Table of Contents

S.No. Page#

1. Introduction 1

2. Swaps 1

3. Swap Market 2

4. Types 3

i. Interest rate swap 4

ii. Currency swap 6

iii. Commodity swap 7
iv. Equity swap 7
v. Credit default swap 8
vi. Other variations 8

5. Valuation 9

6. Currency swap V/S Interest rate swap 11

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Introduction

The implacable wave of credit crisis casualties has financial institutions scrambling to
protect their bottom line. In these uncertain times, once solid investment vehicles are now
looked upon as carrying great risk. A derivative is a financial instrument that allocates the
risks and price exposures associated with a designated asset between the parties to an
instrument. Derivatives can provide price exposure or price insulation to changes in the
price or level of an open-ended range of assets, including stocks, interest rates,
currencies, bonds, commodities, insured risks, credit risks, investment funds, property,
the weather and more. Derivatives are used in an infinite variety of ways by commercial,
eleemosynary and governmental entities to manage the commercial and financial risks
they confront. As the breadth and complexity of derivatives evolve, so too does the
complexity of associated documentation and legal issues.

Swaps

The first swaps were negotiated in the early 1980s. David Swensen, a Yale Ph.D. at
Salomon Brothers, engineered the first swap transaction according to "When Genius
Failed: The Rise and Fall of Long-Term Capital Management" by Roger Lowenstein.
Today, swaps are among the most heavily traded financial contracts in the world.

In finance, a swap is a derivative in which two counterparties exchange certain benefits

of one party's financial instrument for those of the other party's financial instrument. The
benefits in question depend on the type of financial instruments involved. Specifically,
the 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 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 an interest rate, foreign exchange rate, equity
price or commodity price.
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The cash flows are calculated over a notional principal amount, which is usually not
exchanged between counterparties. Consequently, swaps can be used to create unfunded
exposures to an underlying asset, since counterparties can earn the profit or loss from
movements in price without having to post the notional amount in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on
changes in the expected direction of underlying prices. Traditionally, the exchange of one
security for another to change the maturity (bonds), quality of issues (stocks or bonds), or
because investment objectives have changed. If firms in separate countries have
comparative advantages on interest rates, then a swap could benefit both firms. For
example, one firm may have a lower fixed interest rate, while another has access to a
lower floating interest rate. These firms could swap to take advantage of the lower rates

Swap Market

Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties.
Some types of swaps are also exchanged on futures markets such as the Chicago
Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board
Options Exchange, Intercontinental Exchange and Frankfurt-based Eurex AG.

The Bank for International Settlements (BIS) publishes statistics on the notional amounts
outstanding in the OTC derivatives market. At the end of 2006, this was USD 415.2
trillion, more than 8.5 times the 2006 gross world product. However, since the cash flow
generated by a swap is equal to an interest rate times that notional amount, the cash flow
generated from swaps is a substantial fraction of but much less than the gross world
product -- which is also a cash-flow measure. The majority of this (USD 292.0 trillion)
was due to interest rate swaps. These split by currency as:
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The CDS and currency swap markets are dwarfed by the interest rate swap market. All
three markets peaked in mid 2008.

Types of Swaps

The five generic types of swaps, in order of their quantitative importance, are:

i. Interest Rate Swaps

ii. Currency Swaps
iii. Credit Swaps
iv. Commodity Swaps And
v. Equity Swaps..
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Interest rate Swaps

An agreement between two parties (known as counterparties) where one stream of future
interest payments is exchanged for another based on a specified principal amount.
Interest rate swaps often exchange a fixed payment for a floating payment that is linked
to an interest rate (most often the LIBOR). Interest rate swaps are simply the exchange of
one set of cash flows (based on interest rate specifications) for another. Because they
trade OTC, they are really just contracts set up between two or more parties, and thus can
be customized in any number of ways. A company will typically use interest rate swaps
to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally
lower interest rate than it would have been able to get without the swap. Swaps are
sought by firms that desire a type of interest rate structure that another firm can provide
less expensively.

