Project

on
SWAPS-structure, IRS
and how to hedgingSWAPS

Submitted to:-
Prof. Deepak tendon
Submitted by:-
Anuradhasharma
Group-1
Pg20082421

Swap (finance)
In finance, a swap is a derivative in which two counterparties exchange certain benefits of
one party's financial instrument for those of the other party's financial instrument. The
benefits in question depend on the type of financial instruments involved. Specifically, the
two counterparties agree to exchange one stream of cash flows against another stream. These
streams are called the legs of the swap. The swap agreement defines the dates when the cash
flows are to be paid and the way they are calculated. Usually at the time when the contract is
initiated at least one of these series of cash flows is determined by a random or uncertain
variable such as an interest rate, foreign exchange rate, equity price or commodity price.

The cash flows are calculated over a notional principal amount, which is usually not
exchanged between counterparties. Consequently, swaps can be used to create unfunded
exposures to an underlying asset, since counterparties can earn the profit or loss from
movements in price without having to post the notional amount in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes
in the expected direction of underlying prices.

The first swaps were negotiated in the early 1980s. David Swensen, a Yale Ph.D. at Salomon
Brothers, engineered the first swap transaction according to "When Genius Failed: The Rise
and Fall of Long-Term Capital Management" by Roger Lowenstein. Today, swaps are among
the most heavily traded financial contracts in the world.
Swap market
Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some
types of swaps are also exchanged on futures markets such as the Chicago Mercantile
Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options
Exchange, IntercontinentalExchange and Frankfurt-based Eurex AG.

The Bank for International Settlements (BIS) publishes statistics on the notional
amounts outstanding in the OTC derivatives market. At the end of 2006, this was USD 415.2
trillion, more than 8.5 times the 2006 gross world product. However, since the cash
flow generated by a swap is equal to an interest rate times that notional amount, the cash flow
generated from swaps is a substantial fraction of but much less than the gross world product
—which is also a cash-flow measure. The majority of this (USD 292.0 trillion) was due
to interest rate swaps. These split by currency as:
The CDS and currency swap markets are dwarfed by the interest rate swap market. All three
markets peaked in mid 2008.
Source: BIS Semiannual OTC derivatives statistics at end-December 2008

Notional outstanding
in USD trillion

Currency End 2000 End 2001 End 2002 End 2003 End 2004 End 2005 End 2006

Euro 16.6 20.9 31.5 44.7 59.3 81.4 112.1

US dollar 13.0 18.9 23.7 33.4 44.8 74.4 97.6

Japanese yen 11.1 10.1 12.8 17.4 21.5 25.6 38.0

Pound sterling 4.0 5.0 6.2 7.9 11.6 15.1 22.3

Swiss franc 1.1 1.2 1.5 2.0 2.7 3.3 3.5

Total 48.8 58.9 79.2 111.2 147.4 212.0 292.0

Source: "The Global OTC Derivatives Market at end-December 2004", BIS, "OTC
Derivatives Market Activity in the Second Half of 2006", BIS.
Usually, at least one of the legs has a rate that is variable. It can depend on a reference
rate, the total return of a swap, an economic statistic, etc. The most important criterion is
that it comes from an independent third party, to avoid any conflict of interest. For
instance, LIBOR is published by the British Bankers Association, an independent trade
body.
Types of swaps
The five generic types of swaps, in order of their quantitative importance, are: interest
rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There
are also many other types.
Interest rate swaps

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but
wants to pay floating. By entering into an interest rate swap, the net result is that
each party can 'swap' their existing obligation for their desired obligation. Normally
the parties do not swap payments directly, but rather, each sets up a separate swap
with a financial intermediary such as a bank. In return for matching the two parties
together, the bank takes a spread from the swap payments.

