SWAP

Unlike futures and options, which are created and traded in the stock exchanges,
swaps are largely OTC products.
Often a bank finds two parties with divergent views about the market (interest
rates, exchange rates etc.) and facilitates swap trade/s between them.
 Interest Rate Swap
 Suppose Party A is worried about its 2-year loan of Rs. 1 crore, on which it has committed to pay
interest at 1-month MIBOR + 2% (Mumbai Inter-Bank Offered Rate). If interest rates were to go up,
it will have to pay higher interest to its lender.
 On the other hand, Party B is worried that interest rates may fall, and it will earn less on its deposits.
 Party A and Party B can do an interest rate swap. Party A will agree to pay Party B interest at a fixed
rate, say 8%, in return for a receipt of 1-month MIBOR, calculated on a notional principal of Rs. 1
crore.
Interest Rate Swap
 Interest Rate Swap
 Party A will pay MIBOR + 2% to its lender, out of which, it will receive MIBOR
from Party B under the swap. Thus, it is no longer exposed to the fluctuations
in MIBOR. If MIBOR rises, it will receive more from Party B and pay the amount
to its lender.
 Party A’s cost of funds is the 2% additional it needs to pay its lender, plus the
8% it has to pay Party B i.e. 10% fixed.
 Party B, on the other hand, is assured of 8% fixed interest income, from Party
A. In return it has to pay MIBOR, which it expects will fall.
 Cash Flows of Swap Counter
Parties
Date MIBOR
30th June 2016 9%
31st December 2016 9.25%
30th June 2017 8.75%
31st December 2017 7.9%

Rs. 1 crore notional principal

Cash Flows of Swap Counter
Parties
A few points to note:
 Party A's lender will continue receiving MIBOR + 2% from Party A.
 The swap is a separate transaction between Party A and Party B. Party A's
lender may not even be aware of the swap.
 The parties avoid multiple payments by netting. Thus, either Party A
will pay Party B or Party B will Party A, depending on MIBOR.
 Currency Swap
 An American company may be able to borrow in the United States at a rate of 6%, but requires a loan in
rand for an investment in South Africa, where the relevant borrowing rate is 9%.
 At the same time, a South African company wishes to finance a project in the United States, where its
direct borrowing rate is 11%, compared to a borrowing rate of 8% in South Africa.
 Each party can benefit from the other's interest rate through a fixed-for-fixed currency swap.
 In this case, the American company can borrow U.S. dollars for 6%, and then it can lend the funds to the
South African company at 6%. The South African company can borrow South African rand at 8%, then
lend the funds to the U.S. company for the same amount.
Currency Swap
 Currency Swap
 Suppose Party D and Party R, are counter-parties to a 2-year swap.
 Party D agrees to pay Party R, 3% p.a., semi-annually, on a notional principal of USD1mn.
 In return, Party R commits to pay Party D 7% p.a., semi-annually, on a notional principal of Rs. 5 crore.
 When the swap is initiated, Party R pays USD1mn to Party D; and receives Rs. 5 crore from Party D. On
maturity, Party D pays USD1mn to Party R, and receives Rs. 5 crore from Party R.
