by the producer of the commodity who agrees to pay a floating
rate, which is determined by the spot market price of the underlying commodity.

Example to Understand Commodity Swaps

As an example, assume that Company X needs to purchase 250,000 barrels of oil each year for
the next two years. The forward prices for delivery on oil in one year and two years are $50
per barrel and $51 per barrel. Also, the one-year and two-year zero-coupon bond yields are 2%
and 2.5%. Two scenarios can happen: paying the entire cost upfront or paying each year upon
delivery.

To calculate the upfront cost per barrel, take the forward prices, and divide by their respective
zero-coupon rates, adjusted for time. In this example, the cost per barrel would be:

Barrel cost = $50 / (1 + 2%) + $51 / (1 + 2.5%) ^ 2 = $49.02 + $48.54 = $97.56.

By paying $97.56 x 250,000, or $24,390,536 today, the consumer is guaranteed 250,000 barrels
of oil per year for two years. However, there is a counterparty risk, and the oil may not be
delivered. In this case, the consumer may opt to pay two payments, one each year, as the barrels
are being delivered. Here, the following equation must be solved to equate the total cost to the
above example:

Barrel cost = X / (1 + 2%) + X / (1 + 2.5%) ^ 2 = $97.56.

Given this, it can be calculated that the consumer must pay $50.49 per barrel each year.

Types of Commodity Swaps

There are two types of commodity swaps: fixed-floating and commodity-for-interest.

Fixed-floating swaps are just like the fixed-floating swaps in the interest rate swap market,
but they involve commodity-based indices. General market indices in the commodities market
like the Goldman Sachs Commodities Index (GSCI) and the Commodities Research Board
Index (CRB) place different weights on the various commodities, so they’ll be used according
to the swap agent’s requirements.

Commodity-for-interest swaps are similar to the equity swap in that a total return on the
commodity in question is exchanged for some money market rate (plus or minus a spread).

Fixed-Floating Commodity Swaps

➢ Fixed-floating swaps are very similar to interest rate swaps. The difference is that
commodity swaps are based on the underlying commodity price rather than on a floating
interest rate.
➢ In this type of swap contract, there are two legs, the floating-leg, which is tied to the market
price of the commodity, and the fixed-leg, which is the agreed-upon price specified in the
contract.
➢ The party looking to hedge their position will enter into the swap contract with a swap
dealer to pay a fixed price for a certain quantity of the underlying commodity on a periodic
basis.
➢ The swap dealer will, in turn, agree to pay the party the market price of the commodity.
These cash flows will net out each period, and the party who must pay more will pay the
difference.
➢ On the other side, the swap dealer will also find a party looking to pay the floating price of
the commodity.
➢ The swap dealer will enter into a contract with this party to accept the floating market price
and pay the fixed price, which will again net out.
➢ Swap dealers such as financial service companies play the role of a market maker and profit
from the bid-ask spread of these transactions.
Commodity-For Interest Swaps

➢ A commodity-for-interest swap is very similar to an equity swap, however, the underlying

asset is a commodity.
➢ One leg will pay a return based on the commodity price while the other leg is tied to a
floating interest rate such as LIBOR, or an agreed-upon fixed rate.
➢ The swap involves a notional principal or face value, specified duration, and pre-specified
payment periods.
➢ Like the fixed-floating swap, the periodic payments will net out against each other and the
party who must pay more based on the commodity return, interest rate, and face value will
pay the difference.

Uses of Commodity Swaps

➢ For a party looking to hedge their position against the volatility of a commodity price, they
will enter into a swap to pay or receive a fixed price.
➢ On the commodity-producer side, this will guarantee a stable selling price for them.
➢ On the end-user side, this will guarantee a stable buying price for them.

CURRENCY SWAPS

A currency swap is an agreement in which two parties exchange the principal amount of a loan
and the interest in one currency for the principal and interest in another currency. At the
inception of the swap, the equivalent principal amounts are exchanged at the spot rate.
A currency swap, sometimes referred to as a cross-currency swap, involves the exchange of
interest—and sometimes of principal—in one currency for the same in another currency.
Interest payments are exchanged at fixed dates through the life of the contract.

Features of Currency Swaps

➢ A currency swap consists of two streams (legs) of fixed or floating interest payments
denominated in two currencies.
➢ The transfer of interest payments occurs on predetermined dates.
➢ In addition, if the swap counterparties previously agreed to exchange principal amounts,
those amounts must also be exchanged on the maturity date at the same exchange rate.
➢ Currency swaps are primarily used to hedge potential risks associated with fluctuations in
currency exchange rates or to obtain lower interest rates on loans in a foreign currency.
➢ The swaps are commonly used by companies that operate in different countries. For
example, if a company is conducting business abroad, it would often use currency swaps
to retrieve more favourable loan rates in their local currency, as opposed to borrowing
money from a foreign bank.
➢ For example, a company may take a loan in the domestic currency and enter a swap contract
with a foreign company to obtain a more favourable interest rate on the foreign currency
that is otherwise is unavailable.
Working of Currency Swaps

In order to understand the mechanism behind currency swap contracts, let’s consider the
following example.

