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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

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swaps
SWAPS

Dr. Rana Singh

Associate Professor

www.ranasingh.org

hedging instruments
Hedging 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 irs
Purpose 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 irs
Working 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/-
working
Working
  • 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
definition
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
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
IRS : Payout Diagram

Pays Fixed

Receives Floating

Company

ABC Ltd

Bank

XYZ

terminology
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
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
Interest Rate Risk

Loss to

receiving party

Interest

Rate

Loss to

paying party

Time

applications of irs
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
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
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
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
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 receiptsas desired.
creating synthetic positive b s gap
Creatingsynthetic 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
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
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
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
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
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 example
CRA : An Example

Assume 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
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
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
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 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