Unit – V: Swaps – Meaning – Overview – The Structure of Swaps – Interest Rate Swaps – Currency Swaps – Commodity Swaps – Swap Variant – Swap Dealer Role –Equity Swaps –Economic Functions of Swap Transactions - FRAs and Swaps.

Meaning of swaps

The dictionary meaning of ‘swap’ is to exchange something for another. Like other financial derivatives, swap is also agreement between two parties to exchange cash flows. The cash flows may arise due to change in interest rate or currency or equity etc.

In other words, swap denotes an agreement to exchange payments of two different kinds in the future. The parties that agree to exchange cash flows are called ‘counter parties’. In case of interest rate swap, the exchange may be of cash flows arising from fixed or floating interest rates, equity swaps involve the exchange of cash flows from returns of stocks index portfolio. Currency swaps have basis cash flow exchange of foreign currencies and their fluctuating prices, because of varying rates of interest, pricing of currencies and stock return among different markets of the world. 

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The word ‘swap’ literally means an exchange .

In the language of finance , swap is a derivative contract in which two counterparties exchange certain benefits.it is a customised contract in the form of over the counter (OTC) derivative .thus ,swaps are non-standardised contracts that are traded over the counter .

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An Introduction to Swaps

• The word ‘Swap’ literally means an Exchange.
• In the language of Finance, Swap is a derivative contract in which two counterparties exchange certain benefits.
• It is a customized contract in the form of Over The Counter (OTC) derivative. Thus, swaps are non- standardized contracts that are traded Over The Counter (OTC).
• A Swap contract is a type of derivative based on forward claims which can be understood from the following figure:

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A swap is a derivative contract where two parties exchange financial instruments. Most swaps are derivatives in which two counter parties exchange cash flows of one party's financial instrument for those of the other party's financial instrument.

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Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

A Swap is a derivative whose value is derived from a specific underlying may be financial or commodity. Underlying Contract type

1. Equity Equity Swap
2. Interest Rate Interest Rate Swap
3. Credit Credit Default Swap
4. Foreign Exchange Currency Swap
5. Commodity Commodity Swap

Features of swaps: The following are features of financial swaps:

• Counter parties: financial swaps involve the agreement between two or more parties to exchange cash flows or the parties interested in exchanging the liabilities.
• Facilitators: the amount of cash flow exchange between parties are huge and also the process is complex. Therefore, to facilitate the transaction, an intermediary comes into picture which brings different parties together for big deal. These may be brokers whose objective is to initiate the counter parties to finalize the swap deal. While swap dealers are themselves counter partied who bear risk and provide portfolio management service.
• Cash flows: the present values of future cash flows are estimated by the counterparties before entering into a contract. Both the parties want to get assurance of exchanging same financial liabilities before the swap deal.
• Less documentation is required in case of swap deals because the deals are based on the needs of parties, therefore, less complex and less risk consuming.
• Transaction costs: generating very less percentage is involved in swap agreement.
• Benefit to both parties: the swap agreement will be attractive only when parties get benefits of these agreements.
• Default-risk is higher in swaps than the option and futures because the parties may default the payment. 

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Advantages of Swaps:

1. The investors and corporate will be able to obtain cheaper finance than would be possible by borrowing directly in the market .
2. The investors and corporate will have an access to the market in which it is impossible to raise debt directly. for instance the companies with lower credit rating  may  not have access to fixed rate funds but can arrange fixed rate funds through swaps.
3. swaps can be used as long term debt instrument.
4. use of swaps provides an opportunity to restructure a firms capital profile without physical redeeming debt or raising new debt. for example the proportion of debt on which fixed and floating interest rate is paid can be altered by use of swap with-out incurring an extra cost associated with redemption or new issue of debt.

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Disadvantages of Swaps:

1. Difficulty in finding a counter part with opposite cash flow obligation who could enter for a swap deal .
2. Termination of a swap contract requires mutual consent of the both the parties.
3. since swap contract are private bilateral traded on OTC, they necessarily involve an inherent default risk by any of the counter party.
4. swaps are not easily tradable  because the secondary market in swap deal are not fully developed world wide, which is primarily because of slow progress of standardization documentation. 

