`

International
Finance

$WAPS
Under Guidance Of
Prof: Sujata Pandey
SWAPS
Pooja Karvat A 21
Naiti k Modi A 25
Sneha Narkar A 26
Darshit Shah A 37
Raina Shah A 41
Pritesh Sheth A 45
Tejasvi Shirodkar A 49
Bhavin Vyas A 60
OUTLINE
 What Is SWAPS?
 Working Of SWAPS
 SWAPS Market
 Types Of SWAPS
 Valuation Of SWAPS
 Swaptions
 Conclusion
 Introduction
Introduction
DERIVATIVES Introduction
Terminology
Introduction
Structure
Introduction
Situations

DERIVATI
VES
 Introduction
Introduction
SWAPS Introduction
Terminology
Introduction
Structure
Exchange of one stream of cash
Introduction
Situations
flows against another stream
Legs of the swap
Used to hedge certain risks
Used to speculate on changes in the underlying
prices
Gold Prices
• Prices are changing At fast rate
Very fast prioritize the things that will
bring about the maximum impact
Fixed
• Then Floating
we must organize Both
resources that will support the priorities
• Finally, we need to plan Something
What 2 do? action and bring
about that change
Gold Prices Agreement
• Prices are changing At fast rate
Very fast prioritize the things that will
bring about the maximum impact
Fixed
• Then Floating
we must organize Both
resources that will support the priorities
• Finally, we need to plan Something
What 2 do? action and bring
about that change
 Introduction
Introduction
SWAPS Terminology
Introduction
Structure
Introduction
Introduction
Situations

 A contract between two parties to exchange two streams

of payments for an agreed period of time.
 A forward contract can be viewed as simple example of
swap.
 A forward contract leads to the exchange of cash flows on
just one future date, swaps typically lead to cash flow
exchanges taking place on several future dates.
 Introduction
Introduction
EVOLUTION Terminology
Introduction
Structure
Introduction
THE ORIGINS OF SWAP BACK TO 1970’S
Introduction
Situations
PARALLEL LOANS/ BACK-TO-BACK LOANS

 YALE PH.D. AT SALOMON BROTHERS, ENGINEERED

THE FIRST SWAP TRANSACTION

 FIRST INTEREST RATE SWAP OCCURRED BETWEEN

IBM AND THE WORLD BANK IN 1981

 INDIAN PERSPECTIVE
 Introduction
Participants Introduction
Introduction
Terminology
Structure
Introduction
Introduction
Situations

Banks

Multinational Companies

Sovereign and public sector institutions

Money Managers
 Introduction
Introduction
OBJECTIVES Introduction
Terminology
Introduction
Structure

Identify the elements of interest rate swaps Introduction

Situations

and Foreign currency swaps

Identify situations where entering into a swap reduces risk

Structure a swap

Calculation of rate is important

 Introduction
Introduction
ADVANTAGES Introduction
Terminology
Introduction
Structure
Introduction
Situations
The swap market is virtually UNREGULATED

The COST of TRANSACTING in the Swap Market is LOW

Swaps are PRIVATE Transactions between 2 parties.

 Introduction
DISADVANTAGES Terminology
Structure
A counter-party that is willing to take the
Situations

other side of the swap is required

A swap cannot be easily terminated

Swaps have more CREDIT RISK than Futures

 Introduction
Introduction
MOTIVATIONS Introduction
Terminology
Introduction
Structure
 COMMERCIAL NEEDS
Introduction
Situations

 COMPARATIVE ADVANTAGE

 PROTECTION AGAINST FUTURE CHANGES IN EXCHANGE

RATES AND INTEREST RATES.

 ELIMINATE INTEREST-RATE RISKS

 TO REDUCE FINANCING COSTS

 Introduction
Introduction
Size of the Swap Market Introduction
Terminology
Introduction
Structure

 In 2005 the notational principal of: Introduction

Situations

Interest rate swaps was $24,810,736,000,000

Currency swaps $2,197,395,000,000
 The most popular currencies are:
U.S.$ (43%)
¥ (23%)
DM (8%)
FF (10%)
£ (16%)
 Introduction
Introduction
Size of the Swap Market Introduction
Terminology
Introduction
Structure
IN 1987, SWAPS MARKET TOTAL NOTIONAL
VALUE OF $865.6 BILLION. BY MID-2006 Introduction
Situations

EXCEEDED $250T
TERMINOLOGIES USED IN Introduction
SWAPS Terminology
Introduction
Introduction
Structure
Transaction Date,
Introduction
Situations
Effective Date

Fixing Date ,Maturity Date

LIBOR, EURIBOR , MIBOR

Government Securities Linked

Benchmark (Inbmk Quote)
TERMINOLOGIES USED IN Introduction
SWAPS Terminology
Introduction
Introduction
Structure
Swap Banks
Introduction
Situations

Governing Bodies

ISDA

MITOR, MIFOR
 STRUCTURE
SWAP
COUNTERPARTY

CASH FLOW CASH FLOW

STREAM A STREAM B

ORIGINAL
YOU COUNTERPARTY
CASH FLOW
STREAM A
 Introduction
Introduction
How SWAPS Work ? Introduction
Terminology

Transform a liability
Structure
Introduction
Situations
Introduction
Transform an asset

Reduce costs associated with inconsistent pricing across

different international credit market segments

Serve the same purpose as long-dated forward

contracts for less cost

Do not require participating parties to have similar

credit quality

Intermediary facilitates swap between parties for a fee

 Introduction
Introduction
Terminology
Structure
Introduction
Introduction
Situations
 All swaps have basically the same structure.

