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Swap – Meaning
 A Swap is an agreement between two counter parties to exchange
cash flows in the future.
 Terms like the...
Evolution of swap market
 Financial experts agree that the origin of the swap markets can be
traced back to 1970s when ma...
 Replaced their existing contracts like parallel(similar,
comparable) and back-to-back loans ,with the swap deals which
f...
 The banks started to find out a counter party with exactly or
nearly matching requirement to hedge the original swap by
...
Features of Swaps
 Counter parties:
 Swap involve the exchange of a series of periodic payment between
at least two part...
 Swap facilitators can be classified into two :
 Brokers -- -function as agent that identify and bring the counter
parti...
 Documentations:
 Swap transaction may be set up with great speed , their
documentations and formalities are much less i...
 Termination:
 Swap is an agreement between two parties, it cannot be
terminated at one’s instance.
 Termination also r...
Interest rate swaps -- Meaning
 An interest rate swap is a financial agreement between the two
parties who wish to change...
 Fixed rate:
 This is the rate, which is used to calculate the size of the fixed
payment.
 Banks or financial instituti...
 Floating payment = (P) x (Rfe) x (Ffe)
 Where P is notional payment, Rfe is the floating rate set on the
reset date, Ff...
 Example for calculation of fixed and floating interest rate:
Let us assume Party X on a semi-annual basis, pays 7 per ce...
 Types of interest rate swaps:
 Plain vanila swap:
 It is also known as fixed-for-floating swap.
 One party with a flo...
 Alternative floating rate:
 Floating reference can be switched to other alternatives as per the
requirement of the coun...
 Swaptions:
 Swaptions are combination of the features of two derivative
instruments i.e. option and swap.
 Option inte...
Currency Swap -- Meaning
 In currency swap, the two payment streams being exchanged are
denominated in two different curr...
Types of currency swaps
 Fixed-to-fixed currency swap:
 Currencies are exchanged at fixed rate.
 One firm raises a fixe...
 Fixed-to-floating currency swap:
 It is a combination of a fixed-to-fixed currency swap and floating
swap.
 One party ...
Debt-Equity swap
 In debt-equity swap, a firm buy’s a county debt on the secondary
market at a discount and swaps it into...
Motivation underlying swaps
 Swap are important techniques or technology for transforming
the characteristics of financia...
 Government regulation makes certain markets more attractive
to particular companies (usually domestic) than others.
 Th...
 Example, a banking company’s assets are the loans issued to
the customers.
 I t is observed that changes overtime may e...
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Unit iv

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Financial Derivatives portions units up to 1 to 5

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Unit iv

  1. 1. Swap – Meaning  A Swap is an agreement between two counter parties to exchange cash flows in the future.  Terms like the dates when the cash flows are to be paid, the currency in which to be paid and the mode of payment are determined and finalized by parties.  Calculation of cash flows involves the future values of one or more market variables.
  2. 2. Evolution of swap market  Financial experts agree that the origin of the swap markets can be traced back to 1970s when many countries imposed exchange regulations and restrictions in order to control cross border capital flows.  Experts are of the opinion that swap markets owe their origin to the exchange rate instability that followed the demise (failure) of Bretton Wood System during the years 1971 to 1973.  Most of the borrowers and investors at the international level wishing to diversify their assets and liabilities compositions in varied currencies in order to control losses arising due to fluctuations in exchange rate.  In 1980s a few countries liberalize their exchange regulatory measures, as a result, some of the MNCs treasurers structured their portfolios and brought out a new financial product, known as swaps.
  3. 3.  Replaced their existing contracts like parallel(similar, comparable) and back-to-back loans ,with the swap deals which found them more flexible and suitable due to simpler documentation and single jurisdiction. (authority, power).  Swap were found to lower financing cost and tax differences.  In 1980s, most of the MNCs and other corporate borrowers were approaching to the investors directly rather than through banks, also encourage them to make financial arrangement through swaps.  First swap contract was negotiated in 1981 between Deutsche Bank and an undisclosed counter party.  Bankers were only acting as brokers in the swap markets to match the complimentary requirement of the counter parties.  Emergence of the large bank and performed as aggressive market makers specifically in dollar interest rate swaps.  Provide bid/ offer quotes for both interest rate and currency swaps.
  4. 4.  The banks started to find out a counter party with exactly or nearly matching requirement to hedge the original swap by entering into a matching swap.  The formation of the international Swap Dealers Association (ISDA) in 1984 was a significant development to speed up the growth in the swap market by standardizing swap documentation.  In 1985, the ISDA published the first standardized swap code.. This code was revised in 1986 and in 1987, published its standard form agreements.  Currency swaps were first introduced in late 1970s, and then interest rate swap in 1981, equity and commodity swap in mid 1980s and credit derivatives in 1990, were floated.
