Chapter 5

Swaps
5.1 Swaps,
5.2 Mechanics of Interest Rate Swaps and Currency Swaps,
5.3 Valuation of Interest rate Swaps & Currency Swaps.

Need is the mother of invention is a general saying and the evolution of swap as a financial
instrument is the classical and a rather recent example of the proverb. There is near
unanimity among the financial experts that swaps developed out of the constraints and the
regulatory controls with respect to cross-border capital flows faced by large corporations in
the 1970s. When multinational corporations operating in various countries could not remit
funds back and forth among their subsidiaries due to exchange controls exercised by various
governments on the capital flows, they came out with innovations of back-to-back or
parallel loans among themselves. Upon removal of restrictions on the capital flows, these
loans later developed into a full financial product called swaps. Since then the market has
grown to be as large as 414 trillion’ in 2009 as the amount of principal involved in swap
transactions and continues to further grow at a rapid rate.

Parallel loans involve four parties—two multinational corporations and two subsidiaries in
two different countries. Imagine IBM as one USA-based company with a subsidiary in
London and British Telecom as another company having operations in New York. The
subsidiary of British Telecom needs money in US dollar, while the subsidiary of IBM in
London has fund requirements in British pound. Due to regulatory controls neither IBM USA
nor British Telecom can fund their subsidiaries. To overcome the problem British Telecom
can arrange funds in British pound to fund the requirement of the subsidiary of IBM in
London. Similarly, IBM USA may raise funds in US dollar to fund the operations of British
Telecom in New York. Such an arrangement is called back-to-back or parallel loans. These
amounts would be re-exchanged at maturity at a rate determined in advance. Besides
overcoming regulatory controls, there were other economical advantages that caused the
development of swaps as full blown financial product and became popular even after the
removal of regulatory controls. By this simple arrangement, each firm has access to capital
markets in foreign country and makes use of their comparative advantage of borrowing in
different capital markets. The growth of the swaps has been so phenomenal that in 1984 a
need for standardization, uniform practices for documentation, trading, and settlement was
felt leading to the formation of International Swaps and Derivatives Association (ISDA).

Interest Rate SWAPS

If the exchange of cash flows is done on the basis of interest rates prevalent at the relevant
time, it is known as interest rate swap. The simplest example of interest rate swap is a
forward contract where only one payment is involved. In a forward transaction of any
commodity the buyer acquires the commodity and incurs an outflow of cash equal to the
forward price, F If the buyer after acquiring the commodity were to sell it for the spot price
5, then there would be a cash inflow of S. From the cash flow perspective a forward contract
for the buyer is a swap transaction with inflow of S and outflow of F. Likewise, the seller
would have equivalent cash flows in the opposite direction. Therefore, a forward contract
can be regarded as a swap with a single exchange of cash flow; alternatively swap can be
viewed as a series of several forward transactions taking place at different points of time.

Features of SWAP
Usually, interest rate swaps involve payment/receipt of fixed rate of interest for
receiving/paying a floating rate of interest. The basis of exchange of cash flows under
interest rate swap is the interest rate. This fixed-to-floating swap, commonly known as
‘plain vanilla swap’, is depicted in-Figure, where Company A agrees to pay Company B fixed
interest rate of 8.5011/o in exchange of receiving from it the interest at 30 bps (100 bps =
111/6) above the floating interest rate, Mumbai Inter Bank Offer Rate (MIBOR), at
predetermined intervals of time.

Apart from difficulties in locating each other if Company A and Company B were to have the
swap arrangement directly there would be the following likely problems.
1. Both of them would assume default risk (also known as counterparty risk) associated with
swap on each other, as one of the parties to the transaction may not honour the
commitments made in the swap.
2. Matching of needs in terms of principal amount of borrowing, its timing, periodicity of
payment of interest, and final redemption of the borrowing, etc. would be a difficult task.
These difficulties in the swap need to be overcome; else the swap market would remain
extremely small. In fact, the growth in the swaps is primarily attributed to the roles the
banks have played as swap intermediaries. Following are the functions of swap
intermediary.

Facilitating the SWAP Deal

The difficulties in finding a matching counterparty can be reduced if an intermediary is
involved. The intermediary or the swap dealer is normally a bank who has widespread
network. Due to deep knowledge of financial markets, network of large number of
customers, and exact understanding of client’s needs it is easier for banks to locate
matching counterparties. Like the forward rates are offered by banks to facilitate the foreign
exchange transaction, few banks offer ready market for firms to enter and exit the swap
deals.

Types of Interest Rate SWAPS

With the bank as intermediary and each party deals with the bank rather than each other.
Interest rate swaps (IRS) can be categorized as follows.