 Two parties, called counterparties, agree to one or more exchanges of

specified quantities of underlying assets.

 These underlying assets are known as notional.

 A swap may involve one exchange of notional, two exchange of

notional, a series of exchange of notional or no exchange of notional.

 The notional exchanged in the swap may be same or different.

 Introduction
SITUATIONS Terminology
Structure
Situations
Fixed loan when interest rates are falling

Floating interest when rates are increasing

Inflows of foreign currency when home

currency is appreciating

Outflows of foreign currency when home

currency is depreciating
Interest Rates Swaps
 5%
5.2 %
LIBOR+0.1%
LIBOR

Example Method Wipro Infosys Swap

Cash
1. Flows:
It pays 5.2% to its outside lenders
1.Infosys
2. ItItPays LIBOR
arranged
pays Plus
LIBOR 0.10borrow
to
under To ` 100
theItsterms
Outside
of Lenders.
crswap.
the at LIBOR plus 10 basis points
2.
3. It receives 5% underFixed
It Receives Libor Under The Terms Of The Swap.
the terms of the swap. Floating
3. It Pays 5% Under The Term Of The Swap.
Wipro has a three year ` 100 cr loan outstanding on which it pay 5.2%.
These three cash flows net out to an interest payment of LIBOR plus 0.2% . Thus for WIPRO
These Three Sets Of Cash Flows Net Out To An Interest Rate Payment Of 5.1%. Thus For Infosys The
Floating
the swap has the effect Fixed
of transforming borrowings at a fixed rate of 5.2% into a
Swap Could Have The Effect Of Transforming Borrowings At A Floating Rate Of LIBOR Plus 10 Basis
borrowings
Point at a floating
Into A Borrowings At Arate ofRate
Fixed LIBOR plus 20 basis points.
Of 5.1%
 5%
Libor-0.25%
4.7%
LIBOR

Example Method Wipro Infosys Swaps

Cash
CashFlows:
Flows:
1.
1. It
It Receives
Receives 4.7%
LIBOROn The Bonds.
Minus 25 Basis Points On Investment.
2.
2. It
It Receives
Pays LiborLibor
Under Floating
Under
The The Terms
Terms Of The
Of The Swap.
Swap. Fixed of 4.7%
Infosys owns Rs.100cr in bonds which provide an interest
3.
3. It
It Pays 5% Under
Receives The The
5% Under Terms Of The
Terms Swap.
Of The Swap.
Wipro has an investment of similar amount that yields LIBOR minus 25
These
These Three
Three Sets
CashOfFlows
Cash Flows NetToOutAnToInterest
An Interest
RateRate Inflow Of Libor Thus
MinusWipro
30 Basis
Fixed
Net Out
basis points.
Inflow Floating
Of 4.75%. Has
Points. Thus Infosys Has Transformed An Asset
Transformed An Asset Earning LIBOR Minus 25 Earning 4.7%Into
Basis Points IntoAn
AnAsset
AssetEarning
Earning4.75%
LIBOR
Minus 30 Basis Points.
 Introduction
CHARACTERISTICS Terms

Types
Contractual Agreement
Valuation
Exchange A Series Of Cash Flows

Only Net Cash Flows Exchanged

Not In Itself Either A Borrowing Or Lending

The Size Of The Swap Is Referred To As The Notional Amount And

Is The Basis For Calculation

Actual Principal Of The Swap Not Exchanged

It Is An Off-balance Sheet Transaction

 NOMINAL PRINCIPAL AMT : ` 10 CR
Interest Rate Swaps CORPORATE TO PAY :7.50 % FIXED
CORPORATE TO RECEIVE : 3M MIBOR

START DATE OF THE SWAP: 18TH AUG 2010

3 MONTH MIBOR
TENOR OF THE SWAP: 6 M
TERMINATION OF THE SWAP : 18TH FEB 2011 7.25 % 18TH AUG ’10

INTEREST PAYMENT DATES: 18TH NOV & 18TH FEB 7.60 % 18TH NOV ’10

Find Out The Cash Flow For The Following Dates:

Total Cash Flow:

18th Nov 2010 Bank

18th Feb 2011 Corporate

 18Th Nov 2010 MIBOR Rate: 7.25%
Bank Corporate
` 0.18 CR. `0.19 CR.
(` 10 CR. X 7.25% X 92 DAYS / 365 DAYS) (` 10 CR. X 7.50% X 92 DAYS / 365 DAYS)

18Th Feb 2011 MIBOR Rate: 7.60%

Bank Corporate

` 0.19 CR. `0.19 CR.

(` 10 CR. X 7.60% X 92 DAYS / 365 DAYS) (` 10 CR. X 7.50% X 92 DAYS / 365 DAYS)
 Total Cash Flow

Bank Corporate
` 0.37 CR. `0.38 CR.

FIXED RATE PAYERS :

 Lose When Interest Rates Fall
 Gain When Interest Rates Rise

FLOATING RATE PAYERS :

 Gain When Interest Rates Fall

 Lose When Interest Rates Rise

 Total Cash Flow

Bank Corporate
` 0.37 CR. `0.38 CR.

