interest rate and currency swaps
TRANSCRIPT
Interest Rate SwapsAnd
Currency Swaps
Interest Rate And Currency Swaps 2
Meaning of Financial Swaps A swap is an contractual agreement to
exchange cash flows at specified future times according to certain specified rules (between two parties)
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BackgroundSwaps first evolved in 1981, in the form of
currency swaps, (IBM and the World Bank for $210 million dollars and a term of over ten years)
Interest rate swaps emerged, which offered an alternative method to overcome asset-liability mismatches and to lower the cost of borrowing.
Swaps provide a level playing field for risk management but still struggle to find a future, especially in developing countries like India.
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Types of swapsInterest Rate Swaps
Currency Swaps
Commodity Swaps
Equity Swaps
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Interest rate swapsAn interest rate swap is defined as a mutual
agreement among different parties, to exchange interest payments over a predetermined period.
The primary motives behind the interest rate swaps are to lower the costs of borrowing and to overcome the asset liability mismatch.
Uses of an Interest Rate SwapConverting a
liability fromfixed rate to floating rate
floating rate to fixed rate
Converting an investment from fixed rate to floating rate
floating rate to fixed rate
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Types of Interest SwapsPlain Vanilla SwapsOff Market SwapsIndex Amortization SwapsFloating – Floating SwapsForward SwapsCallable SwapsPutable Swaps
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Fixed to FloatingAlso known as Plain Vanilla swap
customer receives cash flows at a fixed rate of interest and simultaneously pays cash flows at a floating rate of interest or vice versa. The cash flows are calculated on a Notional Principal amount. The floating rate of interest is usually determined by reference to a transparent benchmark
An Example of a Plain Vanilla Fixed-for-Floating InterestParty A- (Receives Floating Rate) Party B- (Pays the Floating Rate)
Notional Principal- $40 million.
Fixed rate day count method is 30/360 day basis.Floating rate is Six- Month LIBOR, determined on a 30/360 day basis.
Swaps origination: July 20, 1999.Swaps termination: July 20, 2000.First payment: January 20, 2000Semiannual payments will be made on each July 20 and January 20.
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7% fixed rate
6 month LIBOR
A B
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Valuation Of Plain Vanilla SwapThe present value of a plain vanilla swap can easily be
computed using standard methods of determining the present value (PV) of the fixed leg and the floating leg.
value of the fixed leg:where; C is the swap rate, M is the number of fixed payments, P is the notional amount, ti is the number of days in period i, Ti is the basis according to the day count convention dfi is the discount factor.
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value of the floating leg:
Where, N is the number of floating payments, fj is the forward rate, P is the notional amount, tj is the number of days in period j,Tj is the basis according to the day count
convention dfj is the discount factor.
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Floating to FloatingIn this kind of a swap, both the counter-
parties exchange interest amounts based on two different floating reference rates, through the life of the swap.
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Index Amortization SwapA swap whereby the notional principal
amount of the agreement is amortized according to the movement of an underlying rate.
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Forward SwapsA swap agreement created through the
synthesis of two swaps differing in duration for the purpose of fulfilling the specific time-frame needs of an investor. Also referred to as a "forward start swap," "delayed start swap," and a "deferred start swap."
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Off market SwapAn interest rate or other swap contract with a
fixed rate payment materially different from current coupon rates on bonds or notes of similar term. Ordinarily, this swap will have a net present value that requires the counterparties to exchange an extra payment at the beginning or end of the swap tenor. Also called Adjustment Swap
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Callable Swaps & Putable SwapsFixed rate receiver has the right, but not the
obligation to terminate the swap at one or more pre-determined times during the life of the swap.
A Swap where the fixed rate payer has the right to terminate is known as a Callable Swap. Both the Putable and Callable Swaps are also known as Cancellable Swaps.
The foreign exchange version of a Cancellable Swap is called the Break Forward or Cancellable Forward.
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Limitations of Swap DealsCounter Party Risk
Fund Requirement
Cordial Relationships
Information Network
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Currency swapsForeign currency swaps involve the exchange
of the principal at the beginning of the contract and the re-exchange of the principal at the end of the contract.
A Currency Swap involves exchange of principal and/or interest payments on a loan or on an asset in one currency for principal and/or interest payments on an equivalent loan or on an asset in another currency, with a predetermined prevailing spot / predetermined forward rate (for forward start swaps) as agreed on the date the transaction is entered into.
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In an interest rate swap the principal is not exchanged
In a currency swap the principal is exchanged at the beginning and the end of the swap
Uses of a Currency SwapConversion from a liability in one currency to
a liability in another currencyConversion from an investment in one
currency to an investment in another currency
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Types of currency swapsFixed for fixed
Fixed for floating
Floating for fixed
Floating for floating
Fixed-for-Fixed Currency SwapExample
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Party C Party DDM 25 million
$10 million
DM Lender
DM 25 mil
US$ Lender
US$ 10 mil
1. Initial Cash Flow (Exchange of Principal)
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US$ 1 million
US$ 1 milDM 2 million
DM 2 mil Party C Party D
DM Lender US$ Lender
2. Periodic Annual Interest Payments
$10 millionUS$ 10 mil
DM 25 million
DM 25 milParty C Party D
DM Lender US$ Lender
3. Final Cash Flow (Repayment of Principal)
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Fixed-for-Floating Currency SwapExamplePrincipal 1: ¥2080million and rate of interest
is 1%Principal 2: $20 million @ six month LIBORSettlement date is every 6 month
Swaps origination: July 20, 1999.Swaps termination: July 20, 2000.
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• ¥ 2080Mn. @ 1% fixed int.
• $ 20 Mn.@ 6m LIBOR
A B
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Valuation of Currency SwapsLike interest rate swaps, currency swaps can
be valued either as the difference between 2 bonds or as a portfolio of forward contracts.
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