.

Features of Interest Rate Swaps

Need for Intermediary
Applications of Swaps
Transforming Nature of Liabilities
Transforming Nature of Assets
Hedging with Swaps
Reducing Cost of Funds
Rationale for Swaps
Types of Interest Rate Swaps

.
 Swap as financial instrument came into
existence due to presence of exchange controls
restricting movement of capital from one country to
another.
 Swaps overcame the operational difficulties faced
in parallel loans and developed into an instrument
independent of the underlying loan transaction.
  Swap, in the simplest form may be defined as
an exchange of future cash flows between two parties as
agreed upon according to the terms of the contract.
The basis of future cash flow can be exchange rate for
 currency/ financial swap, and/or the interest rate for
interest rate swaps.
Apart from interest rates and currency rates the formula
 for determination of the periodic cash flows can be
equity returns, commodity prices etc.

.
  In a swap
 one of the cash flow would be fixed, called fixed leg while
 theother cash flow, called floating leg would be variable
depending upon the value of the variable identified for the
swap.

.
 If the exchange of cash flows is done on the
basis of interest rates prevalent at the relevant time, it is
known as interest rate swap.
 The simplest example of interest rate swap is a forward
contract where only one payment is involved.
Forward contract can be regarded as a swap with single
 exchange of cash flow, or alternatively swap can be
viewed as series of several forward transactions taking
place at different points of time.
  Cash flows under Interest Rate Swaps
 Have notional principal as underlying,
 Are netted by exchange of differential cash flows, and

 Are independent of the original loan.

“Plain Vanilla” Interest Rate Swap

Fixed at 8.50%
Company A
Company B
Floating at MIBOR + 30 bps

Company A pays fixed interest rate at 8% in exchange of receiving

floating interest from Company B based on value of MIBOR at periodic
intervals

.
  Swap intermediaries promote market
development by fulfilling the gaps
 By matching of needs,
 With warehousing, and
 Assuming the counterparty risk.

.
 Interest rate swaps can be used for
 transforming the floating rate liability to fixed rate
liability and vice versa,
 transforming floating rate asset to fixed rate asset and vice
versa,
 hedging against changing interest rates and
 reducing cost of funds.
  Swap can be used to convert a floating rate
asset to fixed rate and vice versa.
 Swap can also be used for converting fixed
rate liability to floating rate and vice-versa.
Swap to Transform Fixed Rate Asset to Floating Rate
8.50%
9.00% Company A M + 30 bps Bank

Company A pays fixed interest rate at 8.50% to Bank. Bank pays M + 30 bps in return.
Company A continues to receive 9.00% from its investment as originally agreed.

.
 When interest rates are rising:
A floating rate liability must be converted to fixed rate
liability, and
 A fixed rate asset must be converted to floating rate
asset.
 When interest rates are falling:
A fixed rate liability must be converted to floating rate
liability, and
 A floating rate asset must be converted to
fixed rate asset.

.
 Conversion of liability or asset from fixed
to floating or from floating to fixed is achieved
without disturbing the original contract.


The swap contract is independent of the original
contract.

Like it is originated without altering the original
contract, the swap can be cancelled too
independently, should the environment change.
  Reduction in cost of funding through
swap is based on the principle of comparative
advantage and is classical application of credit
arbitrage.
 Swap serves as a tool of reducing the financing
cost because of credit quality spread prevailing in
different kinds of markets.

.
 IRS has two legs of payment both of which may be
based on different parameters; one fixed and the other floating or
both floating but on different benchmarks.
 Fixed-to-floating: In this swap the party pays fixed rate of interest and
in exchange receives a floating rate at predetermined intervals of time.
 Floating-to-fixed: In this swap the party pays floating rate of interest
and in exchange receives a fixed rate interest at predetermined intervals of
time.
 Basis swap: This involves both legs on floating basis with different
benchmarks converting cash flows based on T Bills to MIBOR based rate
or vice versa.
Hedging Against Exchange Rate Risk
Reducing Cost of Funds
Features of Currency Swap
 Currency swaps also called financial
swaps, are exchange of cash flows in two different
currencies based on exchange rates.
Currency swap are useful in
 a) hedging the exchange rate risk,

b)transforming asset/liability from one

currency to another, and
c)reducing the financing cost.

This may be done without altering the
original contract.
CURRENCY SWAP: Converting Asset/Liability from One Currency to Another

US Asset
$ income
Swap Transaction

Rupee Liability Indian $ Interest US $ Liability

Rupee Interest Firm Firm $ Inter
$ Interest
Rupee Interest

Rupee Income Indian Asset

 Like interest rate swaps, currency swaps
are used to reduce funding cost for firms needing
funds in different currencies.
 Guiding principle remains theory of comparative
advantage.
 Comparative advantage results from two distinct
and separate markets governed by different set of
rules in vastly different economic conditions.
 Operationally currency swaps are different
from interest rate swaps as principal amount being
in different currencies, is exchanged both at
initiation and conclusion of swap.
Under currency swap the cash flows are as follows:
  Exchange of principal at the time of setting the swap deal
at the current spot rate,
 Exchange of periodic interest payments, and

 Exchange of the principal back upon maturity.

