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Attribution Non-Commercial (BY-NC)

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Fundamentals of Swaps

Introduction

What is a swap?

It is basically an exchange of two payment streams that are different from each other. To acquire one stream of payments and to dispose off another stream.

Introduction (Cont)

It is a contract where two counterparties commit themselves to exchange, over an agreed time period, two streams of payments, each calculated using a different type of interest rate, but with the same notional principal.

Introduction (Cont)

In the case of a currency swap the two streams of payment are denominated in different currencies. In an equity swap one stream is calculated based on an equity price. In a commodity swap one stream is calculated based on a commodity price.

Illustration

Citibank and HSBC agree to exchange over a period of two years, two streams of cash flows at six monthly intervals.

Citibank will calculate its payments based on a fixed interest rate of 6% per annum. HSBC will calculate its payments based on the 6M LIBOR that is prevailing at the start of the six monthly period for which the payment is being computed.

Terms

Counterparties: Citibank and HSBC Maturity: 2 Years Interest Rate (1): Fixed 6% per annum Citibank pays HSBC Frequency of payment: Semi-annual Interest Rate (2): 6M LIBOR HSBC pays Citibank Frequency of payment: Semi-annual Notional Principal: 100 MM USD

Illustration (Cont)

The interest rate is normally fixed at the start of the period to which it applies. But the payment calculated using this rate is made at the end of the period. This is what is meant by `determined in advance and paid in arrears. We can also have a system of `determined in arrears and paid in arrears.

Time Days in the 6M interval Fixed Rate Amount payable by Citibank LIBOR Amount payable by HSBC

0

6M 12M 18M 24M TOTAL

6%

6% 6% 6% -

5.75

6.125% 6% 5.5% -

12000000 -

Sample Calculations

Cash Outflow for Citibank after 6 months: 0.06 x 100,000,000 x 181 ------ =2,975,343 365

Calculations (Cont)

Notional Principal

In the case of an interest rate swap only the interest is exchanged. There is no exchange of principal. The principal is specified purely for the computation of interest. Hence it is termed as a `notional principal.

Off-Balance-Sheet

Since the principal is not exchanged the swap does not impact the balance sheets of the counterparties. Hence interest rate swaps are referred to as off-balance-sheet transactions.

Netting

In our illustration the counterparties were required to make payments to each other on the same date. Hence the payments are usually netted and only a single amount representing the difference is exchanged.

Illustration

Settlement Date Amount Payable by Citibank Amount Payable by HSBC Net Amount Payable by Citibank

6M 12M

18M 24 M

2975343 3024658

2975343 3024658 12000000

2851370 3087671

2975343 2772603 11686987

123973 -63013

0 252055 313013

Netting

What is delivery risk? It is a default risk that can arise when an exchange of payments does not occur simultaneously. Thus a delay exposes the counterparty making the earlier payment to the risk that the other party may not honour its commitment.

Netting (Cont)

In order to facilitate netting, the frequency and timing of fixed rate payments will usually match the frequency and timing of the floating rate counter payments.

Frequency of Payments

The frequency of the floating rate payments is usually set by the tenor of the benchmark rate that is used in the swap.

Thus if 6M LIBOR is used as the benchmark then the payments will be made semi-annually, whereas if 3M LIBOR were to be used, the payments would be made quarterly.

Terms

The names of the counterparties The maturity date of the swap The fixed interest rate The benchmark for the floating rate The notional principal amount And the frequency of payments

Frequency of Payments

In our illustration, both fixed as well as floating rate payments were made on a semi-annual basis.

Purpose of a Swap

Let us consider the swap between Citibank and HSBC. What did it achieve?

In the case of Citibank the fixed interest rate payments were known from the outset. But in the case of HSBC since LIBOR is variable, the cash outflows were subject to uncertainty, except for the first six months.

Purpose (Cont)

Hence it is subject to the risk that the LIBOR will fall during the life of the Swap.

It is therefore exposed to the risk that the LIBOR will rise during the life of the swap.

Purpose (Cont)

Thus an interest rate swap exposes both the counterparties to interest rate risk.

Such swaps may therefore be used for speculation or for profiting from an expected interest rate change by deliberately taking risk.

Purpose (Cont)

Or they may be used for hedging against another source of interest rate risk. What is a hedge?

Speculation

Assume that Citibank is anticipating rates to rise whereas HSBC is expecting that rates will fall.

