4587_2288_53_1549_57_fin.al swap
TRANSCRIPT
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
1/36
FINANCIAL SWAPS
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
2/36
SWAPS
Swaps is the agreed exchange of future cash flows with orwithout any exchange of cash flows at present.
Financial swaps are broadly classified into :
Currency Swaps
If the terms of agreement also provide forexchange of principal, whichnormally happens when two currencies are involved.
Interest Rate Swaps
If the terms provide forexchange of interest payments without involving
exchange of principal payments .
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
3/36
Classification on the basis of the time period
involved:
Short term : maturity period of less than 3
years
Medium term : matures between 3-5 years
Long term : extending beyond 5 years
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
4/36
UTILITY
Swaps can be used to convert liabilities or assets to the benefitof the owner.
a floating rate liability ( loan) can be converted into fixedrate liability (loan), thus ensuring that the volatility in theinterest rates does not increase the burden of payments or
else ,
convert a fixed rate liability (loan) into a floating rateliability (loan) when the interest rates fall steeply in themarket.
Similarly ,the nature of an asset can be changed to converta floating rate earning asset into a fixed rate earning assetor vice versa according to the requirements of the holder.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
5/36
LIMITATIONS
It is difficult to identify a counterparty to take the oppositeside of the transaction .
The swap deal cannot be terminated without the consent ofthe parties involved in the transaction.
Existence of inherent default risk.
Under developed markets for swaps , mainly as a result of veryslow development of standardized documentation. This clearlyshows that swaps are not easily tradable.
The swap market is not exchange controlled and it is over
the counter market. This calls for extra caution on the part ofthe parties involved to look into the creditworthiness of thecounterparties before entering into the agreement.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
6/36
SWAP FACILITATORS
Swaps are mutual obligations among the swap parties .
But it may not be necessary for the counter parties involved in a
swap deal to be aware of each other because of the role
assumed by a swap dealer (market-maker) or swap broker.
Collectively , the swap facilitators are known as `Swap Banks`or simply `Banks`.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
7/36
Swap Broker :
When the swap facilitator : does not take any financial position in a swap arrangement
he initiates and
he dissociates himselffrom the deal after making thearrangement between the counter parties who haveapproached him ,
then he is called a `swap broker`.
He charges a fee (commission) for the services provided
He is not a party to the swap contract. He merely acts as a intermediary.
Thus a swap broker is an economic agent who helps inidentifying the potential counter parties to a swap transaction.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
8/36
Swap Dealer :
Swap dealerbears the financial risk associated with the dealhe is arranging in addition to the functions of a swap broker and
He becomes an actual party to the transaction
He serves as a financial intermediary ,earning profits by
helping complete the swap transactions .
The swap dealers face two main problems (i) pricing of swaps(ii) managing of default risk of the company
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
9/36
IMPORTANTTERMINOLOGY
SWAP COUPON
The fixed rate of interest on the swap.
NOTIONAL PRINCIPAL
The principal amount on which the fixed and floating interestcalculations are made.
It is notionalbecause the parties do not exchange this amountat any time , it is only used to compute sequence payments .
In a standard swap the notional principal remains constantthrough the life of the swap .
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
10/36
TRADE DATE
It is the date on which swap is entered into .This is the date on
which both the parties have agreed for a swap.
EFFECTIVE DATE
This is also known as value date .The maturity of the fixed andfloating rate is calculated from the effective date.
RESET DATE
The applicable LIBOR for each period is to be determinedbefore the date of payment .The 1st reset date will generally be
2 days before the first payment date , 2nd reset date will be 2days before the second payment.
MATURITY DATE
The date on which the interest accrual stops.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
11/36
RELEVANCE OF DATES
X Ltd enters into a swap contract on 10 th June 2001.Firm will paya fixed rate of 10.10% (semi-annually) to bank and in turn it willreceive the flexible rate LIBOR+ 0.05% (semi-annually) .
____________________________________________________10 June,`01 12 Jun,`01 10 Dec,`01 12 Dec,`01 10Jun,`02 12 Jun`02Trade Dt. Effective Dt. - 1stPay - 2nd Pay
1st Reset Dt. Receipt Dt. 2nd Reset Dt. Receipt Dt.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
12/36
DAY COUNT CONVENTIONS for the calculation of interests:
Fixed Floating
30 / 360 Actual / 360
Actual / 360 Actual / 365
Actual / 365
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
13/36
CURRENCY SWAPS
Step 1: Initial exchange of principal
Theprincipal amount is agreed at the outset.