FIXED RATE PAYERS :

 Lose When Interest Rates Fall
 Gain When Interest Rates Rise

FLOATING RATE PAYERS :

 Gain When Interest Rates Fall

 Lose When Interest Rates Rise

 Introduction
Interest Rate Swaps Terms
Types & Risk
Trade Date
Valuation

Effective Date

Reset Date

Payment Date
 Role Of A Swap Dealer

4.95% 5.015 %
5.2 % LIBOR+0.1%
LIBOR LIBOR

4.95% 5.015 %
Libor-0.25% 4.7%
LIBOR LIBOR
Bank A is a AAA-rated international bank located in the U.K. who wishes
to raise $10,000,000 to finance floating-rate Eurodollar loans.

 Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 %.

 It would make more sense to for the bank to issue floating-rate notes at LIBOR to
finance floating-rate Eurodollar loans.

Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an

investment with a five-year economic life.

 Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 %.

 Alternatively, firm B can raise the money by issuing 5-year FRNs at LIBOR + ½ %.
 Firm B would prefer to borrow at a fixed rate.
The borrowing opportunities of the two firms are shown
in the following table:

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%

Bank Swap Company

A Bank B
 The swap bank makes
this offer to Bank A:
Swap
You pay LIBOR – 0.125 %
10 .375% Bank per year on $10 million
for 5 years and we will
pay you 10 .375% on $10
LIBOR – 0.125% million for 5 years
Bank
A

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
0.5 % of $10,000,000 = Bank A: They can borrow
$50,000. That’s quite a externally at 10% fixed and
cost savings per year for 5 have a net borrowing position
years. Swap of
-10 .375 + 10 + (LIBOR – 0.125)
Bank =
10 .375%
LIBOR – ½ % which is ½ %
better than they can borrow
10% Bank LIBOR – 0.125% floating without a swap.

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
The swap bank makes this offer
to company B:
You pay us 10.5% per year on $10
million for 5 years and we will pay Swap
you LIBOR – 0.25 % per year on Bank
$10 million for 5 years. 10 .5%

LIBOR – 0.25%
Company
B
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
Here’s what’s in it for B: 0.5% of $10,000,000 =
$50,000 that’s quite a cost
They can borrow externally at LIBOR
+ ½ % and have a net borrowing
savings per year for 5
position of Swap years.
10.5 + (LIBOR + 0.5 ) - (LIBOR -0.25 ) Bank
= 11.25% 10 .5%
which is ½ % better than they can
borrow floating without a swap. LIBOR – 0.25%
Company LIBOR +
0.5%
B

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
 0.25 % of $10 million =
The swap bank $25,000 per year for 5
years.
makes money too. Swap

10 .375% Bank
10.5%

LIBOR – 0.125% LIBOR – 0.25%

10% Bank Company LIBOR +
LIBOR – 0.125 – [LIBOR – 0.25 ]= 0.125 0.5%
A B
10.5 – 10.375 =0.125
A saves 0.5 % B saves 0.5 %
0.25

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
 The swap bank makes 0.25 %

Swap
10.375 % Bank 10 .5%

LIBOR – 0.125% LIBOR –

10% 0.25%
Bank Company LIBOR +
Note that the total savings 0.5%
A B
0.5 + 0.5 + 0.25 = 1.25 % =
A saves 0.5 % QSD B saves 0.5 %
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
 Introduction
QSD Terms

Types & Risk

 The Quality Spread Differential (QSD) Valuation

represents the potential gains from the swap that can be shared between the
counterparties and the swap bank.

 There is no reason to presume that the gains will be shared equally.

 In the above example, company B is less credit-worthy than bank A, so they

probably would have gotten less of the QSD, in order to compensate the swap
bank for the default risk.
 Introduction
Interest Rate Swaps Terms
Types & Risk
Plain Vanilla
Valuation

Floating To Floating

Zero Coupon IRS

Forward IRS
 Introduction
RISKS Terms
Types & Risk
Interest Rate Risk Valuation

Liquidity Risk
VALUATION
 A B
Rate
Interest
Swaps NOMINAL PRINCIPAL AMT : 100 Million
A : FIXED Rate Payer
B : FIXED Rate Receiver

