What is Swaps?
Exchange of cash flows on account of an investment or payment obligation is termed as Swap. A swap is an agreement to exchange cash flows between counter parties at specified future times according to certain specified rules.
The investment or the payment obligation based on which the cash flows are determined is termed as the underlying or the notional value of the swap.
Typically, these cash flows are categorized as two legs. They are Receivable Leg and Payable Leg.
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Swaps Additional Details
Swaps are non-standardized contracts that are traded over the counter (OTC). However, to facilitate trading, market participants have developed the ISDA Master Agreement, which covers the 'non-economic' terms of a swap contract, such as representations and warranties, events of default and termination events. Parties to the trade still need to negotiate the rate or price, notional amount, maturity, collateral, etc.
Swaps are contracts that exchange assets, liabilities, currencies, securities, equity participations and commodities. Some are simple, such as floating-for-fixed-rate loans or Japanese yen for British pound sterling, while others are quite complex incorporating multiple currencies, interest rates, commodities and options. Both types are flexible in terms of specifications such as pricing or evaluation benchmarks, timing or contractual horizons, settlement procedures, resets, and other variables.
Generally, swaps are used for risk management by institutions such as banks, brokers, dealers and corporations. Some qualified individuals may also be suitable users of these basic derivatives products.
Swap Characteristics
Most involve multiple payments, although one-payment contracts are possible
A series of forward contracts.
When initiated, neither party exchanges any cash; a swap has zero value at the beginning.
One party tends to pay a fixed rate while the other pays on the movement of the underlying asset. However, a swap can be structured so that both parties pay each other on the movement of an underlying asset.
Parties make payments to each other on a settlement date. Parties may decide to agree to just exchange the difference that is due to each other. This is called netting.
Final payment is made on the termination date.
Usually traded in the over-the-counter market. This means they are subject credit risk.
LIBOR (Floating Interest Rate)
London Interbank Offer Rate (LIBOR): It is the rate at which British banks are ready to lend amongst one another. It is Benchmark Interest Rate
It is collected and compiled by British Banker’s Association (BBA) from its 17 member banks on a daily basis and publishes the average rate on the morning 11:30 every day.
How is it calculated?
The 1st 25% and bottom 25 % are trashed and the weighted average is taken of the remaining.
The rates are for lending in 10 different currencies. The most common currencies are GBP, EUR and USD.
Credit Default Swaps
It is an agreement between two counterparties, protection buyer and the protection seller wherein the protection seller promises to compensate reference obligation to the protection buyer in case of any credit event and in return protection buyers pay the regular risk premium to protection sellers.
CDS does not provide protection against market risk. It provide protection against credit event like bankruptcy, failure to pay, obligation default, organizational restructuring etc. but not related to market events.
So now we can say that credit default swap (CDS) is an agreement to buy protection against the financial performance of a reference entity.
It is an instrument to transfer the credit risk of an asset without transferring its ownership.
Risk Premium can be decided based on below points
- Term of the Contract
- Possibility or probability of default is seen (Probability of event happening)
- Value of the contract
- Credit Rating of the company
- Survival Rate
Example of CDS
- Suppose a protection buyer purchases 5-year protection on a company at a default swap spread of 300bp. The face value of the protection is $10 million. The protection buyer therefore makes quarterly payments approximately6 equal to $10 million × 0.03 × 0.25 = $75,000. Assume that after a short period the reference entity suffers a credit event and that the CTD asset of the reference entity has a recovery price of $45 per $100 of face value. The payments are as follows:
- The protection seller compensates the protection buyer for the loss on the face value of the asset received by the protection buyer. This is equal to $10 million × (100% – 45%) = $5.5 million.
- The protection buyer pays the accrued premium from the previous premium payment date to time of the credit event. For example, if the credit event occurs after a month then the protection buyer pays approximately $10 million × 0.03 × 1/12 = $18,750 of premium accrued. Note that this is the standard for corporate reference entity linked default swaps. For sovereign-linked default swaps there may be no payment of premium accrued.
Important Dates in CDS –
§ Trade Date – This is a date when CDS actually traded in the market.
§ Effective Date – This is a date when contract become effective
§ Valuation Date – This is a date when valuation for the quarterly payment is calculated
§ Maturity Date – This is a date when CDS contract tenure get matured
§ Payment Date – This is a date when payment is done to Protection seller Interest Rate Swaps
Interest Rate Swaps
An interest rate swap is a contractual arrangement between two parties, often referred to as “counterparties “agree to exchange payments based on a defined principal amount, for a fixed period of time.
In interest rate swaps, both the counterparties are speculating or hedging the risk on the interest market.
The party who is bullish about the market will pay fixed interest rate and the party who is bearish about the market will pay floating interest rate.
The party who is paying fixed interest rate is buyer of the IRS and the person who is paying floating interest rate is seller of the IRS.
In an interest rate swap, the principal amount is not actually exchanged between the counterparties; rather, interest payments are exchanged based on a “notional amount” or “notional principal.”
The basic premise to an interest rate swap is that the counterparty choosing to pay the fixed rate and the counterparty choosing to pay the floating rate each assume they will gain some advantage in doing so, depending on the swap rate. Their assumptions will be based on their needs and their estimates of the level and changes in interest rates during the period of the swap contract.
