S UNDERSTANDINGSW

W AP
AP S
S

03
 MEANING
GENERAL
Give something in exchange for something else.
(Oxford Advanced Learner’s Dictionary)

FINANCE
Exchange of Risk/Return
(ALAN McDOUGALL, Mastering Swaps Market, Prentice Hall)
EXAMPLE
 DEFINITION
A derivative in which two parties agree…

To exchange one stream of cash flows against another.

R

To exchange their risk.

MECHANICS OF SWAPS

Match
HEDGER
Create

IDENTIF
Y
 TYPES
 Interest Rate Swap

 Bond Swap

 Commodity Swap

 Credit Default Swap

 Non-Deliverable Swap

 Total Return Swap

 Currency Swap
 CDS
The buyer of a credit swap receives credit protection, whereas the
seller of the swap guarantees the credit worthiness of the
product. By doing this, the risk of default is transferred from the
holder of the fixed income security to the seller of the swap.
$45 TRILLION
INSURANCE MARKET
TO
GAMBLING MARKET
EXAMPLE

PRABHU CEMENT HOUSE

2,00,000
50,00,000 X
5
=
10,00,000
PARALLEL SITUATION

BOND
COMMON IN AIG& EXAMPLE

$400 BILLION 50,00,000

 CDS (USES)
HEDGING

SPECULATION ARBITRAGE

Risk
 INTEREST RATE SWAPS(IRS)
An agreement between two parties in which they contracts
to make payments of interest amount on their outstanding
debt to the other in future till a specified termination date.

 Generally involve fixed-to-floating rates of interest

 Two Parties:
Fixed Rate Payer
Floating Rate Payer

 Also called Plain Vanilla Swaps

 TERMINOLOGY
 NOTIONAL PRINCIPAL
TRADE
 BASIS POINTS

 SWAP COUPON
PAYMENT DATES EFFECTIVE
 FIXED RATE

 FLOATING RATE
RESET

 LIBOR
 TYPES
BASIS

EXTENDABLE FORWARD

IRS
CALLABLE PUTTABLE

RATE
CAPPED
USES & USERS
USES
To,
 Lower Cost of Funding

 Hedge Interest Rate Exposure

 Obtain Higher Yielding Investment Assets

 Speculate

USERS
 Commercial Banks

 Investment Banks

 Investment Companies

 Mortgage Companies

 GOVT Agencies etc

 EXAMPLE
Fixed Rate Bond Floating Rate Bond
Quality Co 9% LIBOR+1/2%
Risky Co 10.5% LIBOR+1%

Variable Payments at LIBOR+1/2%

QUALITY
CO RISKY CO
Fixed Payments at 9.5 %
Variable Fixed
Payments Payments
at LIBOR+1% at 9%

INVESTORS INVESTORS
CONSIDERING NOTIONAL PRINCIPAL

In the previous example if we consider Notional Principal as $50m,

then

Year LIBOR Quality Co Payment Risky Co Payment Net Payment

1 8 8.5%*$50m=$4.25 9.5%*$50m= $4.75m Risky pays $0.5m
2 7 7.5%*$50m=$3.75 9.5%*$50m= $4.75m Risky pays $0.5m

3 5.5 6%*$50m=$3m 9.5%*$50m= $4.75m Risky pays $0.5m

4 9 9.5%*$50m=$4.75m 9.5%*$50m= $4.75m Risky pays $0.5m

5 10 10.5%*$50m=$5.25m 9.5%*$50m= $4.75m Risky pays $0.5m

 BENEFITS
 Converts Floating Rate borrowing
to Fixed Rate or vice versa

 Can be applied to either New or

Existing Borrowings

 Off Balance Sheet Treatment

 Only the Net Interest Differential

is paid
 CURRENCY SWAP (CS)
A swap that involves the exchange of principal and
interest in one currency for the same in another
currency.
Like,
•Sell
•Repurchase

SWAP RATE
 TYPES

FX SWAP

BACK TO
CURRENCY SWAPS BACK
LOAN

CROSS
CURRENCY
SWAP
 EXAMPLE
A Canadian company wants to borrow € 10 million.
The company, however, believes that it can get better
terms if it issues $-denominated bonds in Canada
where it is well known, and then swap the $ for € with
a German company that wants to borrow $ but for the
same reasons finds it easier to borrow € in Europe
 SOLUTION
Canadian Canadian
Can$ Coupon + Principal
Company Investors

Can$ DM
Swap Swap
Payments Payments

German German
DM Coupon + Principal
Company Investots
 EXAMPLE
Assets Amount Liabilities Amount
$-Denominated $188m $-Denominated $50m

€-Denominated $12m €-Denominated $30 m

#(€7.5 m @ $1.6/€) *Net worth =$120 m

(€18.75 m @ $1.6/€)

 If the $ depreciates relative to the €, € denominated

assets and liabilities will be worth more $.
 Because the bank has more € denominated liabilities
than € denominated assets, it will suffer losses.
Now, if the $/€ exchange rate increases to $1.7, then the bank
will have a capital loss of $1.05 m, as can be seen:

Assets Amount Liabilities Amount

$-Denominated $88 m $-Denominated $50m
€-Denominated $112.75 €-Denominated $31.8
Net worth $118.95
Total m @ $1.7/€)
#(€7.5 $200.75 Total $200.75
(€18.75 m @ $1.7/€)
To reduce its exposure to the $/€ exchange rate risk, the bank could swap $18 million of its € denominated liabilities for $ denominated
liabilities.

This would leave the bank with $12 million in € denominated liabilities, which matches its $12 million of € denominated assets.

With € denominated assets = € denominated liabilities, a change in $/€ exchange rate does not change the bank’s net worth.
 CS (BENEFITS)
 Help in regulation of exposure to interest
rates.

 Benefit Speculators from favourable change

 Reduce uncertainty in with future cash

flows

 Reduce costs and risks of currency

exchange.
 LIMITATIONS
 Exposed to credit risk as either one or both the
parties could default
 Vulnerable to the central government’s intervention
in the exchange markets.
 CS (USES)
To hedge against exchange rate
fluctuations

To secure cheaper debt

ADVANTAGES & DISADVANTAGES
 ADVANTAGES
 Reduces transactions costs
 Maintains informational advantages
 Very long time period hedge possible

DISADVANTAGES
 Not much Liquidity
 Subject to Default Risk
 Non availability of Counter-party