Swap is an agreement between two parties to exchange cash flows over time. The key types of swaps discussed in the document are interest rate swaps, currency swaps, and credit default swaps. Interest rate swaps involve the exchange of interest payments in the same currency, while currency swaps exchange payments in different currencies and may also exchange principal amounts. Credit default swaps provide credit protection to the buyer in the event of default by a reference entity. Swaps are used for hedging risks and reducing borrowing costs.

1. Dr.Divya M
Assistant Professor in Commerce
MES Keveeyam College, Valanchery
SWAP

2. Contents
 Meaning and Definition
 Development
 Structure of swap dealing for risk management
 Interest rate swap
 Forward swap and swap options contracts
 Cancellable and extendable swaps
 Non-generic swap transactions
 Currency swap
 Pricing and valuation of swap
 Risk management function of swap transactions

3. Swap
“Necessity is the mother
of invention”
 Swap is based on the Ricardo’s theory of
Comparative Advantage”

4.  Exchange
 Agreement between two parties to exchange a
series of cash flows over a period in the future.
 The parties of swap contract are known as
Counter parties
 Swap is an agreement to exchange one stream
of cash flow for another in future.
 The two streams of cash flows are known as two
legs of a swap contract.
 Swap-not a funding instrument, rather just like a
device to obtain a desired form of financing
indirectly , which otherwise might be inaccessible
or too expensive.
 Cash settled OTC derivative.
 Switch=exchange of one security for another

5. Features of Swap
 Combination of forwards. So all the features of
forward contract.
 Requires two parties with equal and opposite
needs must come into contact with each other.
 Involves multiple future points of exchange
 Like long dated forward contract
 Intermediary-Swap facilitator (large financial
institutions/banks)
 bilateral contract-more risky-chance of default
risk
 Do not involve upfront payment-zero value at
start

6. Special terms
Parties
• Two parties
• Counter parties
Swap
facilitators
/ swap
banks
• Swap broker (economic agent-identifying the
potential counter parties in swap deal)
• Swap dealer (often becomes an actual party-
financial intermediary-market maker
Notiona
l
principa
l
• Underlying amount in swap contract
• Amount does not vary- but the cash flows in the
swap are attached to this amount

7. Special terms
Trade
date
• Date on which both the parties in the swap deal are
enter into the contract
Effective
date
• Date when the initial cash flows in a swap contract
begin.
• Value date
• Maturity of contract is calculated from this date
Maturity
date
• The date on which the outstanding cash flows stop in
swap contract
Reset
date
• Date on which the LIBOR rate is determined

8. LIBOR=London Inter Bank
Offered Rate
 Rate decided on daily basis based on a sample of
lending rates offered by leading banks in London
 It is the offer rate that a Euro market bank
demands in order to place a deposit at or make a
loan to another Euromarket bank.
 LIBID-London Interbank Bid rate- Bid rate that a
Euro market bank is willing to pay to attract
deposit from another Euro market bank (No
formal correspondent responsible for fixing the
daily rate)

9. Advantages
 Obtain cheaper finance
 Can arrange funds
 Long term hedge instrument
 Flexible in maturity, amount and other contract
terms
 Meeting the financial needs of MNCs
 Useful when there are market fluctuations

10. Disadvantages
 Difficult to find counter party
 Termination of contract-mutual consent
 Inherent default risk
 OTC, not exchange traded
 Not easily tradable-secondary market is not fully
developed

11. Uses
 To treasurers
 Rising interest rates
 Reducing borrowing cost
 Financial managers
 Converting floating rate debt to fixed rate and vice
versa
 To lock in an attractive interest rate
 Position fixed rate liabilities in anticipation of decline
in interest rate
 Arbitrage debt price differentials in capital market
 Financial institutions

12. Evolution
 Parallel loans and back to back loans (1960s and
1970s)
 Parallel loans=four parties
 Back to back loans=two parties
First currency swap=august 1981 (solomon brothers)