The most common type of swap is a “plain Vanilla” interest rate swap. It is the
exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from
2 years to over 15 years. The reason for this exchange is to take benefit
from comparative advantage. Some companies may have comparative advantage in
fixed rate markets while other companies have a comparative advantage in floating rate
markets. When companies want to borrow they look for cheap borrowing i.e. from the
market where they have comparative advantage. However this may lead to a company
borrowing fixed when it wants floating or borrowing floating when it wants fixed. This
is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a
floating rate loan or vice versa.
For example, party B makes periodic interest payments to party A based on
a variable interest rate of LIBOR +70basis points. Party A in turn makes periodic
interest payments based on a fixed rate of 8.65%. The payments are calculated over
the notional amount. The first rate is called variable, because it is reset at the beginning
of each interest calculation period to the then current reference rate, such as LIBOR. In
reality, the actual rate received by A and B is slightly lower due to a bank taking a
spread.
Currency swaps
A currency swap involves exchanging principal and fixed rate interest payments on a
loan in one currency for principal and fixed rate interest payments on an equal loan in
another currency. Just like interest rate swaps, the currency swaps also are motivated
by comparative advantage.
Commodity swaps
A commodity swap is an agreement whereby a floating (or market or spot) price is
exchanged for a fixed price over a specified period. The vast majority of commodity
swaps involve oil.
Equity Swap
An equity swap is a special type of total return swap, where the underlying asset is a
stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in
this case you do not have to pay anything up front, but you do not have any voting or
other rights that stock holders do have.
Credit default swaps
A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a
series of payments to the seller and, in exchange, receives a payoff if a credit instrument
- typically a bond or loan - goes into default (fails to pay). Less commonly, the credit
event that triggers the payoff can be a company undergoing restructuring, bankruptcy or
even just having its credit rating downgraded. CDS contracts have been compared
with insurance, because the buyer pays a premium and, in return, receives a sum
of money if one of the events specified in the contract occur
Other variations
There are myriad different variations on the vanilla swap structure, which are limited
only by the imagination of financial engineers and the desire of corporate treasurers and
fund managers for exotic structures.A total return swap is a swap in which party A
pays the total return of an asset, and party B makes periodic interest payments. The total
return is the capital gain or loss, plus any interest or dividend payments. Note that if the
total return is negative, then party A receives this amount from party B. The parties have
exposure to the return of the underlying stock or index, without having to hold
the underlying assets. The profit or loss of party B is the same for him as actually
owning the underlying asset.

 An option on a swap is called a swaption. These provide one party with the
right but not the obligation at a future time to enter into a swap.
 A variance swap is an over-the-counter instrument that allows one to
speculate on or hedge risks associated with the magnitude of movement,
i.e. volatility, of some underlying product, like an exchange rate, interest rate, or
stock index.
 A constant maturity swap, also known as a CMS, is a swap that allows the
purchaser to fix the duration of received flows on a swap.
 An Amortising swap is usually an interest rate swap in which the notional
principal for the interest payments declines during the life of the swap, perhaps at a
rate tied to the prepayment of a mortgage or to an interest rate benchmark such
LIBOR.

Valuation
The value of a swap is the net present value (NPV) of all estimated future cash flows. A
swap is worth zero when it is first initiated, however after this time its value may
become positive or negative.[1] There are two ways to value swaps: in terms
of bond prices, or as a portfolio of forward contracts.[1]
Using bond prices
While principal payments are not exchanged in an interest rate swap, assuming that
these are received and paid at the end of the swap does not change its value. Thus, from
the point of view of the floating-rate payer, a swap can be regarded as a long position in
a fixed-rate bond (i.e. receiving fixed interest payments), and a short position in
a floating rate note (i.e. makingfloating interest payments):
Vswap = Bfixed − Bfloating
From the point of view of the fixed-rate payer, the swap can be viewed as having
the opposite positions. That is,
Vswap = Bfloating − Bfixed
Similarly, currency swaps can be regarded as having positions in bonds whose
cash flows correspond to those in the swap. Thus, the home currency value is:
Vswap = Bdomestic − S0Bforeign, where Bdomestic is the domestic cash flows of the
swap, Bforeign is the foreign cash flows of the swap, and S0 is the spot exchange rate.
Using forward rate agreements
Consider a three year interest rate swap with semiannual payments. The first cash flow is
known at the time the swap is initiated, however the other five exchanges can be regarded as
forward rate agreements. The payment for these other exchanges is the 6 month rate observed
in the market 6 months earlier. Assuming that forward interest rates are realised, this method
values the swap by firstly calculating the required forward rates using the LIBOR/swap
curve, then calculating the swap cash flows using these rates, and then finally discounting
these cash flows back to today.
London Interbank Offered Rate (LIBOR)
LIBOR is the rate of interest offered by banks on deposit from other banks in
the eurocurrency market. One-month LIBOR is the rate offered for 1-month deposits, 3-
month LIBOR for three months deposits, etc. LIBOR rates are determined by trading
between banks and change continuously as economic conditions change. Just like the prime
rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the
International Market.
Arbitrage arguments
As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the
NPV of these future cash flows is equal to zero. Where this is not the case, arbitrage would
be possible.

