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Institute For Technology & Management
Institute For Technology & Management
ATUL VAGAL VISHAL KATARIA ADITYA JAMBHEKAR PRAFUL AMBRE ANKITA SHAH SNEHA PATEL ROMIT SHAH
04 07 08 11 24 43 64
A Swap is an agreement between two parties to Exchange Cash Flows based on underlying asset.
Using Swaps Manage risks Arbitrage Enter new markets Create new instruments
In ancient medieval period there was no currency or money. So people use to exchange things Today, swaps are among the most heavily traded financial contracts in the world Most swaps are traded over-the-counter
Benefits
Customizable due to over-the-counter nature of the product No regulatory issues Low cost
Disadvantages
Significant cash flows can result in distress sale Termination date and rolling over cost Cost due to customization Credit Risk
Interest rate swaps Circus swaps Credit default swaps Equity swaps Commodity swaps Equity default swaps Swapation
Suppose company x in USA has borrowed $10 million floating-rate loan for 5 years which is indexed to LIBOR. The interest amount each year will be: LIBOR RATE X $10 million.
Suppose LIBOR rate is either 5.75% , 6.25% or 6.75%. The companys floating-rate interest payments will be:
LIBOR Rate 5.75% Floating-rate loan interest (LIBOR rate x $10 million ) 5,75,000 6.25% 6,25,000 6.75% 6,75,000
Suppose company x expected to have a steady flow of revenue from its investment. The company, instead of a floating-rate loan, could have taken fiveyear fixed-rate loan to finance the capital expenditure.
The company can swap the fixed-rate loan for the floating-rate loan. It would pay fixed payments for payments indexed to floating interest rate. If the interests rise, it will increase the companys interest amount on the floating-rate loan but, under swap, its receipts will also increase. Thus, swap will offset the companys exposure.
COMPANY X
SWAP DEALER
LIBOR RATE
5.75% Swap cash payment (LIBOR rate x $10 million) Swap cash receipts (0.0625 x $10 million) Net cash flow on swap 5.75% 6.25% 6.25% 6.75% 6.75%
6,25,000
6,25,000
6,25,000
+50,000
-50,000
The net cash flow consequences of swap agreement and the floating-rate loan for the company under the three different LIBOR rates will be shown bellow:
LIBOR RATE
5.75%
Floating-rate loan interest payment (LIBOR rate x $10 million ) + Net cash flow on swap [(0.0625-LIBOR)] Net payment 5,75,000
6.25%
6,25,000
6.75%
6,75,000
50,000 6,25,000
6,25,000
-50,000 6,25,000
CONCLUSION
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