Swaps

1. Swaps Introduction Types of Swaps Why Swaps Evolution of the Swaps Uses New Innovations Swaps in Indian Markets Valuation of Swaps

2. Introduction A swap is an asset and liability management technique which permits a borrower to access one market and then exchange the liability for another type of liability Investors can change one type of asset for another with a preferred income stream using swaps

3. Types of Swaps Interest Rate Swaps Currency Swaps

4. Interest Rate Swaps Interest Rate Swaps are also known as coupon swaps An IRS is a contract in which one party exchanges payments determined by reference to a ‘fixed rate of interest’ in return for payments from the other party, determined by reference to ‘market rates’ on an agreed contract amount

5. IRS (Contd.) This defines a plain ‘vanilla’ interest rate swap There is no movement of principal funds It is a financial transaction in which two counterparties agree to exchange streams of interest payments over a period of time

6. IRS (Contd.) The characteristics of an IRS: A Notional Principal Contract Amount A Fixed Rate A Floating Rate Duration No movement of principal funds

7. IRS (Contd.) A Notional Principal Contract Amount Is the amount on which the interest settlement will be determined The amount is a ‘notional’ principal amount because this principal is not exchanged This amount remains constant in a standard IRS A Fixed Rate Is used to calculate the amount of fixed payment This amount remains constant throughout the life of a standard IRS

8. IRS (Contd.) A Floating Rate In a standard IRS it is one of the benchmark rates used to calculate the floating payments The floating rate changes at every ‘interest rate fixing’ Consequently the floating amount of interest also changes as the floating rate changes Duration Is the total period for which the IRS will run The duration would also specify the fixed and floating interest payment dates The floating dates add up to the fixed duration

9. IRS (Contd.) Duration The fixed interest payment could either be ‘semi-annual’ or ‘annual’ as decided at the start of the contract The floating interest payment dates, by mutual agreement, could be monthly, quarterly, semi-annually or annually

10. Currency Swap Currency Swaps are also known as FX swaps or Cross Currency IRS A Currency Swap involves two payment streams being exchanged in different currencies It involves the exchange of principal amount at the start date and a re-exchange of the same principal amount on maturity date

11. Currency Swap (Contd.) The characteristics of a Currency Swap: Two currencies Exchange of principal at start date Re-Exchange of principal at maturity date The ‘notional’ conversion rate is determined on the start date Interest payments exchanged at the agreed frequency during the tenure of the swap

12. Currency Swap (Contd.) Two currencies One party raises a liability in one currency The other party raises funding in another currency Exchange of principal at start date The parties exchange the currency they have for the currency they require The notional conversion rate is determined to calculate the currency amounts The notional conversion rate is usually the on-going Market Spot Rate

13. Currency Swap (Contd.) Re-Exchange of principal at maturity date The principal amounts are re-exchanged on the termination date The amounts are the same, i.e., the notional conversion rate remains constant Interest payments exchanged at the agreed frequency during the tenure of the swap Interest payments are made at the agreed benchmark/fixed rate and at pre-determined frequencies

14. Why IRS The reason why corporates get involved in Interest Rate Swaps, over and above need is called Comparative Advantage Comparative Advantage arises due to: Ratings Preferential Treatment Access to Market

15. Comparative Advantage Rating Some companies have an advantage due to better credit rating Because of better rating they can access funds cheaper from the market Such companies use the IRS market to reduce the cost of their borrowings

16. Comparative Advantage Preferential Treatment Some companies are provided preferential treatment in matters of raising funds, cost of funds or collateral Such preferential treatment puts them at an advantage to the others They use the IRS market to reduce the cost of their borrowings

17. Comparative Advantage Access to Markets Some companies have better access to the market as compared to the others This could be due to selectively accessing the market for borrowings as opposed to frequently borrowing from markets Such companies can use the IRS market to reduce the cost of their borrowings as well