 Valuing Interest Rate Swaps
As Pair of Bonds
As Series of Forward Contracts
Swap Quotes and Initial Pricing
Counterparty Risks and Swaps
Valuing Currency Swaps
 We can price currency swap on the
same lines and principle as that of interest rate
swap; i.e. equating the value of cash inflows
with the value of cash outflows.
These cash flows are in different currencies,
 domestic and foreign and need to be converted
to the domestic currency.

 The value of swap is Vs = S x Vf - Vd

 Problem
• RIL borrowed $100 million from Citi Bank NY
@4% for 5 years. It goes to SBI and converts
the USD loan to INR loan. The applicable
interest rate for INR is 8%. Find the value of
the swap.
• Current Exchange rate is $1=₹45.00
 Initial value of currency swap is zero.
 The PV of cash inflows and outflows is equal, as for 4% US
$ swap for 8% INR.
Initial Value of Swap ₹million
Year ₹ Interest and US $ Interest PV ₹Discounted at PV $ Discounted
principal and principal 8% at 4%
1 360.00 4.00 333.33 3.85
2 360.00 4.00 308.64 3.70
3 360.00 4.00 285.78 3.56
4 360.00 4.00 264.61 3.42
5 360.00 4.00 245.01 3.29
5 4,500.00 100.00 3,062.62 82.19
4,500.00 100.00
Equivalent Domestic Currency @ ₹ 45/$ 4,500.00
SWAP VALUE -
 After one year $1= Rs.50
Interest rate for USD = 3% and INR= 10%
Year ₹ Interest $ Interest DF at 10% DF at 3% PV at 10% PV at 3%
and and
principal principal

2 360 4 0.909 0.971

327.24 3.884
3 360 4 0.826 0.943
297.36 3.772
4 360 4 0.751 0.915
270.36 3.66
5 360 4 0.683 0.888
245.88 3.552
5 4500 100 0.683 0.888
3073.5 88.8

4214.34 103.668
 After one year $1= Rs.50
Interest rate for USD = 3% and INR= 10%
• Value of the swap after one year
• =103.668 x 50 -4214.34
• = 5183.40 – 4214.34
• = 969.06
 Value of the swap would be dependent
upon the term structure of the two currencies
involved and the spot and forward exchange rates.
 Present values of the cash inflows and cash outflows
would determine the value of the swap
Commodity Swaps
Equity Swaps
 By entering into futures hedge traders can render
stability to profits in the short-term.
 Swaps, being over-the-counter product can ensure a
level of profit for the longer period, as for Jeweller
hedging against gold prices:
Plain Vanilla Commodity Swap

Fixed ₹ 13,000/10 gm of Gold

Jeweller Swap
Average of 1 month Price of Gold Dealer

Jeweller pays fixed price of ₹ 13,000 per 10 gm of gold in exchange of

receiving the average price of gold during the month .
 Under equity swap one party pays a fixed rate of return while
receives a return based on the stock market index returns
(say NIFTY) of the preceding period
“Plain Vanilla” Equity Swap

NIFTY Returns
Swap
Mutual Fund
Fixed 10%
Dealer

Mutual Fund pays returns equal to% gains/losses on the

index in exchange of receiving fixed 10% locking in 10%
return.

 By such a swap the mutual fund locks in a return of 10% on the

value of the swap. The part of the portfolio would then be
transformed from equity to bonds.
Interest Rate and Currency Swap
 Interest rate Swap
• Vodafone and DLF both want to raise ₹100 crores
for 5 years. Vodafone wants a fixed rate of interest
and DLF wants a floating rate of interest.