For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays
a fixed rate, and Party B pays a floating rate. In such an agreement the fixed rate would be
such that the present value of future fixed rate payments by Party A are equal to the present
value of the expected future floating rate payments (i.e. the NPV is zero). Where this is not
the case, an Arbitrageur, C, could:

1. assume the position with the lower present value of payments, and borrow funds
equal to this present value
2. meet the cash flow obligations on the position by using the borrowed funds, and
receive the corresponding payments - which have a higher present value
3. use the received payments to repay the debt on the borrowed funds
4. pocket the difference - where the difference between the present value of the loan and
the present value of the inflows is the arbitrage profit.

Subsequently, once traded, the price of the Swap must equate to the price of the various
corresponding instruments as mentioned above. Where this is not true, an arbitrageur could
similarly short sell the overpriced instrument, and use the proceeds to purchase the correctly
priced instrument, pocket the difference, and then use payments generated to service the
instrument which he is short.

Swaps: complex structures

Complex swap structures refer to non-standard swaps whose coupons,notional, accrual and
calendar used for coupon determination and paymentsare tailored made to serve client’s
perspectives and needs in terms of riskmanagement, accounting hedging, asset re-packaging,
credit diversificationand or speculation rationale.Complex swap structure are often part of
more complex structures issued viaa special purpose vehicle, referred to as an SPV, which
combines a swap, abond, and many other potential elements, like credit related instruments.
Thistotal package is called in structurers’ jargon a structured note.On the risk engineering
side, exotic (also called non-generic) swapsstructures can be quite involving in terms of
pricing risk management andproduct applications. Compared to vanilla interest rate swaps,
exotic swapsoffer the additional challenge of modeling accurately the yield curve, the skew
and correlation of the various forward Libor and longer maturity rates involvedin the product.
Exact estimation of the number of factors needed to price agiven exotic swap is also
crucial.The first generation of non-generic swap, which by today’s standards havebecome
vanilla products, includes:
Simple structures:
Forward starting swap, for protection in the future . On the liability
side,this allows to pre-hedge anticipated debt like a bond issue, or loanwhile on the asset
side, to lock in the expected revenues of the sell ofan asset like in a asset swap and so on.
Amortizing and rollercoaster swaps. Compared to vanilla swaps, thesestructures
offer the additional advantage to match their notional withthe one of the liabilities or assets
payment, following the sameschedule. A typical example is the case of a swap against a pool
ofmortgages.
Deferred coupon, predefined stepped coupon and zero coupon
swaps ,whose coupons are designed to provide additional pick-up to clients aswell as
appropriate duration of cash flows.
Non-generic cross currency swap: cross currency swap with off marketrates.
Structures requiring some adjustment on the forwards like convexity
correction and quanto correction:
Constant Maturity Swaps (CMS) and Constant Maturity
TreasurySwaps (CMT) swaps: designed to risk manage yield curve exposure,these
swaps needs to be priced with appropriate convexity correctiondue to the mismatch between
the payment and the swap rate . CMS, CMT caps/floors, swaptions. Compared to vanilla
swaptions,these options are based on longer maturity rates to risk manage longmaturity
interest rates risks.
In-Arrears Swaps: swaps whose Libor rates reset and are paid at thesame time.
Because of the mismatch between the payment scheduleof the Libor and the one of the swap,
the pricing of the In-arrear Liborsare equal to the standard forward plus a convexity
correction.
Differential Swaps, which are quanto swap. The quanto featureenables to get exposure
to foreign market without any foreignexchange exposure. The quanto risk depends on the
joint movement ofthe Libor rates and the forward fx, hence the terminology of correlation
product.
Power swap: swap whose floating leg pays Libor square, Libor cubicand more generally a
power function of the Libor rate.
Non standardunderlyings like inflation related, equity and asset
swap: CPI (Real Interest Rate) Swaps paying an inflation-linked index, oftenin a zero
coupon swap form.
Asset swap : one leg pays the cash flows of a bond, while the floatingleg pays a spread
over Libor to make the two legs equal.
Equity swap : it follows a similar logic to an asset swap.
Credit related swap like Credit default swap . Although this is a swap, it is
often risk managed and traded by the deskof credit derivatives and not the swap and exotic
swap desk.