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Special Terms used in Swap contract:  

1. Parties: generally there are two parties in a swap deal, and this excludes the intermediary. for  example in an interest rate swap, the first party could be a fixed payer/ receiver and the second party could be a floating rate receiver/ payer.
2. Swap Facilitator: Swap Facilitators are generally referred to as swap banks. There are two kinds of swap facilitators. i.e. Swap Broker and Swap dealer.
3. Swap Broker: also known as swap Intermediary, a swap broker as an economic agent helps in identifying the potential counterparties in a swap deal.  the swap broker  only act as a facilitator charging a commission for his service and does not take any individual position in the swap contract.
4. Swap Dealer: swap dealer associates himself  with a swap deal and often becomes an actual party to the transaction. also known as market maker . the swap dealer may be actively involved as a financial intermediary  for earning profit.
5. National Principal:  the underlying amount in a swap contract which becomes the basis for deal between counterparties in a swap deal is known as national principal. it is called national because this amount does not vary, but cash flows in the swap attaches to this amount. 
6. Trade Date:  the date on which both the parties in a swap deal enter in to the swap contract  is known as trade date.
7. Effective/ Value Date: This is the date when the initial cash flows in a swap contract begin The maturity of the swap contract is calculated from this date.
8. Reset Date: Reset date is the date on which the LIBOR rate is determined. The first reset date will be generally two days before the first payment date and the second reset date is two days before to the second payment date.

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9.Maturity Date: the date on which the outstanding cash flows stop in the swap contract is referred as the maturity date.

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Types of financial swaps:

Two major types of financial swaps are : 1. Interest rate Swap

                                                                    2. Currency swap

�Interest rate swap : 

An interest rate swap is a contractual agreement between two parties to exchange interest payments.

Where cash flows at a fixed rate of interest are exchanged for those referenced to a floating rate. An interest rate swap is a contractual agreement to exchange a series of cash flows. One leg of cash flow is based on a fixed interest rate and the other leg is based on a floating interest rate over a period of time. There is no exchange of principal. The size of the swap is referred to as the notional amount and is the basis for calculating the cash flows.

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Mechanism of swaps How it works (example): the most common type of interest rate swap is one in which party a agrees to make payments to party b based on a fixed interest rate, and party b agrees to make payments to party a based on a floating interest rate. The floating rate is tied to a reference rate (in almost all cases, the london interbank offered rate, or LIBOR).

For example, Assume that Ashok owns a rs.1,000,000 investment that pays him LIBOR + 1% every month. As LIBOR goes up and down, the payment Ashok receives changes.

• Now assume that Nikhil  owns a rs.1,000,000 investment that pays her 1.5% every month. The payment she receives never changes.

Ashok decides that he would rather lock in a constant payment and Nikhil  decides that she'd rather take a chance on receiving higher payments. So Ashok  and Rani  agree to enter into an interest rate swap contract.

under the terms of their contract, Ashok agrees to pay Nikhil  LIBOR + 1% per month on a rs.1,000,000 principal amount (called the "notional principal" or "notional amount"). Nikhil  agrees to pay Ashok 1.5% per month on the rs.1,000,000 notional amount.

Let's see what this deal looks like under different scenarios.

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Ashok receives a monthly payment of rs.12,500 from his investment (1,000,000 x (0.25% + 1%)). Nikhil    receives a monthly payment of 15,000 from her investment (1,000,000 x 1.5%).

According to the swap contract both the parties Ashok and Nikhil    exchange their interest flows i.e Ashok will pay 12500 to Nikhil    and Nikhil    needs to pay 15000 to Ashok. So, as a netting Nikhil    needs to pay rs.2500 (15000-12500) to pay Ashok.

now, under the terms of the swap agreement,�

10,00,000

LIBOR+1 % = 0.25+1% = Rs 12500

ASHOK

10,00,000

Fixed i.e = 1.5% = 15,000

NIKHIL

12500

15000

PAYS

PAYS

ASHOK

RETURN=2500

Scenario b: LIBOR = 1.0%

now, with LIBOR at 1%, Ashok receives a monthly payment of rs.20,000 from his investment (1,00,000 x (1% + 1%)). Nikhil  still receives a monthly payment of rs. 15,000 from her investment (1,000,000 x 1.5%).