Fixed-to-Floating
In the fixed-to-floating rate swaps the party pays fixed rate of interest to the bank or swap
dealer and in exchange receives a floating rate interest determined on the basis of a
reference/benchmark rate at predetermined intervals of time.

Such a swap is used by a firm wich has floating rate liability and it anticipates a rise in the
interest rates. Through the swap the firm will cancel out the receipts and payments of
floating rate and have cash outflow based on the fixed rate of interest.

Floating-to-Fixed
In this kind of swap the party pays floating rate of interest to the bank or swap dealer and in
exchange receives a fixed rate interest at predetermined intervals of time. Such a swap is
used by a firm who has fixed rate liability and it anticipates a fall in the interest rates.
Through the swap the firm will cancel out the receipts and payments of fixed rate liability
and have cash outflow based on the floating rate of interest.

Basis SWAP
In contrast to the fixed-to-floating or floating-to-fixed where one leg is based on fixed rate
of interest, the basis swaps involve both the legs on floating rate basis. However, the
reference rates for determining the two legs of payment are different. Basis swaps are used
where parties in the contract are tied to one asset or liabilities based on one reference rate
and want to convert the same to other reference rate. For example, if a firm having
liabilities based on T-bills rate wants to convert it to MIBOR-based rate, then the firm can
enter a basis swap where it pays MIBOR-based interest to the swap dealer in exchange of
receiving interest based on T bills rate.

Currency SWAPS
In a currency swap the exchange of cash flows between counterparties take place in two
different currencies. Since two currencies are involved, currency swaps become different
from interest rate swaps in its uses functionality, and administration. The first recorded
currency swap was initiated in 1981 between IBM and World Bank.

Where the exchange of cash flows is in two different currencies on the basis of a
predetermined formula of exchange rates, it is known as currency swap. More complex
swaps involve two currencies with fixed and floating rates of interest in two currencies.
Such swaps are called ‘cocktail swaps’.

Hedging Against Exchange Rate Risk

Currency swaps cover different kind of risk. It is way of converting liabilities or assets from
one currency to another. While in case of interest rate swaps assets or liabilities are
transformed from fixed interest rate to floating or vice versa providing hedge against
fluctuating interest rates, the currency swaps provide a hedge against exchange rate risks as
it transforms liability/asset from one currency to another.

Let us consider an example to see how multinational firms face currency risks and how can
these be overcome through a swap deal. Assume that an Indian firm needs funds for its US
operations. The firm raises funds in Indian rupees and commits to serve the interest
obligation and the final repayment in Indian rupees. The funds raised in rupees are
converted in US dollar to acquire assets in the USA. These assets provide income in US
dollar. The Indian firm is facing a risk if rupee strengthens (dollar depreciates) in the
currency markets as it receives lesser rupee amount for the fixed return earned in US dollar.

Similarly, an US firm which needs to acquire assets in India while raises dollar funds in USA,
faces the same risk. Its earnings would be in Indian rupees and the liabilities need to be
serviced in US dollar. Like the Indian firm the US firm also faces a risk of shortfall in US dollar
if dollar appreciates (or rupee depreciates).

The vulnerability of both, the Indian firm and the US firm, is due to uncertainty of exchange
rate movement, which may take place in either direction. While depreciation of dollar
harms the Indian firm it benefits the US firm. In case dollar appreciates, the US firm is at loss
while the Indian firm gains. The risks for both the firms arise because it is not known what
direction exchange rates would take. Even though it is possible to make an estimate of the
likely direction of exchange rates based on many theories, such as purchasing power parity
(PPP) and interest rate parity (IRP), we are concerned here with the unexpected and adverse
movement of exchange rates as all forecasts factor in the likely movement while making
estimates.

The element of risk can be removed if the Indian firm and the US firm enter into a swap as
depicted in Figure, which would reveal that the Indian firm has financed its US operations by
creating rupee liability. This liability to be serviced by income generations in US dollar faces
currency exchange rate risk. Likewise, the US firm having funded Indian operations through
US dollar loan would be serviced by rupee income and needs to be converted to US dollar
for payment of interest and principal in future whenever they fall due. Under the swap
transaction the mismatch of cash inflow and cash out flow in different currencies for both
the firms can be eliminated, by 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.

Thus the rupee asset income flows to the Indian firm, facilitating service of rupee liability. In
exchange, US dollar asset income flows to the US firm to meet its US dollar obligations. Both
the firms avoid the conversion of currencies from one to another eliminating the exchange
rate risk. Through the swap both the firms will have assets and liabilities translated in the
same currency eliminating the currency risk.