13. Structure of swaps
 Swap dealer-bank-intermediary
 Eg: fixed for floating rate swap
 One of the counter parties agrees to make fixed
rate payment to other. In return the second
counter party agrees to make floating rate
payment to the first counter party.
 These two payments are known as the legs or the
sides of the swap.
 Fixed rate is known as swap coupon
 These payments are calculated on the basis of
hypothetical amount called notional principal.
 Exit swap contract-
 Opposite position

14. Economic functions of swap
transactions
 Transforming the nature of liabilities ( fixed-to-
floating & floating –to- fixed)
 Transforming the nature of asset
 Hedging
 Reducing the cost of funds

15. Types of swap
Interest rate swap
Currency swap
Credit default swap
Commodity swap
Equity swap

16. Currency swap
 Foreign exchange agreement between two
parties to exchange a given amount of one
currency for another, and after a specified period
of time , give back the original amounts swapped.
 Used to hedge against foreign exchange risk
 Involve two different currencies
 Banks are intermediaries between the two parties
to swap
 Currency swap is a contract or agreement, not a
loan by itself

17.  Currency swap gives the parties the right to
offset, namely the non payment of principal or
interest with corresponding non payment in the
other currency
 In currency swap there is always an exchange of
principal amount at maturity, based on the original
amounts of currency at the predetermined
exchange rate.
 In practice, currency swap also include interest
rate swap

18. Three aspects
Parties involve exchange
debt obligations in different
currency
Each party agrees to pay the
interest obligation of the
other party
On maturity, principal
amounts are exchanged at
pre determined exchange
rate

19. Mechanism of currency swap
Firm A Firm B
Available Euro-Fixed rate 6%
US $ -floating rate-LIBOR
Euro-Fixed rate 8%
US $ -floating rate-LIBOR
Need Floating rate –US $ Fixed rate –Euro
Borrow Fixed rate 6% -Euro Floating rate –LIBOR –US $
Possess Floating rate –US $ (LIBOR) Fixed rate –Euro(6%)
Interest
rate flows
US $---Swap dealer---Firm B Firm B will pay fixed rate of
interest to swap dealer that
will be more than 6%, but
less than 8%...
7% (swap dealer charges
commission ---balance
(6.80%)----Firm A
Swap

20. Benefits from currency swap
1. Firm A and firm B gets the currency of their
own choice
2. Cost of borrowing gets reduced
3. Can be used as a tool for hedging foreign
exchange exposure
Firm A
• Without
Swap=LIBOR
• With swap
• 6%+LIBOR-6.80%
• Gain=0.80%
Firm B
• Without Swap=8%
• With swap
• 7%+LIBOR-LIBOR
• Gain=1%

21. Hedging through currency swap
 Hedging foreign exchange risk
 Eg: Indian Firm –Borrow fund from India-doing
operation in US –Acquire assets in USA-get profit
from USA in $
 Dollar depreciate-risk (lesser rupee amount for the
fixed return earned in US $)
 Similarly US firm –borrow from US market-doing
operation in India- Acquire asset in India
 Rupee depreciate-risk (lesser dollar amount for the
fixed return earned in Indian rupee)

22.  Under swap transactions , the mismatch of cash
inflow and cash outflow in different currency for
both the firms can be eliminated=US firm
agreeing to pay rupee generated out of its Indian
operations to Indian firm in exchange of Indian
firm agreeing to pay dollar generated out of its US
operations
 Both the firms avoid the conversion of currencies
from one to another
 Eliminates exchange rate risk-currency risk

23. Types of currency swap
Fixed –for- floating currency swap
Fixed- for- fixed currency swap
Floating –for-floating currency swap
Amortizing swap
Basis swaps