This first generation of non-generic swap has been widely used for asset andliability
management as well as simple trading strategies1. However, interestrates derivatives dealers
have developed more exotic swaps to answer aneed for higher sophistication of interest rates
risk exposure. The secondgeneration refers to more exotic option requiring modeling of the
evolution ofthe yield curve but also the correlation and the distribution between its various
components (both conditional and terminal distributions).
Index amortizing swaps , whose notional amortization schedule is linked toa floating
rate. This swap are of great use when hedging pool of liabilitieswhose notional can amortize
according to early redemption mainlyinfluenced by the overall level of the interest rate. This
type of swaprequires a good modeling of the dependence between the different floatingrates.
Bermudan structures : used for instance to hedge structured (callable,putable) bonds,
as well as providing additional flexibility when to exercisethe Bermudan swaption (either
receiver or payer Bermudan swaptions).
Range accrual Swaps: swaps whose notional accretes when a certainfloating rate,
often a different rate from the one used to pay, lies within arange. Accrual swaps are in fact a
strip of digital options.
Asian swap, whose Libor fixing are averaged to get smoother payment.Often used in
combination of other exotic features.
Digital (Binary) options : swap that pays a certain fix amount if the rates isabove or
below a certain level. Binaries can be completely replicated.1Zero cost structures are very
popular among investors. Typical example is zero cost collars where thepurchase of the call
is financed by the sale of a put or vice versa.However, for practical hedging, one needs to
aggregate the static hedgeacross a few instruments and get the best approximating hedge.
Barrier option structures, also referred to a trigger swaps and swaptions,whose
payoff is activated or dis-activated when a certain floating rate goes above or below a certain
threshold. The attractive cheaper premium is alogic consequence of the upside given up.
Chooser swap/swaptions , where the option holder can choose to enter intoa receiver
or a payer swap. Other forms of choose swap/swaptions allowthe user to specify when to fix
the floating rate, during an observationwindow.
Extendible and cancelable swaps (callable and putable swaps): verysimilar to
Bermudan swaption, this structure allows extending orterminating a given swap. Useful to
hedge liabilities whose terminationdate is uncertain.
Complex swap structures are widely used for additional flexibility to matchbetter liabilities
whose notional and payment dates can be very uncertain.Complex swap can be a
combination of the above individual component, likefor instance power Libor, quanto, knock
out swap. Complex swap structurescan be used to get additional leverages for relative value
trading and quasiarbitrage on the yield curve.When designing a complex swap structure,
structurers and financialengineers need to get a good understanding of the client’s situation
andneeds and to perform a thorough analysis of the impact of the structuredproduct on her
portfolio. To analyze risk, one decomposes the derivative intosimple hedgeable components
to isolate the various optionality and risk. Thestructurer makes also the difference between
asset and liability point of view,as investor and borrower strategies have very different needs.

What is an interest rate swap?

The interest rate swap is a very efficient instrument. It can be constructed at extremely low
cost and is probably less expensive than taking out a new fixed rate loan and using the
proceeds to buy an offsetting floating rate security paying LIBOR. Technically this would
accomplish the same thing but it would surely be much more costly and time consuming to
set up.

Interest rate swaps have several advantages over futures contracts. First, futures are only
available two to four years out. Interest rate swaps can be arranged at any time. Secondly,
futures contracts have to be marked to market every day, which could bring unexpected cash
outflows. Interest rate swaps do not enact this often. Finally, and most importantly, the
interest rate swap is cheaper and requires less monitoring. These are the reasons corporations
are becoming involved more in interest rate swaps than futures as part of their treasury
management.

(i) An interest rate swap is a contractual agreement entered into between two counterparties
under which each agrees to make periodic payment to the other for an agreed period of time
based upon a notional amount of principal. The principal amount is notional because there is
no need to exchange actual amounts of principal in a single currency transaction: there is no
foreign exchange component to be taken account of. Equally, however, a notional amount of
principal is required in order to compute the actual cash amounts that will be periodically
exchanged.

