Risk Management

SWAP A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price. The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices. The Swaps Market Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap. (For background reading. The first interest rate swap occurred between IBM and the World Bank in 1981. However, despite their relative youth, swaps have exploded in popularity. In 1987, the International Swaps and Derivatives Association reported that the swaps market had a total notional value of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International Settlements. That's more than 15 times the size of the U.S. public equities market. Types of swaps The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also many other types of swaps.

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Interest rate swaps A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an interest rate swap, the net result is that each party can 'swap' their existing obligation for their desired obligation. Normally the parties do not swap payments directly, but rather, each sets up a separate swap with a financial intermediary such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. Currency swaps A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps are also motivated by comparative advantage. Currency swaps entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction. Commodity swaps A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil. Equity Swap An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do. Credit default swaps A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure.

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Other variations There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures.
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A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then party A receives this amount from party B. The parties have exposure to the return of the underlying stock or index, without having to hold the underlying assets. The profit or loss of party B is the same for him as actually owning the underlying asset. An option on a swap is called a swaption. These provide one party with the right but not the obligation at a future time to enter into a swap. A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks associated with the magnitude of movement, a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap. An Amortising swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such as the LIBOR. It is suitable to those customers of banks who want to manage the interest rate risk involved in predicted funding requirement, or investment programs. A Zero coupon swap is of use to those entities which have their liabilities denominated in floating rates but at the same time would like to conserve cash for operational purposes. A Deferred rate swap is particularly attractive to those users of funds that need funds immediately but do not consider the current rates of interest very attractive and feel that the rates may fall in future. An Accreting swap is used by banks which have agreed to lend increasing sums over time to its customers so that they may fund projects. A Forward swap is an agreement created through the synthesis of two swaps differing in duration for the purpose of fulfilling the specific time-frame needs of an investor. Also referred to as a forward start swap, delayed start swap, and a deferred start swap.

INTEREST RATE SWAP In a plain vanilla interest rate swap, two counterparties agree to exchange interest cash flows on a periodic basis for a predetermined length of time. Usually, one party will pay a certain fixed interest rate to the other while receiving an amount that is based on a benchmark floating interest rate. This constitutes a "fixed-for-floating" swap where the cashflows are based on the same notional principal sum and are denominated in the same currency.

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Example Interest Rate Swap Consider a two year swap that is initiated on February 1, 2000. The terms of the deal require that company A pay company B a fixed amount of 7.5% on a notional principal of $10M, while company B pays company A on the basis of 3-month LIBOR for the same principal amount. This means that company A will pay fixed and receive floating, while company B will pay floating and receive fixed. All payments are made on a quarterly basis, meaning that there will be 8 payments in total. If we assume (unrealistically) that the length of each 3 month period is exactly 0.25 years, then the schedule of payments for the swap might follow that shown in the table below. Reset Date 1 Feb 2000 1 May 2000 1 Aug 2000 1 Nov 2000 1 Feb 2001 1 May 2001 1 Aug 2001 1 Nov 2001 Payment Date 1 May 2000 1 Aug 2000 1 Nov 2000 1 Feb 2001 1 May 2001 1 Aug 2001 1 Nov 2001 1 Feb 2002 LIBOR 7.35 7.42 7.45 7.67 8.05 7.75 7.80 8.00 Floating Payment $183,750 $185,500 $186,250 $191,750 $201,250 $193,750 $195,000 $200,000 Fixed Payment $187,500 $187,500 $187,500 $187,500 $187,500 $187,500 $187,500 $187,500 Net CashFlow -$3,750 -$2,000 -$1,250 $4,250 $13,750 $6,250 $7,500 $12,500

The amount of the fixed payment is of course constant for all 8 payments, and is computed as 0.2510,000,0000.075. However, the values of all but the first of the floating payments are unknown at the inception of the swap because they are dependent on the realizations of the LIBOR rate on each of the subsequent reset dates. The payments actually shown in the table are based on one possible path for the LIBOR rate over the next two years, and each payment is computed as 0.2510,000,000(LIBOR/100). Note that it is possible to forecast the level of the floating payments when the swap agreement is entered into by using the existing zero curve. In most cases an interest rate swap is structured so that both the fixed and floating payments are not actually paid. Rather, the difference between the two amounts is paid by the counterparty who faces the net shortfall at each payment date. The net cashflow figures shown in the table
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above are expressed from company A's point of view and indicate that company A must pay company B on each of the first 3 payment dates. Because the floating payment received by company A exceeds the fixed payment on all of the other payment dates, company A will receive a net cash inflow on the remaining 5 payment dates. CURRENCY SWAP Currency Swap is an agreement between two parties of two countries for exchanging of principle and interest of loan at its present value. This swap is very useful for controlling foreign exchange risk. Interest rate swap is different from currency swap, because in interest rate swap, we just exchange the interest from fixed to floating rates but in currency swap, we both principle and interest of loan is exchanged from one party to another party for mutual benefits. Example of Currency Swap Company A is doing business in USA and it has issued bond of $ 20 Million to bondholders that has been nominated in US $. Other company B is doing business in Europe. It has issued bond of $ 10 Million Euros. Now, both company's directors sit in one room and agreed for exchanging the principle and interest of both bonds. Company A will get $ 10 million Euros Bonds with its interest payment and Company B will get $ 20 million bond for exchanging his principle and interest. This is the simple example of currency swap.

