HEDGING WITH SWAPS

A swap is nothing but a barter or exchange but it plays a very important role in international finance.  A swap is the exchange of one set of cash flows for another.  A swap is a contract between two parties in which the first party promises to make a payment to the second and the second party promises to make a payment to the first.

HEDGING PURPOSE
Swaps can be used for hedging purpose and to manage risks:
Swaps can be used to lower borrowing costs and generate higher investment returns. Swaps can be used to transform floating rate assets into fixed rate assets, and vice versa. Swaps can transform floating rate liabilities into fixed rate liabilities, and vice versa. Swaps can transform the currency behind any asset or liability into a different currency.

INTEREST RATE SWAPS

Hedging against rising and falling Interest Rate :
An interest rate swap is an agreement between 2 parties agreeing to exchange one regular stream of interest from a fixed rate contract for another regular stream of interest from a variable rate contract for a specific period and on the basis of a predetermined amount. To covert a fixed-rate obligation to a floating-rate obligation. Therefore, the parties do not swap the notional amount, but only the agreed interest rate structures.

Example
Interest Rate Swaps can be used to make money or to hedge and protect assets. For example, if a bank has made a 5-year loan and is receiving a fixed 3 percent return on that money, it could swap its revenue stream against someone else's 5-year money earning a variable rate.  Each party to the transaction is making a play on the future of interest rates. If the rate increases, the variable rate income stream will produce more revenue than the fixed rate stream, which outperforms if rates decline. The party swapping into the fixed rate, however, could simply be creating the clarity of a fixed rate as a hedge for future investment, while the party swapping into a variable rate could be offsetting other fixed rate investments.

CURRENCY SWAPS
A currency swap involves two principal amounts, one for each currency. There is an exchange of the principal amounts and the rate generally used to determine the two principal amounts is the then prevailing spot rate. To convert an obligation in one currency to an obligation in other currency. A currency swap is similar to a series of foreign exchange forward contracts, which are agreements to exchange two streams of cash flows in different currencies. Like all forward contracts, the currency swap exposes the user to foreign exchange risk. The swap leg the party agrees to pay is a liability in one currency and the swap leg the party agrees to receive is an asset in the other currency.

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 A Currency swap is viable whenever one counterparty has comparatively cheaper access to one currency than it does to another.

Types of currency swaps

 Hedge both the principal & interest payments (preferred swap)  Hedge the principal payments only  Hedge the interest payment only

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Example
Suppose: Firm B can borrow in $ at 8.0%, or in at 6.0%. Firm A can borrow in $ at 6.5% or in at 5.2%. If A wants to borrow , and B wants to borrow $, then they may be able to save on their borrowing costs if each borrows in the market in which they have a comparative advantage, and then swapping into their preferred currencies for their liabilities.

COMMODITY SWAPS
 A swap in which exchanged cash flows are dependent on the price of an underlying commodity .  A commodity swap is usually used to hedge against the price of a commodity.  In a commodity swap, the first counterparty makes periodic payments to the second at a per unit fixed price for a given quantity of some commodity. The second counterparty pays the first a per unit floating price for a given quantity of some commodity.

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Example
Commodity swaps are used for hedging against :
Fluctuations in commodity prices or Fluctuations in spreads between final product and raw material prices (E.g. Cracking spread which indicates the spread between crude prices and refined product prices significantly affect the margins of oil refineries) The vast majority of commodity swaps involve oil

EQUITY SWAPS
 An equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future.  The two cash flows are usually referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also commonly referred to as the "floating leg".  The other leg of the swap is based on the performance of either a share of stock or a stock market index.  This leg is commonly referred to as the "equity leg".  Most equity swaps involve a floating leg vs. an equity leg, although some exist with two equity legs

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INDEX SWAPS
 Hedging arrangement in which one party exchanges one cash flow with another party s cash flow on specified dates for a specified period.  These cash flows are associated with a debt index, equity(stock) index, or any asset or price index.  An index swap is a variant of the conventional fixed-rate swap, and its term may range from 3 months to a year or more.

