swap revised

8/11/2019 Swap Revised

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2011 Dorling Kindersley (India) Pvt. Ltd

Objectives of the ChapterWhat are swaps?What is an interest rate swap?What is a currency swap?

What is an equity swap?What is a commodity swap?What is the rationale for swaps?


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What are swaps? A swap is a private agreement between two parties to exchangeone stream of cash flows for another stream of cash flows inaccordance with a pre-arranged formula

Agreement will provide details of how cash flows will becalculated, and dates on which cash flows will be exchanged

At least one party will be exposed to an uncertain variable suchas interest rate, exchange rate, equity price, or commodity price

The other partys cash flow would be based on a fixed paymentor determined on the basis of another variable


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Types of Swaps An interest rate swap is one in which one partyagrees to exchange interest payments based ona fixed rate with another party based on a floatingrate

A currency swap is one in which one party agreesto exchange payments based on one currencywith another party based on another currency

A commodity swap is one in which variable

market prices are exchanged for a fixed priceover a period of time An equity swap is one in which one party agreesto exchange payments based on an equityportfolio for payment based on a floating rate


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The Terminology of SwapsSwap : an agreement to exchange cash flows over afixed period of time Counterparties : the two parties in a swap contract Notional principal : a monetary figure used as a part ofthe calculation to determine payment amounts Tenor : The length of time for which payments will beexchanged, also known as term , maturity , orexpiration of swap

Swap facilitators : specialists who help clients todesign swapsSwap brokers : bring counterparties together for aswap transactionSwap dealers : can enter into swap agreements as


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Interest Rate Swap A fixed interest rate loan is exchanged for a floatinginterest rate loan

Party A will borrow in the market at a fixed rate; Party

B will borrow in the market at a floating rate; interestpayments will be swapped at every reset period of thefloating-rate loan

The rate at which party A will pay interest to party Band vice versa are known as swap rates , which aredetermined in the market

Principal will not be exchanged, and interest amount

will be calculated on notional principal


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Designing a SwapMicrosoft has arranged to borrow a 100 million loan atfloating rate of LIBOR+.10. The same amount ofmoney has been borrowed by Intel at a fixed rate of5.2% . They entered into a swap agreement whereMicrosoft will pay a fixed interest @5% to Intel wherewill pay Microsoft at LIBOR. Show the flow chart ofSwap and describe the cash flow of the Swaparrangement.Ford motor owns $100 million bond providing a fixedinterest of 4.7% and Hyundai motors owns $100million bond getting interest at floating interest rate ofLIBOR-.30.They entered into a swap arrangementwhere Ford Motor will pay 5% fixed rate to Hyundaiagainst the receipt of LIBOR from them. Show the flow


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Forward Swaps A forward swap is a swap that will commence at somefuture time

Fixed interest rates will be fixed at the time the contract isentered into

The floating rate is determined at the first period of theagreement when the swap comes into effect

Useful when investment or borrowing will take place at afuture time

One major challenge is to find the fixed rate for the forwardswap: the implied forward rate from the current yield curveis usually used


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Uses of the Interest Rate SwapHedging interest rate

Reduce funding costs

Manage the duration gap by banks

Speculating on interest rate movements


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Swap arrangementTwo companies AAA Corp and BBB Corp both wish toborrow 10 million for five years and have been offeredthe following rates . BBB corp wants to borrow at afixed rate and AAA corp wants to borrow at floatingrate. Following are the offered rates :


Company Fixed Floating

AAA Corp 10% LIBOR+.3%

BBB Corp 11.20% LIBOR+1%

The two companies tried to arrange a swap agreement in such way that

they are benefitted equally out of the swap agreement. Show the flowdiagram how they will arrange their swap and explain the cash flows. Usethe concept of Comparative Advantage concept to solve the case.


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Answer:Swap arrangement :BBB Corp will pay to AAA corp at 9.95% and AAAcorp will pay at LIBOR to BBB Corp.



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Swap Arrangement

Company A and B was offered the following rates


Company Fixed Floating

AAA Corp 12% LIBOR+.1%

BBB Corp 13.4% LIBOR+.6%

Company A requires a floating rate loan and company Brequires a a fixed rate loan. Design a swap that will give

both the parties equal benefit after providing a net to abank of .10% for acting as intermediary.


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Swap arrangement: Answer :- A will receive from bank at 12 . 3% andwill pay at Libor to Bank and B will receive atLIBOR and pay to Bank at 12.4%.



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Interest Rate Swaps: An Example A can borrow at either LIBOR + 70 points, or at a fixed rateof 9%

B can borrow at either LIBOR + 20 points, or at a fixed rateof 8.2%

Both can have a lower cost of funding if A borrows atLIBOR + 70, and B borrows at a fixed rate of 8.2%, andthey swap

Swap rates are fixed at 8.2%, and the floating rate atLIBOR + 5

Net cost for A will be 8.85% fixed, and for B will be LIBOR+ 5 points


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SwaptionsThis is an option to enter into a swap

A party will enter into a swap only when it isadvantageous to do so; otherwise the option willnot be undertaken

Used to:Bring a swap into place when hedging is necessary;Removing an existing swap when it is no longerattractive;Enhance yield with an underlying position by sellinga swaption;

Obtain access to a swap when uncertainty of whenfunding will be required persists


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Assignment 1Company A can borrow at a fixed rate of 8% orat a floating rate of MIBOR + 150 basis points.Company B can borrow at a fixed rate of 9%or at a floating rate of MIBOR + 50 basispoints. Show that these two companies canimprove their position through an interest rateswap. What would be the gain to the twoparties?



