swaps
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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 - PowerPoint PPT PresentationTRANSCRIPT
Swaps – An agreement between two companies to exchange cash flows in the future.
Hedging InstrumentsHedging 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 IRSPurpose 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 IRSWorking 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’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/-
•
WorkingWorking
• 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 months 8.00 7.75
1 year 9.25 8.75
2 years 9.85 9.35
3 years 10.25 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 ExampleAssume 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 - Cont’d
• 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
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