DERIVATIVES
SWAP
• Swap refers to an exchange of one set of cash flows for another
between the parties concerned.
• Exchange takes place at a predetermined time, as specified in the contract
according to a prearranged formula.
• Swaps are not exchange oriented and are traded over the counter, usually
the dealing are oriented through banks.
• Swaps can be used to hedge risk of various kinds which includes interest
rate risk and currency risk.
• You can exchange your fixed interest outflows into variable rate outflows pegged to a
benchmark.
• Receivables in dollars can be converted into Yen receivables.
INDIAN LENDING RATES
HISTORICALLY
INDIAN RUPEE Vs DOLLAR
EXCHANGE RATE
DOLLAR Vs OTHER GLOBAL CURRENCIES
Interest Rate Swaps
• An interest rate swap is an agreement between two parties to exchange one
stream of interest payments for another, over a set period of time.
• Swaps are derivative contracts and trade over-the-counter.
• You can enter into two types of interest rate swaps: The Fixed to Floating Swap
and the Floating to Floating Rate Swap
• In a fixed to floating interest rate swap, a customer receives cash flows at a fixed
rate of interest and simultaneously pays out at a floating rate of interest or vice
versa.
• The interest is calculated on a notional principal amount.
• The floating rate of interest is usually referenced to a transparent benchmark
like MIBOR or (Mumbai Inter-Bank Offer Rate) or LIBOR (London Inter-Bank
Offered Rate).
• In floating to floating swap, two parties exchange receipts on a notional principal
based on a floating interest rate referenced to two different benchmarks.
INTEREST RATE VIEW POINTS
FROM BORROWERS PERSPECTIVE
• Flexible interest rate borrower is worried if
interest rates increase then his costs of interest
(EMI) payment will increase.
• Fixed interest rate borrower is worried if
flexible interest rates decrease then they will
be paying higher EMI payments.
INTEREST RATE VIEW POINTS FROM
INVESTOR/BANKS PERSPECTIVE
1st Year MIBOR @ 8% 2nd Year MIBOR @ 10%
SWAP CASH FLOWS SWAP CASH FLOWS
‘A’ ‘B’ Rs. 10 Lakhs & ‘B’ ‘A’ Rs 9 Lks ‘A’ ‘B’ Rs. 10 Lakhs & ‘B’ ‘A’ Rs11 Lks
Net payment A B Rs. 1 Lakh Net payment B A Rs. 1 Lakh
A to HDFC B to ICICI A to HDFC B to ICICI
Pays 1 Lkh to B Recieves 1 Lkh from A Recives 1 Lkh B Pays 1 Lkh A
Pays 10 lkhs to Pays 11 Lkh to ICICI Pays 12 Lkh HDFC Pays 11 Lkh ICICI
HDFC
EXAMPLE 1: INTEREST RATE SWAP B/W A & B
OVERVIEW OF SWAP DEALS
• An interest rate or currency swaps are possible between two
parties with opposing needs.
• Both parties have an arrangement to be win to win situation.
• Notional principal and time horizons should be the same.
• Interest rate swaps occur between same currencies. Hence, only
interest rate payments are swapped ie., netting is done which
reduces the default risk.
• Any party can loose if the future interest rate moves against their
wish.
EQUITY SWAP
• An ‘Equity Swap’ is where one of those cash flows being
exchanged is the return on the equity index. It is a derivative
contract where one party agrees to pay the return on an equity
index and the other agrees to pay a fixed or floating interest
rate.
• An example would be if a client (one party) is paying interest
(LIBOR), whereas the bank (another party) is agreeing to pay
the return on the Nifty 50 index.
• The outcome of this swap is that the client is in a position of
having effectively borrowed money to invest in the securities of
the Nifty 50.
EQUITY SWAP TERMINOLOGY
• Notional principal: This is determined within the Swap contract and is the amount of
money that is not paid between the two counterparties but which is the basis for the
calculations of the interest and equity return legs .
• So, if the notional principal on an equity swap trade was $100 million dollars, then you need to
multiply the LIBOR rate by $100 million to get the cash flow on the interest rate leg.
• The return generated on the S&P 500 would need to be multiplied by the $100 million to get the
cash flow on the equity return leg.