According to swap contract

Ashok and Nikhil exchange their interest flows

Ashok will pay rs. 20,000 (1,000,000 x LIBOR+1%), Nikhil will pay 15000 (1,000,000 x 1.5 %) The two transactions partially offset each other and now Ashok owes Nikhil    the difference between swap interest payments: rs.5,000.(20000-15000).

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10,00,000

LIBOR+1 % = 1+1% = Rs 20,000

ASHOK

10,00,000

Fixed i.e = 1.5% = 15,000

NIKHIL

20000

15000

PAYS

PAYS

NIKHIL

RETURN=5000

An interest rate swap is an agreement between two parties in which each party makes periodic interest payments to the other party based on a specified principal amount. One party pays interest on a variable rate while the other party pays interest on a fixed rate.

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The fixed interest rate is known as the swap rate. We will use the symbol R to represent the swap rate. The swap rate will be determined at the start of the swap and will remain constant for each payment. In contrast, while the variable interest rate will be defined at the start of the swap (e.g., equal to LIBOR plus 100 bps), the rate will likely change each time a payment is determined. The two parties in the agreement are known as counterparties. The counterparty who agrees to pay the swap rate is called the payer. The counterparty who agrees to pay the variable rate, and thus receive the swap rate, is called the receiver

The specified principal amount is called the notional principal amount or just notional amount. The word “notional” means in name only. The notional principal amount under an interest rate swap is never paid by either counterparty

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The specified period of the swap is known as the swap term or swap tenor

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An interest rate swap will specify dates during the swap term when the exchange of payments is to occur. These dates are known as settlement dates. The time between settlement dates is known as the settlement period. Settlement periods are typically evenly spaced. For example, settlement periods could be daily, weekly, monthly, quarterly, annually, or any other agreed upon frequency. The first settlement period normally begins immediately with the first payment at the end of the settlement period.

Currency Swap Definition A currency swap is an agreement between two parties to exchange the cash flows of one party’s loan for the other of a different currency denomination. They allow companies to exploit the global capital markets more efficiently because they are an integral arbitrage link between the interest rates of different developed countries.

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swap contracts also can be arranged across currencies. such contracts are known as currency swaps and can help to manage both interest rate and exchange rate risk.

Currency swaps are derivative products that helps to manage exchange rate and interest rate exposure on long term liabilities. A currency swap involves exchange of interest payment denominated in two different currencies for a specified term along with exchange of principals. the rate of interest in each leg could either be a fixed rate or a floating rate indexed  to some reference rate like the LIBOR.

�In a typical currency swap counter parties will perform the following :

• Exchange equal initial principal amounts of two currencies at the spot exchange rate.
• exchange a stream of fixed or floating interest payments in their swapped currencies for the agreed period of the swap and then
• re exchange the principal amount at maturity at the initial spot  exchange rate.

�Definition:  A currency swap is an agreement between two parties to exchange a given amount in one currency for another, and to repay these currencies with interest in the future.

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Purpose of Currency Swaps

An American multinational company (Company A) may wish to expand its operations into India. Simultaneously, Indian company (Company B) is seeking entrance into the U.S. market. Financial problems that Company A will typically face stem from Indian banks' unwillingness to extend loans to international corporations. Therefore, in order to take out a loan in India, Company A might be subject to a high interest rate of 10%. Likewise, Company B will not be able to attain a loan with a favorable interest rate in the U.S. market. The Indian Company may only be able to obtain credit at 9%.

While the cost of borrowing in the international market is unreasonably high, both of these companies have a competitive advantage for taking out loans from their domestic banks. Company A could hypothetically take out a loan from an American bank at 4% and Company B can borrow from its local institutions at 5%. The reason for this discrepancy in lending rates is due to the partnerships and ongoing relations that domestic companies usually have with their local lending authorities.