Under the commonest form of interest rate swap, a series of payments calculated by applying
a fixed rate of interest to a notional principal amount is exchanged for a stream of payments
similarly calculated but using a floating rate of interest. This is a fixed-for-floating interest
rate swap. Alternatively, both series of cash flows to be exchanged could be calculated using
floating rates of interest but floating rates that are based upon different underlying indices.
Examples might be Libor and commercial paper or Treasury bills and Libor and this form of
interest rate swap is known as a basis or money market swap.

1. Pricing Interest Rate Swaps

If we consider the generic fixed-to-floating interest rate swap, the most obvious difficulty to
be overcome in pricing such a swap would seem to be the fact that the future stream of
floating rate payments to be made by one counterparty is unknown at the time the swap is
being priced. This must be literally true: no one can know with absolute certainty what the 6
month US dollar Libor rate will be in 12 months’ time or 18 months’ time. However, if the
capital markets do not possess an infallible crystal ball in which the precise trend of future
interest rates can be observed, the markets do possess a considerable body of information
about the relationship between interest rates and future periods of time.
In many countries, for example, there is a deep and liquid market in interest bearing
securities issued by the government. These securities pay interest on a periodic basis, they are
issued with a wide range of maturities, principal is repaid only at maturity and at any given
point in time the market values these securities to yield whatever rate of interest is necessary
to make the securities trade at their par value.

It is possible, therefore, to plot a graph of the yields of such securities having regard to their
varying maturities. This graph is known generally as a yield curve -- i.e.: the relationship
between future interest rates and time -- and a graph showing the yield of securities
displaying the same characteristics as government securities is known as the par coupon yield
curve. The classic example of a par coupon yield curve is the US Treasury yield curve. A
different kind of security to a government security or similar interest bearing note is the zero-
coupon bond. The zero-coupon bond does not pay interest at periodic intervals. Instead it is
issued at a discount from its par or face value but is redeemed at par, the accumulated
discount which is then repaid representing compounded or "rolled-up" interest. A graph of
the internal rate of return (IRR) of zero-coupon bonds over a range of maturities is known as
the zero-coupon yield curve.

Finally, at any time the market is prepared to quote an investor forward interest rates. If, for
example, an investor wishes to place a sum of money on deposit for six months and then
reinvest that deposit once it has matured for a further six months, then the market will quote
today a rate at which the investor can re-invest his deposit in six months’ time. This is not an
exercise in "crystal ball gazing" by the market. On the contrary, the six month forward
deposit rate is a mathematically derived rate which reflects an arbitrage relationship between
current (or spot) interest rates and forward interest rates. In other words, the six month
forward interest rate will always be the precise rate of interest which eliminates any arbitrage
profit. The forward interest rate will leave the investor indifferent as to whether he invests for
six months and then re-invests for a further six months at the six month forward interest rate
or whether he invests for a twelve month period at today's twelve month deposit rate.

The graphical relationship of forward interest rates is known as the forward yield curve. One
must conclude, therefore, that even if -- literally -- future interest rates cannot be known in
advance, the market does possess a great deal of information concerning the yield generated
by existing instruments over future periods of time and it does have the ability to calculate
forward interest rates which will always be at such a level as to eliminate any arbitrage profit
with spot interest rates. Future floating rates of interest can be calculated, therefore, using the
forward yield curve but this in itself is not sufficient to let us calculate the fixed rate
payments due under the swap. A further piece of the puzzle is missing and this relates to the
fact that the net present value of the aggregate set of cash flows due under any swap is -- at
inception -- zero. The truth of this statement will become clear if we reflect on the fact that
the net present value of any fixed rate or floating rate loan must be zero when that loan is
granted, provided, of course, that the loan has been priced according to prevailing market
terms. This must be true, since otherwise it would be possible to make money simply by
borrowing money, a nonsensical result However, we have already seen that a fixed to
floating interest rate swap is no more than the combination of a fixed rate loan and a floating
rate loan without the initial borrowing and subsequent repayment of a principal amount. The
net present value of both the fixed rate stream of payments and the floating rate stream of
payments in a fixed to floating interest rate swap is zero, therefore, and the net present value
of the complete swap must be zero, since it involves the exchange of one zero net present
value stream of payments for a second net present value stream of payments.
The pricing picture is now complete. Since the floating rate payments due under the swap can
be calculated as explained above, the fixed rate payments will be of such an amount that
when they are deducted from the floating rate payments and the net cash flow for each period
is discounted at the appropriate rate given by the zero coupon yield curve, the net present
value of the swap will be zero. It might also be noted that the actual fixed rate produced by
the above calculation represents the par coupon rate payable for that maturity if the stream of
fixed rate payments due under the swap are viewed as being a hypothetical fixed rate
security. This could be proved by using standard fixed rate bond valuation techniques.

