Interest Rate Swaps

And
Currency Swaps

3/14/23 Slide 1
 What are swaps?
 The number of varieties of swaps makes it difficult to give a good all-
encompassing definition, but in general, a swap is a financial derivative in which
two parties make a series of payments to each other at specific dates (in future) –
Don Chance
 It is common for manufacturing companies to prefer fixed rate of borrowings
(remember projects are evaluated on cost of capital) and funding companies to
prefer floating rates of interest – to protect ‘spr`ead’
 Similarly, some investors will prefer fixed returns while others will prefer floating
rates – to each his poison!
1. It is also possible that a corporate could borrow at cheaper rate in one market
but not in the other (the +ve equation)
2. Not always can borrowers get what they want (the –ve equation)
 However, if there is anyway that two best borrowers in two different markets,
however with different aspirations can be brought together and then made to
exchange their preferences, it results in a ‘swap position’.
 If above conditions exist, an ‘interest rate swap’ can be employed to the advantage
of both parties in 1 above and possibly a currency swap can be employed in
situation 2.
3/14/23 Slide 2
 Swaps – Simple or Complicated??
 Swaps can be constructed as simple single structure exchange of cash
flows or can be as complicated as a series of multi-level transactions to
achieve a desired objective.
 We will see two illustrations – one a simple swap and another a slightly
complicated swap
 Simple : Reliance knows that the output cost of its petroleum products are
sticky in India. Hence, it would want to peg its crude oil prices for the next
6 months. It imports half a billion barrels of crude every month. The
solution can be picturised as follows :-
Supplier
Spot (Variable)

Spot (Variable)
Commodity
Reliance
Fixed (non-variable) Swap Dealer

3/14/23 Slide 3
Now, let us look at a slightly (?) complicated illustration (not really complicated, if
you break it down into modules!)

 A NY Investment Bank holds a volatile portfolio comprising of LSE listed

shares, whose returns is highly correlated to the FTSE

 A new Fund Manager takes over the portfolio and he is distinctly uncomfortable
with the exposure and would rather hold fixed-rate USD debt (fixed income
bonds)

 How does he achieve his objective?

 He will have to combine three different swaps to achieve the desired result:!!
 Firstly, a fixed-for-floating £ interest rate swap
 Secondly, a $ for £ currency swap
 Finally, a equity swap for fixed-rate $/£ (which one?) debt

3/14/23 Slide 4
 Shares Portfolio

£ Variable Return £ Fixed Interest rate Equity

NY Inv. Bank AllDealer
Swap in
(UK) £ Variable Return (UK)
One!!!

Locations
LIBOR $ rate don’t
Currency
Swap Dealer
matter
NY Inv. Bank
(UK)
(UK) £ Fixed Interest rate
USA/UK/
Anywhere
Fixed Rate $ Interest in the
Interest rate
NY Inv. Bank
world!!
Swap Dealer
(USA) LIBOR $ rate (USA)

3/14/23 Slide 5
 Interest Rate Swaps (IRSs)
 Interest rate swap (IRS) is a popular tool with bankers, corporate treasurers
and portfolio managers who need to manage interest rate risk (or take
interest rate risk!)
 As with any other derivate, IRS enables the Manager to alter the level of
risk without disrupting the underlying portfolio
 Student Loan Marketing Association (Sallie Mae) is credited with the
second major contract in 1982. The first one being WB and IBM in 1981
 The common floating rates are – LIBOR, MIBOR, Treasury Bill rates in
respective countries. The rates are available for various tenors & currencies
 The payer of the fixed rate is buyer of the swap and, therefore, the
payer of the floating rate is the seller of the swap.
 Negotiated terms include starting and ending dates, settlement frequency,
notional amount on which swap payments are based, and published
reference rates on which swap payments are determined.

3/14/23 Slide 6
 The mechanics
 Let us go back to 1981. WB wanted floating rate borrowings and IBM wanted fixed
rate debt (for a moment ignore the currency dynamics)
 The enabling reason for a swap arrangement to materialise is the benefit of the
agreement for both parties
 But then how do parties know what the other one is looking for?
 In almost all circumstances, there is an intermediary, or swap facilitator
 For a fee, the swap facilitator finds a counterparty to a desired swap
 Most often than not, the facilitator (bank) takes the other side itself
 In the first case, where the swap facilitator does not take a position, he is referred to
as swap broker
 In the second case, he is referred to as swap dealer, also called swap bank.
 Over time a swap bank accumulates a portfolio of swap positions, which is called
its swap book.
 The bank may choose to hedge all or part of its swap book in say, futures market.
 The utopian situation for the bank is net swap book position = ZERO (ie matched,
in other words, no market position)
 Needless to say, interest rate swaps are used by both borrowers and lenders