Thus a swap which requires Citibank to pay fixed and HSBC to pay floating, can be used as a speculative mechanism by both the parties.

Hedging

Assume that Citibank has already borrowed on a floating rate basis. It can use the swap with HSBC to hedge interest rate risk.

If rates rise it will have to pay more interest on its original borrowings, but will receive a net cash inflow from the swap.

Hedging (Cont)

Assume that HSBC has already made a loan on floating rate basis. If so it can use the swap to hedge.

If interest rates were to fall it would receive less on its original investment but will receive a cash inflow from the swap.

Advantages

Before swaps became available interest rate risk had to be managed using assets and liabilities in the form of cash instruments.

For instance assume that a bank anticipates a fall in interest rates. It could make a medium term fixed rate loan and fund it by taking a series of consecutive short term deposits.

Advantages (Cont)

If it were to rollover a series of short term deposits, it would be effectively borrowing at a floating rate and lending at a fixed rate.

If rates were to fall as expected it would pay a lower rate of interest on its deposits but would continue to receive a fixed rate of interest from its loan.

Advantages (Cont)

An interest rate swap where the bank receives fixed and pays floating can be used to achieve the same result.

The swap would yield the same profit but would there would be no transfer of principal and consequently no impact on the balance sheet.

Advantages (Cont)

Since a swap is an off-balance-sheet transaction as opposed to the alternative entailing the use of assets and liabilities, it offers several advantages.

Only interest payments are at risk whereas in the case of assets and liabilities the full principal is at risk.

Advantages (Cont)

Swaps are subject to lower capital adequacy requirements because they involve less credit risk. Swaps involve lower transaction costs because less money is being transferred and funded. They offer greater flexibility.

Coupon swaps

What we have just seen is a coupon swap. It entails the exchange of a payment based on a fixed rate in return for a payment based on a floating rate. In these swaps both streams of payment are calculated using a floating rate index. For instance one stream could be based on the LIBOR whereas the other could be based on the prevailing commercial paper rate.

Basis swaps

Types (Cont)

Asset swaps

If one of the payment streams is funded with interest received from an asset, the swap and the asset as a whole are called an asset swap. There is no change in the swap mechanism per se. Strictly speaking we could also have liability swaps. But this term is rarely used. Thus swaps used in conjunction with a liability are merely referred to as interest rate swaps.

Types (Cont)

Currency swap

It is a swap where each stream on interest is denominated in a different currency. These swaps also involve an exchange of principal.

Terminology

In the case of a coupon swap, the party paying on a fixed rate basis is said to be the `payer in the swap and the other counterparty is the `receiver in the swap. In the case of a basis swap we cannot use this convention since both the cash flow streams are based on floating rates.

Terminology (Cont)

Thus it is a good practice in the case of basis swaps to describe each counterparty in terms of both the rate it pays as well as the rate it receives.

In the inter-bank swap market the terms buyer and seller are used in the case of coupon swaps.

Terminology (Cont)

In most coupon swaps the 6M LIBOR is the standard index for the floating rate.

Thus these swaps can be defined purely in terms of the fixed rate of interest.

For example in the case of the Citibank-HSBC swap, the price of the swap would have been quoted as 6% per annum, which is nothing but the fixed rate.

Terminology (Cont)

Example in our case the rate was 6%. This is called an all-in price.

Terminology (Cont)

the convention of quoting the price on an all-in basis has been replaced by the convention of quoting the differential between the all-in rate and an accepted benchmark rate.

Terminology (Cont)

The benchmark rate is usually the rate on the government bond with a remaining period to maturity closest to that of the swap.

The difference between the all-in price and the benchmark rate is called the swap spread. For instance assume that the all-in price is 5.5% for a 5 year swap and that 5 year T-notes are yielding 5.3% per annum. The swap price will be quoted as 20 basis points.

Terminology (Cont)

The trade date or the fixing date is the date on which the terms are agreed upon.

maturity swap rate floating rate index payment frequency notional principal

Terminology (Cont)

The value date is the date on which the interest payments start to accrue.

For swaps involving only the domestic currency the value date is usually the same as the trade date. For foreign currency swaps the value date is usually two days after the trade date.

Terminology (Cont)

The date on which the floating rate is re-fixed for the next period is called

The date on which the interest is paid for the preceding period is called the effective date.

For domestic currency swaps the effective dates are the same as the re-fixing dates. For currency swaps the effective date is two business days after the re-fixing date.