Financial Benefits Created By Swap Transactions

Consider the following statements:

(a) A company with the highest credit rating, AAA, will pay less to raise funds under
identical terms and conditions than a less creditworthy company with a lower rating, say
BBB. The incremental borrowing premium paid by a BBB company, which it will be
convenient to refer to as a "credit quality spread", is greater in relation to fixed interest rate
borrowings than it is for floating rate borrowings and this spread increases with maturity.

(b) The counterparty making fixed rate payments in a swap is predominantly the less
creditworthy participant.

(c) Companies have been able to lower their nominal funding costs by using swaps in
conjunction with credit quality spreads.

The Theory of Comparative Advantage

When we begin to seek an answer to the questions raised above, the response we are most
likely to meet from both market participants and commentators alike is that each of the
counterparties in a swap has a "comparative advantage" in a particular and different credit
market and that an advantage in one market is used to obtain an equivalent advantage in a
different market to which access was otherwise denied. The AAA company therefore raises
funds in the floating rate market where it has an advantage, an advantage which is also
possessed by company BBB in the fixed rate market.

The mechanism of an interest rate swap allows each company to exploit their privileged
access to one market in order to produce interest rate savings in a different market. This
argument is an attractive one because of its relative simplicity and because it is fully
consistent with data provided by the swap market itself. However, as Clifford Smith, Charles
Smithson and Sykes Wilford point out in their book MANAGING FINANCIAL RISK, it
ignores the fact that the concept of comparative advantage is used in international trade
theory, the discipline from which it is derived, to explain why a natural or other immobile
benefit is a stimulus to international trade flows. As the authors point out: The United States
has a comparative advantage in wheat because the United States has wheat producing acreage
not available in Japan. If land could be moved -- if land in Kansas could be relocated outside
Tokyo -- the comparative advantage would disappear. The international capital markets are,
however, fully mobile. In the absence of barriers to capital flows, arbitrage will eliminate any
comparative advantage that exists within such markets and this rationale for the creation of
the swap transactions would be eliminated over time leading to the disappearance of the swap
as a financial instrument. This conclusion clearly conflicts with the continued and expanding
existence of the swap market.

It would seem, therefore, that even if the theory of comparative advantage does retain some
force -- notwithstanding the effect of arbitrage -- which it almost certainly does, it cannot
constitute the sole explanation for the value created by swap transactions. The source of that
value may lie in part in at least two other areas.

Information Asymmetries

The much- vaunted economic efficiency of the capital markets may nevertheless co- exist
with certain information asymmetries. Four authors from a major US money centre bank
have argued that a company will -- and should -- choose to issue short term floating rate debt
and swap this debt into fixed rate funding as compared with its other financing options if:

(1) It had information -- not available to the market generally -- which would suggest that its
own credit quality spread (the difference, you will recall, between the cost of fixed and
floating rate debt) would be lower in the future than the market expectation.

(2) It anticipates higher risk- free interest rates in the future than does the market and is more
sensitive (i.e. averse) to such changes than the market generally.

In this situation a company is able to exploit its information asymmetry by issuing short term
floating rate debt and to protect itself against future interest rate risk by swapping such
floating rate debt into fixed rate debt.

Fixed Rate Debt and Embedded Options

Fixed rate debt typically includes either a prepayment option or, in the case of publicly traded
debt, a call provision. In substance this right is no more and no less than a put option on
interest rates and a right which becomes more valuable the further interest rates fall. By way
of contrast, swap agreements do not contain a prepayment option. The early termination of a
swap contract will involve the payment, in some form or other, of the value of the remaining
contract period to maturity.