TERM OF THE SWAP – 3 YEARS Cash Flows For 3 Months

Find The Fixed Rate Price And Valuation After 1 Year

CALCULATING THE FLOATING RATE PAYMENTS
QUARTER NO.OF CURRENT 3 FORWARD FLOATING RATE
DAYS MONTH LIBOR RATE ( % ) PAYMENTS
JAN-MARCH 1 90 4.05 % 1012500
APR- JUNE 1 91 4.15 1049028
JULY – SEP 1 92 4.55 1162778
OCT – DEC 1 92 4.72 1206222
JAN-MARCH 2 90 4.90 1225000
Step 1 NOTIONAL AMOUNT * 3 MONTH LIBOR *NO. OF DAYS/360
APR- JUNE 2 91 5.03 1271472
JULY – SEP 2 92 5.15 1316111
OCT – DEC 2 100000000*4.05%*90/360=
92 5.25 1341667
JAN-MARCH 3 90 1012500 5.40 1350000
APR- JUNE 3 91 5.50 1390278
JULY – SEP 3 92 5.65 1443889
OCT – DEC 3 92 5.76 1472000
CALCULATING THE FORWARD DISCOUNT FACTOR
FORWARD
QUARTER NO.OF DAYS FORWARD RATE PERIOD FORWARD DISCOUNT
RATE ( % ) FACTOR
JAN-MARCH 1 90 4.05 1.0125 0.9899
APR- JUNE 1 91 4.15 1.0490 0.9796
JULY – SEP 1 92 4.55 1.1628 0.9684
OCT – DEC 1 92 4.72 1.2062 0.9568
Step
JAN-MARCH 2 2 90 1/(1+Forward
4.90 rate for period t)
1.2250 0.9453
APR- JUNE 2 91 5.03 1.2715 0.9334
JULY – SEP 2 92 5.15 1.3161 0.9213
APR-JUNE
Jan-March11
OCT – DEC 2 1/(1+0.01025)=0.98997648805
920.98997648805 /(1+0.010490)=0.97969944091
5.25 1.3471 0.9091
JAN-MARCH 3 90 5.40 1.3500 0.8970
APR- JUNE 3 91 5.50 1.3903 0.8847
JULY – SEP 3 92 5.65 1.4439 0.8721
OCT – DEC 3 92 5.76 1.4720 0.8594
PRESENT VALUE OF FLOATING RATE PAYMENTS
QUARTER FORWARD DISCOUNT FLOATING RATE PAYMENTS PV OF FLOATING
FACTOR RATE PAYMENTS

JAN-MARCH 1 0.9899 1012500 1002351

APR- JUNE 1 0.9796 1049028 1027732
JULY – SEP 1 0.9684 1162778 1126079
OCT – DEC 1 0.9568 1206222 1154229
JAN-MARCH 2 0.9453 1225000 1158012
APR- JUNE 2 0.9334 1271472 1186852
JULY – SEP 2 0.9213 1316111 1212562
OCT – DEC 2 0.9091 1341667 1219742
JAN-MARCH 3 0.8970 1350000 1210970
APR- JUNE 3 0.8847 1390278 1229999
JULY – SEP 3 0.8721 1443889 1259248
OCT – DEC 3 0.8594 1472000 1265141
TOTAL 14,052,917
CALCULATING THE DENOMINATOR FOR THE SWAP RATE FORMULA
FORWARD FORWARD DIS. FACTOR *DAYS/360 *
QUARTER NO.OF DAYS DISCOUNT
NOTIONAL
FACTOR
JAN-MARCH 1 90 0.9899 24749412
APR- JUNE 1 91 0.9796 24764618
JULY – SEP 1 92 0.9684 24748981
OCT – DEC 1 92 0.9568 24454011
JAN-MARCH 2 90 0.9453 23632899
APR- JUNE 2 91 0.9334 23595477
JULY – SEP 2 92 0.9213 23544891
OCT – DEC 2 92 0.9091 23233179
JAN-MARCH 3 90 0.8970 22425368
APR- JUNE 3 91 0.8847 22363622
JULY – SEP 3 92 0.8721 22287568
OCT – DEC 3 92 0.8594 21964255
TOTAL 281,764,282
DETERMINATION OF SWAP RATE

SR = PV OF FLOATING RATE PAYMENTS

(Sum) NOTIONAL AMOUNT *DAYS/360*FDF(T)

SR = 14,052,917
281,764,282
= 0.049875

= 4.9875%
CALCULATING FIXED RATE PAYMENTS
QUARTER NO.OF DAYS FIXED RATE PAYMENTS (Swap rate =
4.9875 %)

JAN-MARCH 1 90 1246875
APR- JUNE 1 91 1260729
JULY – SEP 1 92 1274583
OCT – DEC 1 92 1274583
JAN-MARCH 2 90 1246875
APR- JUNE 2 91 1260729
JULY – SEP 2 92 1274583
OCT – DEC 2 92 1274583
JAN-MARCH 3 90 1246875
APR- JUNE 3 91 1260729
JULY – SEP 3 92 1274583
OCT – DEC 3 92 1274583
VALUATION AFTER 1 YEAR
RATES AND FLOATING PAYMENTS ONE YEAR LATER IF RATES INCREASE

