Swap Revised

2011 Dorling Kindersley (India) Pvt.
Ltd
Swaps
Chapter 10
2011 Dorling Kindersley (India) Pvt. Ltd
Objectives of the Chapter
What are swaps?
What is an interest rate swap?
What is a currency swap?
What is an equity swap?
What is a commodity swap?
What is the rationale for swaps?
What are swaps?
A swap is a private agreement between two parties to exchange
one stream of cash flows for another stream of cash flows in
accordance with a pre-arranged formula

Agreement will provide details of how cash flows will be
calculated, and dates on which cash flows will be exchanged

At least one party will be exposed to an uncertain variable such
as interest rate, exchange rate, equity price, or commodity price

The other partys cash flow would be based on a fixed payment
or determined on the basis of another variable
Types of Swaps
An interest rate swap is one in which one party
agrees to exchange interest payments based on
a fixed rate with another party based on a floating
rate
A currency swap is one in which one party agrees
to exchange payments based on one currency
with another party based on another currency
A commodity swap is one in which variable
market prices are exchanged for a fixed price
over a period of time
An equity swap is one in which one party agrees
to exchange payments based on an equity
portfolio for payment based on a floating rate
The Terminology of Swaps
Swap: an agreement to exchange cash flows over a
fixed period of time
Counterparties: the two parties in a swap contract
Notional principal: a monetary figure used as a part of
the calculation to determine payment amounts
Tenor: The length of time for which payments will be
exchanged, also known as term, maturity, or
expiration of swap
Swap facilitators: specialists who help clients to
design swaps
Swap brokers: bring counterparties together for a
swap transaction
Swap dealers: can enter into swap agreements as
one of the counterparties
Interest Rate Swap
A fixed interest rate loan is exchanged for a floating
interest rate loan

Party A will borrow in the market at a fixed rate; Party
B will borrow in the market at a floating rate; interest
payments will be swapped at every reset period of the
floating-rate loan

The rate at which party A will pay interest to party B
and vice versa are known as swap rates, which are
determined in the market

Principal will not be exchanged, and interest amount
will be calculated on notional principal
Designing a Swap
Microsoft has arranged to borrow a 100 million loan at
floating rate of LIBOR+.10. The same amount of
money has been borrowed by Intel at a fixed rate of
5.2% . They entered into a swap agreement where
Microsoft will pay a fixed interest @5% to Intel where
will pay Microsoft at LIBOR. Show the flow chart of
Swap and describe the cash flow of the Swap
arrangement.
Ford motor owns $100 million bond providing a fixed
interest of 4.7% and Hyundai motors owns $100
million bond getting interest at floating interest rate of
LIBOR-.30.They entered into a swap arrangement
where Ford Motor will pay 5% fixed rate to Hyundai
against the receipt of LIBOR from them. Show the flow
chart of Swap and describe the cash flow of the Swap
arrangement

Forward Swaps
A forward swap is a swap that will commence at some
future time

Fixed interest rates will be fixed at the time the contract is
entered into

The floating rate is determined at the first period of the
agreement when the swap comes into effect

Useful when investment or borrowing will take place at a
future time

One major challenge is to find the fixed rate for the forward
swap: the implied forward rate from the current yield curve
is usually used
Uses of the Interest Rate Swap
Hedging interest rate

Reduce funding costs

Manage the duration gap by banks

Speculating on interest rate movements
Swap arrangement
Two companies AAA Corp and BBB Corp both wish to
borrow 10 million for five years and have been offered
the following rates . BBB corp wants to borrow at a
fixed rate and AAA corp wants to borrow at floating
rate. Following are the offered rates :

