Swaps

SWAPS:

exchange assets now; return them later; in meantime, pay differential.

1
Ill use your house until July for $4,000/mo.
Ill use your boat until July for $3,000/mo.

2
Heres your house back; thanks for returning my boat. Thanks for returning my house; heres your boat back.

($4,000 - $3,000)/mo = $1,000/mo

Swaps
SWAP

is exchanging things between two parties at a reasonable price.

A has a commodity that B needs, and B has another commodity that A needs, they can exchanges exchange (swap) these two commodities at a reasonable price.
If Suppose

A is European firm that needs borrowing USD and B is an USA firm requiring to borrow . A can get better loan conditions in than B, and B can get better loan conditions in USD than A. A and B can borrow in their own markets and then swap the loans.
A

swap is an agreement to exchange cash flows in the future according to certain rules about when the cash flows are to be paid and the way in which they are calculated.

Interest Rate Swaps

Types of foreign currency swaps: Interest rate swaps. Cross-currency swaps

In an interest rate swap, two parties agree to exchange interest payments, one party agrees to make a fixed interest payments and the other agrees to make variable or floating interest payments over period of time.

Floating rate is reset each period. London Interbank Offered Rate (LIBOR) is the benchmark plus a risk premium.

Currency Swaps

It is an exchange of currencies. Example: An agreement to pay 11% on a sterling principal of 10,000,000 & receive 8% on a US$ principal of $15,000,000 every year for 5 years. This is a fixed-for-fixed currency swap. In a currency swap, the parties make either fixed or variable payments to each other in different currencies. While, in an interest rate swap the principal is not exchanged, in a currency swap the principal is usually exchanged at the beginning and the end of the swaps life. Uses of a currency swap: Conversion from a liability in one currency to a liability in another currency or conversion from an investment in one currency to an investment in another currency.

Key reasons for using an Interest Rate Swap

Expectations are the driver for financial decisions and many other decisions in life. Expectations about the future behaviour of interest rates give rise interest rates swaps. If you have a fixed interest rate loan and expect interest rates to fall, you are willing to swap your interest rate loan from fixed to loan. The opposite is also true. At the end, your expectations may prove to be false or true. Need for HEDGING is the other reason for using swaps.

Interest Rate Swap: Example No. 1

APM agrees to pay BNZ 5% interest rate on $1,000 million each year for the next five years and BNZ agrees to pay APM LIBOR on $1,000 million for each of the next five years. $1,000 million is the notional .

If LIBOR > 5%, BNZ pays APM: (LIBOR - 5%) * $1,000 million

If LIBOR < 5%, APM pays BNZ: (5% - LIBOR) * $1,000 million

INTEREST RATE SWAP: Relevant Elements

Relevant Elements

Notional is fixed at inception and is never exchanged, it is only used to calculate interest payments. One party agrees to make are fixed rate of interest applied to the notional on the futures dates.

Other party agrees to pay floating rate of interest applied to the same notional.
When floating payment is made, the interest rate is reset to establish the next floating payment.

Interest Rate Swap: Example No. 2

Assume A is a firm that has borrowed GBP 100 million for a 4 years term. Interest rate is LIBOR rate plus 75 basis points (0.75%) per year. Interest payments on the loan are made annually in arrears (at the end of each year). A is exposed to rising interest rates, which would increase its borrowing costs and impact on its profitability and cost of capital for valuation purposes. A approaches B which deals in swaps and agrees the following conditions to enter int to a SWAP under the following conditions: Notional GBP 100 million A pays a fixed rate of 5% per year B pays a floating rate of LIBOR per year Maturity 4 years

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Interest Rate Swap: Example No. 2

A range of possible LIBOR rates are shown below with As interest payments on its loan and cash flows from the swap at each possible rate. NET EFFECT OF SWAP ON "A" COST OF DEBT
Expected LIBOR rates 4% 5% 6% 7% Loan Interest Fixed Rate Payment GBP millions GBP millions LIBOR + 0.75% 5% -4.75 -5.0 -5.75 -5.0 -6.75 -5.0 -7.75 -5.0 Floating Rate Net Payment Receipt (LIBOR) LIBOR 5.75% 4.0 -5.75 5.0 -5.75 6.0 -5.75 7.0 -5.75

By entering into the swap A moved from a floating rate liability to a fixed rate of 5.75% per year. If LIBOR rate rises, A will receive LIBOR payments from B. LIBOR on As debt is cancelled out by the LIBOR receipt on the swap. What remains is the 5% fixed payment on the swap plus the margin of 0.75% on the loan. Whatever the LIBOR rate, the As net payment is always the same.