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Another Example of Currency Swap Suppose one USA company wants to start his factory in India. For this it gets $10 billion dollar in the form of loan from USA market and Exchanges this amount from India company B. Now company A has Indian currency for doing business in India and company B which is Indian company has USA currency and it can get Forex earning. It means that both are benefited with single deal of currency swap.

Who would use a swap? The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of interest on deposits (i.e., liabilities) and earns a fixed rate of interest on loans (i.e., assets). This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets, which would match up well with its floating-rate liabilities. Some companies have a comparative advantage in acquiring certain types of financing. However, this comparative advantage may not be for the type of financing desired. In this case, the company may acquire the financing for which it has a comparative advantage, then use a swap to convert it to the desired type of financing. For example, consider a well-known U.S. firm that wants to expand its operations into Europe, where it is less well known. It will likely receive more favorable financing terms in the US. By then using a currency swap, the firm ends with the euros it needs to fund its expansion. Exiting a Swap Agreement Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This is similar to an investor selling an exchange-traded futures or option contract before expiration. There are four basic ways to do this. 1. Buy Out the Counterparty Just like an option or futures contract, a swap has a calculable market value, so one party may terminate the contract by paying the other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance, or the party who wants out must secure the counterparty's consent.
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2. Enter an Offsetting Swap For example, Company A from the interest rate swap example above could enter into a second swap, this time receiving a fixed rate and paying a floating rate. 3. Sell the Swap to Someone Else Because swaps have calculable value, one party may sell the contract to a third party. As with Strategy 1, this requires the permission of the counterparty. 4. Use a Swaption A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks associated with Strategy 2.. COMPONENTS OF SWAP PRICE There are four major components of a swap price.
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Benchmark price Liquidity (availability of counter parties to offset the swap). Transaction cost Credit risk

Benchmark price: Swap rates are based on a series of benchmark instruments. They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP rates and PLR rates. Liquidity: Liquidity, which is function of supply and demand, plays an important role in swaps pricing. This is also affected by the swap duration. It may be difficult to have counterparties for long duration swaps, especially so in India. Transaction Costs: Transaction costs include the cost of hedging a swap. Say in case of a bank, which has a floating obligation of 91 day T. Bill. Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The transaction cost would thus involve such a difference. Yield on 91 day T. Bill - 9.5% Cost of fund (e.g.- Repo rate) 10% The transaction cost in this case would involve 0.5%
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Credit Risk: Credit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an AAA rating. Valuation The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap is worth zero when it is first initiated, however after this time its value may become positive or negative. There are two ways to value swaps: in terms of bond prices, or as a portfolio of forward contracts. Using bond prices While principal payments are not exchanged in an interest rate swap, assuming that these are received and paid at the end of the swap does not change its value. Thus, from the point of view of the floating-rate payer, a swap is equivalent to a long position in a fixed-rate bond (i.e. receiving fixed interest payments), and a short position in a floating rate note (i.e. making floating interest payments): From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite positions. That is, Similarly, currency swaps can be regarded as having positions in bonds whose cash flows correspond to those in the swap. Thus, the home currency value is: Vswap = Bdomestic S0Bforeign, where Bdomestic is the domestic cash flows of the swap, Bforeign is the foreign cash flows of the LIBOR is the rate of interest offered by banks on deposit from other banks in the eurocurrency market. One-month LIBOR is the rate offered for 1-month deposits, 3month LIBOR for three months deposits, etc. LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just like the prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the international market. Arbitrage arguments As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the NPV of these future cash flows is equal to zero. Where this is not the case, arbitrage would be possible. For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement the fixed rate would be such that the present value of future fixed rate payments by Party A are equal to the present value of the expected future floating rate payments (i.e. the NPV is zero). Where this is not the case, an Arbitrageur, C, could:

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y y y y assume the position with the lower present value of payments, and borrow funds equal to this present value meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding payments - which have a higher present value use the received payments to repay the debt on the borrowed funds pocket the difference - where the difference between the present value of the loan and the present value of the inflows is the arbitrage profit. This section requires additional example

Subsequently, once traded, the price of the Swap must equate to the price of the various corresponding instruments as mentioned above. Where this is not true, an arbitrageur could similarly short sell the overpriced instrument, and use the proceeds to purchase the correctly priced instrument, pocket the difference, and then use payments generated to service the instrument which he is short. Conclusion Swaps can be a very confusing topic at first, but this financial tool, if used properly, can provide many firms with a method of receiving a type of financing that would otherwise be unavailable. This introduction to the concept of plain vanilla swaps and currency swaps should be regarded as the groundwork needed for further study.

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