Returning, therefore, to our initial question as to why an interest rate swap can produce
apparent financial benefits for both counterparties the true explanation is, I would suggest, a
more complicated one than can be provided by the concept of comparative advantage alone.
Information asymmetries may well be a factor, together with the fact that the fixed rate payer
in an interest rate swap -- reflecting the fact that he has no early termination right -- is not
paying a premium for the implicit interest rate option embedded within a fixed rate loan that
does contain a pre-payment rights. This saving is divided between both counterparties to the
swap.

2. Reversing or Terminating Interest Rate Swaps

The point has been made above that at inception the net present value of the aggregate
cashflows that comprise an interest rate swap will be zero. As time passes, however, this will
cease to be the case, the reason for this being that the shape of the yield curves used to price
the swap initially will change over time. Assume, for example, that shortly after an interest
rate swap has been completed there is an increase in forward interest rates: the forward yield
curve steepens. Since the fixed rate payments due under the swap are, by definition, fixed,
this change in the prevailing interest rate environment will affect future floating rate
payments only: current market expectations are that the future floating rate payments due
under the swap will be higher than those originally expected when the swap was priced. This
benefit will accrue to the fixed rate payer under the swap and will represent a cost to the
floating rate payer. If the new net cashflows due under the swap are computed and if these
are discounted at the appropriate new zero coupon rate for each future period (i.e. reflecting
the current zero coupon yield curve and not the original zero coupon yield curve), the
positive net present value result reflects how the value of the swap to the fixed rate payer has
risen from zero at inception. Correspondingly, it demonstrates how the value of the swap to
the floating rate payer has declined from zero to a negative amount.

What we have done in the above example is mark the interest rate swap to market. If, having
done this, the floating rate payer wishes to terminate the swap with the fixed rate payer's
agreement, then the positive net present value figure we have calculated represents the
termination payment that will have to be paid to the fixed rate payer. Alternatively, if the
floating rate payer wishes to cancel the swap by entering into a reverse swap with a new
counterparty for the remaining term of the original swap, the net present value figure
represents the payment that the floating rate payer will have to make to the new counterparty
in order for him to enter into a swap which precisely mirrors the terms and conditions of the
original swap.

Credit Risk Implicit in Interest Rate Swaps

To the extent that any interest rate swap involves mutual obligations to exchange cash flows,
a degree of credit risk must be implicit in the swap. Note however, that because a swap is a
notional principal contract, no credit risk arises in respect of an amount of principal advanced
by a lender to a borrower which would be the case with a loan. Further, because the
cashflows to be exchanged under an interest rate swap on each settlement date are typically
"netted" (or offset) what is paid or received represents simply the difference between fixed
and floating rates of interest. Contrast this again with a loan where what is due is an absolute
amount of interest representing either a fixed or a floating rate of interest applied to the
outstanding principal balance. The periodic cash flows under a swap will, by definition, be
smaller therefore than the periodic cash flows due under a comparable loan.

An interest rate swap is in essence a series of forward contracts on interest rates.. In

distinction to a forward contract, the periodic exchange of payment flows provided for under
an interest rate swap does provide for a partial periodic settlement of the contract but it is
important to appreciate that the net present value of the swap does not reduce to zero once a
periodic exchange has taken place. This will not be the case because -- as discussed in the
context of reversing or terminating interest rate swaps -- the shape of the yield curve used to
price the swap initially will change over time giving the swap a positive net present value for
either the fixed rate payer or the floating rate payer notwithstanding that a periodic exchange
of payments is being made.

Users and Uses of Interest Rate Swaps

Interest rate swaps are used by a wide range of commercial banks, investment banks, non-
financial operating companies, insurance companies, mortgage companies, investment
vehicles and trusts, government agencies and sovereign states for one or more of the
following reasons:

1. To obtain lower cost funding

2. To hedge interest rate exposure

3. To obtain higher yielding investment assets

4. To create types of investment asset not otherwise obtainable

5. To implement overall asset or liability management strategies

6. To take speculative positions in relation to future movements in interest rates.

The advantages of interest rate swaps include the following:

1. A floating-to-fixed swap increases the certainty of an issuer's future obligations.

2. Swapping from fixed-to-floating rate may save the issuer money if interest rates decline.

3. Swapping allows issuers to revise their debt profile to take advantage of current or
expected future market conditions.