  5. 5. Features of Swaps  Counter parties:  Swap involve the exchange of a series of periodic payment between at least two parties.  Example, a firm having a loan of ten crore payable at ten percent fixed coupon rate for five years, wants to exchange for a floating interest rate with that party who is also interest to exchange its liability from floating to fixed.  Facilitators:  Swap agreements are arranged through an intermediary which is usually a large international financial institution/ bank having network of its operation in major countries.  These intermediaries plays a significant role in bringing closer the various parties for such deals.  Facilitator will note down the requirement of the parties and try to match and fulfill these with other parties.
  6. 6.  Swap facilitators can be classified into two :  Brokers -- -function as agent that identify and bring the counter parties on the table for the swap deal.  Initiate the counter parties to finalize the swap deal according to their respective requirement.  Swap dealers – they themselves become counter parties and takeover the risk.  Swap dealer are the part of the swap deal, they face two problems .  First, how to price swap to provide for his service. Second problem is to manage this portfolio.  Cash flows:  Swap deal is an exchange of two financial obligation in future, both the parties would desire to have same financial liabilities as before the swap deal.  In swap deal, the present value of future cash streams are examined, and then appropriate decision is taken.
  7. 7.  Documentations:  Swap transaction may be set up with great speed , their documentations and formalities are much less in comparable to loan deals.  It is an evaluation of various future cash stream arisen out in various contract done in past.  The terms of different contract suit the interested firms requirements, the deal will be enacted.  Transaction cost:  It is observed that the transaction cost are relatively low in swap in comparison to loan agreement.  Unlikely to exceed half percent of the total sum involved in the swap agreement.  Benefits to parties:  Swap agreement will be done only when the parties will be benefited by such agreement, otherwise such deals will not be excepted.
  8. 8.  Termination:  Swap is an agreement between two parties, it cannot be terminated at one’s instance.  Termination also requires to be accepted by counter parties.  Default risk:  Swap deals are bilateral agreement, the problems of potential default by either of the counter party exist.
  9. 9. Interest rate swaps -- Meaning  An interest rate swap is a financial agreement between the two parties who wish to change the interest payment or receipts in the same currency on assets or liabilities to a different basis.  No exchange of principal amount in this swap.  This is also known in the market as plain vanilla swap.  Principal amount applies only for the purpose of calculating the interest to be exchanged under interest rate swap.  Maturities range from a year to over 15 years.  Feature of interest rate swaps:  Notional principal:  Interest amount whether fixed or floating is calculated on a specified amount borrowed or lent.  Parties do not exchange this amount at any time., it remains constant throughout the life of the swap.
  10. 10.  Fixed rate:  This is the rate, which is used to calculate the size of the fixed payment.  Banks or financial institutions who make market in interest rate swap quote the fixed rate, they are willing to pay if they are fixed rate payers in a swap (bid swap rates) , they are willing to receive if they are floating rate player in a swap (ask swap rate). Fixed payment =( P ) x (Rfp) x (Ffp) Where P is the notional payment, Rfp is the fixed price, Ffp is the fixed day count fraction.  Floating rate:  Floating rate as one of the market indexes like LIBOR (London Inter Bank Offer Rate).  Treasury Bill rate, primary rate, etc. on which basis the floating interest rate is determined in the swap agreement.
  11. 11.  Floating payment = (P) x (Rfe) x (Ffe)  Where P is notional payment, Rfe is the floating rate set on the reset date, Ffx is the floating rate day count fraction.  Trade date, effective date, reset date, payment date:  Trade date:  Fixed rate payment are normally paid semi-annually or annually. For example, it may be March 1, September 1 etc.  Trade date may be defined as such date on which the swap deal is concluded.  Effective date:  Effective date is that date from which the first fixed and floating payment start to accrue.  For example, a 5- year swap is traded on August 30, 2002 the effective date may be September 1, 2002, and ten payment dates from March 1, 2003 to September 1, 2007.
  12. 12.  Example for calculation of fixed and floating interest rate: Let us assume Party X on a semi-annual basis, pays 7 per cent rate of interest on the notional amount and receives from the Party Y LIBOR + 30 basis points . The current six- month LIBOR rate is 6.30 per cent per annum. The notional principal is Rs. 35 crore. Amount to be paid as per fixed rate: Notional principal x (Days in period/365) ( Interest rate/100) 350000000 x (182/365) x ( 7/100) = Rs. 1221644 Amount to be paid as per floating rate: Notional principal x (Days in period/365) ( Interest rate + base/100) 350000000 x (182/365) x ( 6.30 + .30/100) = Rs. 1167833 In a swap, the payments are netted. In this case, Party X pays Party Y the net difference. Rs. 1221644 - Rs. 1167833 = Rs.53810
  13. 13.  Types of interest rate swaps:  Plain vanila swap:  It is also known as fixed-for-floating swap.  One party with a floating interest rate liability is exchanged with fixed rate liability.  Period ranges from 2 years to over 15 years for a pre- determined notional principal amount.  Zero coupon to floating:  Holders of zero-coupon bonds get the full amount of loan and interest accrued(accumulate) at the maturity of the bound.  The fixed rate player makes a bullet payment at the end and floating rate player makes the periodic payment through out the swap period.`
  14. 14.  Alternative floating rate:  Floating reference can be switched to other alternatives as per the requirement of the counter party.  These alternatives include three-month LIBOR, one-month commercial paper, T-Bill rate etc.  Alternative floating interest rates are charged in order to meet the exposure of other party.  Floating-to-floating:  One party pays one floating rate, say, LIBOR while the other counter party pays another, say, prime for a specified time period.  These swap deals are mainly used by the non-US banks to manage their dollar exposure.  Forward swap:  This swap involves an exchange of interest rate payment that does not begin until a specified future point of time.