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A and B are two MNCs searching for funds. A rating agency says that As credit risk is lower than than Bs credit risk. Based on expectations and needs of hedging, A prefers a floating-rate and B a fixed-rate. Fixed-rates and floating-rates for A and B are shown below:

MNC Fixed-rate A B

Floating-rate LIBOR + 2% LIBOR

4.00% 5.00%

If a swap is possible, A will borrow for B at fixed-rate, and B borrow for A at a floating-rate, then A and B will exchange cash flows. A swap is possible only if, as result of it, gains or savings are available for A and B.
If A borrow for B at a fixed-rate market, B would save 1%. If B borrow for A at a floating rate, A would save 2%. If the swap is done, total savings or gains amount to 3%.

After new market conditions, fixed-rates and floating-rates for A and B are now as follows:

MNC Fixed-rate A B

Floating-rate LIBOR LIBOR

4.00% 5.00%

Again, a swap is possible only if, as result of it, gains or savings are available for A and B. If a swap is possible, A will borrow for B at a fixedrate, and B borrow for A at a floating rate, then A and B will exchange cash flows. If A borrow for B at a fixed-rate market, B would save 1%. If B borrow for A at a floating rate, A will face no savings. If the swap is done, total savings or gains amount to 1%.

Now, fixed-rates and floating-rates for A and B are :

MNC Fixed-rate A B

Floating-rate LIBOR LIBOR+0.25%

4.00% 5.00%

Once again, a swap is possible only if, as result of it, gains or savings are available for A and B. If a swap is possible, A will borrow for B at a fixedrate, and B borrow for A at a floating-rate, then A and B will exchange cash flows. If A borrow for B at a fixed-rate market, B would save 1%. If B borrow forA at a floating rate, A will end up paying 0.25% more. If the swap is done, total savings or gains amount to 0.75% = 1%-0.25%.

INTEREST RATE SWAPS: Example No. 3

ABC and XYZ needs to obtain a loan. ABC prefers a loan in the floating-rate market, whereas XYZ a loan in the fixed -rate market. Interest rates for ABC and XYZ are shown in the following table:
Fixed-rate ABC Corp. XYZ Corp. 4.00% 5.20% Floating-rate LIBOR + 0.10% LIBOR + 0.50%

ABC Corp is less risky than XYZ Corp because it is offered a more favorable rate of interest in fixed and floating.

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INTEREST RATE SWAPS: Example No. 3

Spread is the difference between interest rates for two different firms.
Fixed-rate ABC Corp. XYZ Corp. 4.00% 5.20% Floating-rate LIBOR + 0.10% LIBOR + 0.50%

SPREAD

1.20%

0.40%

Spread between the interest rate paid by ABC and XYZ in the two markets are not the same.

XYZ pays 1.2% more than ABC in the fixed-rate market and only 0.4% more than ABC in the floating-rate market.

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INTEREST RATE SWAPS: Example No. 3

Based on the spreads, XYZ has a comparative advantage in the floating market and ABC has a comparative advantage in the fixed-rate market.
Fixed-rate ABC Corp. XYZ Corp. SPREAD 4.00% 5.20% 1.20% Floating-rate LIBOR + 0.10% LIBOR + 0.50% 0.40%

As the spread between fixed-rates is 1.2%, and the spread between floating-rates is 0.40%, ABC and XYZ a total gain of 1.2% - 0.40% = 0.8% per year. And the gain can be equally distributed between ABC and XYZ. Both, ABC and XYZ expect to pay 0.4% less. ABC and XYZ should borrow in the market where they have comparative advantage. ABC should borrow in the fixed-rate market, whereas XYZ should borrow in the floating rate market, and then exchange payments to transform a fixed-rate loan into a floating-rate loan.

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INTEREST RATE SWAPS: Example No. 3

After the swap each party expects to pay 0.4% less than it would have paid if they go direct into the market they want to borrow.

Using a Swap to change fixed to floating / floating to fixed ABC Corp. -4.0% ? ? - (LIBOR-0.3%) XYZ Corp. - (LIBOR +0.5%) ? ? -4.8%

Borrowing Rates Swap Payment Swap Receipt NET PAYMENT

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INTEREST RATE SWAPS: Example No. 3

Swap payments must allowed each party to achieve expected savings on interest rates

Using a Swap to change fixed to floating / floating to fixed ABC Corp. -4.0% - LIBOR ? - (LIBOR-0.3%) XYZ Corp. - (LIBOR +0.5%) ? LIBOR -4.8%

Borrowing Rates Swap Payment Swap Receipt NET PAYMENT

As result of the swap ABC transformed a fixed-rate liability to a floating- rate liability , and XYZ transform a floating-rate liability to a fixed-rate liability .

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Uses of an Interest Rate Swap

Converting a liability from fixed rate to floating rate or from floating rate to fixed rate

Converting an asset from fixed rate to floating rate or from floating rate to fixed rate