Swap

Swap

            It is another important type of derivative. A swap is a transaction in which two or more parties swap (exchanges) one set of pre-determined payment for another.

Swaps are of two types

(1) Interest rate swap (IRS):-

         It is an agreement between two parties to exchange interest obligations or receipts for an agreed period of time.

The IRS is not a lending facility. Rather, it is an interest rate management tool that can be used in

conjunction with any variable rate lending facility, including a facility with another lender. The

underlying lending facility will continue to be governed by the terms and conditions set out in the facility agreement. There is no exchange of principal – only exchange of interest. No commitment is made by either party to exchange notional principal amounts. The notional principal remains constant throughout the life of the IRS.

A payer and a receiver

An IRS is based on an agreed notional amount (“notional principal”) and is usually transacted on a

fixed for floating rate basis. In every fixed for floating swap transaction, there is one person wanting to

pay a fixed interest rate (payer) and the other looking to receive that fixed payment (receiver). The

payer's purpose is to "swap" an underlying variable interest rate into a fixed rate obligation.

Alternatively, the receiver chooses to "swap" a fixed rate obligation for a floating rate obligation.

How does it work?

At each reset date:

Ø     If the reference rate is greater than the swap rate, then the payer will receive a cash payment

                from the receiver based on the difference between the reference rate and the swap rate; or

Ø     If the reference rate and the swap rate are the same, no amounts are payable; or

Ø     If, however, the reference rate is less than the swap rate, then the receiver will receive from

                the payer an amount based on the difference between the swap rate and the reference rate.

Periodic settlement

Ø     Settlement occurs on every reset date (at the end of the interest rate period).

Ø     The IRS settlement will occur at the same time your underlying loan facility rolls over.

Advantages/Benefits

Ø     An IRS is flexible in that you can tailor the notional principal, payment frequency and

                maturity date to suit your underlying exposure.

Ø     An IRS allows you to manage interest rate risk without affecting the underlying exposure.

Ø     An IRS can be bought and sold easily and structured to suit your individual requirements.

Ø     No upfront premium is payable by you.

Disadvantages/Risks

Ø     You effectively “lock in” a fixed rate and therefore cannot participate in favorable interest

                rate movements.

Ø      Receiver, the counter party to an IRS, must fulfill its contractual obligations to you in the

               manner set out in the relevant contract with you. If receiver is unable to fulfill those

               obligations, you will be exposed to market fluctuations as if you had not entered into an IRS.

Example

Scenario

XYZ Ltd is a borrower with a 3 year   INR 1,000,000 (from ICICI) variable rate bank bill facility, which rolls on a quarterly basis. Your view is that interest rates are likely to rise during the period of your loan and your borrowing costs may exceed 7.00%. You would like to lock in your borrowing costs at the current swap rate of 7.00%.

To hedge against the risk of interest rates rising you elect to enter into a 3 year interest rate swap with

UTI to pay a fixed interest rate of 7.00 % (the swap rate), on a notional principal of Rs10, 00,000, quarterly reset dates.

For the purposes of this example, assume that there are 90 days in the quarter.

If variable rate is say above 7.00%...

Assume variable rate is 8.00% on the reset date. Therefore, the variable base interest rate that would apply under your bank bill facility would be 8.00%. However, as you have entered into an IRS with UTI with a swap rate of 7.00%, you will be compensated for the difference between variable and the swap rate. Therefore, you receive an amount based on the difference (1.00%). This amount off-sets the increased base amount payable under your underlying bank bill facility, which has risen by 1.00%. This effectively means you have “locked in” your borrowing costs at 7.00%. This process is repeated on each quarterly reset date.

UTI uses the following formula to determine the amount payable where the underlying lending

facility is a bank bill facility.

Floating amount:

Floating amount = notional principal x reference rate % x actual/365

Fixed amount:

Fixed amount = notional principal x fixed swap rate % x actual/365

The difference between these amounts is the amount payable. Using the figures in the example, this is

calculated as follows:

Amount payable at reference rate:

Floating amount: = 10,00,000 x 8.00% x 90 / 365

= Rs 19,726

Amount received at swap rate:

Fixed amount: = 10,00,000 x 7.00% x 90 / 365

= Rs 17,260

The payment made by UTI to XYZ is the difference between the above amounts, that is:

19,726 – 17,260

 = Rs 2,466

 (2) Currency Swap

Description

In currency swap, two parties agree to exchange interest payments in two different currencies.

Unlike interest rate swaps, Currency Swaps usually involve an exchange of the nominal amounts at the start and maturity of the swap. This nominal exchange takes place at the current exchange rate at the start of the swap agreement.

Advantages-

Cross-Currency Swaps are used for corporate funding and currency management. There may be a number of reasons for using such swaps:

Ø     They enable the client to exploit financing advantages caused by different credit ratings in different markets, e.g. countries (see example below).

Ø     They enable the client to exploit financing advantages in a foreign currency resulting from lower interest rates, whilst accepting the currency risk at maturity of the swap.

Example

A German company has a subsidiary in Switzerland, and wants to provide it with funds for an investment in the amount of CHF 10mln. The Swiss subsidiary receives payments in Swiss francs for production and shall also bear the financing costs for the investment. The life of the investment is 10 years. In the German market, the German parent is perceived as having better credit than the Swiss subsidiary in the Swiss market. The company decides to take out a loan in EUR (Euro) and to convert the amount to CHF (swiss franks) whilst eliminating the currency risk. The Cross-Currency Swap can be a solution in this case.

Step 1: The company takes out a revolving money market loan indexed to the 3-month Euribor in the amount of EUR 6.289 million, which, by means of a Cross-Currency Swap concluded with Commerzbank, is directly swapped for CHF 10 million (at the current exchange rate of EUR/CHF 1.59).The amount in CHF is transferred to the Swiss subsidiary.

Step 2: During the life of the swap, the subsidiary pays interest in CHF to the parent, which transfers these CHF cash flows to Commerzbank, receiving the 3-month Euribor (in EUR) in return. These cash flows are used to service the interest payments for the loan in EUR.

Step 3: At maturity of the swap, the company receives CHF 10mln from the subsidiary and exchanges them for EUR 6.289mln at the exchange rate set out in the Cross-Currency Swap agreement with Commerzbank (EUR/CHF1.59). This amount is used to repay the floating money market loan.