3/14/23 Slide 7
 More technical terms
 Swap Price is the fixed rate that the two parties agree upon. Also called
swap coupon
 Swap Tenor is the is the life of the swap agreement – this need not be
equal to the life of the underlying risk exposure
 Swap Notional Value determines the size of the interest rate payments.
• In a typical interest rate swap, the principal does not exchange hands (hence
notional principal) – only the net cash flow changes hands
• The party owing the larger amount pays the excess amount to the other party
• Important – the fact that a firm is party to a $100 million (or $1 bn) interest
rate swap does not mean that this is a loan requiring eventual payment
 Swap counterparty risk arises from no clearinghouse guaranteeing the
trade. However, the risk does not appear as big as the notional principal.
The amount at risk is just the net amount owed plus the opportunity cost of
not completing the swap agreement.

3/14/23 Slide 8
 Interest rate swaps
 At this point, let us understand the concept of “comparative advantage” and
absolute advantage
 Suppose the interest rates applicable to two parties, A & B are as follows: The
differential borrowing rates is possible due to credit rating or brand value in the
respective capital markets
Floating Fixed
• A LIBOR + 1% 8%
• B LIBOR + 2% 10%

 A enjoys an ‘absolute advantage’ in both markets but has a ‘comparative advantage’ in fixed
rate markets where the interest differential is 2%. Now, if A wants fixed rate funding, there is
no possibility of an interest rate swap!
 However, A might prefer floating rate funding and B might want a fixed rate loan. Thus, if A
borrows in the fixed rate market and B in the floating rate market, the net benefit is 2% - 1% =
1%. This benefit can be shared between A & B to reduce the cost of fixed rate funds for B and
floating rate funds for A.
 In an interest rate swap, only the net interest payment is settled. The principal amounts are not
exchanged. However, a notional principal is used to calculate the interest payments.

3/14/23 Slide 9
 Illustration from where it all began
 During the year 1981, World Bank was looking for fixed rate funding in
US dollars to meet the requirements of its clients. Because of its credibility,
World Bank was in a position to raise fixed rate funds at 9.5% payable
semi-annually and floating rate funds at Prime rate.

 IBM was interested in raising funds on floating rate basis. Its Merchant
Banker had indicated that the cost of such a loan would be 2% over the
prime rate. However, it was possible for IBM to raise funds in the fixed
rate bond market at 2% over 5 year treasury notes which were yielding 9%
at that time.

 The next slide shows how the World Bank and IBM reduced the cost of
funds by an interest rate swap.

Note : The objectives and rates above are assumed for

3/14/23 illustration purposes and are not based on any credible sources Slide 10
 They say, a picture speaks 1,000 words!

What is the assumed Scenario here ?

(what is the sharing pattern?)
Calculate formally the effective cost to
all three parties
3/14/23 Slide 11
 To summarize
 To enable a interest rate swap transaction,
• there must be two parties with different beliefs about future interest
rates!
– Party A wants a floating rate and Party B wants a fixed rate
• One of the two parties must have absolute as well as comparative
advantage in interest rates in different markets
• Both parties must have the willingness to split the ‘benefit’
• An effective intermediary, such as a Commercial Bank, Merchant
Banker or a Financial services intermediary must bring the two parties
together (Swap Broker) or the intermediary must do market making for
swaps (ie run a swap book – Swap dealer)

3/14/23 Slide 12
 Why value Swaps?
 If the value of the swap is +ve, it is an asset; otherwise it is a liability.
Therefore, after entering into a Swap position, you should know whether
you have an asset or a liability on your hand.
 IFRS (39), Ind.AS (30/31) requires valuation of derivatives and bringing
the values into the books – no more are derivatives OBS items. Profit and
Loss needs to be accounted for and asset and liability needs to be
recognised.
 Valuation of swap on a date is a performance metric for operating execs
(swap dealers)
 If you are on the +ve side of value, the counterparty is on the –ve side and
that is a credit risk – if credit limits are fixed for a party, the existing
position needs to be reckoned
 Sometimes, it may be a good idea to ‘profit’ the transaction if on +ve side
(ie., book profits and exit). To do this, you need to know the value of the
swap at the time of reversal of the position

