Heyy guys, Here is a PPT on Interest Rate Swaps Hope it helps :)

1. INTEREST RATE SWAPS
GROUP 5:
IMON
DHRUV
AASHIMA
AASHIKA
AISHWARYA

2. WHAT IS A SWAP?
A swap is an agreement of exchange of cash flows. It is a legal arrangement
between two parties to exchange specific payments.
TYPES OF INTEREST
RATE SWAP
INTEREST RATE SWAPS
CURRENCY SWAPS
CROSS-CURRENCY
SWAPS

3. TYPE OF LOAN POTENTIAL ADVANTAGES POTENTIAL DISADVANTAGES
FLOATING RATE LOAN
● Applicable interest rate tends
to be the lowest available at
the time the loan is initiated.
● If interest rates trend lower,
interest expense can be
reduced.
● When interest rates trend
higher, loans become more
expensive.
● Borrower carries the interest
rate risk.
FIXED RATE LOAN
● Risk of changes in interest
rate market are removed.
● Takes advantage of a
favourable rate environment
to lock in long term interest
stability on a loan.
● More expensive form of a
loan at the time it is initiated
compared to a floating rate
loan.
● Pre-payment penalty may be
required if loan is paid off
early.

4. INTEREST RATE SWAPS DEFINITION
● Interest Rate Swap is one the types of Swap Contract in which two parties
with equal principal amount called notional principal agrees to exchange
their cash flow for a specified period of time.
● Two parties can either enter into interest rate swap contract:
○ To exchange fixed and floating interest cash flows, which is called Plain Vanilla Swap
○ To exchange both floating interest cash flows, which is called Basis Swap

5. TERMS: PLAIN VANILLA INTEREST RATE
SWAPS
Nominal or principal amount
This is the amount on which the interest is calculated. This amount generally
remains the same over the entire lifetime of the swap. The majority of types of
interest rate swaps are single currency, which means that there is only one
nominal amount and thus there is no exchange of nominal between the two
counterparties as the payments would cancel each other out. In the case of
currency swaps however, where there are two nominals, one for each leg, in
different currencies, exchange of nominals usually takes place at the beginning
and the end of the swap.

6. TERMS: PLAIN VANILLA INTEREST RATE
SWAPS
•Interest rates
•Fixed rate
•Floating rate-LIBOR/EURIBOR
•Duration
•The lifetime of the swap. It can go from as short as one week to as long as 30
years or more.

7. TERMS: PLAIN VANILLA INTEREST RATE
SWAPS
•Master agreement
•Master agreements are contracts that are signed between two counterparties
who frequently do over-the-counter derivatives trades with each other and sets
out standard terms that apply to each transaction entered into between those
two entities.
•Cost of a swap transaction
•Entering into a swap itself does not generate any particular cost, with the
exception of fees due to brokers or electronic trading platforms, or the
administrative cost of handling the confirmations, payments etc.

8. TERMS: PLAIN VANILLA INTEREST RATE
SWAPS
•Currency
•The currency in which the swap is denominated and in which payments are
made. As mentionned before, most interest rate swap types are single
currency, but there are also types of interest rate swaps which are using more
than one currency, like currency swaps

9. USES OF INTEREST RATE SWAPS
● Portfolio management:
Interest rate swaps allow portfolio managers to adjust interest rate exposure and offset
the risks posed by interest rate volatility. Swaps can also act as substitutes for other,
less liquid fixed income instruments.
● Speculation.
Because swaps require little capital up front, they give fixed income traders a way to
speculate on movements in interest rates while potentially avoiding the cost of long and
short positions in Treasuries.

10. ● Corporate finance
Firms with floating rate liabilities, such as loans linked to LIBOR, can enter into swaps where
they pay fixed and receive floating, as noted earlier.
● Risk management
Banks and other financial institutions are involved in a huge number of transactions involving
loans, derivatives contracts and other investments. The bulk of fixed and floating interest rate
exposures typically cancel each other out, but any remaining interest rate risk can be offset
with interest rate swaps.
USES OF INTEREST RATE SWAPS (CONTD.)

11. ● Rate-locks on bond issuance
When corporations decide to issue fixed-rate bonds, they usually lock in the current interest
rate by entering into swap contracts. That gives them time to go out and find investors for the
bonds. Once they actually sell the bonds, they exit the swap contracts. If rates have gone up
since the decision to sell bonds, the swap contracts will be worth more, offsetting the
increased financing cost.
USES OF INTEREST RATE SWAPS (CONTD.)

12. PRICE OF SWAP
• The price of a swap is the coupon rate that makes the fixed rate bond to have
a value equal to that of the floating rate bond, and thus causes the initial swap
value to equal zero.
• Price of Swap = 1/q × (1−𝑃𝑉𝐼𝐹(𝑛)/ sum[PVIF(i)])
Where,
q = Adjustment Factor
PVIF(n) = Present Value factor of nth term
1 n PVIF(i) = Sum of Present Value factor of all ith term, where i tends to 1 to n.

13. VALUE OF SWAP
● Value of Swap is the net gain or loss to the parties involved in swap
contract
● It is the difference between present value of two streams of cash flow.
● Value of Swap is obtained by calculating the difference between Value of
Floating Rate Bond and Value of Fixed Rate Bond.

14. RISKS ASSOCIATED WITH INTEREST RATE
SWAPS
● Opportunity Costs:
Locking in a fixed rate may result in higher interest expense than the average of the floating rate
over the same period.
● Potential Mark-to-Market (Make-Whole)
If the swap is unwound prior to maturity and interest rates have declined, the borrower may be
subject to a termination cost.
● Tax & Accounting Issues
Any person or entity entering into a derivative transaction is strongly encouraged to consult with
tax, legal and accounting advisors to determine appropriate tax and accounting treatment.

15. ● Liquidity & Credit Pricing Risk
The derivative contract is separate and distinct from the underlying loan. It does not create any
commitment to lend or act as a source of funding. It represents a hedge of changes in a variable
rate index only, not a hedge of the actual credit pricing on the underlying loan.
● Basis Risk
It is possible that changes in the variable rate index used in the derivative contract do not
perfectly mirror changes in the variable rates used to set the pricing on the underlying loan.
● Settlement
A risk exists that the counterparty will fail to make required payments. A weak credit profile can
offer the potential for increased counterparty risk (increased settlement risk) on derivative
transactions.
RISKS ASSOCIATED WITH INTEREST RATE
SWAPS