Example:

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but
wants to pay floating. By entering into a interest rate swap, the net result is that each
party can 'swap' their existing obligation for their desired obligation. Normally the parties
do not swap payments directly, but rather, each sets up a separate swap with a financial
intermediary such as a bank. In return for matching the two parties together, the bank
takes a spread from the swap payments.
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Plain Vanilla; a type:

The most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange
of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to
over 15 years. The reason for this exchange is to take benefit from comparative
advantage. Some companies may have comparative advantage in fixed rate markets while
other companies have a comparative advantage in floating rate markets. When companies
want to borrow they look for cheap borrowing i.e. from the market where they have
comparative advantage. However this may lead to a company borrowing fixed when it
wants floating or borrowing floating when it wants fixed. This is where a swap comes in.
A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice
versa.

Example:

For example, party B makes periodic interest payments to party A based on a variable
interest rate of LIBOR +70 basis points. Party A in turn makes periodic interest payments
based on a fixed rate of 8.65%. The payments are calculated over the notional amount.
The first rate is called variable, because it is reset at the beginning of each interest
calculation period to the then current reference rate, such as LIBOR. In reality, the actual
rate received by A and B is slightly lower due to a bank taking a spread.

Notional Amount:

The notional amount (or notional principal amount or notional value) on a financial
instrument is the nominal or face amount that is used to calculate payments made on that
instrument. This amount generally does not change hands and is thus referred to as
notional.
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Currency Swaps

It is a swap that involves the exchange of principal and interest in one currency for the
same in another currency. It is considered to be a foreign exchange transaction and is not
required by law to be shown on the balance sheet. Just like interest rate swaps, the
currency swaps also are motivated by comparative advantage.
Example
Suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based
company needs to acquire U.S. dollars. These two companies could arrange to swap
currencies by establishing an interest rate, an agreed upon amount and a common
maturity date for the exchange. Currency swap maturities are negotiable for at least 10
years, making them a very flexible method of foreign exchange.

Working

A currency swap agreement specifies the principal amount to be swapped, a common

maturity period and the interest and exchange rates determined at the commencement of
the contract. The two parties would continue to exchange the interest payment at the
predetermined rate until the maturity period is reached. On the date of maturity, the two
parties swap the principal amount specified in the contract.

The equivalent amount of the loan value in another currency is calculated by using the
net present value (NPV). This implies that the exchange of the principal amount is carried
out at market rates during the inception and maturity periods of the agreement.

Benefits of Currency Swap

The benefits of currency swaps are:

 Help portfolio managers regulate their exposure to interest rates.

 Speculators can benefit from a favorable change in interest rates.
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 Reduce uncertainty associated with future cash flows as it enables companies to

modify their debt conditions.
 Reduce costs and risks associated with currency exchange.
 Companies having fixed rate liabilities can capitalize on floating-rate swaps and
vise versa, based on the prevailing economic scenario.
 Currency swaps can be used to exploit inefficiencies in international debt markets.

Limitations of Currency Swap

The drawbacks of currency swaps are:

 Exposed to credit risk as either one or both the parties could default on interest
and principal payments.
 Vulnerable to the central government’s intervention in the exchange markets.
This happens when the government of a country acquires huge foreign debts to
temporarily support a declining currency. This leads to a huge downturn in the
value of the domestic currency.

Commodity Swap

A commodity swap is an agreement whereby a floating (or market or spot) price is

exchanged for a fixed price over a specified period. It is a swap where exchanged cash
flows are dependent on the price of an underlying commodity. This is usually used to
hedge against the price of a commodity. In this swap, the user of a commodity would
secure a maximum price and agree to pay a financial institution this fixed price. Then in
return, the user would get payments based on the market price for the commodity
involved. The vast majority of commodity swaps involve oil.