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Assignment 2ABC Corporation can borrow at 6% fixed rateor at a floating rate of LIBOR + 50 basispoints. GH Corporation can borrow at 8%fixed rate or at a floating rate of LIBOR + 100basis points. Show that these twocorporations can be better off by entering intoan interest rate swap. Assume that thecomparative advantage is equally shared bythe two parties.



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Currency SwapParty A borrows in one currency, e.g. INR, andparty B borrows in another currency, e.g. USD:the loan is swapped so that party A pays theinterest in USD, and party B pays the interest inINR

In a currency swap, cash flows are exchanged intwo different currencies

Notional principals are the same based on currentexchange rate, which are also exchanged


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The Operation of a CurrencySwap

Initial exchange of a notional principal

Periodic exchange of coupon payments

Final exchange of notional principal at initialexchange rate


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An Example of a Currency SwapSuppose a U.S. MNC wants to finance a10,000,000 expansion of a British plant.They could borrow dollars in the U.S. where theyare well known and exchange for dollars for

pounds.This will give them exchange rate risk: financing asterling project with dollars.

They could borrow pounds in the internationalbond market, but pay a lot since they are not aswell known abroad.


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An Example of a Currency SwapIf they can find a British MNC with a mirror-imagefinancing need they may both benefit from aswap.If the exchange rate is S 0($/) = $1.60/, the U.S.firm needs to find a British firm wanting to financedollar borrowing in the amount of $16,000,000.


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An Example of a Currency SwapConsider two firms A and B: firm A is a U.S. based

multinational and firm B is a U.K. basedmultinational.

Both firms wish to finance a project in each otherscountry of the same size. Their borrowingopportunities are given in the table below.

$

Company A 8.0% 11.6%Company B 10.0% 12.0%


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A is the more credit-worthy of the two firms.

Comparative Advantageas the Basis for Swaps

$

Company A 8.0% 11.6%

Company B10.0% 12.0%

A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in pounds.

A pays 2% less to borrow in dollars than B

A pays .4% less to borrow in pounds than B :


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B has a comparative advantage in borrowing in .


$


Company B10.0% 12.0%

B pays 2% more to borrow in dollars than A

B pays only .4% more to borrow in pounds than A :


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A has a comparative advantage in borrowing in dollars.B has a comparative advantage in borrowing in pounds.

If they borrow according to their comparative advantageand then swap, there will be gains for both parties.



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An Example of a Currency Swap

CompanyA

Swap

Bank

$8% 12%

$8%

11% 12%

$9.4%

$


Company B 10.0% 12.0%

Company

B


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CompanyA

Swap

Bank

$8% 12%

$8%

11% 12%

$9.4%

$


Company B 10.0% 12.0%

Company

BAs net position is to borrow at 11%

A saves .6%


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CompanyA

Swap

Bank

$8% 12%

$8%

11% 12%

$9.4%

$


Company B 10.0% 12.0%

Company

B

Bs net position is to borrow at $9.4%

B saves $.6%


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CompanyA

Swap

Bank

$8% 12%

$8%

11% 12%

$9.4%

$


Company B 10.0% 12.0%

Company

B

The swap bank makesmoney too:

At S 0($/) = $1.60/, thatis a gain of $64,000 peryear for 5 years.

The swap bankfaces exchange raterisk, but maybethey can lay it offin another swap.

1.4% of $16 millionfinanced with 1% of 10

million per year for 5years.


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Assignment 3BHP, Australia, can borrow at 8% fixed rate inAustralia and at 9% fixed rate in India. TataSteel can borrow at a fixed rate of 7% in Indiaand at a fixed rate of 11% in Australia. The

current exchange rate is AUD 1 = INR 36.Explain how the two companies can engage ina five-year currency swap with paymentsevery six months. Assume Swap rate is BHP

pays 8.5% in INR, and Tata Steel pays 9% in AUD draw the flow chart and calculate the netcost.



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Assignment 4Rajesh wants to borrow Singapore dollar (SGD)20,000,000 at a fixed interest rate for 5 years.Rakesh wants to borrow INR 560,000,000 in Indiafor five years at a fixed interest. InvestmentBankers were approached for the same to havethe likely borrowing rates for Rajesh and Rakesh.The borrowing rate for Rajesh was 12% inSingapore and 8% in India and the borrowing ratefor Rakesh was 9% both in Singapore and India.Find a suitable swap strategy between Rajeshand Rakesh considering their comparativeadvantage .

Also find the net cost for them and payment


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Currency Risk in Currency Swap

As periodic coupon and final exchange of notionalprincipal are in different currencies, currency riskcan arise from this

If a company has cash inflow in the swapcurrency, the periodic payments can be paid

without converting local currency currency riskis thus avoided

If a company has no cash inflow in the swap

currency, currency risk exists


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The Uses of a Currency Swap

1. To hedge currency risk; and

2. To reduce funding costs


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Equity Swap

This is a transaction in which one party agrees tomake a series of payments determined by thereturn on a stock to another party for a cash flowbased either on fixed rate, floating rate, or returnon another portfolio of stocks

E.g. one party receives a return on the BSESensex Index in return for paying a 9% fixedinterest rate


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swap revised

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