In contrast futures contracts and listed options are exchange traded instruments.

On an exchange the clearinghouse becomes the buyer for every seller and the seller for every buyer.

The role of the clearinghouse and the margining mechanism minimizes the risk of default.

In OTC markets there is no clearinghouse, and margining is not compulsory. So default risk is a major concern.

Standardization reduces transactions costs and provides greater liquidity. Activity in exchange traded products is limited to certain instruments. However OTC products like swaps are available for any currency and for any tenor provided a counterparty can be found.

Futures and listed options are usually available only for short to medium terms. Swaps on the other hand can extend as far as 20 years into the future.

Maturity 1 year 2 years 3 years 4 years 5 years 7 years Semi-annual Rate 8.00-7.85 8.25-8.05 8.50-8.30 8.85-8.65 9.05-8.85 9.25-9.05

US Dollars 2 years Spread 21/25 Annual Interest A/360 5.70-5.75

3 years

5 years 7 years 10 years

40/45

46/51 46/51 47/52

6.23-6.28

7.01-7.05 7.46-7.51 7.93-7.97

Two-way Prices

As can be seen, two swap rates are quoted for each maturity.

Such prices are quoted between professional dealers and consist of a buying and selling price for the instrument. However the terms buying and selling can be ambiguous in the case of swaps.

When you have two prices, which is being paid and which is received?

The logic is that the dealer hopes to make a profit if he undertakes a fixed-floating swap with one party and a floating-fixed swap with the other. Thus he would like to pay the lower fixed rate and receive the higher fixed rate.

For instance the all-in prices for the 5 year NZ Dollar swap is 9.05-8.85. Thus the dealer will demand 9.05% if he is receiving the fixed rate and will part with 8.85% if he is paying the fixed rate.

What about quotations in terms of spreads? For instance a 5 year USD swap is quoted as 46/51. This means that when the dealer is paying fixed he will give 46 basis points over the yield on the most liquid 5 year T-note. If he is receiving fixed he will demand 51 basis points over the 5 year T-note yield. The equivalent all-in rates are 7.01% and 7.05%.

Swap Documentation

What is a contract?

Documentation (Cont)

That is the rights that the parties enjoy or the obligations that they have accepted.

Documentation (Cont)

What are the rights of enforcement according to law if there is a default by a counterparty. In this context the definition of default must be clearly spelt out The methods of computing damages should be clearly stated

Documentation (Cont)

In the early days, swap documentation was extremely complex because the instrument was new and there was a need to provide adequate financial and legal definitions.

There was a lack of legal precedent and little in the way of `custom and usage. Contracts therefore contained extensive legal opinion.

Documentation (Cont)

Contracts were long winded and often took months to finalize. An attempt has been made subsequently to standardize the documentation.

Initial efforts were on a bilateral basis between active market players. Subsequently multilateral initiatives were launched by market associations.

Documentation (Cont)

The British Bankers Association (BBA) The International Swap Dealers Association (ISDA)

The BBA terms have now been largely superseded by the more comprehensive documentation drafted by ISDA.

But the mechanism for fixing LIBOR which was devised as a part of BBAIRS Terms continues to play a central role in the settlement of swaps.

The BBA arranged for Telerate to calculate and publish on a daily basis a list of BBAIRS Interest Settlement Rates for each monthly maturity between one and twelve months for 9 currencies.

ISDA Documentation

In 1985 ISDA published a Code of Standard Wording, Assumptions and Provisions for Swaps known as the ISDA Swaps Code.

This was a menu from which counterparties could draw when drafting a contract for US Dollar swaps.

The Code dealt mainly with financial terms and conditions such as calculation of interest and termination payments.

It was subsequently revised and expanded to address rights of enforcement and credit provisions.

For USD interest rate swaps The Interest Rate Swap Agreement (Rate Swap Master Agreement) For interest rate and currency swaps in or between a variety of currencies the Interest Rate and Currency Exchange Agreement (Rate and Currency Swap Master agreement)

Once an ISDA Master Contract is in place between two counterparties, the details of new swaps are simply added as appendices.

Thus there will always be a single contract in place between two counterparties regardless of the number of swaps transacted.

A master agreement is designed to net the profits and losses being made on all the swaps outstanding between the same two counterparties.

In the early days of the swap market, the intermediaries were investment banks with fairly limited resources.

They tried to avoid exposure to default risk by assuming the role of an agent rather than a principal in swap transactions. Hence they merely helped arrange such transactions between the counterparties, for which they were paid a fee.