Equity Swap

It is basically a strategy in which an investor sells a bond and at the same time purchases
a different bond with the proceeds from the sale. There are several reasons why people
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use a bond swap: to seek tax benefits, to change investment objectives, to upgrade a
portfolio's credit quality or to speculate on the performance of a particular bond.

An equity swap is a special type of total return swap, where the underlying asset is a
stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this
case you do not have to pay anything up front, but you do not have any voting or other
rights that stock holders do have.

Credit default Swap

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a
series of payments to the seller and, in exchange, receives a payoff if a credit instrument -
typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event
that triggers the payoff can be a company undergoing restructuring, bankruptcy or even
just having its credit rating downgraded. CDS contracts have been compared with
insurance, because the buyer pays a premium and, in return, receives a sum of money if
one of the events specified in the contract occur It is a swap designed to transfer the
credit exposure of fixed income products between parties. The buyer of a credit swap
receives credit protection, whereas the seller of the swap guarantees the credit worthiness
of the product. By doing this, the risk of default is transferred from the holder of the fixed
income security to the seller of the swap.
For example, the buyer of a credit swap will be entitled to the par value of the bond by
the seller of the swap, should the bond default in its coupon payments.

Other variations

There are myriad different variations on the vanilla swap structure, which are limited
only by the imagination of financial engineers and the desire of corporate treasurers and
fund managers for exotic structures.[1]

• A total return swap is a swap in which party A pays the total return of an asset,
and party B makes periodic interest payments. The total return is the capital gain
or loss, plus any interest or dividend payments. Note that if the total return is
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negative, then party A receives this amount from party B. The parties have
exposure to the return of the underlying stock or index, without having to hold the
underlying assets. The profit or loss of party B is the same for him as actually
owning the underlying asset.
• An option on a swap is called a swaption. These provide one party with the right
but not the obligation at a future time to enter into a swap.
• A variance swap is an over-the-counter instrument that allows one to speculate
on or hedge risks associated with the magnitude of movement, i.e. volatility, of
some underlying product, like an exchange rate, interest rate, or stock index.
• A constant maturity swap, also known as a CMS, is a swap that allows the
purchaser to fix the duration of received flows on a swap.
• An Amortising swap is usually an interest rate swap in which the notional
principal for the interest payments declines during the life of the swap, perhaps at
a rate tied to the prepayment of a mortgage or to an interest rate benchmark such
LIBOR.

Valuation

The value of a swap is the net present value (NPV) of all estimated future cash flows. A
swap is worth zero when it is first initiated, however after this time its value may become
positive or negative. There are two ways to value swaps: in terms of bond prices, or as a
portfolio of forward contracts.

Using bond prices

While principal payments are not exchanged in an interest rate swap, assuming that these
are received and paid at the end of the swap does not change its value. Thus, from the
point of view of the floating-rate payer, a swap can be regarded as a long position in a
fixed-rate bond (i.e. receiving fixed interest payments), and a short position in a floating
rate note (i.e. making floating interest payments):

Vswap = Bfixed − Bfloating

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From the point of view of the fixed-rate payer, the swap can be viewed as having the
opposite positions. That is,

Vswap = Bfloating − Bfixed

Similarly, currency swaps can be regarded as having positions in bonds whose cash flows
correspond to those in the swap. Thus, the home currency value is:

Vswap = Bdomestic − S0Bforeign, where Bdomestic is the domestic cash flows of the swap,
Bforeign is the foreign cash flows of the swap, and S0 is the spot exchange rate.

Using forward rate agreements

Consider a three year interest rate swap with semiannual payments. The first cash flow is
known at the time the swap is initiated, however the other five exchanges can be regarded
as forward rate agreements. The payment for these other exchanges is the 6 month rate
observed in the market 6 months earlier. Assuming that forward interest rates are
realised, this method values the swap by firstly calculating the required forward rates
using the LIBOR/swap curve, then calculating the swap cash flows using these rates, and
then finally discounting these cash flows back to today.