QUARTER NO.OF DAYS CURRENT 3 FORWARD FLOATING RATE

MONTH LIBOR RATE ( % ) PAYMENTS

JAN-MARCH 2 90 5.25 % 1,312,500

APR- JUNE 2 91 5.73 1,448,417

JULY – SEP 2 92 5.78 1,477,111

OCT – DEC 2 92 6.00 1,533,333

JAN-MARCH 3 90 6.15 1,537,500

APR- JUNE 3 91 6.25 1,579,861

JULY – SEP 3 92 6.46 1,650,889

OCT – DEC 3 92 6.75 1,725,000

PRIOD FORWARD RATES AND FORWARD DISCOUNT RATES IF RATES INCREASE

FORWARD
QUARTER NO.OF DAYS FORWARD RATE (%) PERIOD FORWARD RATE ( % )
DISCOUNT FACTOR

JAN-MARCH 2 90 5.25 1.3125 0.9870

APR- JUNE 2 91 5.73 1.4484 0.9729

JULY – SEP 2 92 5.78 1.4771 0.9587

OCT – DEC 2 92 6.00 1.5333 0.9443

JAN-MARCH 3 90 6.15 1.5375 0.9300

APR- JUNE 3 91 6.25 1.5799 0.9155

JULY – SEP 3 92 6.46 1.6509 0.9006

OCT – DEC 3 92 6.75 1.7250 0.8854

VALUING THE SWAP ONE YEAR LATER IF RATES INCREASE

FORWARD DISCOUNT FLOATING CASH PV OF FLOATING CASH

QUARTER FACTOR FLOW FLOW

JAN-MARCH 2 0.9870 1,312,500 1,295,497

APR- JUNE 2 0.9729 1,448,417 1,409,241

JULY – SEP 2 0.9587 1,477,111 1,416,240

OCT – DEC 2 0.9443 1,533,333 1,447,943

JAN-MARCH 3 0.9300 1,537,500 1,429,893

APR- JUNE 3 0.9155 1,579,861 1,446,438

JULY – SEP 3 0.9006 1,650,889 1,486,920

OCT – DEC 3 0.8854 1,725,000 1,527,324

TOTAL 11,459,495
VALUING THE SWAP ONE YEAR LATER IF RATES INCREASE

FORWARD DISCOUNT PV OF FIXED CASH

QUARTER FACTOR FIXED CASH FLOW FLOW

JAN-MARCH 2 0.9870 1,246,875 1,230,722

APR- JUNE 2 0.9729 1,260,729 1,226,630

JULY – SEP 2 0.9587 1,274,583 1,222,058

OCT – DEC 2 0.9443 1,274,583 1,203,603

JAN-MARCH 3 0.9300 1,246,875 1,159,609

APR- JUNE 3 0.9155 1,260,729 1,154,257

JULY – SEP 3 0.9006 1,274,583 1,147,990

OCT – DEC 3 0.8854 1,274,583 1,128,523

TOTAL 9,473,390
 VALUING THE SWAP ONE YEAR LATER
FIXED RATE PAYER FIXED RATE RECEIVER
PARTICULARS “A” “B”

PV OF PAYMENTS RECEIVED 11,459,485 9,473,390

PV OF PAYMENTS MADE 9,473,390 11,459,495

VALUE OF SWAP 1,986,105 (1,986,105)

Credit Default Swaps
 Introduction
Credit Default Swaps Meaning

Features
Credit derivative
Features Contd….
Instrument

Early 1990’s

Isolate the risk

Individual or basket of credits

 Introduction
Credit Default Swaps Meaning
Features
Features Contd….

•It is a bilateral derivative contract.

•One party agrees to pay periodic fixed payments.
•Other party in return gives a protection for a Credit event.
•If the third party is subject to any pre-agreed credit events.
•Pre agreed time period.
•Credit events include bankruptcy, failure to pay, moratorium,
etc.
 Introduction
Credit Default Swaps Meaning

Features
Features Contd….

•Two Parties: Protection Buyer & Seller.

•Annual Protection Fees paid (Premium).
•Third Party is reference entity & reference obligation.
•Reference Credit is contingent amount paid by the
protection seller in case of adverse credit event occurs.
 Introduction
Credit Default Swaps Meaning

Features
Features Contd….
•Reference credit asset issued must be specified under the
default swap contract
•Seller should pay for the Obligation.
•Credit Events like bankruptcy, insolvency, restructuring,
administration, failure to meet payment obligation, etc
•Swap can be settled through cash or delivery of underlying
asset.
 Structure
Credit Default Swaps Mechanism
Mechanism Contd…

Periodic fee(Premium) Criticism

(X bps per annum)
Protection Protection
buyer ZERO No credit event seller
Credit event
CEP

Periodic fee(Premium)
(X bps per annum)
Protection Protection
Reference Bond
buyer seller
Entity If a credit event occurs

Default protection
Par amount (if a credit event occurs)
 Structure
Credit Default Swaps Mechanism
Mechanism Contd…

Criticism

•On the start date, no payments are made by either of the party.

•On periodic interim dates premium is paid.

•If credit event do not occur no payments are made by the

protection seller.
•If credit event occurs, in case of physical settlement, buyer must

deliver the deliverable obligation in exchange for a pre-agreed

amount.
 Structure
Credit Default Swaps Mechanism

Mechanism Contd…
Criticism

•If a Credit event occurs and cash payment applies then the seller
pays excess of par value of the deliverable obligation over the
market value of the deliverable at the time of credit event.
•Deliverable obligations are assets eligible for delivery as a
settlement.
•Credit default swaps can be terminated prior to its term with the
consent of both the parties.
 Structure
Credit Default Swaps Mechanism
Mechanism Contd…

Criticism
•CDS lacks proper regulation.
•All contracts are privately negotiated, the market has no
transparency
•In many instances the amount of credit derivatives outstanding for
an individual name is vastly greater than the bonds outstanding.
•CDS premiums can act as a barometer of company's
unhealthiness.
Currency Swaps
 Introduction
CURRENCY SWAPS Steps
Types
Example
 A Contract Which Commits
Two Counter Parties To An Exchange Over An Agreed Period

 Two Streams Of Payments In Different Currencies.

 Different Interest Rate

 Exchange Rate Agreed At The Start Of The Contract.