  15. 15.  Swaptions:  Swaptions are combination of the features of two derivative instruments i.e. option and swap.  Option interest rate swaps are referred as swaptions.  Buyer of the swaption has the right to enter into an interest rate swap agreement by some specified date in the future.  Swaption will specify whether the buyer of the swaption will be a fixed rate receiver or a fixed rate payer.  Buyer exercises the option then the writer of the option will become the counter party.  Equity swap:  Equity swap involves the exchange of interest payment linked to the change in the stock index.  Example , an equity swap agreement may allow a company to swap a fixed interest rate of 6 per cent in exchange for the rate of appreciation on a particular index say BSE or NSE index.
  16. 16. Currency Swap -- Meaning  In currency swap, the two payment streams being exchanged are denominated in two different currencies.  Example , a firm which has borrowed Japanese yen at a fixed interest rate ‘can swap’ away the exchange rate risk by setting up a contract whereby it receives yen at a fixed rate in return for dollars at either a fixed or a floating interest rate.  In currency swap three basic step are involved  1.Initial exchange of principal amount – at an agreed rate of exchange. This rate is based on the spot exchange rate.  2.Ongoing exchange of interest – after establishing the principal amount, the counter parties exchange interest payment on agreed date based on the outstanding principal amount at the fixed interest rates agreed at the outset of the transaction.  3.Re-exchange of principal to principal – agreement on this enables the counter parties to re-exchange the principal sums at the maturity date.
  17. 17. Types of currency swaps  Fixed-to-fixed currency swap:  Currencies are exchanged at fixed rate.  One firm raises a fixed rate liability in currency X, say US dollar while the other firm raises fixed rate funding in currency Y say pound.  Principal amount are equivalent at the current market rate of exchange.  In swap deal, first party will get pound where the second party gets dollars.  The first party will make periodic get (pound) payment to the second, in turn gets dollar computed at interest at a fixed rate on the respective principal amount of both currencies.  Floating-to-floating:  The counter parties will have payments at floating rate in different currencies.
  18. 18.  Fixed-to-floating currency swap:  It is a combination of a fixed-to-fixed currency swap and floating swap.  One party makes the payment at a fixed rate in currency, say, X while the other party makes the payment at a floating rate in currency, say Y.  Contract without the exchange and re-exchange of principals do exist.  A financial intermediary (a swap bank) structures the swaps deal and routes the payment from one party to other party.
  19. 19. Debt-Equity swap  In debt-equity swap, a firm buy’s a county debt on the secondary market at a discount and swaps it into local equity.  Debts are exchanged for equity by one firm with the other.  Enable the investors to purchase the external debts of such underdeveloped countries to acquire equity or domestic currency in those same countries.  For example, a multinational firm wants to invest in, say, brazil, hires an intermediary (normally a bank) to buy brazil loans in the secondary market.  MNC (again through a middleman) presents the loans, denominated in dollar as, to the brazil central bank, which redeems them for brazil currency. The central bank, which redeems them at face value more than the loans trade in the secondary markets.
  20. 20. Motivation underlying swaps  Swap are important techniques or technology for transforming the characteristics of financial claim.  There is a different risk perception between markets. Example, bond market and bank credit market evaluate the companies differently because their credit assessment is subjective.  A company can raise the fund in particular market at lower cost where it receives better evaluation, which it can swap into the desired type of instrument.  I t relates with regulation of issuers and investors concerning the respective governments.  Government regulation that seeks to limit the amount of debt issue by the foreign companies to protect domestic investors from increased risks and preventing to borrow from local markets.
  21. 21.  Government regulation makes certain markets more attractive to particular companies (usually domestic) than others.  There is subsidized financing available in certain type of business , for example export financing.  A currency swap may allow a company to take advantage of such situation.  The availability of funds in different markets changes due to temporary supply/ demand imbalances.  Lowering reserve requirement for bank will result in increase of supply of funds in the bank credit and rates fall down.  The borrower will desire to go in such market where the supply is in excess.  It is related to balance-sheet position of the counter parties.  Swapping provides better opportunities to determine the type of assets and liabilities it wants to carry.
  22. 22.  Example, a banking company’s assets are the loans issued to the customers.  I t is observed that changes overtime may effect the differences between markets and the prevailing rates may be changes.
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Financial Derivatives portions units up to 1 to 5

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