IMB 4 – July 2022

Slide Set n. 3
Using Swaps to Hedge Risk

Prof. Vincenzo Capizzi, SDA Bocconi

SDA Bocconi Asia Center I FMI Course

 Table of contents

 Again on the risk management function of the

financial system
 Understanding derivatives: interest rate swaps (IRS)
 Reasons for signing IRS
 Creating synthetic assets through IRS
 Assignment n. 6 (Red/Blue Batch)
 Using swaps to hedge currency risk

SDA Bocconi Asia Center I FMI Course Prof. Vincenzo Capizzi 2

 Risk management function
In addition to the monetary and allocative functions, the financial
system plays a risk-management function, allowing the possibility to
manage two different kind of risks: speculative risks and pure risks

Forward/Derivatives Contracts Insurance Activity

Through specific contracts an operator Insurance activity deals with the
can manage the case of a future negotiation of “pure risks”, which produce
increase/decrease in the prices of the certain losses, not determined with
goods bought/sold. reference to the amount nor to the timing.

Potential sources of risk:

-) exchange rate
Some financial institutions protect
-) interest rate
i sks
r economic units against these risks by
-) securities price v e
l a ti transforming a future, negative event in a
-) stock index ecu certain limited cost (insurance premium)
-) inflation Sp

SDA Bocconi Asia Center I FMI Course Prof. Vincenzo Capizzi 3

 Understanding derivatives: IRS

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SDA Bocconi Asia Center I FMI Course Prof. Vincenzo Capizzi 4

 Reasons for signing Interest Rate Swaps (IRS)
«Plain vanilla IRS (floating-to-fixed)»
Fears Fears
Maturity: 5 years Expects an increase
Expects a decrease
Frequency: every 6 months of market interest
of market interest
rates rates
Libor + 50 b.p.

1,000,000 INR
Nidhi («Notional capital») Pankaj
(Floating rate payer) (Fixed rate payer)

5%

Mortgage Loan (bullet): Mortgage Loan (bullet):

Principal: 1,000,000 INR Principal: 1,000,000 INR
Expiration: 5 years Expiration: 5 years
Interest rate: fixed (5%) Interest rate: variable (Libor + 50 b.p.)
Periodicity of payments: 6 months Periodicity of payments: 6 months

Existing loan + IRS = new «synthetic» loan with different interest rate regime
SDA Bocconi Asia Center I FMI Course Prof. Vincenzo Capizzi 5
 Creating Synthetic Assets through IRS

15-Year Government Bonds FIXED COUPON (3.5%)

IRS

Short Position (-) Long Position (+)

+ 3.5% + - 3.5% Libor + 75 b.p.

Existing security + IRS = new «synthetic» asset with different interest rate regime

Therefore, through IRS you can create not only synthetic liabilities,
but also, synthetic assets
SDA Bocconi Asia Center I FMI Course Prof. Vincenzo Capizzi 6
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SDA Bocconi Asia Center I FMI Course Prof. Vincenzo Capizzi 7

 Q.6 – Red Batch

Team Assignment
Hedging Interest Rate Risk with IRS
… to be downloaded from the eLearning platform …

1 exam credit available (up to 5% of the Final FMI grade)

for those groups who will send me the right answer by
July 13th - h. 08:30 a.m. (CET)
(vincenzo.capizzi@unibocconi.it)

SDA Bocconi Asia Center I FMI Course Prof. Vincenzo Capizzi 8

Q.6 – Red Batch

SDA Bocconi Asia Center I FMI Course Prof. Vincenzo Capizzi 9

 Q.6 – Blue Batch

Team Assignment
Hedging Interest Rate Risk with IRS
… to be downloaded from the eLearning platform …

1 exam credit available (up to 5% of the Final FMI grade)

for those groups who will send me the right answer by
July 13th - h. 12:30 a.m. (CET)
(vincenzo.capizzi@unibocconi.it)

SDA Bocconi Asia Center I FMI Course Prof. Vincenzo Capizzi 10

Q.6 – Blue Batch

SDA Bocconi Asia Center I FMI Course Prof. Vincenzo Capizzi 11

 Using swaps to hedge currency risk

Possible case involving an Indian company

Nidhi is an Indian company buying from Italy raw materials.

According to a trade contract recently signed, she has to pay,
starting from now, every 12 months € 7, 143 to the Italian importer
for the next 5 years.
Today the exchange rate is 70 INR/€.

However, soon after the closing of the trade contract, Nidhi starts
fearing about a future depreciation over time of INR against €.

Design an appropriate hedging strategy based on a Swap contract

signed with Pankaj (having opposite expectations).

SDA Bocconi Asia Center I FMI Course Prof. Vincenzo Capizzi 12

 Currency Fixed-to-Fixed IRS

Maturity: 5 years Expects a future

Expects a future
Frequency: every 12 months appreciation of INR
depreciation of INR
5% = 500,000 INR

10,000,000 INR
Nidhi Pankaj
t0 70 INR/€ = 142,857€
(Fixed rate payer) (Fixed rate payer)
Might be an importer Might be an exporter
fearing a depreciation 5% = 7,143 € fearing an appreciation
of home currency of home currency
Scenario 1 (favourable to Nidhi): after 12 months E.R. = 80 INR/€

Pankaj receives 500,000 INR and pays 571,440 INR (7,143€ x 80)

Scenario 2 (favourable to Pankaj): after 12 months E.R. = 65 INR/€

Nidhi pays 500,000 INR and receives 464,000 INR (7,143€ x 65)

SDA Bocconi Asia Center I FMI Course Prof. Vincenzo Capizzi 13

 THANKS YOU

SDA Bocconi Asia Center I FMI Course