Distinguishing Features of Currency SWAP

It may be seen that currency swap is similar to parallel loan. However, swaps are better
because they may be entered with the financial intermediary saving the trouble of finding
the counterparty with matching needs as also reducing the counterparty risk.

Though working on the same principle of comparative advantage, operationally currency

swaps become different than interest rate swaps. Under currency swap the cash flows are
as follows:
1. Exchange of principal at the time of setting the swap deal at the current spot rate
 2. Exchange of periodic interest payments
3. Exchange of the principal back upon maturity

Under interest rate swap there is no exchange of principal at the begin-fling of swap or at its
conclusion.

Currency swaps may be classified as following –

In a fixed-to-fixed currency swap the interest rates in the two currencies involved are fixed. For
example, a British firm may raise loan in pound and exchange it for dollar to an US firm.
Interest payment may be made by the British firm in dollar while receiving pound interest
from the US firm. The US firm would do the reverse, making interest payment in pound and
receiving dollar interest. The interest rate in US dollar and pound both are fixed.
(a) Fixed-to-Floating
In a fixed-to-floating currency swap the interest rate in one of the currencies is fixed while
other is floating. In the earlier example if the British firm made interest payment in dollar at
a fixed rate while receiving pound interest based on London Inter Bank Offer Rate (LIBOR)
from the US firm, such a swap would be fixed to floating. Such swaps not only transform the
nature of asset/ liability from one currency to another but also change it from fixed rate to
floating rate. It becomes a complex tool for hedging against currency risk as well as interest
rate risk.
(b) Floating-to-Floating
In a floating-to-floating currency swap both the interest rates are floating but in different
currencies. In the earlier example if the British firm made interest payment in dollar based
at prime rate in the USA while receiving pound interest based on LIBOR from the US firm,
such a swap would be floating-to floating.

Valuation of Swaps
Pricing of the swap is an important issue for two reasons. First, as stated earlier banks function
as warehouse of swaps and are ready to offer swap to the desired customers. For this they
are required to quote the swap rates for paying and receiving a fixed rate of interest for
receiving/paying the benchmark variable rate. The other reason for valuing the swap is for
the purpose of cancellation of an existing swap. For reasons of economy a firm may like to
cancel the obligations or part thereof by paying or receiving the value of the swap at that
point of time.

Valuing Interest Rate Swap

As stated earlier, an interest rate swap consists of fixed rate cash flow and floating rate cash
flow in the opposite direction. At the time of inception of the swap the present value of
these payments must be equal in the opinions of both the parties to the swap else they
would not agree to it.

Therefore, at inception the value of swap is zero implying that the present values of cash
inflows and outflows are equal and its aggregate flow is zero.

However, the circumstances would change after the swap is initiated. The value of an interest
rate swap at any time is the net difference between the present value of the
payments to be received’ and the present value of the payments to be made. It becomes
positive to one party and is equivalently negative to the other party. This tells how much
cash the two parties must exchange to nullify the remaining obligations in the swap.

From the valuation perspective a swap transaction may be interpreted in at least two ways.
It can be thought of either as a pair of bonds or a series of forward agreements. Any of the
interpretation of the swap helps in its initial pricing as well as its valuation, if and when one
wants a premature closure. We take the pricing of swap by both methods by treating the
swap as pair of bonds or as a series of forward agreements.

Swap as Pair of Bonds

The most common interpretation of interest rate swaps is to consider the inflows and
outflows of interest at periodical intervals equivalent to that of bonds. In an interest rate
swap one leg of transaction is on a fixed rate and the other leg is on the floating rate of
interest. We also know that if one owns a bond he receives interest and if one issues a bond
he pays the interest. Therefore, a swap comprises the following.
1. The cash inflow equivalent to the interest on the bond owned
2. The cash outflow equivalent to paying the interest on the bond issued Interest rate swap

Therefore, a swap is a pair of bonds—one issued and the one owned. A swap where one
pays fixed and receives floating can be viewed as combination of having issued a fixed rate
bond, paying the fixed coupon rate and simultaneously owning a floating rate bond,
receiving a floating rate as per the market conditions

SWAP as Series of Forward Contracts

In a swap regular payments of interest are made and received by the counter- parties.
Next cash flow of interest can be considered as forward transaction. Similarly, all
subsequent cash flows are regarded as future dated delivery commitments.

Swaption
Innovations in the swaps are taking place at a fast pace. Swaption, the options on swaps, are
also becoming popular. A call swaption gives one the right to pay a fixed payment of interest
and a put swaption gives the holder a right to receive a fixed rate of interest. In each case
the holder pays a nominal front-end premium to cover, the risk of rising interest rate or
falling interest rate.

