# SWAPS Dr. Rana Singh Associate Professor www.ranasingh.org.

## Presentation on theme: "SWAPS Dr. Rana Singh Associate Professor www.ranasingh.org."— Presentation transcript:

SWAPS Dr. Rana Singh Associate Professor www.ranasingh.org

Swaps – An agreement between two companies to exchange cash flows in the future.

Hedging Instruments Rupee Interest Rate Swaps (IRS) Nature: Contract for exchange of a fixed to floating,or floating to floating rates of interest Tenor/Size:No restriction Participants:Banks, PDs, Corporates and All India Financial Institutions Benchmark:Reuters and NSE MIBOR, PLR, CP reference rates, T-Bill rates, etc.

Purpose of an IRS An IRS is an agreement between two parties to exchange stated interest obligations for a certain period in respect of a notional principal amount. To hedge an existing exposure: A corporate having predominantly floating rate liability linked to a bank PLR can enter into a swap where it pays fixed rates for t years and receive bank PLR from ICICI Ltd. for that duration. The corporate could thus hedge its business from risks arising out a possible upward movement in interest rates.

Working of an IRS PLR Swap : An Example A "AAA" rated corporate enters into a PLR swap with ICICI on the following terms as on 31st August 1999 Trade Date 31st August 1999, Effective Date 1st September 1999 Termination Date 1st September 2004 Principal Amount Rs. 50 crores (notional) Corporate to pay Fixed rate of 12.50% (quarterly) Corporate to receive SBI PLR (floating) Tenor 5 years Reset Dates As and when the SBI PLR changes. Settlement Dates 1st December, 1st March, 1st June and 1st September of each year

Working- Contd 31st August 1999 12.00% 31st October 1999 13.50% 15th November 1999 13.75% Therefore the corporate receives interest : @ 12.00% for 60 days @ 13.50% for 15 days @ 13.75% for 16 days The floating rate would be calculated as follows: (12.00% * 60 * 50 crs)+ (13.50% * 15 * 50 crs) + (13.75% * 16 * 50 crs)/365= Rs. 1,56,50,685/-

Working The fixed rate would be as follows: 12.50% * 91 * 50 crs = Rs. 1,55,82,192/- _________________ 365 Therefore the net settlement on 1st December 1999 will be - Corporate to receive 1,56,50,685/- Corporate to pay 1,55,82,192/- Net corporate to receive from ICICI 68,493

UNDERSTANDING INTEREST RATE SWAPS

DEFINITION An interest rate swap is a contract which commits two counter-parties to exchange, over an agreed period, two streams of interest payments, each calculated using a different index, but applied to a common notional principal

Features of an IRS Fixed rate is known in advance and is the yield on the bond of a similar tenor Floating rate is calculated in terms of a benchmark, agreed upon by the parties e.g. LIBOR Fixed and floating rates are computed and exchanged at the end of defined periods. Simultaneous exchange facilitates netting Contract is off-balance sheet, as principal is notional, and only interest payments are exchanged.

IRS : Payout Diagram Pays Fixed Receives Floating Company ABC Ltd Bank XYZ

Terminology Generic (coupon swaps) (plain vanilla) are simple fixed to floating rate swaps. Payer and receiver of the fixed rate is referred to as payer and receiver in the swap Buyer is the one who pays the fixed rate, and seller is the one who receives the fixed rate. Swap rate is the rate of the fixed rate component of the swap

Reading Swap Rates 6 months8.007.75 1 year9.258.75 2 years9.859.35 3 years10.25 9.50 For a 1 year swap, the swap dealer is willing to receive 9.25% fixed, and pay 8.75% fixed, earning a spread of 50 bps.

Interest Rate Risk Loss to receiving party Interest Rate Loss to paying party Time

Applications of IRS Managing risks of individual instruments – alter the interest rate risk by creating synthetic fixed or floating rate liabilities –alter interest rate risk by creating synthetic fixed or floating rate asset Managing Gaps in Balance Sheet –Alter B/S exposure to align with interest rate view Hedging interest rate exposure –creating offsetting positions –hedge asset-liability mis match Return management through arbitrage

Creating a synthetic floating rate liability Company has borrowed fixed 3-year, at 12%, and anticipates a fall in interest rates. Enter into a swap deal to receive fixed 12% and pay floating at six month Mibor +100bp Payments : – Fixed 12% semi-annual to lender –Floating Mibor+100bp to swap dealer Receipts : –Fixed 12% semi-annual from swap dealer Net effect: Floating Mibor+100bp semi- annual liability

Creating a synthetic fixed rate liability Company has borrowed for 3 years using a FRN that resets six monthly at Mibor+150bp. Anticipates interest rate increase. Enters into a swap deal to receive floating Mibor + 150bp and pay fixed at 12%. Payments : –Mibor +150 bp six monthly to lender –pay fixed at 12% to swap dealer Receipts : –Mibor + 150 bp from swap dealer Net effect: Fixed payment of 12% semi-annual.

