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Tarheel ConsultancyServices Manipal, Karnataka

Corporate Training and Consulting

Course on Fixed Income Securities For XIM -Bhubaneshwar

For PGP-II 2003-2005 Batch Term-V: September-December 2004

Module-I Part-VI-A Fundamentals of Swaps

Introduction • What is a swap? • It is basically an exchange of two payment streams that are different from each other. • Why do parties enter into a swap? • To acquire one stream of payments and to dispose off another stream.

Introduction (Cont…) • What is an interest rate swap? • It is a contract where two counterparties commit themselves to exchange, over an agreed time period, two streams of payments, each calculated using a different type of interest rate, but with the same notional principal.

Introduction (Cont…) • Are there other types of swaps? • Yes • In the case of a currency swap the two streams of payment are denominated in different currencies. • In an equity swap one stream is calculated based on an equity price. • In a commodity swap one stream is calculated based on a commodity price.

Illustration • Citibank and HSBC agree to exchange over a period of two years, two streams of cash flows at six monthly intervals. • Citibank will calculate its payments based on a fixed interest rate of 6% per annum. • HSBC will calculate its payments based on the 6M LIBOR that is prevailing at the start of the six monthly period for which the payment is being computed.

Terms • Counterparties: Citibank and HSBC • Maturity: 2 Years • Interest Rate (1): Fixed 6% per annum Citibank pays HSBC • Frequency of payment: Semi-annual • Interest Rate (2): 6M LIBOR HSBC pays Citibank • Frequency of payment: Semi-annual • Notional Principal: 100 MM USD

Illustration (Cont…) • The interest rate is normally fixed at the start of the period to which it applies. • But the payment calculated using this rate is made at the end of the period. • This is what is meant by `determined in advance and paid in arrears.’ • We can also have a system of `determined in arrears and paid in arrears.’

Summary of Cash Flows

Sample Calculations • Cash Outflow for Citibank after 6 months: 0.06 x 100,000,000 x 181 ------ = 2,975,343 365 • Cash Outflow for HSBC after 12 months: 0.06125 x 100,000,000 x 184 ------ = 3,087,671 365

Notional Principal • In the case of an interest rate swap only the interest is exchanged. • There is no exchange of principal. • The principal is specified purely for the computation of interest. • Hence it is termed as a `notional principal’.

Off-Balance-Sheet • Since the principal is not exchanged the swap does not impact the balance sheets of the counterparties. • Hence interest rate swaps are referred to as off-balance-sheet transactions.

Netting • In our illustration the counterparties were required to make payments to each other on the same date. • Hence the payments are usually netted and only a single amount representing the difference is exchanged.

Illustration

Netting • Netting of payments reduces the delivery risk. • What is delivery risk? • It is a default risk that can arise when an exchange of payments does not occur simultaneously. • Thus a delay exposes the counterparty making the earlier payment to the risk that the other party may not honour its commitment.

Netting (Cont…) • In order to facilitate netting, the frequency and timing of fixed rate payments will usually match the frequency and timing of the floating rate counter payments.

Frequency of Payments • The frequency of the floating rate payments is usually set by the tenor of the benchmark rate that is used in the swap. • Thus if 6M LIBOR is used as the benchmark then the payments will be made semi-annually, whereas if 3M LIBOR were to be used, the payments would be made quarterly.

Terms • A swap agreement ought to contain the following details • The names of the counterparties • The maturity date of the swap • The fixed interest rate • The benchmark for the floating rate • The notional principal amount • And the frequency of payments

Frequency of Payments • In our illustration, both fixed as well as floating rate payments were made on a semi-annual basis. • Such a swap is called a semi/semi. • Longer term swaps can even be annual/semi. • Short-term swaps can often be quarterly/quarterly. • In some cases fixed payments are made annually and floating payments are received quarterly. • These are called annual/threes swaps.

Purpose of a Swap • Let us consider the swap between Citibank and HSBC. • What did it achieve? • In the case of Citibank the fixed interest rate payments were known from the outset. • But in the case of HSBC since LIBOR id variable, the cash outflows were subject to uncertainty, except for the first six months.

Purpose (Cont…) • Citibank is paying fixed and receiving floating. • Hence it is subject to the risk that the LIBOR will fall during the life of the Swap. • HSBC is paying floating and receiving fixed. • It is therefore exposed to the risk that the LIBOR will rise during the life of the swap.

Purpose (Cont…) • Thus an interest rate swap exposes both the counterparties to interest rate risk. • Such swaps may therefore be used for speculation or for profiting from an expected interest rate change by deliberately taking risk. • Or they may be used for hedging against another source of interest rate risk.

Speculation • Assume that Citibank is anticipating rates to rise whereas HSBC is expecting that rates will fall. • Thus a swap which requires Citibank to pay fixed and HSBC to pay floating, can be used as a speculative mechanism by both the parties.

Hedging • Assume that Citibank has already borrowed on a floating rate basis. • It can use the swap with HSBC to hedge interest rate risk. • If rates rise it will have to pay more interest on its original borrowings, but will receive a net cash inflow from the swap.

Hedging (Cont…) • Assume that HSBC has already made a loan on floating rate basis. • If so it can use the swap to hedge. • If interest rates were to fall it would receive less on its original investment but will receive a cash inflow from the swap.

Advantages • Before swaps became available interest rate risk had to be managed using assets and liabilities in the form of cash instruments. • For instance assume that a bank anticipates a fall in interest rates. • It could make a medium term fixed rate loan and fund it by taking a series of consecutive short term deposits.

