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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

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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 • 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.**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 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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