FINANCIAL SWAPS

GROUP MEMBERS

Parvathy Soman
Reshma Ramesh
Roshni R.
Shilpa Sreenivasan
Sujitha Varghese
Vasuda Pradeep
WHAT IS A SWAP ?
Swap refers to an exchange of one financial instrument for another
between the parties concerned. This exchange takes place at a
predetermined time, as specified in the contract.

Swaps can be used to hedge risk of various kinds which includes interest
rate risk and currency risk. Currency swaps and interest rates swaps are
the two most common kinds of swaps traded in the 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.

As swaps occur on the OTC market, there is always the risk of

a counterparty defaulting on the swap
INTEREST RATE SWAP

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.

Interest rate swaps can be used for both hedging and speculating.
CURRENCY SWAPS

A currency swap is a foreign-exchange agreement between two

institute to exchange aspects (namely the principal and/interest
payments) 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.
 A currency swap is a contract to exchange two streams of future cash
flows in different currencies. Usually an exchange of principal amounts
at the beginning and a re-exchange at termination are also a feature of a
currency swaps.
Currency swaps were designed in the 1980s to circumvent capital
controls imposed by governments and to make borrowing more efficient
in global markets.
 As a example, suppose the Company A plans to issue five-year bonds worth
100 million at 7.5% interest, but actually needs an equivalent amount in
dollars, $150 million to finance its new refining facility in the U.S.

Also, suppose that the Company B, a U. S. company, plans to issue $150

million in bonds at 10%, with a maturity of five years, but it really needs
100 million to set up its distribution center in London.

To meet each other's needs, suppose that both companies go to a swap bank
that sets up the following agreements:
Agreement 1:
1. The Company A will issue 5-year 100 million bonds paying 7.5% interest.
It will then deliver the 100 million to the swap bank who will pass it on to
the U.S. Company B to finance the construction of its British distribution
center.

2. The Company B will issue 5-year $150 million bonds. The Company B
will then pass the $150 million to swap bank that will pass it on to the
Company A who will use the funds to finance the construction of its U.S.
project.
Agreement 2:
1. The A company, with its U.S. asset will pay the 10% interest on $150
million to the swap bank who will pass it on to the American company so
it can pay its U.S. bondholders.

2. The American company, with its British asset will pay the 7.5% interest
on 100 million to the swap bank who will pass it on to the British
company so it can pay its British bondholders.
Agreement 3:
1. At maturity, the British company will pay $150 million to the swap bank
who will pass it on to the American company so it can pay its U.S.
bondholders.

2. At maturity, the American company will pay 100 million to the swap
bank who will pass it on to the British company so it can pay its British
bondholders.
 In a cross currency basis swap, the European company would
borrow US$1 billion and lend 500 million to the American
company assuming a spot exchange rate of US$2 per EUR for
an operation indexed to the London Interbank Rate (Libor),
when the contract is initiated. Throughout the length of the
contract, the European company would periodically receive
an interest payment in euros from its counterparty at Libor
plus a basis swap price, and it would pay the American
company in dollars at the Libor rate. When the contract comes
to maturity, the European company would pay US$1 billion in
principal back to the American company and would receive
its initial 500 million in exchange .
USES OF CURRENCY SWAPS

Currency swaps have two main uses:

To secure cheaper debt (by borrowing at the best available rate regardless
of currency and then swapping for debt in desired currency using a back-
to-back-loan).

To hedge against (reduce exposure to) exchange rate fluctuations

 MANAGEMENT OF INTEREST RATE RISK

It is the risk to income or capital arising from fluctuating interest rates.

All firms domestic or multinational, small or large, leveraged, or
unleveraged -are sensitive to interest rate movements in one way or
another.
Interest rate management must focus on managing existing or anticipated
cash flow exposures of the firm. It is also same in the case of foreign
exchange.
Interest rate movements have historically shown more stability and less
volatility than foreign exchange rate movements.
 Prior to describing the management of the most common interest rate
pricing risks, it is important to distinguish between credit risk and
repricing risk.
Credit risk , sometimes termed as roll-over risk , is the possibility that a
borrower's credit worthiness, at the time of renewing a credit, is
reclassified by the lender(resulting in changes to fees, interest rates,
credit line commitments or even denial of credit).
Repricing risk is the risk of changes in interest rates charged (earned) at
the time of financial contracts rate is reset.
Some alternatives available to management as a means to manage
interest rate risk are as follows

Refinancing

Forward rate agreements

Interest rate futures

Interest rate swaps

FORWARD RATE AGREEMENT

It is an interbank traded contract to buy or sell interest rate payments on a notional principal
These contracts are settled in cash
The buyer of FRA obtains the right to lock in an interest rate for a desired term that begins at
a future date
The contract specifies that the seller of the FRA will pay the buyer the increased interest
expense on a nominal sum (the notional principal) of money if interest rates rise above the
agreed rate, but the buyer will pay the seller the differential interest expense if interest rates
fall below the agreed rate
INTEREST RATE FUTURES

Interest rate futures are relatively widely used by financial managers and treasures of
non financial companies.
Their popularity stems from the relatively high liquidity of the interest rate futures
markets, their simplicity in use, and the rather standardized interest rate exposures most
firms possess.
Interest rate futures strategies for common exposures :

Paying interest on a future date(sell a futures contract/short position)If

rates go up, the futures price falls and the short earns a profit If rates go
down, the futures price rises and the short earns a loss

Earning interest on a future date(buy a futures contract/long position)If

rates go up, the futures price falls and the short earns a loss If rates go
down, the futures price rises and the long earns a profit.
Thanks