24. Advantages-currency swap
 Hedge against foreign exchange risk
 Increases the total amount that the firm can
borrow
 Facilitates economies of scale
 Reduces operating costs
 Surplus fund can be used effectively in blocked
currencies
 Means for exploiting the opportunity for arbitrage
 Integrating the world’s capital markets

25. Interest rate swap/Generic
swap/Plain vanilla swap
 1980s
 Contractual agreement entered into between two
counter parties under which each agrees to make
periodic payment of interest to the other for an
agreed period of time based on the principal
amount.
 Swap Buyer= The counter party who pays the
fixed rate cash flow
 Swap Seller = The counter party who receives
the fixed rate cash flow
 Exchange of interest payments

26.  Occurs when a person or firm need fixed rate
loan but is able to get floating rate loan. It finds
another party who needs floating rate loan but is
able to get a fixed rate loan.
 The two parties are known as counter parties.
 Conditions
1. Amount of loan –same
2. Periodic payment of interest-same currency
3. Synchronization of interest between two parties-
one getting cheaper fixed rate fund and another
also get cheaper floating rate fund
 The interest payments are called the legs of the
swap
 Fixed rate is called swap coupon

27. Mechanism of interest rate swap
Firm A Firm B
Available Floating rate fund available
@ LIBOR +0.3%
Fixed rate fund @ 8.5%
Need Fixed rate fund @ 9.5% Floating rate fund available
@ 6 month LIBOR flat
Borrow Floating rate fund available
@ LIBOR +0.3%
Fixed rate fund @ 8.5%
Approach swap
dealer (Bank)

28. Mechanism of interest rate swap
Firm A Firm B
Pay to
Swap
dealer
Pay fixed rate interest
to swap dealer , which
is greater than interest
rate of firm B (8.5%)
and lower than
interest rate of firm A
(9.5%)=9%
6 month LIBOR
Pay to
lender
Pay LIBOR+0.3%
to the lender
8.5%
Pay by the
swap dealer
LIBOR 9.00%-
0.1%(commission)
=8.9%

29. Cost of Borrowing
Firm A
• Cost of floating rate loan
=LIBOR+0.3%
• Less floating rate
received=LIBOR
• Net cost
differential=0.3%
• Add swap coupon=9.0%
• Total cost of
borrows=9.3%
• Interest saving=9.5%-
9.3%=0.2%
Firm B
• Cost of fixed rate
borrowing =8.5%
• Less fixed rate
borrowing=8.9%
• Net cost differential=-
0.4%
• Total cost of borrowing
=LIBOR-0.4%
• Interest saving =0.4%

30. Hedging of interest rate risk
 Apart from reducing cost of borrowing, interest
rate swap are also used for hedging interest rate
risk
 Eg: A person borrows fixed interest rate loan ,
expect a price fall…..convert it into floating rate
 Like a person borrows floating rate loan , expect
a price rise= convert it into fixed rate loan

31. Various forms of interest rate
swap
 Coupon swap (same as plain vanilla# fixed
interest payment-lumpsum , floating =periodically)
 Basis swap (different instruments)
 Putable swap =give the swap seller(floating rate)
the right to terminate before its maurity, if interest
rate rises)
 Callable swap =give the swap buyer (fixed rate)
the right to terminate before its maturity, if interest
rate falls)
 Rate capped swap=fix a capped rate
 Protect the borrower against the rise in interest rate
 Interest rate floors=protect the depositor against a

32. Advantages
 Does not involve any exchange of pricnipal
amounts
 Documentation charge is minimum
 Off balance sheet item
 Used for hedging and increasing profitability
 Borrower can raise funds at a fixed rate when the
interest rates are rising and then switch to floating
rates in case they are falling

33. Difference between interest rate swap and currency
swap
Interest rate swap Currency swap
Cash flow exchanged
are in the same
currency
In different currency
One notional principal
amount
Two notional principal
amount
Notional principal
amount is not
exchanged
Notional principal
amount are exchanged
No counter party risk Counter party risk
Bench mark rate is Bench mark rate is

