SWAPS Dr. Rana Singh Associate Professor .

SWAPS

Dr. Rana Singh

Associate Professor

www.ranasingh.org

Swaps – An agreement between two companies to exchange cash flows in the future.

Hedging InstrumentsHedging Instruments

• Rupee Interest Rate Swaps (IRS)• Nature: Contract for exchange of a fixed to

floating,or floating to floating rates of interest• Tenor/Size:No restriction • Participants:Banks, PDs, Corporates and All

India Financial Institutions • Benchmark:Reuters and NSE MIBOR, PLR, CP

reference rates, T-Bill rates, etc.

Purpose of an IRSPurpose of an IRS

• An IRS is an agreement between two parties to exchange stated interest obligations for a certain period in respect of a notional principal amount.

• To hedge an existing exposure: A corporate having predominantly floating rate liability linked to a bank PLR can enter into a swap where it pays fixed rates for t years and receive bank PLR from ICICI Ltd. for that duration.

• The corporate could thus hedge its business from risks arising out a possible upward movement in interest rates.

Working of an IRSWorking of an IRS

• PLR Swap : An Example A "AAA" rated corporate enters into a PLR swap with ICICI on the following terms as on 31st August 1999

• Trade Date 31st August 1999, Effective Date 1st September 1999 • Termination Date 1st September 2004 • Principal Amount Rs. 50 crores (notional) • Corporate to pay Fixed rate of 12.50% (quarterly)• Corporate to receive SBI PLR (floating) • Tenor 5 years Reset Dates As and when the SBI PLR changes. • Settlement Dates 1st December, 1st March, 1st June and 1st

September of each year

Working- Contd’Working- Contd’• 31st August 1999 12.00% • 31st October 1999 13.50% • 15th November 1999 13.75%• Therefore the corporate receives interest :

@ 12.00% for 60 days @ 13.50% for 15 days @ 13.75% for 16 days

The floating rate would be calculated as follows:

(12.00% * 60 * 50 crs)+ (13.50% * 15 * 50 crs) + (13.75% * 16 * 50 crs)/365= Rs. 1,56,50,685/-

•

WorkingWorking

• The fixed rate would be as follows: 12.50% * 91 * 50 crs = Rs. 1,55,82,192/- _________________             365 Therefore the net settlement on 1st December 1999 will be -

• Corporate to receive 1,56,50,685/-

• Corporate to pay 1,55,82,192/-

• Net corporate to receive from ICICI 68,493

UNDERSTANDING INTEREST RATE SWAPS

DEFINITION

An interest rate swap is a contract which

commits two counter-parties to exchange,

over an agreed period,

two streams of interest payments,

each calculated using a different index,

but applied to a common notional principal

Features of an IRS• Fixed rate is known in advance and is the yield on

the bond of a similar tenor• Floating rate is calculated in terms of a

benchmark, agreed upon by the parties e.g. LIBOR

• Fixed and floating rates are computed and exchanged at the end of defined periods. Simultaneous exchange facilitates netting

• Contract is off-balance sheet, as principal is notional, and only interest payments are exchanged.

IRS : Payout Diagram

Pays Fixed

Receives Floating

Company ABC Ltd Bank

XYZ

Terminology

• Generic (coupon swaps) (plain vanilla) are simple fixed to floating rate swaps.

• Payer and receiver of the fixed rate is referred to as payer and receiver in the swap

• Buyer is the one who pays the fixed rate, and seller is the one who receives the fixed rate.

• Swap rate is the rate of the fixed rate component of the swap

Reading Swap Rates

6 months 8.00 7.75

1 year 9.25 8.75

2 years 9.85 9.35

3 years 10.25 9.50

For a 1 year swap, the swap dealer is willing to receive 9.25% fixed, and pay 8.75% fixed, earning a spread of 50 bps.

Interest Rate Risk

Loss to

receiving party

Interest

Rate

Loss to

paying party

Time

Applications of IRS• Managing risks of individual instruments

– alter the interest rate risk by creating synthetic fixed or floating rate liabilities

– alter interest rate risk by creating synthetic fixed or floating rate asset

Managing Gaps in Balance Sheet– Alter B/S exposure to align with interest rate

view

• Hedging interest rate exposure– creating offsetting positions– hedge asset-liability mis match

• Return management through arbitrage

Creating a synthetic floating rate liability

• Company has borrowed fixed 3-year, at 12% , and anticipates a fall in interest rates.

• Enter into a swap deal to receive fixed 12% and pay floating at six month Mibor +100bp

• Payments :

– Fixed 12% semi-annual to lender– Floating Mibor+100bp to swap dealer

• Receipts :

– Fixed 12% semi-annual from swap dealer• Net effect: Floating Mibor+100bp semi-annual liability

Creating a synthetic fixed rate liability

• Company has borrowed for 3 years using a FRN that resets six monthly at Mibor+150bp. Anticipates interest rate increase.

• Enters into a swap deal to receive floating Mibor + 150bp and pay fixed at 12%.