Company Fixed Floating
AAA Corp 10% LIBOR+.3%
BBB Corp 11.20% LIBOR+1%
The two companies tried to arrange a swap agreement in such way that
they are benefitted equally out of the swap agreement. Show the flow
diagram how they will arrange their swap and explain the cash flows. Use
the concept of Comparative Advantage concept to solve the case.
Answer:
Swap arrangement :
BBB Corp will pay to AAA corp at 9.95% and AAA
corp will pay at LIBOR to BBB Corp.
Swap Arrangement
Company A and B was offered the following rates
Company Fixed Floating
AAA Corp 12% LIBOR+.1%
BBB Corp 13.4% LIBOR+.6%
Company A requires a floating rate loan and company B
requires a a fixed rate loan. Design a swap that will give
both the parties equal benefit after providing a net to a
bank of .10% for acting as intermediary.
Swap arrangement:
Answer :- A will receive from bank at 12 . 3% and
will pay at Libor to Bank and B will receive at
LIBOR and pay to Bank at 12.4%.
Interest Rate Swaps: An Example
A can borrow at either LIBOR + 70 points, or at a fixed rate
of 9%

B can borrow at either LIBOR + 20 points, or at a fixed rate
of 8.2%

Both can have a lower cost of funding if A borrows at
LIBOR + 70, and B borrows at a fixed rate of 8.2%, and
they swap

Swap rates are fixed at 8.2%, and the floating rate at
LIBOR + 5

Net cost for A will be 8.85% fixed, and for B will be LIBOR
+ 5 points

Both save an interest rate of 0.15%
Swaptions
This is an option to enter into a swap

A party will enter into a swap only when it is
advantageous to do so; otherwise the option will
not be undertaken

Used to:
Bring a swap into place when hedging is necessary;
Removing an existing swap when it is no longer
attractive;
Enhance yield with an underlying position by selling
a swaption;
Obtain access to a swap when uncertainty of when
funding will be required persists
Assignment 1
Company A can borrow at a fixed rate of 8% or
at a floating rate of MIBOR + 150 basis points.
Company B can borrow at a fixed rate of 9%
or at a floating rate of MIBOR + 50 basis
points. Show that these two companies can
improve their position through an interest rate
swap. What would be the gain to the two
parties?

Assignment 2
ABC Corporation can borrow at 6% fixed rate
or at a floating rate of LIBOR + 50 basis
points. GH Corporation can borrow at 8%
fixed rate or at a floating rate of LIBOR + 100
basis points. Show that these two
corporations can be better off by entering into
an interest rate swap. Assume that the
comparative advantage is equally shared by
the two parties.
Currency Swap
Party A borrows in one currency, e.g. INR, and
party B borrows in another currency, e.g. USD:
the loan is swapped so that party A pays the
interest in USD, and party B pays the interest in
INR

In a currency swap, cash flows are exchanged in
two different currencies

Notional principals are the same based on current
exchange rate, which are also exchanged
The Structure of a Currency
Swap
Party A Party B
Pay fixed in USD Pay fixed in INR
Pay floating in USD Pay fixed in INR
Pay fixed in USD Pay floating in INR
Pay floating in USD Pay floating in INR
The Operation of a Currency
Swap

Initial exchange of a notional principal

Periodic exchange of coupon payments

Final exchange of notional principal at initial
exchange rate
10-21
An Example of a Currency Swap
Suppose a U.S. MNC wants to finance a
10,000,000 expansion of a British plant.
They could borrow dollars in the U.S. where they
are well known and exchange for dollars for
pounds.
This will give them exchange rate risk: financing a
sterling project with dollars.
They could borrow pounds in the international
bond market, but pay a lot since they are not as
well known abroad.
10-22
If they can find a British MNC with a mirror-image
financing need they may both benefit from a
swap.
If the exchange rate is S
0
($/) = $1.60/, the U.S.
firm needs to find a British firm wanting to finance
dollar borrowing in the amount of $16,000,000.
10-23
Consider two firms A and B: firm A is a U.S.based
multinational and firm B is a U.K.based
multinational.
Both firms wish to finance a project in each others
country of the same size. Their borrowing
opportunities are given in the table below.
$
Company A 8.0% 11.6%
Company B 10.0% 12.0%

10-24
A is the more credit-worthy of the two firms.