THEORY QUESTIONS

Question 1: Explain in detail the procedure for valuing a swap.

(AM-7 Marks Summer-15)
Question 2: What are the advantages of swap over futures?
(AM-7 Marks Summer-15)
Question 3: What are the important reactions for the growth of swap markets?
(AK-7 Marks Summer-14)
Question 4: How can a currency swap remedy the problems of parallel loans?
 (AH-7 Marks Winter-12)
Question 5: What is a financial swap? Discuss the features of a swap contract with suitable
examples.
(AE-7 Marks Summer-11)
Question 6: What is swap contract? What are various motivations underlying swap
contract?
(AD-7 Marks Winter-10)
Question 7: ‘Options on interest rate swaps are referred to as swaptions.’ Explain the
statement.
(JSD-7 Marks Summer-09)

PRACTICAL QUESTIONS

Question 1: Define a swap deal for ‘P’ and ‘Q’ when they face the following rates.
Company Fixed Floating rate
P 8.75% CP yield + 0.65%
Q 6.25% CP yield + 0.25%
(i) With intermediary who intends to make 75 Bps.
(ii) Without an intermediary.
(AM-7 Marks Summer-15)
Question 2: On Oct. 4, 2009 the spot term structure is as follows:
12 months 24 months 36 months 48 months
2.52 5.08 7.73 10.4
Determine the fixed rate on a year swap for the pay fixed party.
(AM-7 Marks Summer-15)
Question 3: Suppose that A Ltd. Wants a floating rate, B Ltd. Derives a fixed rate, design a
swap deal for A & B Ltd. In such a way that if will net a bank 50 BPS and will be equality
beneficial to both the companies. When they face the following rates.
Fixed rate Floating rate
A Ltd. 10% MIBOR + 25 BPS
B Ltd. 12% MIBOR + 75 BPS

(AK-7 Marks Summer-14)

Question 4: A financial institution has entered into an interest rate swap with X Ltd. Under
the terms of the swap. If receivable 10% per annum and pays 6 months LIBOR on a principle
of Rs. 10 million for 5 years? Payments are made every 6 months. Suppose the company
defaults on the sixth payment date (at the end of year 3) when the interest rate (with semi-
annual compounding) is 8% per annum for all maturities. What is the loss to the financial
institutions? Assume that 6 month LIBOR was 9% per annum halfway through year 3.
(AK-7 Marks Summer-14)
Question 5: The Little Prince Co. (LP) has $100 million of two year fixed rate debt with a
bond equivalent yield of 8.25% compounded semi-annually. Given the nature of LP would
prefer to have floating rate debt. The market is asking LIBOR 100 Bps. How could an
investment banker help LP achieve its objective with a swap contract?
(AH-7 Marks Winter-12)

Question 6: Suppose that on July 25, a fison knew that it will have to borrow $10 million on
September 22for three months. A bank agrees to provide these funds of one percent above
whatever the three month LIBOR is on September 22. By chance September 22 is also the
last trading of the September, 2009 Eurodollar futures contracts. Firm is concerned about
that by that time the LIBOR may rise. How firm can hedge its risk by using Eurodollar futures
if on July 25, Eurodollar price is 91.72 and implied three month Eurodollar rate is 8.28%. The
three month LIBOR on July 25 is 8.375%.
(AE-7 Marks Summer-11)

Question 7: Company A & B both wish to borrow Rs. 10 crore for 5 years. Company B wants
to arrange a floating rate loan. The rate of interest is six month LIBOR Company. A wants to
arrange a fixed rate loan. They have been offered the following terms.
Company Fixed rate Floating rate
Six month LIBOR +
A 10.0%
0.3%
Six month LIBOR +
B 11.2%
1.0%
Show the transaction without intermediary and with intermediary.
(AE-7 Marks Summer-11)

Question 8: Company XYZ a British manufacturer, wished to borrow US dollar of fixed rate
of interest. Company ABC, a VS MC wished to borrow sterling of fixed rate of interest. The
rates are as follows.
Sterling US Dollar
Company XYZ 11% 7.5%
Company ABC 10.6% 6.2%
Design a swap that will have a bank acting as intermediary, 10 basis points per annum and
which will produce gain of 15 basis points per annum for each of the two companies?
(AD-7 Marks Winter-10)

Question 9: Calculate the price of a currency swap between domestic currency bond of USD
1,500 and foreign currency bond of JPY 4,200. The exchange rate is JPY 75 = USD 1.2. The
trader holds the bond in domestic currency.
(AD-7 Marks Winter-10)