Firm Requirement Cost of fixed Cost of floating

rate of interest rate of interest
Vodafone Fixed rate 12% MCLR+2%

DLF Floating 9% MCLR+0.5%

• From the above table design an interest rate swap

deal and show the consequent cost of borrowings
for each firm.
 Solution
• From the above information we find that DLF
has an absolute advantage in both the rates.
But Vodafone has a comparative advantage in
floating rate loan (as the difference is 1.5%).
• Therefore DLF has a comparative advantage in
fixed rate loan (as the difference is 3%).
• If both the companies borrow as per their own
requirements, the total borrowing cost of both
the companies will be:
 Solution (cont.)
• Vodafone: 12%
DLF: MCLR+0.5%
Total= MCLR+12.5%
• However if they borrow as per the rate where each has
a comparative advantage, the total borrowing cost of
both the companies will be:
Vodafone: MCLR+2%
DLF: 9%_
Total= MCLR+11%_
• Therefore there is a saving of (MCLR+12.5%)-
(MCLR+11%) =1.5%
 Solution (cont.)
• Suppose Vodafone borrows at floating rate and
transfers the floating rate of interest to DLF and DLF
borrows at fixed rate and transfers the fixed rate of
interest to Vodafone, they can reduce the total interest
outgo by 1.5%
• Assuming that the deal is done through a third party, a
swap bank and if three of them share the saving of
1.5% equally, each gets 0.5%
• Therefore interest cost of Vodafone will be (12-0.5) %
=11.5% and that for DLF will be (MCLR+0.5%-0.5%) =
MCLR, and the swap bank gets 0.5%.
 Solution (cont.)
• So Vodafone will borrow ₹100 crores at
MCLR+2% and DLF will borrow ₹100 crores at 9%
and they will swap the interest rate
• DLF will pay MCLR to the swap bank. Swap bank
will pass that to Vodafone. Vodafone will pay
MCLR+2% to the floating rate lender. Vodafone
will pay 9.5% to swap bank. Swap bank will keep
0.5% for itself and pass 9% to DLF which DLF will
pay to the fixed rate lender.
•
 Solution (cont.)
9% 9.5%
SWAP BANK

MCLR Net profit = 0.5%

MCLR

DLF VODAFONE

9% MCLR+2%

FIXED RATE
LENDER FLOATING RATE LENDER
 Alternative Solution (cont.)
9% 11.5%
SWAP BANK
MCLR+11.5%
MCLR Net profit = 0.5%
MCLR
+2%

DLF VODAFONE

9% MCLR+2%

FIXED RATE
LENDER FLOATING RATE LENDER
 Solution (cont.)
• Therefore cost to the party’s are as follows:
• DLF=-MCLR+9%-9%=-MCLR
• Vodafone=+MCLR-(MCLR+2%)-9.5%=-11.5%
• And the swap bank gets 0.5%
 Currency Swap
• United Breweries Ltd.(UBL) of India wants to set
up a factory in Sydney, Australia. For this purpose
UBL needs a loan of Australian dollar of 50 million
for 5 years. Netbox Blue (NB) a telecom company
in Australia wants to set up their establishment in
India and it needs a loan of ₹ 2355 million for 5
years. Spot rate for AUD/₹=47.10. Therefore both
of them need equal amount of money. The rates
at which both the companies can borrow are
given below:
 Company Requirement Cost of loan in Cost of loan in
Indian ₹ AUD
UBL AUD 9.5% 3%
NB INR 10.5% 2.5%

Design a currency swap between UBL and NB in which both of them can reduce their
cost of funds.
 Solution
• UBL has an advantage in rupee loan but it
needs Australian dollar loan
• On the other hand NB has an advantage in
Australian dollar loan but it needs a rupee
loan
• If UBL borrows AUD, it has to pay 3% which is
0.5% more than what NB will pay for
borrowing AUD
 Solution (Cont.)
• Similarly NB will pay 10.5% on rupee loan,
which in 1% more than UBL’s borrowing cost of
rupee loan
• As per the requirement and the prevailing
exchange rate, both the companies need equal
amount of money for an equal period
• Therefore they can do a currency swap.
Suppose UBL borrows ₹2355 million for 5 years
@ 9.5% and passes this to NB
• NB on the other hand borrows AUD 50 million
for 5 years @ 2.5% and passes this to UBL
 Solution (Cont.)
• For a period of 5 years NB will pay 9.5% on
₹2355 million, i.e. ₹223.725 million to UBL and
at the end of 5th year NB will pay UBL the
principal amount of ₹2355 million
• Similarly UBL will pay 2.5% on AUD 50 million
i.e. AUD 1.25 million to NB for a period of 5
year and at the end of 5th year, UBL will pay the
principal amount of AUD 50 million to NB
• In the process both the companies are saving
in their borrowing cost.
 Solution (Cont.)
• UBL will be paying 2.5% on its AUD loan,
which otherwise would have been 3% and
thus saving 0.5%. NB on the other hand will be
paying 9.5% on its rupee loan which otherwise
would have been 10.5% and thus saving 1%.
 Rupee AUD
Loan Loan

Year 5
AUD 50 million Year 0
AUD 50
million

Year 5 Year Year 0 Year Year 5

2355 1 to 5 Rs. 1 to 5 AUD
223.725 AUD
millio 2355 Year 1 to 5 1.25
50
million million
n million 2.5% on AUD 50 million = AUD 1.25 million million

Rs.2355 million

Year 0 NB
UBL
AUD 50 million

9.5% on Rs. 2355 million = Rs. 223.725 million

Year 1 to 5

Year 5 Rs. 2355 million