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Setting Up the Currency Swap

Based on the companies' competitive advantages of borrowing in their domestic markets, Company A will borrow the funds that Company B needs from an American bank while Company B borrows the funds that Company A will need through a Indian Bank. Both companies have effectively taken out a loan for the other company. The loans are then swapped. Assuming that the exchange rate between India (Rs) and the U.S (USD) is 65Rs/1.00 USD and that both Company's require the same equivalent amount of funding, the Indian company receives $100 million from its American counterpart in exchange for 6500 million real; these notional amounts are swapped.

Company A now holds the funds it required in real while Company B is in possession of USD. However, both companies have to pay interest on the loans to their respective domestic banks in the original borrowed currency. Basically, although Company B swapped IRS for USD, it still must satisfy its obligation to the Indian bank in real. Company A faces a similar situation with its domestic bank. As a result, both companies will incur interest payments equivalent to the other party's cost of borrowing. This last point forms the basis of the advantages that a currency swap provides. 

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COMMODITY SWAPS

Commodities are physical assets such as precious metals, base metals, energy stores (such as natural gas or crude oil) and food (including wheat, pork bellies, cattle, etc.). Commodity swaps were first traded in the mid-1970's, and enable producers and consumers to hedge commodity prices. Swaps involving oil prices are probably the most common; however, swaps involving weather derivatives are increasingly popular. The floating leg of a commodity swap is tied to the price of a commodity or a commodity index, while the fixed leg payments are stipulated in the contract as in an interest rate swap. It is common for a commodity swap to be settled in cash, although physical delivery is becoming increasingly common. The floating leg is typically held by a commodity consumer, who is willing to pay a fixed rate for a commodity to guarantee its price. The fixed leg is typically held by a commodity producer who agrees to pay a floating rate which is set by the market price of the underlying commodity, thereby hedging against falls in the price of the commodity. In most cases, swap rates are fixed either by commodity futures, or by estimating the commodity forward price.

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There are two main types of commodity swaps:

• Fixed-floating commodity swaps are similar to the interest rate fixed-floating swaps except that both legs are commodity based. These are used by commodity producers and consumers to lock in commodity prices.
• Commodity for interest swaps are similar to equity swaps, in which a total return on the commodity is exchanged for some money market rate (plus or minus a spread).

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EQUITY SWAP:

An equity swap is similar to an interest rate swap; however, in an equity swap rather than one leg being the "fixed" side, it is based upon the return of an equity index. For example, one party will pay the floating leg (typically linked to LIBOR) and receive the returns on a pre-agreed upon index of stocks relative to the notional amount of the contract. If the index traded at a value of 500 at inception on a notional amount of $1,000,000, and after three months the index is now valued at 550, the value of the swap to the index receiving party has increased by 10% (assuming LIBOR has not changed). Equity swaps can be based upon popular global indexes such as the S&P 500 or Russell 2000, or can be made up of a customized basket of securities decided upon by the counterparties.

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CREDIT DEFAULT SWAP:

A credit default swap, or CDS, is a different type of swap, in that the traditional counterparty-periodic payment structure does not exact in the same way as other types of swaps. A CDS can be viewed almost as a type of insurance policy, by which the purchaser of the CDS will make periodic payments to the issuer in exchange for assurance that if the underlying fixed income security goes into default, the purchaser will be reimbursed for the loss. The payments, or premium, is based upon the default swap spread for the underlying security, also referred to as the default swap premium.

For example, a portfolio manager holds a $1 million bond (par value) and wants to protect his portfolio from a possible default. He can seek a counterparty willing to issue him a credit default swap (typically an insurance company) and pay the annual 50 basis point swap premium to enter into the contract. So, every year the portfolio manager will pay the insurance company $5,000 ($1,000,000 x 0.50%) as part of the CDS agreement, for the life of the swap. If in one year the issuer of the bond defaults on its obligations and the bond's value falls 50%, the CDS issuer is obligated to pay the portfolio manager the difference between the bond's notional par value and its current market value, $5,000,000. (This derivative can help manage portfolio risk, but it isn't a simple vehicle

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