BTL 706 - Swaps

 

The Banking Tutor’s Lessons

BTL 706                                                                          21-09-2024

Swaps

A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price. 

The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter (OTC) contracts primarily between businesses or financial institutions that are customized to the needs of both parties. 

Interest Rate Swaps

In an interest rate swap, the parties exchange cash flows based on a notional principal amount of an underlying security. The amount of the security itself is not actually exchanged, only the interest rates. Also, the swap can be an amortizing swap, where the underlying principle of a loan will decrease over time.

Parties undertake swaps in order to hedge against interest rate risk or to speculate. 

For example, imagine ABC Co. has just issued Rs 1 million in five-year bonds with a variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). Also, assume that LIBOR is at 2.5% and ABC management is anxious about an interest rate rise. 

The management team finds another company, XYZ Inc., that is willing to pay ABC an annual rate of LIBOR plus 1.3% on a notional principal of Rs 1 million for five years. In other words, XYZ will fund ABC's interest payments on its latest bond issue. In exchange, ABC pays XYZ a fixed annual rate of 5% on a notional value of Rs 1 million for five years. 

ABC benefits from the swap if rates rise significantly over the next five years. XYZ benefits if rates fall, stay flat, or rise only gradually. 

According to an announcement by the Federal Reserve, banks should stop writing contracts using LIBOR by the end of 2021. The Intercontinental Exchange, the authority responsible for LIBOR, will stop publishing one week and two month LIBOR after December 31, 2021. All LIBOR contracts were wrapped up by June 30, 2023.

Below are two scenarios for this interest rate swap: LIBOR rises 0.75% per year and LIBOR rises 0.25% per year. 

Scenario 1

If LIBOR rises by 0.75% per year, Company ABC's total interest payments to its bondholders over the five-year period amount to  Rs 225,000.

Let's break down the calculation:

	Libor + 1.30%	Variable Interest Paid by XYZ to ABC 5%	Interest Paid by ABC to XYZ Rs	ABC's Gain Rs	XYZ's Loss Rs
Year 1	3.80	38000	50000	(12000)	12000
Year 2	4.55	45500	50000	(4500)	4500
Year 3	5.30	53000	50000	3000	(3000)
Year 4	6.05	60500	50000	10500	(10500)
Year 5	6.80	68000	50000	18000	(18000)
Total				15000	(15000)

 

** Figures in Brackets indicate Loss

In this scenario, ABC did well because its interest rate was fixed at 5% through the swap. ABC paid Rs15,000 less than it would have with the variable rate. XYZ's forecast was incorrect, and the company lost Rs15,000 through the swap because rates rose faster than it had expected. 

Scenario 2

In the second scenario, LIBOR rises by 0.25% per year:         

	Libor + 1.30%	Variable Interest Paid by XYZ to ABC 5%	Interest Paid by ABC to XYZ Rs	ABC's Gain Rs	XYZ's Loss Rs
Year 1	3.80	38000	50,000	(12000)	12000
Year 2	4.05	40500	50,000	(9500)	9500
Year 3	4.30	43000	50,000	(7000)	7000
Year 4	4.55	45500	50,000	(4500)	4500
Year 5	4.80	48000	50,000	(2000)	2000
Total				(35000)	35000

In this case, ABC would have been better off by not engaging in the swap because interest rates rose slowly. XYZ profited Rs35,000 by engaging in the swap because its forecast was correct.

This example does not account for the other benefits ABC might have received by engaging in the swap. For example, perhaps the company needed another loan, but lenders were unwilling to do that unless the interest obligations on its other bonds were fixed.

In most cases, the two parties would act through a bank or other intermediary, which would take a cut of the swap. Whether it is advantageous for two entities to enter into an interest rate swap depends on their comparative advantage in fixed or floating-rate lending markets.

Other Swaps

The instruments exchanged in a swap do not have to be interest payments. Countless varieties of exotic swap agreements exist, but relatively common arrangements include commodity swaps, currency swaps, debt swaps, and total return swaps.