The principal amount is agreed in one currency along with
the exchange rate which will be used to determine the
equivalent amount in the other currency.
The principal amounts may bephysically exchangedon the
commencement date of the swap ormay be notionally
exchangedas with the interest rate swap.
The exchange rate will usuallybe spot
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
14/36
Step 2: Exchange of Interest Rate
Interest rate obligations have been swapped, resulting in
interest payments and receipts on agreed dates based upon
the swapped principal amounts .
Interest will be either fixed or floating as appropriate to thetype of swap and each counterpartys obligations.
Naturally the two interest rate flows will be in different
currencies.
Step 3: Re- exchange of the principal at the end of thecontract i.e. at maturity.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
15/36
ILLUSTRATION 1 :Assume that there are two firms A and B who are in need ofdollar funds and sterling funds respectively. A wants USD 100million and B wants 65 million Sterling. The exchange rate is0.65 GBP / USD. They have access to the foreign currencymarket at the following rates:
Firms Dollars Sterling
Firm A (BBB rating) 10.5% 11.8%
Firm B (AAA rating) 8.5% 11%
How can A and B make use of financial swap to reduce their borrowing cost incase they wish to share the benefit equally?
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
16/36
B has absolute advantage in both dollar and
sterling markets.
A has a comparative advantage in sterling
market in relation to the dollar, as it has to payonly 0.8% more in the sterling market ascompared to 2.0% in the dollar market.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
17/36
As A wants dollar funds and B wants sterling funds , acurrency swap can be arranged between them using
the comparative principle. So that A and B can reduce their effective cost of
borrowing to the extent of the available spreaddifferent currency market .
Spread in Dollar market : 10.5 8.5 = 2 % Spread in Sterling market : 11.8 11 = 0.8 %
Effective Swap Spread / Quality Spread Differential
= 2 0.8 = 1.2 %
The two parties i.e. A and B can share this spread totheir advantage in reducing their effective cost ofborrowing in a number of ways depending on thecreditworthiness of each of them.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
18/36
Option I
There is no swap dealerto mediate between the twoparties.
The quality spread is equally shared between A andB.
The effective cost of borrowing for each of them willget reduced by 0.6 % in the respective markets inwhich they wish to borrow.
FirmA
- Net Borrowing Cost :10.5 0.6 = 9.9 %
Firm B - Net Borrowing Cost :
11 0.6 = 10.4 %
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
19/36
B borrows dollar funds at 8.5 % and lends it to A at9.9 %.
A borrows sterling funds at 11.8 % and lends it to Bat 11.8 %.
B is gaining 1.4 % on dollar payments from A whichcan be used to pay the sterling borrowings to A and
hence the effective cost of B works out to be 10.4 %[11.8 1.40].
Note :The above example assumes that there is no
intermediary, i.e. a swap dealer. But in practice , aswap dealer arranges the swap agreement betweenthe two potential parties.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
20/36
Firm A Firm B
9.9 %9.9 %
11.8 %11.8 %
Borrows Dollars at 8.5 %Borrows Sterlings at 11.8 %
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
21/36
Firms Receipts Payments NetBorrowingCost
Savings
A
(BBB)
11.8 on 11.8 on
9.9 on $
9.9 10.5 (-)9.9
= 0.6
B
(AAA)
9.9 on $ 8.5 on $
11.8 on
11.8 -1.4
= 10.4
11(-)10.4
= 0.6
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
22/36
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
23/36
ILLUSTRATION 1 :Assume that there are two firms A and B who are in need ofdollar funds and sterling funds respectively. A wants USD 100million and B wants 65 million Sterling. The exchange rate is0.65 GBP / USD. They have access to the foreign currencymarket at the following rates:
Firms Dollars Sterling
Firm A (BBB rating) 10.5% 11.8%
Firm B (AAA rating) 8.5% 11%
How can A and B make use of financial swap to reduce their borrowing cost incase they wish to share the benefit equally?Assume that both the companies decide to appoint a financialintermediary as a swap dealer and are ready to pay 0.2% of theswap benefit to him and will share the remaining profit equally.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
24/36
Firm A Net Borrowing Cost: 10.5 0.5 = 10 %
Firm B Net Borrowing Cost: 11 0.5 = 10.5 %
Steps involved in Swap will be:
B borrows dollar funds at 8.5 % and lends it to A at 10 %.