 Introduction
CURRENCY SWAPS Steps
Types
Example
Step 1:

Initial Exchange Of The Principal Amount

Step 2:

Ongoing Exchange Of Interest

Step 3:

Re-exchange Of The Principal Amounts

STEP
STEP
STEP1:
3:
2:INITIAL
EXCHANGEEXCHANGE
SETTLEMENTOFOF
THE OF
THE THECONTRACT
FINAL PRINCIPAL
NOTIONAL AMOUNT
ANNUAL INTEREST
Suppose Firm A has SWISS FRANC 100 Million liability but
firm wants DOLLAR loan

Suppose Firm B has US DOLLAR 100 Million liability but firm

US DOLLAR
SWISS FRANC
wants SWISS FRANC loan
US DOLLAR INTEREST

So Firm A & Firm B can enter into currency swap with

FIRM A
FIRM steps
following A FIRM
FIRM B
B
FIRM A FIRM B
SWISS
SWISS FRANC
FRANC INTEREST
CHF/USD = 1.00
US DOLLAR
 Introduction
CURRENCY SWAPS Steps
Types
Example

Fixed To Fixed Currency Swap

Floating To Floating Currency Swap

Fixed To Floating Currency Swap

 US DOLLAR PRINCIPAL

GBP PRINCIPAL

GBP FIXED INTEREST RATE

FIRM A FIRM B
USD FIXED INTEREST RATE

GBP PRINCIPAL

US DOLLAR PRINCIPAL
 US DOLLAR PRINCIPAL

GBP PRINCIPAL

GBP FLOATING INTEREST RATE

FIRM A FIRM B
USD FLOATING INTEREST RATE

GBP PRINCIPAL

US DOLLAR PRINCIPAL
 US DOLLAR PRINCIPAL

GBP PRINCIPAL

GBP FIXED INTEREST RATE

FIRM A FIRM B
USD FLOATING INTEREST RATE

GBP PRINCIPAL

US DOLLAR PRINCIPAL
Firm A is a AAA-rated multinaitional Company located in the U.S who
wishes to raise £ 10,000,000 for their British Plant
 They could borrow dollars in the U.S. where they are well known and exchange
for dollars for pounds.
 They could borrow pounds in the international bond market, but pay a lot since
they are not as well known abroad.

Firm B is a BBB-rated U.K. company. It needs $16,000,000 to finance

their US plant
 They could borrow dollars in the U.K. where they are well known and exchange for
Pounds for Dollars.
 Alternatively, they could borrow dollars in the international bond market, but pay
a lot since they are not as well known abroad.
The borrowing opportunities of the two firms are shown
in the following table:

$ £
Company A 8% 11.6%
Company B 10% 12%

GBP/USD = 1.6
 An Example of a Currency Swap

Swap
Bank
$8% $9.4%
£12%
£11%
$8% Company A Company B £12%

$ £

Company A 8% 11.6%
Company B 10% 12%
 An Example of a Currency Swap

Swap
Bank
$8% $9.4%
£12%
£11%
$8% Company A Company B £12%

A’s net position is to borrow at £11%

$ £
A saves £.6%
Company A 8% 11.6%
Company B 10% 12%

10-83
 An Example of a Currency Swap

Swap
Bank
$8% $9.4%
£12%
£11%
$8% Company A Company B £12%

B’s net position is to borrow at $9.4%

$ £
B saves $.6%
Company A 8% 11.6%
Company B 10% 12%
 An Example of a Currency Swap
1.4% of $16 million financed
The swap bank makes Swap with 1% of £10 million per
money too: year for 5 years.
Bank
$8% $9.4%
£12%
£11%
$8% Company A Company B £12%
At S0($/£) = $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
Company A 8% 11.6%
lay it off in another
Company B 10% 12% swap.
 PRIOR ARRANGEMENT

Swap
Bank
$8% $9.4%
£12%
£11%
$8% Company A Company B £12%

$ £

Company A 8% 11.6%
Company B 10% 12%
 ALTERNATIVE STRATEGY
0.4% of $16 million
The swap bank makes Swap
money too:
Bank
$8% $8.4%
£11%
£11%
$8% Company A Company B £12%
At ANY S0($/£) Bank makes
a profit of $ 64000
Company B faces
£ exchange rate risk
$
Company A 8% 11.6%
Company B 10% 12%
 PRIOR ARRANGEMENT

Swap
Bank
$8% $9.4%
£12%
£11%
$8% Company A Company B £12%

$ £

Company A 8% 11.6%
Company B 10% 12%
 ALTERNATIVE STRATEGY
0.4% of $16 million
The swap bank makes Swap
money too:
Bank
$9% $9.4%
£12%
£12%
$8% Company A Company B £12%
At ANY S0($/£) Bank makes
a profit of $ 64000
Company A faces
£ exchange rate risk
$
Company A 8% 11.6%
Company B 10% 12%
 Introduction
BENEFITS OF CURRENCY SWAPS Steps
Types
Example

 Give Companies Extra Flexibility To Exploit Their Comparative

Advantage In Their Respective Borrowing Markets.

 Allow Companies To Exploit Advantages Across A Matrix Of

Currencies And Maturities.

 Opens Up Diverse Avenues Of Funding.