4. Interest rate swaps are a financial tool that potentially can help issuers lower the amount of
debt service.

“Typical transactions would certainly include the following, although the

range of possible permutations is almost endless.”

(a) Reduce Funding Costs . A US industrial corporation with a single A credit rating
wants to raise US$100 million of seven year fixed rate debt that would be callable at par after
three years. In order to reduce its funding cost it actually issues six month commercial paper
and simultaneously enters into a seven year, Nona mortising swap under which it receives a
six month floating rate of interest (Libor Flat) and pays a series of fixed semi- annual swap
payments. The cost saving is 110 basis points.

(b) Liability Management . A company actually issues seven year fixed rate debt
which is callable after three years and which carries a coupon of 7%. It enters into a fixed-
to- floating interest rate swap for three years only under the terms of which it pays a floating
rate of Libor + 185 bps and receives a fixed rate of 7%. At the end of three years the
company has the flexibility of calling its fixed rate loan -- in which case it will have actually
borrowed on a synthetic floating rate basis for three years -- or it can keep its loan obligation
outstanding and pay a 7% fixed rate for a further four years. As a further variation, the
company's fixed- to- floating interest rate swap could be an "arrears reset swap" in which --
unlike a conventional swap -- the swap rate is set at the end and not at the beginning of each
period. This effectively extends the company's exposure to Libor by one additional interest
period which will improve the economics of the transaction.

(c) Speculative Position . The same company described in (b) above may be willing to
take a position on short term interest rates and lower its cost of borrowing even further
(provided that its judgment as to the level of future interest rates is correct). The company
enters into a three year "yield curve arbitrage swap" in which the floating rate payments it
makes under the swap are calculated by reference to a formula. For each basis point that
Libor rises, the company's floating rate swap payments rise by two basis points. The
company's spread over Libor, however, falls from 185 bps to 144 bps. In exchange, therefore,
for significantly increasing its exposure to short term rates, the company can generate
powerful savings.

(d) Hedging Interest Rate Exposure . A financial institution providing fixed rate
mortgages is exposed in a period of falling interest rates if homeowners choose to pre- pay
their mortgages and re- finance at a lower rate. It protects against this risk by entering into an
"index-amortizing rate swap" with, for example, a US regional bank. Under the terms of this
swap the US regional bank will receive fixed rate payments of 100 bps to as much as 150 bps
above the fixed rate payable under a straightforward interest rate swap. In exchange, the bank
accepts that the notional principal amount of the swap will amortize as rates fall and that the
faster rates fall, the faster the notional principal will be amortized.

A less aggressive version of the same structure is the "indexed principal swap". Here the
notional principal amount continually amortizes in line with a mortgage pre- payment index
such as PSA but the amortization rate increases when interest rates fall and the rate decreases
when interest rates rise.

(e) Creation of New Investment Assets . A UK corporate treasurer whose

company has substantial business in Spain feels that the current short term yield curves for
sterling and the peseta which shows absolute interest rates converging in the two countries is
exaggerated. Consequently he takes cash currently invested in the short term sterling money
markets and invests this cash in a "differential swap". A differential swap is a swap under
which the UK Company will pay a floating rate of interest in sterling (6 mth. Libor) and
receive, also in sterling, a stream of floating rate payments reflecting Spanish interest rates
plus or minus a spread. The flows might be: UK Corporation pays six month sterling Libor
flat and receives six month Peseta Mibor less 210 bps paid in sterling. Assuming a two year
transaction and assuming sterling interest rates remained at their initial level of 5.25%, peseta
Mibor would have to fall by 80 bps every six months in order for the treasurer to earn a lower
return on his investment than would have been received from a conventional sterling money
market deposit.

(f) Asset Management. A German based fund manager has a view that the sterling
yield curve will steepen (i.e. rates will increase) in the range two to five years during the next
three years he enters into a "yield curve swap "with a German bank whereby the fund
manager pays semi- annual fixed rate payments in DM based on the two year sterling swap
rate plus 50 bps. Every six months the rate is re- set to reflect the new two year sterling swap
rate. He receives six monthly fixed rate payments calculated by reference to the five year
sterling swap rate and re- priced every six months. The fund manager will profit if the yield
curve steepens more than 50 bps between two and five years.