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SWAPS

Swaps

  • A swap is an agreement between two parties(companies) to exchange the cash flows in future
  • The agreement define the date and when the cash flows are to be paid
  • Cash flows depends on the future value of an interest rate, exchange rate, and other market variables
  • It is one of the risk elimination tool

Swap Spread

The difference between the swap rate, which is normally the interest rate on the fixed leg of an interest rate swap, and the underlying benchmark government bondyield at any given maturity. The swap spread is seen as a barometer of risk appetite, and represents the premium for investors' exposure to future interest rate fluctuations. The narrower of the spread, the greater the appetite for risk.

Features of Swaps

  1. Counter parties
  2. Facilitators
  3. Cash flows
  4. Documentations
  5. Transaction costs
  6. Benefit to the parties
  7. Termination
  8. Default risk

Advantages and Disadvantages of Swaps

The advantages of swaps are as follows:

  1. Swap is generally cheaper. There is no upfront premium and it reduces transactions costs.
  2. Swap can be used to hedge risk, and long time period hedge is possible.
  3. It provides flexible and maintains informational advantages.
  4. It has longer term than futures or options. Swaps will run for years, whereas forwards and futures are for the relatively short term.
  5. Using swaps can give companies a better match between their liabilities and revenues.

The disadvantages of swaps are:

  1. Early termination of swap before maturity may incur a breakage cost.
  2. Lack of liquidity.
  3. It is subject to default risk.
  4. Tax and legislative risk

Types of Swaps

  1. Interest rate swap
  • Plain vanila swap
  • Zero coupon to floating
  • Alternative floating rate
  • Floating to floating
  • Forward swap
  • Rate capped swap
  • Swaptions
  • Extendable swap
  1. Currency swap
  2. Equity swaps
  3. Commodity swap

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). 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.

Without intermediary (Bank or Financial Institutions)

Without intermediary (Bank or Financial Institutions)

Currency swaps

A currency swap is an agreement between two parties in which one party promises to make payments in one currency and the other promises to make payments in another currency. Currency swaps are similar yet notably different from interest rate swaps and are often combined with interest rate swaps.

Currency swaps help eliminate the differences between international capital markets. Interests rates swaps help eliminate barriers caused by regulatory structures. While currency swaps result in exchange of one currency with another, interest rate swaps help exchange a fixed rate of interest with a variable rate. The needs of the parties in a swap transaction are diametrically different. Swaps are not traded or listed on exchange but they do have an informal market and are traded among dealers.

Commodity swaps

In commodity swaps, the cash flows to be exchanged are linked to commodity prices. Commodities are physical assets such as metals, energy stores and food including cattle. E.g. in a commodity swap, a party may agree to exchange cash flows linked to prices of oil for a fixed cash flow.

Commodity swaps are used for hedging against Fluctuations in commodity prices orFluctuations in spreads between final product and raw material prices (E.g. Cracking spread which indicates the spread between crude prices and refined product prices significantly affect the margins of oil refineries)

Equity swaps

An equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also commonly referred to as the "floating leg". The other leg of the swap is based on the performance of either a share of stock or a stock market index. This leg is commonly referred to as the "equity leg". Most equity swaps involve a floating leg vs. an equity leg, although some exist with two equity legs.

Types of interest swaps

Plain Vanila Swap

The most common interest swap involving one party, the fixed rate payer, making fixed payments, and the other party, the floating rate payer making payments which depend on the level of future interest rates. Interest rate payments are made on a notional amount and there is no exchange of principal.

Zero Coupon to floating

The holders of zero-coupon bonds get the full amount of loan and interest accrued at the maturity of the bond. The fixed rate player make the bullet payment at the end and floating rate player makes the periodic payment through the swap period.

Alternative Floating rate

In this swap the floating rate may be changed to other alternative according to the interest of the counterparty. The alternatives are three month LIBOR, one month commercial paper (reference of Federal Reserve), and Treasury Bills rate.

Floating -to -Floating

In these both the party enter with floating rate, one party pays one floating rate and other counter party pays the another.

Forward Swap

This swap is the exchange of interest payment only after expiry of particular period. It is a kind of swap involving for fixed -for- floating interest rate

Rate -capped swap

It is exchange of fixed rate payments for floating rate, but the floating rate payments are capped. Upfront fee is paid by floating rate party to the fixed interest rate party for the cap.

Swaptions

It is the combination of the features of two derivative instruments i.e. option and swap. Option interest rate swaps are called Swaptions.

Extendable swap

This swap is having the facility to extend the swap time period.

Currency Swap

Steps to be involved in Currency swap

  1. Initial exchange of principal amount
  2. Exchange of interest
  3. Re-exchange of principal amount

Types of currency swaps

  1. Fixed - to fixed currency swap
  2. Floating- to- floating swap
  3. Floating- to- fixed currency swap

LIBOR (London Inter Bank Offer Rate)

The London Interbank Offered Rate (or LIBOR) is a daily reference rate based on the interest rates at which banks borrow unsecured funds from other banks in the London wholesale money market (or interbank market).

MIBOR (Mumbai Inter Bank Offer Rate)

The interest rate at which banks can borrow funds, in marketable size, from other banks in the Indian interbank market. The Mumbai Interbank Offered Rate (MIBOR) is calculated everyday by the National Stock Exchange of India (NSEIL) as a weighted average of lending rates of a group of banks, on funds lent to first-class borrowers.

Role of Financial Intermediary

  • Usually two non financial companies such Intel and Microsoft do not get in touch directly to arrange a SWAP
  • They each deal with financial intermediary such as bank and financial institutions.
  • For this deal the intermediary earn some basis points (commission)
  • The Financial Institutions enters two offsetting swap transactions with Intel and Microsoft
  • If one of company defaults, the financial institutions is in a position to honor its agreement with other company

Warehousing/Market Makers

Meaning

In practice the two companies will contact the financial institutions at the same time want to take opposite positions in exactly the same Swap. For this reason, many large financial institutions act as the market makers of the swap. This means that they are prepared to enter into a swap without having an offsetting swap with another counterparty. This is referred as warehousing the swaps.

SWAP Rate

The average of the Bid and offer of fixed rate is known as swap rate

Swap Bonds

A strategy in which an investor sells a bond and at the same time purchases a different bond with the proceeds from the sale. Swaps may be made to establish a tax loss, upgrade credit quality, extend or shorten maturity, etc. Bond swaps are sometimes called bond switches.

Floating Rate Note (FRN)

Floating Rate Noted (FRN) are medium/long term debt instruments that pay a variable interest rate. The final interest rate payable by FRN is composed of a reference rate (floating part, tied to a certain money-market index like EURIBOR or LIBOR) and a spread (fixed part, payable on top of the reference rate). Floating part of the note is typically being periodically adjusted on quarterly or semiannual basis.

Credit Default Swap

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.

Credit Risk

Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Another term for credit risk is default risk.