Advantages (Cont…) • For instance if it were to rollover a series of short term deposits, it would beeffectively borrowing at a floating rate and lending at a fixed rate. • If rates were to fall as expected it would pay a lower rate of interest on its deposits would continue to receive a fixed rate of interest from its loan.

Advantages (Cont…) • An interest rate swap where the bank receives fixed and pays floating can be used to achieve the same result. • The swap would yield the same profit would there would be no transfer f principal and consequently no impact on the balance sheet.

Advantages (Cont…) • Since a swap is an off-balance-sheet transaction as opposed to the alternative entailing the use of assets and liabilities, it offers several advantages. • There is less credit risk. • Only interest payments are at risk whereas in the case of assets and liabilities the full principal is at risk.

Advantages (Cont…) • Swaps are subject to lower capital adequacy requirements because they involve less credit risk. • Swaps involve lower transaction costs because less money is being transferred and funded. • They offer greater flexibility.

Types of Interest Rate Swaps • Coupon swaps • What we have just seen is a coupon swap. • It entails the exchange of a payment based on a fixed rate in return for a payment based on a floating rate. • Basis swaps • In these swaps both streams of payment are calculated using a floating rate index. • For instance one stream could be based on the LIBOR whereas the other could be based on the prevailing commercial paper rate.

Types (Cont…) • Asset swaps • If one of the payment streams is funded with interest received from an asset, the swap and the asset as a whole are called an asset swap. • There is no change in the swap mechanism per se. • Strictly speaking we could also have liability swaps. • But this term is rarely used. • Thus swaps used in conjunction with a liability are merely referred to as interest rate swaps.

Types (Cont…) • Term swap • A swap with an original maturity of more than two years is called a term swap. • Money market swap • A swap with an original maturity of up to one year is called a money market swap. • Currency swap • It is a swap where each stream on interest is denominated in a different currency. • These swaps also involve an exchange of principal.

Terminology • The counterparties to a swap are called payers or receivers. • In the case of a coupon swap, the party paying on a fixed rate basis is said to be the `payer in the swap’ and the other counterparty is the `receiver in the swap’. • In the case of a basis swap we cannot use this convention since both the cash flow streams are based on floating rates.

Terminology (Cont…) • Thus it is a god practice in the case of basis swaps to describe each counterparty in terms of both the rate it pays as well as the rate it receives. • In the inter-bank swap market the terms buyer and seller are used in the case of coupon swaps. • Buyers are payers and sellers are receivers.

Terminology (Cont…) • In most coupon swaps the 6M LIBOR is the standard index for the floating rate. • Thus these swaps can be defined purely in terms of the fixed rate of interest. • For example in the case of the Citibank-HSBC swap, the price of the swap would have been quoted as 6% per annum, which is nothing but the fixed rate. • The price of a coupon swap is also called the swap rate.

Terminology (Cont…) • In most markets swap rates are quoted as full percentage figures. • Example in our case the rate was 6%. • This is called an all-in price. • However in certain inter-bank swap markets, particularly the US dollar market, the convention of quoting the price on an all-in basis has been replaced by the convention of quoting the differential between the all-in rate and an accepted benchmark rate.

Terminology (Cont…) • The benchmark rate is usually the rate on the government bond with a remaining period to maturity closest to that of the swap. • The difference between the all-in price and the benchmark rate is called the swap spread.. • For instance assume that the all-in price is 5.5% for a 5 year swap and that 5 year T-notes are yielding 5.3% per annum. • The swap price will be quoted as 20 basis points.

Terminology (Cont…) • The trade date or the fixing date is the date on which the terms are agreed upon. • The following terms have to be agreed upon • The maturity • The swap rate • The floating rate index • The payment frequency • The notional principal • On this date the counterparties contractually commit themselves to the transaction.

Terminology (Cont…) • The value date is the date on which the interest payments start to accrue. • For swaps involving only the domestic currency the value date is usually the same as the trade date. • For foreign currency swaps the value date is usually two days after the trade date.

Terminology (Cont…) • The date on which the floating rate is re-fixed for the next period is called • The re-fixing or re-pricing or reset date. • The date on which the interest is paid for the preceding period is called the effective date. • The effective dates are calculated from the value date. • For domestic currency swaps the effective dates are the same as the re-fixing dates. • For currency swaps the effective date is two business days after the re-fixing date.

Swaps versus Other Derivatives • Swaps are traded on a bilateral basis in decentralized markets. • Thus swaps are OTC instruments. • In contrast futures contracts and listed options are exchange traded instruments. • On an exchange the clearinghouse becomes the buyer for every seller and the seller for every buyer.

Swaps vs. Others (Cont…) • Both the parties have to provide daily collateral called margins. • The role of the clearinghouse and the margining mechanism minimizes the risk of default. • In OTC markets there is no clearinghouse, and margining is not compulsory. • So default risk is a major concern.

Swaps vs. Others (Cont…) • Futures contracts and listed options are standardized instruments. • Standardization reduces transactions costs and provides greater liquidity. • OTC contracts are however customized. • Activity in exchange traded products is limited to certain instruments. • However OTC products like swaps are available for any currency and for any tenor provided a counterparty can be found.

Swaps vs. Others (Cont…) • Futures and listed options are usually available only for short to medium terms. • Swaps on the other hand can extend as far as 20 years into the future.

Trading Swaps • The swap market is an OTC market. • Trading is conducted primarily by telephone. • Indicative prices are disseminated over screen services by agencies like Reuters.

Negotiations • Key financial details are agreed verbally between dealers. • Key details are then confirmed y an exchange of telexes or faxes within 24 hours. • Full contract documentation is agreed, signed, and exchanged subsequently.

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