Comparative Advantage
as the Basis for Swaps
$
Company B 10.0% 12.0%

A has a comparative advantage in borrowing in dollars.
B has a comparative advantage in borrowing in pounds.
A pays 2% less to borrow in dollars than B
A pays .4% less to borrow in pounds than B:
10-25
B has a comparative advantage in borrowing in .
$
Company B 10.0% 12.0%

B pays 2% more to borrow in dollars than A
B pays only .4% more to borrow in pounds than A:
A has a comparative advantage in borrowing in dollars.
B has a comparative advantage in borrowing in pounds.

If they borrow according to their comparative advantage
and then swap, there will be gains for both parties.

10-27
Company
A
Swap
Bank
$8%
12%
$8%
11%
12%
$9.4%
$
Company B 10.0% 12.0%

Company
B
10-28
Company
A
Swap
Bank
$8%
12%
$8%
11%
12%
$9.4%
$
Company B 10.0% 12.0%

Company
B
As net position is to borrow at 11%
A saves .6%
10-29
Company
A
Swap
Bank
$8%
12%
$8%
11%
12%
$9.4%
$
Company B 10.0% 12.0%

Company
B
Bs net position is to borrow at $9.4%
B saves $.6%
10-30
Company
A
Swap
Bank
$8%
12%
$8%
11%
12%
$9.4%
$
Company B 10.0% 12.0%

Company
B
The swap bank makes
money too:
At S
0
($/) = $1.60/, that
is a gain of $64,000 per
year for 5 years.
The swap bank
faces exchange rate
risk, but maybe
they can lay it off
in another swap.
1.4% of $16 million
financed with 1% of 10
million per year for 5
years.
Assignment 3
BHP, Australia, can borrow at 8% fixed rate in
Australia and at 9% fixed rate in India. Tata
Steel can borrow at a fixed rate of 7% in India
and at a fixed rate of 11% in Australia. The
current exchange rate is AUD 1 = INR 36.
Explain how the two companies can engage in
a five-year currency swap with payments
every six months. Assume Swap rate is BHP
pays 8.5% in INR, and Tata Steel pays 9% in
AUD draw the flow chart and calculate the net
cost.
Assignment 4
Rajesh wants to borrow Singapore dollar (SGD)
20,000,000 at a fixed interest rate for 5 years.
Rakesh wants to borrow INR 560,000,000 in India
for five years at a fixed interest. Investment
Bankers were approached for the same to have
the likely borrowing rates for Rajesh and Rakesh.
The borrowing rate for Rajesh was 12% in
Singapore and 8% in India and the borrowing rate
for Rakesh was 9% both in Singapore and India.
Find a suitable swap strategy between Rajesh
and Rakesh considering their comparative
advantage .
Also find the net cost for them and payment
process.
Assume spot rat SGD 1 = INR 28. Swap rate
Rajesh to pay rakesh @10% SGD and Rakesh to
Rajesh @8% INR.
Currency Risk in Currency Swap

As periodic coupon and final exchange of notional
principal are in different currencies, currency risk
can arise from this

If a company has cash inflow in the swap
currency, the periodic payments can be paid
without converting local currencycurrency risk
is thus avoided

If a company has no cash inflow in the swap
currency, currency risk exists
The Uses of a Currency Swap

1. To hedge currency risk; and

2. To reduce funding costs
Equity Swap

This is a transaction in which one party agrees to
make a series of payments determined by the
return on a stock to another party for a cash flow
based either on fixed rate, floating rate, or return
on another portfolio of stocks

E.g. one party receives a return on the BSE
Sensex Index in return for paying a 9% fixed
interest rate
Commodity Swap
Used to hedge risk associated with prices of input
resources

Involves exchange of payments between two parties
at set time periods

One leg of payment is based on commodity price

The other leg usually involves a fixed rate

Usually average price over a set period of time is
used as settlement price

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2011 Dorling Kindersley (India) Pvt.

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