Swaps - financial derivatives

2. SWAPS
 In SWAPS two counter parties agree to enter into a
contractual agreement wherein they agree to
exchange cash flows at periodic intervals.
 Most SWAPS are traded ‘Over the counter’.
 Some are also traded on futures exchange market.

3. TYPES OF SWAPS
There are two main types of SWAPS:
 Plain Vannila fixed for floating SWAPS
or simply interest rate swaps.
 Fixed for fixed currency SWAPS or simply
currency swaps.

5. An interest rate swap (IRS) is a liquid financial
derivative instrument in which two parties agree to
exchange interest rate cash flows, based on a specified
notional amount from a fixed rate to a floating rate (or
vice versa) or from one floating rate to another.
Types:
Floating for fixed
Fixed for floating
Floating for floating (basis swap)
No exchange of principal; coupon flows only.

6. Example:
FIXED RATE FLOATING RATE
COMPANY A 11% LIBOR – 1%
COMPANY B 10% LIBOR + 0.5%

7. BANK
B
LENDER
A
GAIN = 0.1%
9.7%
10%
LIBOR + 1 %
LIBOR
9.8% LIBOR
After swap A - 9.8% +1%
B - LIBOR + 0.3%

8. USES OF INTEREST RATE
SWAPS
Hedging
Speculation

9. FOREX SWAPS
A FOREX swap is an agreement to
exchange currencies now at the prevailing spot
rate and also to exchange the currencies back in
the future at the prevailing forward rate.
Two types of FOREX swap:
• Current to forward
• Forward to forward

11.  A currency swap is a foreign exchange
agreement between two institute to
exchange aspects of a loan in one currency
for equivalent aspects of an equal in net
present value loan in another currency.
 A currency swap should be
distinguished from a central bank liquidity
swap.

12. USES OF CURRENCY
SWAPS
Two main uses :
 To secure cheaper debt
 To hedge against exchange rate
fluctuations

13. HEDGE
• Instead of forward contracts, the swap bank
also could hedge it’s swap position by using a
money market position.
• For example:
On it’s first sterling liability of £50000 due in
one year, the bank would need to credit a sterling
asset worth £50000 one year later and a dollar
liability worth $ 764524.

14. TYPICAL USES OF CURRENCY
SWAPS
• To convert a liability in one currency into a
liability in another currency.
• To convert an investment (asset) in one
currency to an investment in another
currency.

15. CREDIT RISK
• Note that there is greater credit risk with a
currency swap when there will be a final
exchange of principal.
• This means that there is a higher probability of
a large build-up in value, giving one of the
counter-parties (the losing party) the incentive
to default.

16. • NO credit risk exists when a swap is first
created.
• The credit risk in a swap is greater when
there is an exchange of principle amounts at
termination.
• Only the winning party ( for whom the swap
is an asset) faces credit risk. This risk is the
risk that the counter-party will default.

17. The vehicles exist to manage credit risk :
• Collateral or collateral triggers.
• Getting agreements.
• Credit derivatives.
• Making to market.

18. ADVANTAGES OF SWAPS
Swap is generally cheaper. There is no upfront
premium and it reduces transactions costs.
Swap can be used to hedge risk, and long time period
hedge is possible.
It provides flexible and maintains informational
advantages.

19. It has longer term than futures or options.
Swaps will run for years, whereas forwards
and futures are for the relatively short term.
Using swaps can give companies a better
match between their liabilities and revenues.

20. DISADVANTAGES OF SWAPS
☺Early termination of swap before maturity
may incur a breakage cost.
☺Lack of liquidity.
☺ It is subject to default risk.

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