VALUATION
 A
Swaps
Currency

B
PRINCIPAL AMT : 25 Cr
Interest rate : 14% fixed
Spot USD/INR = 44.8
1 yr forward = 45
LIBOR : 3.52 %

TERM OF THE SWAP – 1 YEAR

Find The Valuation for Firm A After 1 Year under

different Currency and Interest rate
CALCULATING OUTFLOW FOR THE BANK

PRINCIPAL + INTEREST

25 Cr + 14% of 25 Cr = 28.5 Cr
CALCULATING THE INFLOW FOR THE BANK

DOLLAR PRINCIPAL
LIBOR + SPREAD

PRINCIPAL

25 CR 44.8 $ 55,80,357
CALCULATING THE INFLOW FOR THE BANK

DOLLAR PRINCIPAL
LIBOR + SPREAD

LIBOR = 3.52%

ANNUAL COMPOUNDING RATE 3.52 E^(0.0352*1*365/360)

LIBOR = 3.63245%

3.63245% of $ 55,80,357 = $ 202703

CALCULATING THE INFLOW FOR THE BANK

DOLLAR PRINCIPAL
LIBOR + SPREAD

5580357 + 202703 + X% 5580357 * 365/360 45 28.5 Cr

SPREAD = 9.86%
VALUATION FOR FIRM A

LIBOR SPREAD TOTAL INTEREST USD/INR NET PAYMENT PROFIT/LOSS

5% 9.86% 14.86% 47 30,12,51,108 (1,62,51,108)

2% 9.86% 11.86% 47 29,33,82,805 (83,82,805)
5% 9.86% 14.86% 43 27,56,12,716 93,87,284
2% 9.86% 11.86% 43 26,84,14,055 1,65,85,945
Equity Swaps
 Equity Swaps
EQUITY SWAPS Types
Applications

An Equity Swap Is A Transaction Between Two Parties In Which Each Party Agrees
To Make A Series Of Payments To The Other, With At Least One Set Of Payments
Determined By The Return On A Stock Or Stock Index.

The Payments Occur On Regularly Scheduled Dates Over A Specified Period Of

Time.
EQUITY SWAP

FTSE FTSE
LIBOR Party A
Party B FTSE
LIBOR LIBOR

Notional price-€5000000 Libor-5.97% Tenor-180 days FTSE-10%

INFLOW OUTFLOW

PARTY A 10%*€5000000=€500000 5.97%*180/360*€5000000=€1

49250

PARTY B 5.97%*180/360*€5000000=€1 10%*€5000000=€500000

49250
 Equity Swaps
TYPES OF EQUITY SWAPS Types
Applications

Equity For Fixed Swap

Equity For Floating Swap

Equity For Equity Swap

Equity for Fixed swap

5% 5%

Stock returns ABC ltd Swap 5%

Index Index dealer
returns returns

On December 15 of a year, ABC Ltd, enters into a swap to pay the return on the S&P 500 and receive fixed rate of 5% with
payment terms of 30/360 with payments to occur on March 15, June 15, September 15, and December 15 for one year.
Payments to be calculated on a notional principal of $20 million. The S&P 500 is at 1105.15 on the day the swap is initiated
Equity for Floating swap

LIBOR LIBOR

Stock returns ABC ltd Swap LIBOR

Index Index dealer
returns returns

On December 15 of a given year, ABC Ltd enters into a swap to pay the return on the S&P 500 and receive a floating rate of
90-day LIBOR with payment terms of 30/360 with payments to occur on March 15, June 15, September 15, and December 15
for one year. Payments will be calculated on a notional principal of $20 million. The S&P 500 is at 1105.15 and 90-day LIBOR
is 4.75% on the day the swap is initiated.
Equity for Equity swap

S&P 500 S&P 500

ABC ltd Swap

NASDAQ S&P 500
NASDAQ
dealer
NASDAQ

On December 15 of a given year ABC Ltd, enters into a swap to pay the return on the NASDAQ Composite index and receive
the return on the S&P 500 with payments to occur on March 15, June 15, September 15, and December 15 for one year.
Payments will be calculated on a notional principal of $20 million. The S&P 500 is at 1105.15 and NASDAQ is at 1705.51.
 Equity swaps
APPLICATIONS Types
Applications

Mitigate the negative returns on the stock

Using an equity swap the investor can pass on the negative
returns on equity position without losing the possession of
the shares and hence voting rights

Achieving International Diversification

It allows an investor to receive the return on a security
which is listed in such a market where he cannot invest due
to legal issues
 Other Swaps
BASIS SWAPS Basis swaps
Asset Swaps
Commodity swaps
BASIS SWAP:
•It involves the exchange of two floating rate instruments.

•A floating-floating interest rate swap under which the floating rate payments is
referenced to different bases.

• It is possible to enter into a swap with a 3-month Libor against a 6-month Libor.
• It is also possible to enter into a swap with a 91-Day T-Bill Yield against a 6-Month
Libor.
 Other Swaps
ASSET SWAPS Basis Swaps
Asset Swaps
Commodity Swaps

Rather than regular fixed and floating loan interest rates being swapped,
fixed and floating investments are being exchanged.
 Other Swaps
COMMODITY SWAPS Basis Swaps
Asset Swaps
Commodity Swaps
A swap where exchanged cash flows is dependent on the
price of an underlying commodity.

 This is usually used to hedge against the price of a

commodity.