18. Evolution of IRS Earliest IRS transactions date back to the 1970s Back to back loans or parallel loans is how it originated With the lifting of exchange control across the developed world in the 1980s, currency swaps replaced such back to back/parallel loans Easy documentations and ease of operations made the swap market even more attractive

19. Evolution of IRS From being mere intermediaries, banks started pricing of swaps and became ‘market-makers’ The use of swaps for Asset/Liability Management saw a virtual explosion in swap volumes This improved liquidity in swaps and also led to finer pricing Banks took the credit risk of the counterpart on its own books Eventually customisaton became popular

20. Uses of IRS To lock in an Acceptable Fixed Rate A long term borrow may want to use an IRS to lock in an Asset Rate for the long term A long term investor uses an IRS to lock in a Liability Rate for the long term To manage duration A long term borrower can use an IRS to reduce the duration of his liability to a short term A long term investor uses an IRS to reduce the duration of the asset to a short term

21. Uses of IRS Speculation A speculator who expects interest rates to fall can use an IRS to create a long term fixed rate asset against a short term floating rate liability If interest rates are expected to rise a speculator uses an IRS to create a long term fixed rate liability against a floating rate short term asset

22. Uses of Currency Swaps Funding A corporate has or raises funds in one currency but requires funding in another currency, uses a currency swap to raise the required currency Arbitrage A currency swap can be used to generate ‘risk-free profits’ by exploiting price differences

23. Innovations in Swaps Customisation Exotic Swaps Stepped up Amounts Reducing Amounts Callable/Puttable Swaps Embedded Swaps – With Options

24. IRS in the India The RBI has permitted the use of Swaps since July 1999 Banks can make market in Swaps IRS Agreements for corporates can be for hedging purpose only The benchmark for the floating can be any debt/money market rate ISDA documentation is the preferred one with suitable modifications

25. Swap Valuations Valuation of an existing swap is nothing but the prevent value of a future stream of interest income or cost The future value need to be discounted at current market rates to calculate the present value The fixed rate on an IRS is linked, generally, to the government securities’ yield for the appropriate maturity A margin (or spread) over the yield is applied depending on the rating of the counterpart

26. FOREX Risk Management • Nature and Exposure of Risk • Volatility • Classification of FX Risk • Accounting Treatment • Inflation Rates and Exposure • Interest Rate Risk

27. Nature of Risk • Risk arises due to adverse fluctuations in rates • But risk arises only if one has an exposure • And exposure arises if you have a receivable or a payable • International Business involves exports, imports, borrowing and lending in foreign currencies

28. FX Exposures • Therefore international business results in foreign currency receivables and payables • Where FX Receivable > FC Payable risk is of foreign currency depreciating • Where FX Receivable < FC Payable risk is of foreign currency appreciating • If FC Receivable = FC Payable there is no risk

29. FX Exposures

30. Volatility • Volatility can be defined as the change in the value of the underlying currency or instrument that exposes the holder to the risk of losing money • Put simply we need to understand that prices/currency values change over time • Higher the degree of change, higher is the risk and higher the probability of losing money due to adverse changes

31. Volatility • The fluctuations seen in USD/INR has increased significantly in recent times • In the early 1990s the average monthly trading range was 5 paise, sometime even less • In fact over a 2 ½ year period during 1993/95 the range for USD/INR was a mere 60 paise • The month range in early 2000s was about 15 paise

32. Volatility • But in recent times fluctuations have increased significantly with rising uncertainty and unpredictability • Quite often we see a daily range in excess of 25 paise • In fact just Tuesday’s (18.03.08) USD/INR range was 40.48 to 40.73 • And what this means is risk management becomes even more critical as risk has become much higher

33. Volatility • Gone are the days when markets were ‘one-way’ • Till 2004, we had a clear trend of Rupee depreciation which took USD/INR up, all the way to 49.08 • Then started a long period of rupee appreciation when USD/INR fell almost uninterrupted till Nov 2007 to 39.16 • Since the we are seeing a clear two-way movement which makes forecasting all the more difficult