Commodity Swaps

Commodity swaps involve the exchange of a floating commodity price, such as the Brent Crude oil spot price, for a set price over an agreed-upon period.

As this example suggests, commodity swaps most commonly involve crude oil.

Currency Swaps

In a currency swap, the parties exchange interest and principal payments on debt denominated in different currencies. Unlike an interest rate swap, the principal is not a notional amount, but it is exchanged along with interest obligations. Currency swaps can take place between countries.

Debt-Equity Swaps

A debt-equity swap involves the exchange of debt for equity—in the case of a publicly-traded company, this would mean bonds for stocks. It is a way for companies to refinance their debt or reallocate their capital structure.

Total Return Swaps

In a total return swap, the total return from an asset is exchanged for a fixed interest rate. This gives the party paying the fixed-rate exposure to the underlying asset—a stock or an index.

For example, an investor could pay a fixed rate to one party in return for the capital appreciation plus dividend payments of a pool of stocks.

Credit Default Swap (CDS)

A credit default swap (CDS) consists of an agreement by one party to pay the lost principal and interest of a loan to the CDS buyer if a borrower defaults on a loan. Excessive leverage and poor risk management in the CDS market were contributing causes of the 2008 financial crisis.

Purpose of a Swap

A swap allows counterparties to exchange cash flows. For instance, an entity receiving or paying a fixed interest rate may prefer to swap that for a variable rate (or vice-versa). Or, the holder of a cash-flow generating asset may wish to swap that for the cash flows of a different asset. The purpose of such a swap is to manage risk, to obtain funding at a more favourable rate than would be available through other means, or to speculate on future differences between the swapped cash flows.

Structure of Swap

A swap is an over-the-counter (OTC) derivative product that typically involves two counterparties that agree to exchange cash flows over a certain time period, such as a year. The exact terms of the swap agreement are negotiated by the counterparties and are then formalized in a legal contract. These terms will include precisely what is to be swapped and to whom, the notional amount of the principal, the maturity of the contract, and any contingencies. The cash flows that are ultimately exchanged are computed based on the terms of the contract, which maybe an interest rate, index, or other underlying financial instrument. 

Users of Swaps

Swaps are mainly used by institutional investors such as banks and other financial institutions, governments, and some corporations. They are intended to be used to manage a variety of risks, such as interest rate risk, currency risk, and price risk.

Risks Associated with Swaps:

Interest Rate Risk: Swaps are often used to manage interest rate risks, but they themselves are exposed to changes in interest rates. If market interest rates move differently from what was expected, one party might end up with unfavourable cash flow exchanges.

Counterparty Risk: Swaps are typically private agreements, which means that if one party fails to meet its obligations (such as making cash flow payments), the other party could suffer financial losses.

Market Risk: Swaps involve exchanging cash flows based on market conditions. If the market takes unexpected turns, the value of the exchanged cash flows might not be as favourable as initially anticipated.

Liquidity Risk: Unlike options that can be bought or sold in markets, swaps are customized agreements. This lack of standardisation can make it difficult to find another party willing to enter into the same type of swap, especially in volatile markets.

Tail Notes

Interest Rate Swap

An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount.

Zero-Coupon Inflation Swap (ZCIS)

A zero-coupon inflation swap is a derivative where a fixed-rate payment on a notional amount is exchanged for a payment at the rate of inflation.

Forward Rate Agreement (FRA)

Forward rate agreements are over-the-counter contracts between parties that determine the rate of interest to be paid on an agreed-upon date in the future.

Notional Principal Amount

Notional principal amount, in an interest rate swap, is the predetermined dollar amounts on which the exchanged interest payments are based.

Liability Swap

A liability swap is a financial derivative in which two parties exchange debt-related interest rates, usually a fixed rate for a floating rate.

Index Amortizing Swap (IAS)

An index amortizing swap (IAS) is a type of interest rate swap agreement in which the principal is gradually reduced over the life of the agreement.

Plain Vanilla Swap

The term Plain Vanilla Swap is most commonly used to describe an interest rate swap in which a floating interest rate is exchanged for a fixed rate or vice versa.

Sekhar Pariti

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