The vast majority of commodity swaps involve oil

Swaptions
 Introduction
INTRODUCTION Terminologies
Characteristics

OPTION Types of Swaptions

SWAPS
SWAPTIONS
TERMINOLOGIES Introduction
Terminologies
Characteristics
Payer Swaptions
Types of Swaptions

Receiver Swaptions

European Style

American Style
TERMINOLOGIES Introduction
Terminologies
Characteristics
Bermudan Style
Types of Swaptions

Premium
CHARACTERISTICS Introduction
Terminologies
Characteristics
Maturity
Types of Swaptions

Flexibility

Term Interest Rate

Markets
 Types Introduction
Terminologies
Characteristics
Contingent Swaps
Types of Swaptions

Extendible Swaps

Cancellable Swaps

Callable Swaps

Putable Swaps
CALL SWAPTIONS
 Variable Rate
Seller Holder
(Payer)
Fixed Rate (Receiver)

Example

FIXED RATE RECEIVER:

 Lose When Interest Rates Rise
The Holder of a RECEIVER (Call) SWAPTION has the RIGHT
 Gain When Interest Rates Fall
PUT SWAPTIONS
 Variable Rate
Holder Seller
(Payer)
Fixed Rate (Receiver)

Example

FIXED
The Holder of a Payer (Put) RATEhas
SWAPTION PAYER:
the RIGHT

 Lose When Interest Rates Fall

 Gain When Interest Rates Rise
MECHANISM
 LIBOR Call Swaption LIBOR
Call Swaption Third Party
Writer Owner
7% 6.5%

Reverse
Example Method Call Writer Call Owner Position

Consider 6-month Call Swaption whose underlying Swap is a 5-year swap

Cashwith a fixed rate of 7% v. LIBOR on the notional amount of $1,000,000.
Flows:
1. It pays 7% under swap to Call Swaption Owner.
1. It pays 6.5%
LIBORtounder
the third
swapparty to swap
to the take the reverse position.
writer.
2. It receives LIBOR under the terms of the swap from Call Swaption Owner.
2. It Receives LIBOR from
7% from third
swap party
writer for the
under reverse
swap position.
contract.
Premium on this swap is 25 basis points. resulting $2,500
After these cash flows:
Call Option Owner’s Profit per Year = $1,000,000(7.0% + LIBOR – LIBOR – 6.5%) = $5,000. = $5,000
Call Option Owner’s Profit per Year = $1,000,000(7.0% + LIBOR – LIBOR – 6.5%) = $5,000
EXAMPLES
 Corporate XYZ issues $50,000,000 of Non-callable 9%
bonds that mature in 5 years.

Corporate Sentiment: The firm believes that the

rates may fall substantially before this debt matures.
Example
Solution:

1. The Corporation wants to OWN the CALL SWAPTION because it Want the Right to
Question:
Exercise or not Exercise the option.

1. What
2. kind
XYZ will to BUY A is
of Swaption
want CALL SWAPTION
Appropriate fortoitsbecome FIXED RATE RECEIVER.
objective?

3. XYZ acquires a 5-year Swaption for 75 Basis Points, so requires to pay $ 3,75,000
One- time Swap Premium.
Scenario 1: IF INTEREST RATES RISE OR REMAIN UNCHANGED OVER THE NEXT 5
YEARS

Example 9%
BOND
HOLDER

$ 3,75,000 One- time Swap Premium

Scenario 2: IF INTEREST RATES DECLINE AFTER THE NEXT 5 YEARS

8%
Example DEALER
LIBOR

9%

BOND
HOLDER

Net Cost of Funds to XYZ = 9% + LIBOR – 8% = LIBOR + 1%

Scenario 3: IF INTEREST RATES DECLINE AFTER THE NEXT 5 YEARS AND CORPORATE
XYZ EXERCISE REVERSE SWAP

LIBOR 8%
DEALER
Example DEALER
7% LIBOR

9%
BOND
HOLDER

Net Cost of Funds to XYZ = 9% + LIBOR +7% – 8%LIBOR = 8%

 Corporate ABC issues $50,000,000 of CALLABLE 8%
coupon bonds that mature in 3 years.

Corporate Sentiment: The firm believes that rates

will remain the same or rise in the future.
Example

Solution:

1. The Corporation wants to SELL the SWAPTION because it no longer believes that
Question:
the right to call the bond has any value.

1.
2. What kindwant
ABC will of Swaption
to SELL A is Appropriate
SWAPTION forBasis
for 60 its objective?
Points.

3. ABC receives $300,000 for selling the swaption.

Scenario 1: IF INTEREST RATES RISE OR REMAIN UNCHANGED OVER THE NEXT 3
YEARS.

Example 8%
BOND
HOLDER

$ 3,00,000 One- time Swap Premium

Scenario 2: IF INTEREST RATES DECLINE AFTER THE NEXT 3 YEARS

LIBOR
Example DEALER
7%

8%

BOND
HOLDER

Net Cost of Funds to ABC = 8% + 7% - LIBOR = 15% - LIBOR

Scenario 3: IF INTEREST RATES DECLINE AFTER THE NEXT 3 YEARS, BONDS ARE
CALLABLE, CORPORATE ABC CAN CALL ITS BONDS

LIBOR
Example DEALER
7%

LIBOR + 1 %

BOND
HOLDER

Net Cost of Funds to ABC = LIBOR + 1% + 7% - LIBOR = 8%

SWAP MARKET IN
INDIA
IRS- OUTSTANDING NOTIONAL PRINCIPAL
Introduction
Introduction
GROSS CREDIT EXPOSURE IN IRS MARKET
Introduction
Introduction
CURRENCY SWAP AS % OF FORIGN EXCHANGE
MARKET
`
Conclusion