• Payment frequency/reset period: This refers to how frequently within the entire lifetime of
the swap these cash flows are going to be exchanged ie., (how frequently the return on the
two legs of the swaps is paid)
• Netting: This refers to the payments between two parties of the swap that are not made in
total, but are netted off. In other words, as the terminology suggests, the full amount of the
payment on the interest leg and the return on the S&P 500 leg is always made. However,
the two payments are netted off.
• If the interest rate leg has a higher dollar value than the return on equity index leg – there will be a
payment of a net amount from the interest rate leg payer to the counterparty that is responsible for
paying the return on the S&P 500.
• Tenor: Refers to the total life or tenor of the swap. Ex: A 5-year tenor swap with semi-annual
payment frequency, which means that the swap’s total life is 5 years and every six months.
We calculate the interest payable on both the interest rate leg and the return on the equity
index leg and exchange those cash flows.
Advantages & Disadvantage of
Equity Swap
Advantages: Disadvantages:
• Benefits the returns from • Collateral requirements
stocks without owning them.
• Illiquid
• Initial Outlay
• No disclosures /taxes/Custom • No Voting Rights
fees
• Avoiding restrictions
• Rebalancing
PRICE RETURN + DIVIDEND =
TOTAL RETURN
INDIAN LENDING RATES
HISTORICALLY
INDIAN RUPEE Vs DOLLAR
EXCHANGE RATE
Currency Swaps
• A currency swap contract (also known as a cross-currency swap
contract) is a derivative contract between two parties that involves
the exchange of interest payments, as well as the exchange of
principal amounts in certain cases, that are denominated in different
currencies.
• Although currency swap contracts generally imply the exchange of
principal amounts, some swaps may require only the transfer of the
interest payments.
• For example, a customer in India with a long-term USD borrowing is
typically exposed to exchange rate risk between the USD and the
INR as well as USD interest rate risk. The company can eliminate the
risk by entering into a USD/ INR currency swap with a bank (as per
the prevailing regulations).
• Users : Exporters, Importers, Corporates with currency risk in
balance sheet
How a Currency Swap is priced ?
• Pricing is expressed as a value based on LIBOR +/-
spread, which is based on the credit risk between the
exchanging parties.
• LIBOR is considered a benchmark interest rate that major
global banks lend to each other in the interbank market
for short-term borrowings.
• The spread stems from the credit risk, which is a premium
that is based on the likelihood that the party is capable of
paying back the debt that they had borrowed with
interest.
Risks of CDS
• One of the risks of a credit default swap is that the buyer may default on the
contract, thereby denying the seller the expected revenue.
• Where the original buyer drops out of the agreement, the seller may be
forced to sell a new CDS to a third party to recoup the initial investment.
• However, the new CDS may sell at a lower price than the original CDS,
leading to a loss
The seller of a credit default swap also faces a jump-to-jump risk.
• The seller may be collecting monthly premiums from the new buyer with the
hope that the original buyer will pay as agreed.
• However, a default on the part of the buyer creates an immediate obligation
on the seller to pay the millions or billions owed to protection buyers.
CREDIT DEFAULT SWAPS
• Speculation:
• An investor can buy an entity’s credit default swap believing that it is too low or too high and attempt
to make profits from it by entering into a trade. Also, an investor can buy credit default swap
protection to speculate that the company is likely to default since an increase in CDS spread reflects a
decline in creditworthiness and vice-versa.
• A CDS buyer might also sell his protection if he thinks that the seller’s creditworthiness might
improve. The seller is viewed as being long to the CDS and the credit while the investor who bought
the protection is perceived as being short on the CDS and the credit. Most investors argue that a CDS
helps in determining the creditworthiness of an entity.
• Uses of Credit Default Swap (CDS)
• Arbitrage
• Arbitrage is the practice of buying a security from one market and simultaneously selling it in another
market at a relatively higher price, therefore benefiting from a temporary difference in stock prices. It
relies on the fact that a firm’s stock price and credit default swaps spread should portray a negative
correlation. If the company’s outlook improves, then the share price should increase and the CDS
spread should tighten.
• • However, if the company’s outlook fails to improve, the CDS spread should widen and the stock
price should decline. For example, when a company experiences an adverse event and its share price
drops, an investor would expect an increase in CDS spread relative to the share price drop. Arbitrage
could occur when the investor exploits the slowness of the market to make a profit