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DIFFERENTIAL SWAPS
A plain vanilla swap in which one of the legs is paid in a currency other than the one in which it is calculated. For example, the notional amount over which the interest rates are calculated may be in U.S. dollars, but one of the payments may be made in yen. A differential swap may be entered in order to take advantage of a favorable exchange rate.

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MISCELLANEOUS RISK MANAGEMENT INSTRUMENTS

MORTGAGE SWAP
INNOVATIONS IN OVER-THE-COUNTER OPTIONS MARKET

DIVERSIFICATION CREDIT RISK ENHANCEMENT OVERCOLLATERISATION ASSIGNMENT

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MORTGAGE SWAP
 Mortgage swaps can be used to replicate a mortgage portfolio earnings stream without the need to hold the mortgage assets. They can also be used to hedge mortgage portfolios from variations in earnings  Cash flows based on a group of Government National Mortgage Association (GNMA) mortgage backed securities of America are exchanged for a floating rate of interest.  Upon termination of swap, a final cash settlement is made on the change in the market values of the mortgages.  In case of mortgage hedging, the standard prepayment assumption , called the PSA (Public Securities Association) standard prepayment model is used for prepayment pattern on the mortgages  However, the mortgage swaps use the actual prepayment experience of the index pool in determining the amortization of the principal on the swap.

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INNOVATIONS IN OVER-THE-COUNTER OPTIONS MARKET

A. PATH DEPENDENT OPTIONS These are cash-settled options in which pay-off is based on an average value of the underlying asset over some period of time as opposed to the customary settlement based on the value of the underlying asset at the time of the options expiry. These options assist in hedging multi-period exposure with a single-period option. Example : Cruise line fuel problem. LOOK BACK OPTIONS These are the cash settlement options that are settled on the basis of the highest (or lowest) price of the underlying asset to prevail over the course of the option s life. These options command higher premium than the options that settle based on the value of the underlying asset.

B.

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C. OPTION-LINKED LOANS
 These are the loans denominated in one currency, requiring the borrower to write an option that allows the lender to redenominated in another currency. In this case, the cost of the loan is less as it reflects the option granted to the lender. Where the option is possessed by the borrower and borrowers are multinational companies earning various foreign currencies, then option-linked loans can be used by using the less profitable currencies to payback the loan.

 

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DIVERSIFICATION
 Diversification is an excellent and nearly costless way to eliminate the unsystematic risks associated with various financial positions.  To illustrate, the junk bonds individually involve high risk.  However, portfolio of junk bonds where no single component represents more than few percentage of overall portfolio have outperformed far more conservative portfolios for extended periods even after allowing for losses due to default.  This suggests that the risk-premiums on junk bonds may have been excessive.

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CREDIT ENHANCEMENT
 Credit Risk can be reduced by Credit Enhancement.  This technique offers the lenders an alternative means of collecting the interest and the principal due to the lender in the event that the borrower defaults.  For e.g.., the lender can recourse to bank guarantor in the event that the borrower is unable to meet its commitment to the lender.  This method was widely used by Japanese borrowers in the late 1980s.

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OVERCOLLATERIZATION
 It facilitates in converting high risk loans or instruments into low risk loans or instruments.  This is done by keeping the actual amount lent always some percentage below the value of the collateral property.  Overcollaterization is used in both the securitization of mortgages and other assets (such as corporate receivables).  Most recently it has been used to convert the risk character of junk bonds.

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ASSIGNMENT
 The holder of a position transfers both the rights and obligations associated with that position to the third party.  This is widely used in the insurance industry in the form of reinsurance where the risk is transferred by one insurer to another insurer. Insurers shall write down policies that far exceed their risk-bearing capabilities.  Then, they assign the risks to larger size insurance firms or farm out portions of the policy to number of smaller insurers.

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