34. Volatility • Volatility is neither an exclusively Indian nor an Indian Rupee phenomena • The movement in major currency pairs too has been increasing steadily • Increased competition, large volumes, finer pricing and numerous participants has seen margins shrink • Consequently making money is all the more tough prompting speculators to place even bigger bets, increasing volatility

35. Classification of FX Risk • Risks arising out of FX Markets can be classified as: • Economic (Exposure/Market) Risk • Balance Sheet Translation risk • Operations Risk

36. Economic Risk • Economic Risk refers to the risk of adverse movement in FX rates on the net exposures • Risk arises because we have an exposure, either Long or Short • We need to limit the amount of exposure by fixing appropriate • Daylight Limit and • Overnight Limit

37. Economic Risk • Daylight limit defines the maximum exposure that can be built up during the course of the working day • No exposure in excess of this limit should be created • Overnight limit defines the maximum exposure that can carried forward from one working day to another • Daylight limit is always greater than the Overnight Limit

38. Translation Risk • Translation Risk refers to the risk of adverse FX Rate movement on Net Foreign Currency Assets and Liabilities funded out of Domestic Currency • Therefore it is also known as Balance Sheet Translation Risk • One cannot limit Translation risk but it can be managed through the use of Currency Swaps and Options

39. Operations Risk • Operations Risk refers to the risk of human errors (of omission and commission), systems and procedures • One cannot put a limit on such risks • However effective control systems need to be put in place, quite often post-event, to avoid their recurrence • MIS often is an effective tool in controlling operations risks

40. Accounting Treatment • Treatment of Transaction Risk • Mark to Market • An internal adjustment to the value of the open exposure to reflect current market rates • Accounting entries need to be passed and exposures carried forward from one accounting period to another at current market rates • Current market rate is the agreed benchmark • Value at Risk • Is the value of the exposure that is at risk • Accounting entries may be passed

41. Accounting Treatment • Treatment of Translation Risk • Mark to Market • The accounting treatment is the same except that translation risk is not on open exposures • These are strategic exposures not connect with any trading or speculative transactions

42. Inflation Rates and Exposures • Inflation has a direct linkage to interest rates • Interest rates have an impact on exchange rates • The immediate effect of interest rate changes are often contrary to the longer term effect • The value of an exposure may therefore change with changing inflation rates

43. Interest Rate Exposures and Risk • Interest rates are no more fixed by the Reserve bank • Commercial banks have the flexibility to decide their own deposit and lending rates • Changes in economic fundamentals and RBI policy influence interest rates • With frequency of re-pricing of money market products, there has been a marked increase in volatility in interest rates

44. Interest Rate Exposures and Risk • The frequent use of interest rates by central bankers to guide economic growth and control inflation means increased volatility in interest rates • The need for money is at two-levels: • Short term for liquidity and working capital • Long term for capital expenditure • Companies access the money for both these requirements, either directly or through the use of instruments

45. Interest Rate Exposures and Risk • Interest Rate Risk Management becomes necessary due to these factors • Risk arises because interest rates move • Moreover interest rates are for a particular duration • If Asset duration is > than Liability duration risk is interest rates Fall • If Liability duration is > than Asset duration risk is interest rates Rise • If Asset duration is = Liability duration there is no Interest rate risk

46. Interest Rate Exposures and Risk • Interest Rate Risk Management becomes necessary due to these factors • Risk arises because interest rates move • If Asset duration is > than Liability duration risk is interest rates Fall • If Liability duration is > than Asset duration risk is interest rates Rise • If Asset duration is = Liability duration there is no Interest rate risk • Companies access the money for both these requirements, either directly or through the use of instruments

47. Interest Rate Exposures and Risk

48. Interest Rate Exposures and Risk