Company A is a US-based company that is planning to expand its operations in Europe.

Company A requires €850,000 to finance its European expansion.

On the other hand, Company B is a German company that operates in the United States.
Company B wants to acquire a company in the United States to diversify its business. The
acquisition deal requires US$1 million in financing.

Neither Company A nor Company B holds enough cash to finance their respective projects.
Thus, both companies will seek to obtain the necessary funds through debt financing. Company
A and Company B will prefer to borrow in their domestic currencies (that can be borrowed at
a lower interest rate) and then enter into the currency swap agreement with each other.

The currency swap between Company A and Company B can be designed in the following
manner. Company A obtains a credit line of $1 million from Bank A with a fixed interest rate
of 3.5%. At the same time, Company B borrows €850,000 from Bank B with the floating
interest rate of 6-month LIBOR. The companies decide to create a swap agreement with each
other.

According to the agreement, Company A and Company B must exchange the principal amounts
($1 million and €850,000) at the beginning of the transaction. In addition, the parties must
exchange the interest payments semi-annually.

Company A must pay Company B the floating rate interest payments denominated in euros,
while Company B will pay Company A the fixed interest rate payments in US dollars. On the
maturity date, the companies will exchange back the principal amounts at the same rate ($1 =
€0.85).
Types of Currency Swaps

Similar to interest rate swaps, currency swaps can be classified based on the types of legs
involved in the contract. The most commonly encountered types of currency swaps include the
following:

Fixed vs. Float: One leg of the currency swap represents a stream of fixed interest rate
payments while another leg is a stream of floating interest rate payments.

Float vs. Float (Basis Swap): The float vs. float swap is commonly referred to as basis swap.
In a basis swap, both swaps’ legs both represent floating interest rate payments.

Fixed vs. Fixed: Both streams of currency swap contracts involve fixed interest rate payments.

CREDIT DERIVATIVES

Credit derivatives are one of the many specialized derivatives that are used for the purpose of
hedging, speculation and arbitrage. The primary purpose of a credit derivative or the need
behind the creation of such a product is to serve as a credit risk transfer mechanism. Credit risk
is one of the four broadly classified types of risks (others being operational risk, market risk
and liquidity risk). It is the possibility of a loss resulting from a borrower’s failure to repay a
loan or meet contractual obligations.

Financial institutions need to manage their financial risk so as to protect themselves from any
kind of uncertainty and to adhere to the norms. While managing risk, the institution may choose
to accept the risk, avoid the risk, reduce the risk or transfer the risk.

With credit risk, it is not possible to accept or avoid all of the risk and reducing the risk most
certainly leads to a decrease in profitability of the institution. That is why transferring the credit
risk is the most viable option with credit derivatives being the best method.

Credit derivatives are traded over-the-counter and so most of the participation is institutional
(non-retail) as is evident by the need created for institutions to manage their credit risk. A retail
investor might not need to encounter such derivatives, but they may choose to do so for
speculation purposes.

Meaning of Credit Derivatives

A credit derivative is a financial contract in which the underlying is a credit asset (debt or fixed-
income instrument). The purpose of a credit derivative is to transfer credit risk (and all or part
of the income stream in relation to the borrower) without transferring the asset itself.

A credit derivative serves as a sort of insurance policy allowing an originator or buyer to

transfer the risk on a credit asset (of which he may or may not be the owner) to the seller(s) of
the protection or counterparties.

A credit derivative is a financial contract that allows parties to minimize their exposure to credit
risk. Credit derivatives consist of a privately held, negotiable bilateral contract traded over-the-
counter (OTC) between two parties in a creditor/debtor relationship. These allow the creditor
to effectively transfer some or all of the risk of a debtor defaulting to a third party. This third
party accepts the risk in return for payment, known as the premium.

Types of Credit Derivatives

There are four types of credit derivatives. They are

A. Credit Default Swaps (CDS);
B. Collateralized Debt Obligations (CDO)
C. Total Return Swaps (TRS)
D. Credit Spread Options / Credit Default Options

A. Credit Default Swap (CDS):

A credit default swap (CDS) allows a market participant to transfer his/ her credit risk to
another market participant. If a lender is worried that borrower(s) might default, he may choose
to buy a CDS in the over-the-counter (OTC) market and potentially offset his/ her credit risk
to the CDS seller.
The CDS agreement is similar to an insurance agreement and a lender is insured of his/ her
credit risk default by the CDS seller who acts as the insurer. Similar to insurance contracts,
most of the CDS contracts have a periodic premium payment system.

