Swaps

Session 5 Derivatives & Risk Mgt

What are Swaps?

An agreement to exchange cash flows at specified future times according to certain specified rules

How swaps developed

Restrictions on cross-border capital flows Gave rise to parallel or back-to-back loans Difficulties in back-back loans
Finding counterparty with matching needs in terms of amount, duration, periodicity of interest etc Assuming the risk of counterparty default

Banks step in as intermediaries initially as brokers, later as market makers Concept of warehousing Benefits to all parties involved

Applications of Swaps
Transforming nature of asset or liability through off-balance sheet transactions Hedging against fluctuating interest rates Reducing the cost of funds

Transforming nature of asset/liability

Example 1Floating rate asset to fixed rate asset CR Ltd has invested Rs.50 crore in MIBOR-linked securities currently yielding 8% with MIBOR at 7.5%. Its treasurer anticipates a steady decline in interest rates. Companys banker has offered a 3-year MIBOR based swap at 7.30%-7.40%. What is the outcome of the swap arrangement? Example 2 Fixed rate liability to floating rate liability Shriram Transport Ltd raised funds of Rs.1000 crore through 10 year non-convertible debentures carrying 12% two years ago. Interest rates have since declined to 10% and are expected to decline further. The Company wishes to reduce its funding cost through swaps. Bank has offered a 5-year swap at 9.5%-9.6% against MIBOR. What is the outcome of the swap arrangement?

Hedging against interest rate risk

Nature Fixed rate asset Risk Interest rates may rise Action Convert asset from fixed rate to floating rate using swaps Convert asset from floating rate to fixed rate using swaps Convert liability from fixed rate to floating rate using swaps

Floating rate asset

Interest rates may fall

Fixed rate liability

Interest rates may fall

Floating rate liability

Interest rates may rise

Convert liability from floating rate to fixed rate using swaps

The Comparative Advantage Argument

AAACorp wants to borrow floating BBBCorp wants to borrow fixed

Fixed

Floating

AAACorp
BBBCorp

4.0%
5.2%

6-month LIBOR 0.10%

6-month LIBOR + 0.6%

The Swap
4.35% 4% AAACorp

BBBCorp
LIBOR+0.6% LIBOR

The Swap when a Financial Institution is Involved

4.33% 4% AAACorp 4.37%

F.I .

BBBCorp LIBOR+0.6% LIBOR

LIBOR

Reducing cost of funds

Theory of Comparative Advantage or arbitrage on credit rating Example Two companies Megasoft Ltd rated AAA and MiniSoft Ltd rated AA wish to raise finances of Rs.500 crore. Rates offered by investors are:
Fixed rate Megasoft Ltd MiniSoft Ltd Floating rate

11.00% MIBOR+30 bps 12.00% MIBOR + 70 bps

Megasoft Ltd believes rates will decline and wants to borrow at a floating rate while Minisoft Ltd wants to raise fixed-rate funds. A banker agrees to broker a swap for a fee of 5 bps from each. What kind of swap arrangement can be worked out? What is the saving to each company?

Pricing a generic IRS

Pricing means finding the fixed rate to be quoted on a new swap Consider a par bond, i.e. where the coupon = yield Suppose the bond is purchased and financed by borrowing at floating rate of LIBOR Combining the cash inflows of the bond and cash outflows on the financing gives the same cash flows as on a fixed-floating interest rate swap

Pricing a generic IRS

The fixed rate on a generic interest rate swap is the same as the yield and coupon on a par bond K-period Swap rate = (1 discount factor for kth period)/(Sum of all discount factors till kth period)

Pricing a generic IRS

Alternatively, fixed rate on a generic IRS would be the rate at which
Value of fixed leg = value of floating leg i.e. NPV of swap is zero

Quotes By a Swap Market maker

Maturity
2 years 3 years 4 years

Bid (%)
6.03 6.21 6.35

Offer (%)
6.06 6.24 6.39

Swap Rate (%)

6.045 6.225 6.370

5 years
7 years 10 years

6.47
6.65 6.83

6.51
6.68 6.87

6.490
6.665 6.850

Valuation of a swap
Finding the value of an existing swap entered into some time ago Two methods for valuation As the difference between a fixed rate bond and a floating rate bond As a portfolio of FRAs

Valuation as a pair of bonds

For a floating rate payer Swap is like a long position in a fixed rate bond and short position in floating rate bond PV of fixed leg - PV of floating leg For a fixed rate payer Swap is like a long position in a floating rate bond and short position in fixed rate bond PV of floating leg - PV of fixed leg

Currency Swaps
Exchange of principal and interest payments in one currency for principal and interest payments in another currency Principal is specified in each currency Principal amounts usually exchanged at the beginning of the swap and exchanged back at the end of the swap

Example -1
A currency swap has a remaining life of 15 months. It involves exchanging interest at 10% on 20 million pound sterling for interest at 6% on USD 30 million every year. The term structure of interest rates in both UK and US is currently flat and if the swap were negotiated today the interest rates exchanged would be 4% in USD and 7% in sterling. All interest rates are quoted with annual compounding. The current exchange rate is USD 1.85 per pound. What is the value of the swap to the party paying sterling? (Assume USD is domestic currency)

Example 7.12 from Hull