LOANS- FIXED & VARIABLE &

SWAPS

Vikas Kr. Sinha

Dy.FA&CAO/C/NR

LOANS – FIXED & VARIABLE Interest rates attached to a variable rate loan are dictated by the wider economic situation, and may rise or fall considerably over the course of a loan’s lifespan.

While variable rate loans, offer a number of options that fixed loans do not, they also involve a greater element of risk for borrowers.

LOANS – FIXED & VARIABLE

• Main advantage of Fixed rate – payments are pegged at a set amount, typically allowing for easier budgeting than with a variable interest rate loan.

• Primary downside - repayments will never fall either, even if the wider interest rates do

• Fixed rate loans are ideal for those who tend towards conservatism and risk avoidance in fiscal matters.

Example

Consider 2 companies, one with a AAA rating and one with a BBB rating:

Fixed Floating AAA Corp 10.00% 1Y INBMK + 0.30% BBB Corp 11.20% 1Y INBMK + 1.00% Difference 1.20% 0.700% • Clearly, BBB Corp has a comparative advantage in floating-rate

markets. • AAA Corp has a comparative advantage in fixed markets. • Expected gains if the enter into a swap = 1.20% - 0.7% = 0.5%

The Comparative Advantage Argument

• Some companies have a comparative advantage when borrowing in fixed-rate markets.

• Other companies have a comparative advantage in floating-rate markets.

• Companies should borrow in the markets where they have a comparative advantage and then use a swap to advantage, and then use a swap to transform their liabilities if so wanted.

3-year swap initiated between AAA Corp and BBB Corp

Notional principal: Rs. 100 Crs.

AAA Corp. pays fixed at 5% annually compounded annually.

BBB Corp. pays floating at One year INBMK.

Payments: Annually.

FLOATING FIXED

AAA Corp could use a swap to transform a floating rate loan into a fixed rate loan.

Assume that AAA Corp has borrowed Rs. 100 Crs. at 1 year INBMK +

30 bps. This is a floating rate loan. When AAA Corp enters into the swap, it will face 3 sets of Cash

Flows: 1. Payment of 1 Y INBMK + 30bps to outside lenders. 2. Inflow of 1 Y INBMK under the terms of the swap. 3.Payment of 5% under the terms of the swap. NET CF = 5.3% FIXED Thus, AAA Corp has been able to switch from a 1 Y INBMK+30bps floating loan to a 5.3% fixed loan.

FIXED FLOATING

On the other hand, BBB Corp. could transform a fixed rate loan into a floating rate loan.

Assume that BBB Corp. has borrowed Rs. 100 Crs. at 11.0 %. This is

a fixed rate loan. When BBB Corp. enters into the swap, it will face 3 sets of CFs: 1. Payment of 11.0 % to outside lenders. 2. Inflow of 5% under the terms of the swap. 3.Payment of 1Y INBMK under the terms of the swap. NET CF = 1Y INBMK + 6%. Thus, BBB Corp. has been able to switch from a 11.0 % fixed loan to

a 1Y INBMK + 6%. floating loan

Company A Company B

1 Y INBMK+30 BPS 11%

The swap in effect transforms a fixed rate liability or asset to a floating rate liability or asset (and vice versa) for the firms respectively.

5.3%

1 Y INBMK

5 %

1 Y INBMK+6%

SWAP DIAGRAM

FEATURES OF SWAPs

• An agreement between two parties to exchange cash flows in the future.

• The agreement specifies the dates that the cash flows are to be paid and the way that they are to be calculated.

• In the case of a swap the cash flows occur at several dates in the future. The CFs are usually dependent on the value of a market variable (i.e. interest rates, currencies, etc.)

• Swaps are generally OTC. • A forward contract is an example of a simple swap. With a

forward contract, the result is an exchange of cash flows at a single given date in the future.

PLAIN VANILLA SWAP

• The most commonly used swap agreement is an exchange of cash flows based upon a fixed and floating rate.

• Often referred to a “plain vanilla” swap, the agreement consists of one party paying a fixed interest rate on a notional principal amount in exchange for the other party paying a floating rate on the same notional principal amount for a set period of time.

• In this case the currency of the agreement is the same for both parties. The agreed amount is called "notional principal" because, since it is not a loan or investment.The principal amount is neither exchanged at the outset nor rapid at maturity.

DIFFERENT TYPES OF SWAP…

• Forward Swap :Involves an exchange of interest payments that does not begin until a specified period of time.

• Callable swap : It is also called swaptions.

A callable swap provides the party making the fixed payment with the right to terminate the swap prior to its maturity.

• Puttable swap : It provides the party making the floating rate payment with the right to terminate the swap prior to its maturity.

DIFFERENT TYPES OF SWAP…

• Extendable swap : It contains a feature that allows the fixed for floating party to extend the swap period.

• Zero Coupon for Floating Swap : Under this type, the fixed rate payer makes upfront payment , i.e. the fixed leg is prepaid.

• Rate capped swap :Floating rate payment is capped.

DIFFERENT TYPES OF SWAP… • Currency swap: Means for exchange of interest

obligations or interest receipts between two different currencies .

• Typically, a fixed rate of interest is quoted in one currency against a floating rate of interest (generally in the US $).

• A rate of exchange between the two currencies must be established at the outset .

• This produces principal amounts in the 2 currencies upon which payments of interest will made.

• At the final maturity - final periodic payment of interest & exchange the principal amounts of the two currencies.

DIFFERENT TYPES OF SWAP…

• Commodity Swap : This is a swap where payments are based on the prices of commodities. One party pays a fixed price for the good over life of the swap while the other pays a floating price for the good, depending on current market prices.

• Equity Swap : With an equity swap, payments are made based on a notional principal, which is an equity portfolio. The payments are fixed & floating. The floating rate sum is based on the return on the relevant index for the period while the fixed rate sum is agreed in advance.

BEYOND PLAIN VANILLA SWAPS

• Amortizing Swap - The notional principal is reduced over time. This decreases the fixed payment. Useful for managing mortgage portfolios and mortgage backed securities.

• Accreting Swap – The notional principal increases over the life of the swap. Useful in construction finances. For example is the builder draws down an amount of financing each period for a number of periods.