The payoff of a CDS is contingent upon the performance of an underlying instrument as is true
for all derivatives. The most common underlying instruments include corporate bonds,
emerging market bonds, municipal bonds and mortgage-backed securities.

Advantages of CDS:
1. Absorbs shocks: CDS enable lenders to engage in risky ventures especially in the
corporate world. Lenders provide funds to risky borrowers who promise high returns and
then protect them using CDSs which serve as shock absorber specially during a corporate
crisis.

2. Increases liquidity: CDS contracts ultimately result in liquidity in the credit

derivatives markets by providing an additional option to an investor for diversification
created by any lender’s need.

3. Indicates financial health: CDS contracts have the prevailing financial health of
the debtor factored in (according to the efficient market hypothesis). It serves a more
accurate measure of credit risk than the periodically-published reports by the various
credit agencies.

Disadvantages of CDS:
1. Encourages speculation: Due to the risky nature of such securities and the
associated possibility of making substantial profits, CDS contracts attract speculators
who can inflate the prices of such securities by increasing the demand and a subsequent
increase in the CDS premium with respect to a particular entity.

2. Presents ambiguity: The underlying default event might be difficult to define in

the contract which may result in conflicts eventually and which may result in substantial
losses for the lender.

3. Can be manipulated: CDS contracts can be abused and manipulated, creating an

illusion of protection for the buyer of the contract. Since, CDS contracts are traded in
the markets, they might be transferred to a completely different entity.
B. Collateralized Debt Obligations (CDO):
Collateralized debt obligations (CDOs) are structured products created by banks to offload risk.
They form a type of structured asset-backed securities (ABS).

Usually, the assets backing a CDO comprise a diversified portfolio of corporate and emerging
market bonds, mortgage and non-mortgage backed securities, bank loans and credit default
swaps along with other assets.

In order to create a CDO, investment banks repackage the diversified portfolio of cash flow-
generating assets mentioned above into discrete classes using the waterfall structure which
creates discrete tranches based on the level of credit risk assumed by the investor.
The three commonly created tranches are:
1. Senior Tranche: As implied by the name, this is the tranche that is the senior most in
superiority since it is the first to receive cash in case the portfolio of loans defaults. It is
the safest of the three tranches and therefore offers the lowest interest rate.
2. Mezzanine Tranche: The mezzanine tranche is the middle tranche and is the second to
receive cash. It offers a slightly higher interest rate than the senior tranche due to the
same.
3. Junior Tranche: The junior tranche is the lowermost tranche that offers the highest
interest rate since it is the riskiest trance due to the greater risk of default. In case the
loans default, this tranche is the last to receive cash.
The riskiness associated with these tranches is reflected in their credit ratings.

Advantages of CDO:
• Increases flow of credit: When used responsibly, CDOs can be excellent financial
tools that can increase the availability and flow of credit in the economy. By selling
CDSs, banks are able to free up more funds that can be lent to other customers.
• Provides options: CDOs take into account the different levels of risk tolerance among
investors and provide options depending on the same.
• Transforms illiquid assets to liquid assets: CDOs allow banks to transform relatively
illiquid assets like bank loans into liquid assets.
Disadvantages of CDO:

• Results in relaxed standards: CDOs can result in relaxed lending standards among
banks as was seen in the 2007-09 financial crisis.
• Creates liquidity problems: Speculative moves in the markets determined by
emotions can result in standstill in trading of such derivatives, thereby creating a
liquidity problem and financial loss for the investor.

C. Total Return Swaps:

A total return swap is a credit derivative that enables two parties to swap both the credit and
market risks. In a total return swap, the payer is able to discreetly remove all the economic
exposure to the asset without having to sell it. On the other hand, the receiver is able to access
the economic pressure of the asset without having to buy it.

For example, a bank that lends money to a borrower and receives interest payments in exchange
may buy a total return swap from an investor. In such an agreement, the bank would pay the
fixed interest obtained from the loan and the capital gains in the loan to the investor who would
pay a variable interest rate, generally some variable spread above the LIBOR, and the loss in
debt in exchange.

D. Credit Default Swap Option:

A credit default swap option or a credit default swaption (CDS option) is an option on a credit
default swap (CDS). It gives its holder the right to buy or sell protection on a specified reference
entity for a specified future time period for a certain spread.

CDS options are usually of 2 types:

• Payer Swaptions: A payer swaption gives the buyer the option to buy protection. The
buyer pays premiums in return.
• Receiver Swaptions: A receiver swaption gives the option buyer the option to sell
protection. The seller receives premiums.