A borrows sterling funds at 11.8 % and lends it to B at10.5 %.
Here the swap dealer is exposed to exchange risk due to theoffset of gain in one currency with the loss in another .Thisrisk can be avoided if the dealer can hedge with forwards orfutures each year during the life of swap.
The exchange risk can be shifted to A or B also .The spreadneed not be shared equally always .The dealer can chargemore from the party he considers to be more risky.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
25/36
SWAP
BANK
Firm A Firm B
8.5 %
$10 % $
10.5% 11.8 %
Borrows Sterlings at 11.8 %
Borrows Dollars at 8.5 %
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
26/36
Firms Receipts Payments NetBorrowing
Cost
Savings
A 11.8 11.8
10 $
10 $ 10.5 10
= 0.5
B 8.50 $ 8.50 $
10.5
0.5 11-10.5
= 0.5
SwapBank
B: 10.5 A :10 $
A :11.8 B :8.5 $
20.5 20.3
= 0.2
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
27/36
TYPES OF SWAPSTYPES OF SWAPS
ZERO COUPON SWAP
It has only one fixed payment at maturity.
BASIS SWAP
It involves an exchange of two floating payments , each tied to a differentmarket index.
CALLABLE SWAPThe fixed rate payer has the option to terminate the agreement prior to thescheduled maturity .
PUTTABLE SWAP
The fixed rate receiver has the option to terminate the agreement prior to thescheduled maturity .
EXTENDABLE SWAP
One of the parties has the option to extend the swap beyond the scheduledtermination date.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
28/36
INTEREST RATES SWAPS
Interest rate swap is an agreement between two ormore parties who agree to exchange interest
payments over a specific time period on agreed terms.The interest rates agreed may be fixed or floating.
LIABILITY SWAP:
If there is an exchange of interest rate obligation.
ASSET SWAP:
If there is an exchange of interest rate income.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
29/36
PLAIN VANILLA SWAPS:
These are the swaps where the fixed rate obligationare exchanged for floating rate obligations over a
specific period of time on notional principals.
They are also called Coupon Swaps orGeneric
Swaps.
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
30/36
Firms Requirement Fixed
Rate
FloatingRate
XYZ
Ltd.
Fixed Rate
USD
11% Prime+
0.75%
ABC
Ltd.
Floating Rate
US
D
9.5% Prime
Illustration 2: Interest Rate Swap
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
31/36
The firm XYZ Ltd. and ABC Ltd. decide to enter intoan interest rate swap and decide to appoint HDFCBank as the facilitator.
If all the three parties mutually agree to share the
benefit arising out of swap deal in the ratio of 1: 1: 1Show how all the three parties yield benefit byentering into an interest rate swap?
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
32/36
ABC Ltd. : Absolute advantage
XYZ Ltd. : Comparative advantage in floating rate
Fixed Rate Spread : 11-9.5 = 1.5
Floating Rate Spread : (prime+0.75) prime = 0.75
Quality Spread = 1.5 0.75 = 0.75
To be shared by ABC ltd ,XYZ ltd and swap bank
equally i.e. each party gets 0.25 .
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
33/36
Net Borrowing Cost for :
ABC Ltd : Prime - 0.25% = Prime - 0.25%
XYZ
Ltd : 11% - 0.25% = 10.75%
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
34/36
ABC borrows USD at 9.5% and lends it to XYZ
through a swap bank at 10.75% .XYZ borrows USD at floating (Prime+0.75) and lends itto ABC through the swap bank at (Prime-0.25).
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
35/36
Firms Receipts Payments NetBorrowing
Cost
Savings
XYZ Prime+0.75 10.75Prime+0.75 = 10.75
11 10.75
= 0.25
ABC 9.50 9.50Prime-0.25
= Prime-0.25
Prime (prime-0.25)
= 0.25
SwapBank
XYZ:10.75
ABC:prime-0.25
ABC:9.50
XYZ:prime+
0.75
Income: 0.25
-
8/3/2019 4587_2288_53_1549_57_fin.al swap
36/36
Thank you