Creating a synthetic floating rate asset Bank has made a 3 year 12.5% fixed rate loan, and anticipates an increase in rates Enters into a swap deal to pay fixed at 12.5% and receive floating at 182-day T bill +150 bp semi- annual. Payment : – Fixed 12.5% to swap counterparty Receipts : –Fixed 12.5% from borrower –Floating 182d tbill rate+150 bp from Swap cp. Net effect : Floating semi-annual receipts.

Creating a synthetic fixed rate asset Housing company has floating 10 year asset re- setting yearly at GOISEC yield +200bp, and expects interest rates to go up. Enters into a swap deal to receive fixed, and pay floating, similar to the contracted VRL. Payments : –floating GOISEC+200bp to swap dealer Receipts : –Floating GOISEC+200bp from borrower –Fixed rate from swap dealer Net effect : Fixed receipts as desired.

Creating synthetic positive B/S Gap Bank has floating rate assets funded by floating rate liabilities. No gap and therefore no IRR position. If interest rates are expected to rise, it can enter into a swap for paying fixed and receiving floating Payments: –Pay floating on liabilities –Pay fixed to swap dealer Receipts: –Receive floating from assets –Receive floating from swap dealer Net effect: –receive floating and pay fixed Desirable gap if interest rates rise as expected.

Creating a synthetic negative gap Company has borrowed fixed and deployed temporarily in fixed interest paying assets. Expects interest rates to fall. Enters into a swap to receive fixed and pay floating. Payments : –Fixed payment to lenders –Floating payment to swap dealer Receipts : –Fixed interest from asset –Fixed interest from swap dealer Net effect: –Fixed receipts from asset –Floating payment on liability

Hedging with IRS Bank had funded 3 year fixed rate loan with 6 month CD. Exposed to IRR arising out of rising rates Enters into a swap for paying fixed semi-annual, and receiving six monthly CD rate. Payments: –Floating rate on 6month CDs –Fixed rate to swap dealer Receipts : –Floating rate on swap –Fixed rate from asset. Net effect: payment and receipts cancel each other out.

Arbitrage Opportunities As long as the underlying benchmark used to price bonds and swaps, there should be no arbitrage opportunities. In practice though, due to segmentation of markets, varying credit worthiness of parties, and temporary supply demand imbalances, arbitrage opportunities exist.

Arbitrage profit from synthetic A/L s ABC company borrows fixed at 10% and enters into a swap with a bank, receiving 10.5% and paying floating MIBOR. Net payment = Mibor - 50 bp XYZ bank has a floating rate asset paying Mibor+75bp. Enters into a swap receiving 8.5% fixed and paying Mibor. Net receipts 9.25%. Specific low liquid instruments typically offer arbitrage opportunities. E.g. Mortgage backed securities, DDBs, Structured facilities.

Credit risk arbitrage The most popular arbitrage opportunity with swaps arises from credit arbitrage, where parties can borrow in different markets, at different rates, and swap to mutual advantage. Credit risk arbitrages occur when markets are segmented. Swaps actually fill these gaps and enable integration of markets

CRA : An Example Assume that 2 companies, XYZ and PQR, can raise funds at the following rates: Bond market : XYZ : 11%PQR : 13% Bank funds : XYZ : Mibor + 100 bp PQR : Mibor +175bp Arbitrage arises from the differing credit spreads in both the markets

CRA : Example - Contd XYZ borrows at 11% in the bond market; PQR borrows from the bank at Mibor+175bp They enter into a swap deal, where XYZ receives 11.25% from PQR, and pays Mibor+ 75 bp to PQR. Net cost of funds to XYZ will be Mibor+50bp Net cost of funds to PQR will be 12.5%

Dealing and Trading in Swaps OTC telephone market : Distributed dealers Spreads over benchmarks are negotiated, and agreed upon, based on counterparty credit limits Master documents, covering financial and legal terms : ISDA and BBAIRS (3750) Types of dealers –Arrangers ( no risk) –Matched book dealers ( credit and market risk) –Market makers ( credit and market risk)smm27smm

Dealing Cycle Negotiate swap spread - usually done on telephone. Check counter party credit risk : exposure limits and credit lines Negotiate floating rate benchmark, and mark-up. Fix the all-in swap rate Confirm deal through exchange of verbal confirmations Document deal through exchange of legal documents

Pricing and Valuation of Swaps Pricing involves setting the fixed rate component of the swap. The initial price is set at par, i.e. the NPVs of the fixed and the floating interest payment streams are equal. The fixed stream is valued at the spot rates, and floating stream on the basis of the forward rates. Value of the swap alters as the floating rate changes over the tenor of the swap

Thank you