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## PowerPoint Slideshow about 'SWAPS' - MikeCarlo

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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
- 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

- 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

- 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’

- 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

- 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

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.

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.

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 receiptsas desired.

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

- 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 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

- 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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