• Payments :

– Mibor +150 bp six monthly to lender– pay fixed at 12% to swap dealer

• Receipts :

– Mibor + 150 bp from swap dealer• Net effect: Fixed payment of 12% semi-annual.

Creating a synthetic floating rate asset

• Bank has made a 3 year 12.5% fixed rate loan, and anticipates an increase in rates

• Enters into a swap deal to pay fixed at 12.5% and receive floating at 182-day T bill +150 bp semi-annual.

• Payment :

– Fixed 12.5% to swap counterparty• Receipts :

– Fixed 12.5% from borrower– Floating 182d tbill rate+150 bp from Swap cp.

• Net effect : Floating semi-annual receipts.

Creating a synthetic fixed rate asset

• Housing company has floating 10 year asset re-setting yearly at GOISEC yield +200bp, and expects interest rates to go up.

• Enters into a swap deal to receive fixed, and pay floating, similar to the contracted VRL.

• Payments :

– floating GOISEC+200bp to swap dealer• Receipts :

– Floating GOISEC+200bp from borrower– Fixed rate from swap dealer

• Net effect : Fixed receipts as desired.

Creating synthetic positive B/S Gap

• Bank has floating rate assets funded by floating rate liabilities. No gap and therefore no IRR position.

• If interest rates are expected to rise, it can enter into a swap for paying fixed and receiving floating

• Payments:– Pay floating on liabilities

– Pay fixed to swap dealer

• Receipts:– Receive floating from assets

– Receive floating from swap dealer

• Net effect:– receive floating and pay fixed

• Desirable gap if interest rates rise as expected.

Creating a synthetic negative gap• Company has borrowed fixed and deployed temporarily in fixed

interest paying assets. Expects interest rates to fall. Enters into a swap to receive fixed and pay floating.

• Payments :

– Fixed payment to lenders

– Floating payment to swap dealer• Receipts :

– Fixed interest from asset

– Fixed interest from swap dealer• Net effect:

– Fixed receipts from asset– Floating payment on liability

Hedging with IRS• Bank had funded 3 year fixed rate loan with 6 month CD.

Exposed to IRR arising out of rising rates• Enters into a swap for paying fixed semi-annual, and

receiving six monthly CD rate.• Payments:

– Floating rate on 6month CDs– Fixed rate to swap dealer

• Receipts :

– Floating rate on swap– Fixed rate from asset.

• Net effect: payment and receipts cancel each other out.

Arbitrage Opportunities

• As long as the underlying benchmark used to price bonds and swaps, there should be no arbitrage opportunities.

• In practice though, due to segmentation of markets, varying credit worthiness of parties, and temporary supply demand imbalances, arbitrage opportunities exist.

Arbitrage profit from synthetic A/L s

• ABC company borrows fixed at 10% and enters into a swap with a bank, receiving 10.5% and paying floating MIBOR. Net payment = Mibor - 50 bp

• XYZ bank has a floating rate asset paying Mibor+75bp. Enters into a swap receiving 8.5% fixed and paying Mibor. Net receipts 9.25%.

• Specific low liquid instruments typically offer arbitrage opportunities. E.g. Mortgage backed securities, DDBs, Structured facilities.

Credit risk arbitrage

• The most popular arbitrage opportunity with swaps arises from credit arbitrage, where parties can borrow in different markets, at different rates, and swap to mutual advantage.

• Credit risk arbitrages occur when markets are segmented.

• Swaps actually fill these gaps and enable integration of markets

CRA : An ExampleAssume that 2 companies, XYZ and PQR, can raise

funds at the following rates:

Bond market :

XYZ : 11% PQR : 13%

Bank funds :

XYZ : Mibor + 100 bp

PQR : Mibor +175bp

Arbitrage arises from the differing credit spreads in both the markets

CRA : Example - Cont’d

• XYZ borrows at 11% in the bond market; PQR borrows from the bank at Mibor+175bp

• They enter into a swap deal, where XYZ receives 11.25% from PQR, and pays Mibor+ 75 bp to PQR.

• Net cost of funds to XYZ will be Mibor+50bp• Net cost of funds to PQR will be 12.5%

Dealing and Trading in Swaps• OTC telephone market : Distributed dealers

• Spreads over benchmarks are negotiated, and agreed upon, based on counterparty credit limits

• Master documents, covering financial and legal terms : ISDA and BBAIRS (3750)

• Types of dealers– Arrangers ( no risk)– Matched book dealers ( credit and market risk)– Market makers ( credit and market risk)smm27smm

Dealing Cycle• Negotiate swap spread - usually done on

telephone.• Check counter party credit risk : exposure limits

and credit lines• Negotiate floating rate benchmark, and mark-up.• Fix the all-in swap rate• Confirm deal through exchange of verbal

confirmations• Document deal through exchange of legal

documents

Pricing and Valuation of Swaps

• Pricing involves setting the fixed rate component of the swap.

• The initial price is set at par, i.e. the NPVs of the fixed and the floating interest payment streams are equal.

• The fixed stream is valued at the spot rates, and floating stream on the basis of the forward rates.

• Value of the swap alters as the floating rate changes over the tenor of the swap

Thank you