London Interbank Offered Rate (LIBOR)

LIBOR is the rate of interest offered by banks on deposit from other banks in the
eurocurrency market. One-month LIBOR is the rate offered for 1-month deposits, 3-
month LIBOR for three months deposits, etc. LIBOR rates are determined by trading
between banks and change continuously as economic conditions change. Just like the
prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest
in the International Market.

Arbitrage arguments

To be arbitrage free, the terms of a swap contract are such that, initially, the NPV of these
future cash flows is equal to zero. Where this is not the case, arbitrage would be possible.
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For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A
pays a fixed rate and Party B pays a floating rate. In such an agreement the fixed rate
would be such that the present value of future fixed rate payments by Party A are equal to
the present value of the expected future floating rate payments (i.e. the NPV is zero).
Where this is not the case, an Arbitrageur, C, could:

1. assume the position with the lower present value of payments, and borrow funds
equal to this present value
2. meet the cash flow obligations on the position by using the borrowed funds, and
receive the corresponding payments - which have a higher present value
3. use the received payments to repay the debt on the borrowed funds
4. pocket the difference - where the difference between the present value of the loan
and the present value of the inflows is the arbitrage profit.

Subsequently, once traded, the price of the Swap must equate to the price of the various
corresponding instruments as mentioned above. Where this is not true, an arbitrageur
could similarly short sell the overpriced instrument, and use the proceeds to purchase the
correctly priced instrument, pocket the difference, and then use payments generated to
service the instrument which he is short.

Currency Swap versus Interest Rate Swap

Currency swaps are often combined with interest rate swaps. For example, one company
would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a
floating-rate debt denominated in Euro. This is especially common in Europe where
companies shop for the cheapest debt regardless of its denomination and then seek to
exchange it for the debt in desired currency.

For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-
based company needs to acquire U.S. dollars. These two companies could arrange to
swap currencies by establishing an interest rate, an agreed upon amount and a common
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maturity date for the exchange. Currency swap maturities are negotiable for at least ten
years, making them a very flexible method of foreign exchange. Currency swaps were
originally done to get around exchange controls.

During the global financial crisis of 2008 the United States Federal Reserve System
offered swaps to the Reserve Bank of Australia, the Bank of Canada, Danmarks
Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the
Reserve Bank of New Zealand, the Norges Bank, the Sveriges Riksbank, and the Swiss
National Bank and also stable emerging economies such as South Korea, Singapore,
Brazil, and Mexico.

A currency swap is exactly the same thing except, with an interest rate swap, the cash
flow streams are in the same currency. With a currency swap, they are in different
currencies.

That difference has a practical consequence. With an interest rate swap, cash flows
occurring on concurrent dates are netted. With a currency swap, the cash flows are in
different currencies, so they can't net. Full principal and interest payments are exchanged
without any form of netting.

Suppose the spot JPY/USD exchange rate is 109 JPY per USD. Two firms might enter
into a currency swap to exchange the cash flows associated with

a five-year USD 100MM loan at 6-month USD Libor, and

a five year JPY 10,900MM loan at a fixed 3.15% semiannual rate.

All cash flows associated with those loans are paid:

initial receipt/payment of loaned principal,

payment/receipt of interest (in the same currency) on that loan,
ultimate return/recovery of the principal at the end of the loan.

Notional Amounts:
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For credit default swaps, notional amount refers to the par amount of credit protection
bought or sold, equivalent to debt or bond amounts, and is used to derive the premium
payment calculations for each payment period and the recovery amounts in the event of a
default.

The reason for using notional amount is that it is relatively simple to identify and gather,
as well as similar to measures of underlying cash markets. In addition, it is consistent
over time; that is, the notional for a deal does not change except in limited cases that are
not likely to have a significant effect on the overall measure.

For most OTC derivatives, cash flow obligations are normally a small percent of notional
amounts and so are mark-to-market exposures.