Interest rate swaps

Swap
Derivative in which two
counterparties exchange cash flows
of one party's financial instrument
for those of the other party's
financial instrument.
For example, in a swap involving two
bonds, cash flows can be the periodic
interest (coupon) payments
associated with such bonds.

Swap
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
accrued and 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 a floating interest rate, foreign
exchange rate, equity price, or commodity price.

SWAP
Exchange of series of cash flows between two parties
as agreed upon according to the terms of the contract
The basis of future cash flows can be exchange rate
for currency swaps and interest rate for interest rate
swaps
One of the cash flow would be fixed, called fixed leg
the other cash flow which varies called floating leg
LIBOR London Inter Bank Offered Rate.
Issued for US Dollar, GB Pound, Euro, Swiss Franc,
Canadian Dollar and the Japanese Yen.
Current LIBOR - 15.45% (1 month, US$)
MIBOR - Mumbai Inter Bank Offered Rate and is closely
modeled on the LIBOR.
Current MIBOR 8.91% (1 month)

SWAP - Example
A company enter into a SWAP contract to pay a fixed rate
of 1.26% for 7 years and in return they would receive
interest payments based on the 1-month LIBOR rate.
The borrowers interest payments would be fixed while
the money they received from the swap would be
variable based on the 1-month LIBOR rate.
LIBOR - the average interest rate that they would be
charged if borrowing from other banks, or estimated by
leading banks in London.
It is the primary benchmark for short-term interest rates
around the world.

SWAP - Example

SWAP - Types
Interest rate swaps
Transfer of interest rate streams without transferring underlying
debt
Currency swaps
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.
Credit Default Swaps
contract in which the buyer makes a series of payments to the seller
and, in exchange, receives a payoff if an instrument, typically a
bond or loan, goes into default (fails to pay)
Commodity swaps
agreement whereby a floating (or market or spot) price is
exchanged for a fixed price over a specified period.
Equity swaps
contract in which the buyer (or equity holder) pays a premium to the
seller (or silent holder) for the option to transfer certain risks.

INTEREST RATE SWAPS

The life of the swap can range from 2 years to over 15
years.
Most popular interest rate swap is Plain Vanilla interest
rate swap.
It is the exchange of a fixed rate loan to a floating rate
loan.
Also called fixed-for-floating rate swap
on the payment date, only the interest differential
between the counterparties change hands
Eg. If the fixed rate payer owes Rs. 1 million and a floating
rate payer owes Rs. 0.9 million, then only Rs.0.10 million
payment by the fixed rate payer to the other party is
made

Plain Vanilla interest rate swap

example
Company B makes periodic interest
payments to Company A based on a
variable interest rate of MIBOR +30
basis points. Company A in return
makes periodic interest payments
based on a fixed rate of 8.5%.
Fixed to floating swap

SWAP

Motives for SWAPs

Offsetting needs among
counterparties
Comparative advantage

Need for swap intermediary

Difficulties in finding a matching
counterparty can be reduced
Assume counter party risk
Promote market development by
matching of needs, warehousing etc.

Warehousing
Banks play the role of market makers in swap
Example: one party looks for interest rate swap
for Rs. 100 crore on semi-annual basis for 3
years, while the counter party want swap for
Rs.80 crore on quarterly basis for 2.5 years only
Bank takes the exposure of Rs.20 crore in
expectation of finding another party
Bank takes the risk of interest rate fluctuations
till a matching counter party is found
The risk is usually covered through interest rate
futures

Applications of SWAPs
Transforming the floating rate liability
to fixed rate liability and vice versa
transform floating rate asset to fixed
rate asset and vice versa
Hedge against fluctuating interest
rates
Reduce cost of funds

Transforming nature of
liabilities

Transforming nature of liabilities

floating to fixed

Payment to lenders
MIBOR +25 bps
Less receipt from bank MIBOR +30 bps
Net benefit
5bps =0.05%
Required Payment to bank 8.5%
Net payment
8.5% -0.05% = 8.45%

Transforming nature of liabilities

fixed to floating
Company A has liability with a fixed interest of
12%. They are exchanging it with the bank by
paying MIBOR, bank in turn pay 9.5% interest
to company A
Cost of funds for Company A
12%-9.5% +MIBOR = MIBOR +2.5%
in case interest rates fall below 9.5%, firm
pays lesser interest than what it is paying now
The interest rate payable would be market
based

Transforming nature of liabilities

fixed to floating

Transforming Nature of Assets

fixed rate asset to floating rate
Company A has made an investment by
subscribing to bonds carrying 9% interest. Bonds
have some years to mature, market interest
rates are moving up what can the Company do?
Receipt from investment 9%
Less payment to bank 8.5%
Net benefit 0.5%
Receipt from bank M +30bps
Net receipts M +0.5% +0.3%
MIBOR +80bps = MIBOR + 0.8%

Transforming Nature of Assets

fixed rate asset to floating rate

Hedging with SWAP strategies

Nature

Risk

Hedging action
Assets

Fixed rate

Rising interest rate

SWAP to transform
fixed to floating rate
asset

Floating rate

Falling interest rate

SWAP to transform
floating to fixed rate
asset

Liabilities
Fixed rate

Falling interest rate

SWAP to transform
fixed to floating rate
liability

Floating rate

Rising interest rate

SWAP to transform
floating to fixed rate
liability

Reducing cost of funds

Assume a highly rated firm(AAA) can raise funds
in the fixed rate market at 10% and in the
floating rate market at MIBOR +100bps
Current rate of MIBOR is 8%
Another firm comparatively lower rated at A can
mobilise capital at 12% and MIBOR +200bps, in
the two markets respectively
so firm AAA goes to fixed rate market to borrow
at 10%
Firm A goes to floating rate market to borrow at
MIBOR+200bps

Reducing cost of funds

So they can enter into a SWAP
contract
Wherein Firm AAA pays firm A,
floating rate at MIBOR+200bps
Firm A pays Firm AAA, fixed at 11.5%

Reducing cost of funds

Types of interest rate Swaps

Fixed to-floating
Floating-to-fixed
Basis Swap both legs on floating rate
basis when parties are tied to one assets or
liabilities based on one reference rate and
want to convert the same to another
reference rate
Eg. A firm having liabilities based on T-bills
rate wants to convert it to MIBOR based
rate, then it can enter into a basis swap