3/14/23 Slide 13
 Valuation of Cur. Swaps and IRS
 In the case of a IRS, each leg of the swap can be treated as a bond, one
fixed rate bond and the other floating rate bond. Therefore, the value of
the interest rate swap is simply the difference in value between the two
bonds – one bond is debt and the other is investment.
 At the time of entering into swap agreement, both the parties, theoretically,
will have the same value for all inflows and outflows and hence the net
value of both parties is equal to zero. This is the reason that neither party
pays the other any amount at the start of the swap!. But after entering into
the swap, the value is most likely to change due to vagaries in interest
rates.
 In fact, each counterparty expects to benefit over time as rates change in
his/her favour.
 What are the pre-requisites to value bonds?
• Cash flows, time and discount rate
 The appropriate discount rates used for discounting the cash flows are
• The prevailing LIBOR rate is used for discounting the cash flows of
floating rate and
• Market/quoted swap rate is used for discounting cash flows associated
3/14/23with fixed rate. Alternatively, ride the yield curve. Slide 14
 Valuation of IRS
 To appreciate and Value Interest Rate Swaps, we need to know a few
conventions/practices and concepts
 Concept – For a FRB, the value will be equal to its par value on the initial date
or at any payment date. Its value on subsequent dates will be par value plus
present value of the interest due on the next payment period.
 Concept - The value of the swap at the beginning of the swap is ZERO. Which
means that the value of the Floating Rate Bond = Fixed Rate Bond. The value of
the Floating Rate Bond at the beginning is par value. Therefore, the value of the
Fixed Rate Bond should be equal to par value of the Floating Rate Bond at the
beginning of the Swap contract.
 Practice - In the case of a FRB interest payment, the next payment of interest is
always set equal to the bench mark rate at the end date of the previous period.
• Therefore, both parties will always know the payment amounts due on the
next immediate transaction – but the floating rate party will not know the
subsequent payments.
 Practice - Unless specified to the contrary, on the fixed leg 365 day year is
assumed. For floating leg, 360-day year is used. This is the tacit format in a
Swap agreement – but can have contrary definitions too. IRS are OTC market
agreements.
3/14/23 Slide 15
 Couple of Simple Illustrations in
Valuation of Swaps

3/14/23 Slide 16
 Illustration 1
 A bank had entered into a currency swap with a Corporate under the
following conditions.
• (a) The bank will pay 7% per annum in dollars every year.
• (b) The bank will receive 4% per annum in yens every year.
• (c) The principals involved would be $ 10 million and Yen 1,000 million.#
• (d) The swap would last another 4 years.

 If the currency exchange rate is Yen 100 / $, what is the value of the swap
to the bank if a discount rate of 3% for Yens and 8% for dollars is
considered to be appropriate for the bank.

 Solution in next slide :

• The value of the swap is calculated using ‘Bond Valuation’ approach. Here, the
bank has issued a Yankee bond and invested in a Samurai Bond
• Another approach is to look at every payment and receipt as a series of forward
contracts. Estimate the cash flows using forward rates for respective dates
3/14/23 # - Exchange rate assumed for ease of calculations Slide 17
 Solution to Illustration 1
 Interest payable on $ loan is (10).7% = $ 0.7 million
 Interest receivable on Yen Loan is (1,000).4% = Y 40 million
 Present value of payments associated with the dollar loan –
.7 .7 .7 (10+.7)
----- + --------- + --------- + ----------- = $ 9.67 million
1.08 (1.08)2 (1.08)3 (1.08)4

 Present value of receipts associated with the Yen loan –

40 40 40 1040
-------- + --------- + --------- + --------- = Yen 1037 million
1.03 (1.03)2 (1.03)3 (1.03)4
 = $ 1,037 mn / 100 = $ 10.37 million
 Present value of the swap to the bank = 10.37 - 9.67 = $ 0.70 million

3/14/23 Slide 18
 Illustration 2
 A bank has entered into a swap with a corporate. Under the terms of the
swap, the bank will receive LIBOR + 50 on a notional principal of $ 1,000
million and pay fixed interest at the rate of 10% per annum on the same
principal. Interest is payable semiannually.

 The relevant discount rates for the fixed end of the swap based on the
expected swap rates are as follows: (riding the yield curve)
• (a) 3 month - 10.0%
• (b) 9 month - 10.5%
• (c) 15 month - 11.0%

 On the last payment date, three months back, the 6 month LIBOR rate was
9.75%. What is the value of the swap to the bank if the remaining life of
the swap is 15 months?

3/14/23 Slide 19
 Solution to Illustration 2
 The fixed rate loan involves payment of (10%).1/2. (1,000) = $50 mn
every six months.
 Which is = 50 / (1+.10). 25 + 50 / (1+.105). 75 + 1050 / (1 + .110)1.25
 Which is = $ 1,016.80 mn

 For the floating rate loan, we ride the yield curve again at 10% for 3
months
 Present Value of cash inflows = 1,048.75 / (1.10). 25 = $ 1,024.06 mn
 Value of the swap to the bank = $ 1024.06 mn - $ 1,016.80 mn
 = $ 7.26 million

3/14/23 Slide 20
THE
END
Thank U

Slide 21