Interest Rate Swaps Introduction: Interest rate swaps are used to hedge interest rate risks as well as to take

on interest rate risks. If a treasurer is of the view that interest rates will be falling in the future, he may convert his fixed interest liability into floating interest liability; and also his floating rate assets into fixed rate assets. If he expects the interest rates to go up in the future, he may do vice versa. Since there are no movements of principal, these are off balance sheet instruments and the capital requirements on these instruments are minimal. A swap transaction, is a custom-tailored bilateral agreement, in which, two counterparties agree to exchange specified cash flows at periodic intervals over a pre-determined life of the swap. It is a powerful tool, which allows the user to align risk characteristics of assets and liabilities (hedging) An interest rate swaps can be defined as a contractual agreement entered into between two banks under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. The principal amount is notional because there is no need to exchange actual amounts of principal. A notional amount is required in order to compute the actual cash amounts that will be periodically exchanged. Swaps can thus transform cash flows through a bank to more closely match the pattern of cash flows desired by management. Payments are based upon a notional principal amount. While any payment frequency is possible, the most common frequencies are overnight and semi-annual. The floating rate side of the swaps is pegged to a floating rate index such as the O/N MIBOR (OIS Swap) and is normally reset at the beginning of each payment interval. The notional principal, swaps tenor, reference floating rate index, fixed rate and payment frequency are all specified at contract inception. Fixed-for-Floating Interest Rate Swaps A series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. Swap participants can convert from fixed to floating or vice-versa and more closely match the maturities of their Assets and Liabilities. Definition: A contract which involves two counter parties to exchange over an agreed period, two streams of interest payments, each based on a different kind of interest rate, for a particular notional amount. Mechanism of an Interest Rate Swap: Firm OBJ X FIXED Y FLOATING Fixed rate 10.75 10.00 Floating Libor+0.5 Libor+0.25

X lends to y at Libor And Y to X at 10 Typical Characteristics of the Interest Rate Swaps: The principal amount is only notional. Opposing payments through the swaps are normally netted. The frequency of payment reflects the tenor of the floating rate index. What is a Coupon Swap? If an interest rate swap involves the swapping of a stream of payments based on the fixed interest rate for a stream of floating interest rate, then it is called a coupon swap. Counter parties to the Coupon Swap: Payer of the fixed interest stream is called the Payer in the swap. Receiver of the fixed interest stream is called the Receiver in the Swap. What is a generic swap? The term generic is used to describe the simplest of any type of financial instrument plain vanilla. So, a plain vanilla swap can be called a generic swap. Typically, generic swaps contain the simple characteristics, such as a constant notional principal amount, exchange of fixed against floating interest (coupon swap), an immediate start (i.e., on the spot date). A simple coupon swap can be called a generic swap. What is a Basis Swap? Two streams of payments can be calculated using different floating rate indices. These are called basis swaps or floating-against-floating swaps. a. It is possible to enter into a swap with a 3-month Libor against a 6-month Libor. b. It is also possible to enter into a swap with a 91-Day T-Bill Yield against a 6-Month Libor. Basis index swaps come under the classification of non-generic swaps. Counterparties to a basis swap: In a basis swap, each counter party is described in terms of both the interest stream it pays and the interest stream it receives. Asset Swap: If in an interest rate swap, one of the streams of payments being exchanged is funded with interest received on an asset, the whole mechanism is called the asset swap. In other words, it is an interest rate swap, which is attached to an asset. It does not however involve any change in the swap mechanism itself. Asset swaps are used by investors. If an investor anticipates a change in interest rates, he can maximize his interest inflow by swapping the fixed interest paid on the asset for floating interest, in order to profit from an expected rise in interest rates.

Term Swaps A swap with an original tenor of more than two years is referred to as a term swap. What does an Interest Rate Swap do? Interest rate swaps can be used to take on fresh interest rate risk as well as to manage existing interest rate risk. Interest Rate swaps without offsetting underlying create interest rate risk. : Each counter party in an interest rate swap is committed to pay a stream of interest payments and receive a different stream of interest payments. A payer of fixed interest rate payments is exposed to the risk of falling interest rates, while a payer of floating interest rate payments is exposed to the risk of rising interest rates. Similarly, a receiver of fixed interest rate payments is exposed to the risk of rising interest rates while the receiver of floating interest payments is exposed to the risk of falling interest rates. To summarize, interest rate swaps create an exposure to interest rate movements, if not offset by an underlying exposure. Interest rate swaps can be used to hedge interest rate risk: Floating rate loans expose the debtor to the risk of increasing interest rates. To avoid this risk, he may like to go for a fixed rate loan, but due to the market conditions and his credit rating, his fixed rate loans are available only at a very high cost. In that case, he can go for a floating rate liability and then swap the floating rate liability into a fixed rate liability. He can do the swap with another counter party whose requirements are the exact opposite of his or , as is more often the case, can do the swap with a bank. Interest Rate Swaps in India: With a view to deepening the money market and also to enable banks; primary dealers and all-India financial institutions to hedge interest rate risks, the Reserve Bank of India has allowed scheduled commercial banks, primary dealers and all-India financial institutions to make markets in Interest Rate swaps from July 1999. However, the market which has taken off seriously so far, is the one based on Overnight Index Swaps(OIS). Benchmarks of tenor beyond overnight have not become popular due to the absence of a vibrant inter bank term money market. The NSE publishes MIBOR(Mumbai Interbank Offered Rate) rates for three other tenors viz., 14-day, 1month and 3 month. The other longer tenor benchmark that is available is the yield based on forex forward premiums. This is called MIFOR(Mumbai Interbank Forward Offered Rate). Reuters published 1m,3m,6m 1yr MIFORs are the market standard for this benchmark. BENCHMARK MIBOR (Mumbai Interbank Offer Rate) It is the benchmark rate for the call money market, interest rate swaps, forward rate agreements, floating rate debentures and term deposits. MIBOR rate is available for overnight, 14-day, 1-month and 3- months. INBMK

This benchmark is gaining popularity in recent times. INBMK is an acronym for Indian Benchmark rate published by Reuters. This effectively presents a yield for government securities for a respective tenor INBMK In a INBMK Swap, the floating rate is decided as the 1 YR GOI yield on the reset date. INBMK refers to the page on which the GOI yields are quoted daily by Reuters, hence they have been named INBMK swaps. Also, by convention, the floating GOI tenor is taken as 1 year GOI yield as it appears on Reuters page 0#INBMK= prevailing 1 day prior. INBMK (GOI) Swap The floating rate is reset annually before settlement date, I.e. the 2 counterparties know their cash flows that they would exchange after 12 months On every settlement date, the floating rate is set for the next settlement date at the Reuters 1year interpolated 0#INBMK= bid yield prevailing 1 day prior Definition and Mechanism of Overnight Index Swap: The Overnight Index Swap (OIS) is an INR interest rate swap where the floating rate is linked to an overnight inter bank call money index. The swaps will be flexible in tenor i.e. there is no restriction on the tenor of the swaps. The interest would be computed on a notional principal amount and settled on a net basis at maturity. On the floating rate side, the interest amounts are compounded on a daily basis based on the index. At the moment, the NSE O/N Mibor is the most widely used floating rate index, the Reuters O/N Mibor being the other used http://www.authorstream.com/Presentation/Alfanso-63559-SWAPS-INTEREST-RATEPLAIN-VANILLA-continued-MOTIVATIONS-SWAP-as-Education-ppt-powerpoint/