Pricing in IRS: -
Because an interest rate swap is just a series of cash flows occurring at known future dates, it can be valued by simply summing the present value of each of these cash flows. In order to calculate the present value of each cash flow, it is necessary to first estimate the correct discount factor (df) for each period (t) on which a cash flow occurs. Discount factors are derived from investors’ perceptions of interest rates in the future and are calculated using forward rates such as LIBOR. The following formula calculates a theoretical rate (known as the “Swap Rate”) for the fixed component of the swap contract:
Theoretical Swap Rate = Present Value of the Floating rate payment / Present Value of Principal * discount factor * days / 360
Important Date in IRS
Sample IRS Trade
Example of Hedging
· Client A has taken a loan of €100m from HSBC at a Floating Rate (LIBOR + 60bps)
· The risk for Client A is that incase the LIBOR go up, he will end up paying a higher EMI
o Client B has taken a loan from DB €100m at a Fixed Rate (@2%)
o The risk for Client B is that incase the LIBOR goes down (below 2%), then he will end up paying a higher amount of EMI, as compared to the floating rate
§ In order to mitigate the risk, Client A & B will enter into an IRS
§ Where A pays Fixed and receives Floating
§ Where B pays Floating and receives Fixed
Examples of Speculations
§ Let’s assume that Client A & B have opposite views of the Interest Rates
§ Client A thinks that LIBOR will go up in the future
§ Client B thinks that LIBOR will go down in the future
§ They can enter into an IRS per below directions
Equity Swaps
Exchange of cash flows between two parties wherein at least one leg of the cash flow is calculated based on return on equity or an index. The other leg of the swap might be based on interest rate (fixed or floating) or might be based on return from another equity or index. They are sometimes used to avoid withholding taxes, obtain leverage, or enjoy from ownership without actually owning equity. Its returns are strictly based on the relative volatility of an individual share or index.
Company A enters a $ 100m semiannual paying equity swap deal with a Swap Bank as fixed-rate payer for one year to receive semiannual return of NASDAQ 100 index.
Sample Equity Swaps Trade
Example of Equity Swaps – Speculations
§ Client A is bullish on the Interest Rates of a country and Bearish on the Stock Market Index’ performance
§ Client B is bullish on the Stock Market Index’ performance and Bearish on the Interest Rates of a country
§ They can enter into a EQS
Example of Hedging in Equity Swaps
Client A has a long position in NASDAQ Futures and wants to hedge his risk of any large rise or fall in the Index
He is happy to give away ‘some’ of his earnings in NASDAQ in return to get a minimum fixed return
Client B has a short position in NASDAQ futures and wants to hedge his position against any rise or fall in the market
They can enter into a EQS
Incase NASDAQ Futures go up
Client A will gain from the Futures but lose in this EQS
Client B will gain from this EQS and but lose this in Futures
In case NASDAQ Futures go down
Client A will lose in his futures position but gain from this EQS
Client B will gain from his futures but lose from this EQS
Currency Swaps
Like an interest rate swap, a currency swap is a contract to exchange cash flow streams from some fixed income obligations (for example, swapping payments from a fixed-rate loan for payments from a floating rate loan). In an interest rate swap, the cash flow streams are in the same currency, while in currency swaps, the cash flows are in different monetary denominations. Swap transactions are not usually disclosed on corporate balance sheets.
As we stated earlier, the cash flows from an interest rate swap occur on concurrent dates and are netted against one another. With a currency swap, the cash flows are in different currencies, so they can't net. Instead, full principal and interest payments are exchanged.
Currency swaps are an essential financial instrument utilized by banks, multinational corporations and institutional investors. Although these type of swaps function in a similar fashion to interest rate swaps and equity swaps, there are some major fundamental qualities that make currency swaps unique and thus slightly more complicated.
A currency swap involves two parties that exchange a notional principal with one another in order to gain exposure to a desired currency.
Currency swaps allow an institution to take leverage advantages it might enjoy in specific countries.
Example (1)
A highly-regarded German corporation with an excellent credit rating can likely issue euro-denominated bonds at an attractive rate. It can then swap those bonds into, say, Japanese yen at better terms than it could by going directly into the Japanese market where its name and credit rating may not be as advantageous.
At the origination of a swap agreement, the counterparties exchange notional principals in the two currencies. During the life of the swap, each party pays interest (in the currency of the principal received) to the other. At maturity, each makes a final exchange (at the same spot rate) of the initial principal amounts, thereby reversing the initial exchange. Generally, each party in the agreement has a comparative advantage over the other with respect to fixed or floating rates for a certain currency. A typical structure of a fixed-for-floating currency swap is as follows:
Example (2)
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 BRL for USD, it still must satisfy its obligation to the Brazilian 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. (Learn which tools you need to manage the risk that comes with changing rates, check out Managing Interest Rate Risk.)
Advantages of the Currency Swap
Rather than borrowing real at 10% Company A will have to satisfy the 5% interest rate payments incurred by Company B under its agreement with the Brazilian banks. Company A has effectively managed to replace a 10% loan with a 5% loan. Similarly, Company B no longer has to borrow funds from American institutions at 9%, but realizes the 4% borrowing cost incurred by its swap counterparty. Under this scenario, Company B actually managed to reduce its cost of debt by more than half. Instead of borrowing from international banks, both companies borrow domestically and lend to one another at the lower rate. The diagram below depicts the general characteristics of the currency swap.
Figure 1: Characteristics of a Currency Swap
For simplicity, the aforementioned example excludes the role of a swap dealer, which serves as the intermediary for the currency swap transaction. With the presence of the dealer, the realized interest rate might be increased slightly as a form of commission to the intermediary. Typically, the spreads on currency swaps are fairly low and, depending on the notional principals and type of clients, may be in the vicinity of 10 basis points. Therefore, the actual borrowing rate for Companies A and B is 5.1% and 4.1%, which is still superior to the offered international rates.
Corporate actions. https://www.youtube.com/watch?v=V8wKtp4aeQQ&t=2195s
Private Equity-03 https://youtu.be/Wip9pwV7fZU
Derivatives https://youtu.be/iV2p9a-TUFU
Cash Recon https://youtu.be/F6H-wgwuDa8
Cash Dividend https://youtu.be/F6H-wgwuDa8
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