34. Credit default swap
 Credit derivative contract between two counter
parties
 The buyer of CDS is known as protection buyer
 The seller of the CDS is known as protection
seller
 The protection buyer makes a series of payment
to the protection seller and in exchange receives
a pay off if an underlying credit instrument
defaults or experiences a similar credit event

35. Equity swap
 An equity stock is a transaction in which one
party agrees to make a series of payments
determined by the return on the stock or a group
of stock or stock index to another party in return
for a cash flow that could be based on a fixed
rate, floating rate or a return on another stock or
stock index.
 Different from interest rate swap
 Stock returns can be negative
 Return of the stock is known at the end of the
period.

36. Commodity swap
 Agreement between two counter parties to
exchange cash flows depending upon the price of
a given commodity
 One party will pay a fixed price for a given
commodity, while the counter party will pay
floating price for the same commodity on the
settlement date.

37. Swap market
 Market where the swaps are traded
 Buyers, sellers and intermediaries
 Commercial bank and investment
banks=intermediaries/ swap dealers
 Direct swap market= no intermediaries, but
default risk
 With intermediaries= default risk is covered by
them

38. Type of swap risks
 Interest rate risk
 Exchange rate risk
 Market risk
 Mismatch risk
 Basis ris
 Sovereign risk
 Credit risk

39. Valuation of interest swap
 The net difference between the present value of
the payments to be received and the present
value of the payments to be made.
 Swap valuation
 Swap as a portfolio of two bonds made
 Inflow and outflow of the interest at periodic
intervals equivalent to that of bond
 A) cash inflow equivalent to the interest on the
bond owned
 B) cash outflow equivalent to paying the interest
on the bond issued

40.  The value of swap for one receiving fixed and
paying floating will be equal to the differential of
the fixed leg and floating rate cash flows
 Vs=Vc-Vf
 Vs=Value of swap
 Vc=Value of Fixed coupen

41. Valuation of currency swap
 Vs=Vf-Vl
 Vf=value of foreign currency bond
 Vc=value of local currency bond

42. Difference between swap and
futures
swap Future
 OTC contracts
negotiated directly by
counter parties
 Payments at times
specified in the swap
agreement
 Long time horizons
(20 yrs)
 No default risk
 Standatised contract
with fixed principal
amount
 Marked to market
daily
 Donot trade for more
than 2 or 3 years
 Default risk

43. Forward Swap
 Forward contract to enter into swap
 Forward contract on swap
 Commencement date is delayed to a future date
 Mostly useful to those investors who donot need
fund immediately but would like benefit from the
existing rate of interest.
 A contract that obliges the two parties to enter
into a swap at al later date at a fixed rate agreed
to in advance

44. Swaptions
 Option on swap
 Give the buyer the right to enter into swap
contract at some future date for payment of a
premium
 Receiver swaption
 Payer swaption
Rate on expiry Payer swaption Receiver
swaption
Interest>strike
rate
Exercise Do not exercise
Interest <strike
rate
Do not exercise Exercise

45. Non generic/exotic swap
 First genaration
 Forward starting swap
 Roller coaster swap
 Amortising swap
 Accreting swap
 Constant swap
 In-arrear swap
 Quanto swap
 Leveraged swap
 Power swap
 Overnight index swap

46. Non generic/exotic swap
 Second genaration
 Index amortising swap
 Bermudan swap
 Range accrual swap
 Asian swap
 Digital or Binary swap
 Barrier swap
 Chooser swap or swaption
 Corridor swap

47. Risk mgt fn of swap transactions
 To hedge against the risk of rising interest rates
 To hedge against the risk of falling interest rates
 To hedge against the market price risk and
interest rate risk
 To derive the benefit of comparative advantage in
borrowing or lending
 To hedge against the risk of decline in revenue
stream
 To hedge against the risk of increase in cost