As the market developed it became necessary for swap intermediaries to assume the role of principals. There were two reasons for this.

End users desired anonymity Secondly they were reluctant to deal with non-bank counterparties because of the default risk.

That is, they would arrange a swap only if there was a more or less equal and opposite swap that was immediately available as a hedge.

While running a matched book, the intermediary is exposed to default risk from both sides.

Consequently they would charge a riskrelated dealing spread in the form of a difference between the fixed interest rate paid to one user and that received from the other user.

Due to competition, arrangement fees have become rare unless the swap structure is unusual and complex. Swaps have now become an active tool for asset-liability management. Intermediaries have now become market makers, that is, they provide continuous two-way quotes.

Such market makers stand ready to accept temporary exposures to a position, until they are able to find a matching swap.

Currency Swaps

It is a contract which commits two counterparties to an exchange, over an agreed period, two streams of payments in different currencies, each calculated using a different interest rate. And an exchange, at the end of the period, of the corresponding principal amounts, at an exchange rate agreed at the start of the contract.

Example

Barclays Bank London agrees to pay Citibank New York over a period of two years a stream of interest on 17MM USD.

The interest rate is fixed at the outset. Citibank in return agrees to pay interest on 10MM GBP at a rate agreed upon at the outset. They also commit to exchange at the end of the two-year period the principal amounts of 17MM USD and 10MM GBP.

Not only is interest exchanged, there is also an exchange of principal. In this case the exchange of principal takes place only at maturity. Thus the impact on the balance sheet is only at maturity.

Differences (Cont)

Thus this kind of a swap is termed an off balance sheet (OBS) transaction. The interest payments being exchanged may be computed on a:

Fixed versus floating basis Floating versus floating basis Or a Fixed-Fixed basis

Motivation

Why may Barclays and Citibank want to enter into such a swap?

At maturity Barclays may have an amount in USD that it wishes to exchange for GBP. Citibank on the contrary may have an amount in GBP that it wishes to exchange for USD.

Motivation (Cont)

In a currency swap the rate for the exchange of principal will be fixed at the outset.

This rate is usually the spot exchange rate prevailing at that time. But is subject to negotiations. By fixing the exchange rate the two banks hedge each other against exchange rate risk.

However it can so be structured so that there is an exchange of currencies at the outset as well. This kind of deal is also called a currency swap but is something more than just a swap.

Exchange (Cont)

This is because to exchange currencies at the outset the two parties must have either borrowed or else accrued income in the respective currencies. This is a source of risk. The actual swap itself is a hedging device.

Mechanics

Let us assume that Citibank and Barclays were to exchange principal amounts at the outset.

Barclays would sell 10MM GBP to Citibank in exchange for 17MM USD. The sterling sold by Barclays and the dollars sold by Citi would be borrowed by these banks specifically for the purpose of the swap.

Mechanics (Cont)

The re-exchange of principals at maturity would be at the original exchange rate. Such swaps are therefore termed as par swaps. The sterling received by Barclays at expiration from Citi would be used to payoff its original borrowing.

Mechanics (Cont)

The periodic interest payments received from Citi would be used by Barclays to service its sterling loan. The dollars received by Citi at maturity would be used by it to retire its original borrowing. The periodic interest payments received from Barclays would be used by Citi to service its dollar loan.

Mechanics (Cont)

Thus, through a currency swap, each counterparty effectively services the debt of the other.

Terminology

The term currency swap is generally used to describe swaps involving two different currencies.

But strictly speaking the term applies only to those swaps in which both the interest streams are calculated using fixed rates. A currency swap in which at least one of the interest streams is calculated using a floating rate is called a cross-currency swap.

Terminology (Cont)

Coupon swaps involve a fixed-floating swap. Basis swaps involve a floating-floating swap. Currency swaps where there is an initial exchange of principal are sometimes referred to as Cash Swaps.

Counterparties

In the case of single currency swaps, counterparties are distinguished on the basis of who pays fixed and who receives fixed.

However in the case of currency or crosscurrency swaps the relationship is complicated by the exchange of currencies.

Counterparties (Cont)

Thus there is a need to describe each counterparty in terms of the interest rate and the currency that it pays, and the interest rate and the currency that it receives.

Credit Risk

In the case of Interest Rate Swaps, the risk is with respect to interest only.

However in the case of currency swaps credit risk is with respect to both interest as well as principal.

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