Swaps

Keshav Billawa (11IFIM2S21) PGDM II Shift

Swaps: Swap refers to an exchange of one financial instrument for another between the parties concerned. This exchange takes place at a predetermined time, as specified in the contract. Description: Swaps are not exchange oriented and are traded over the counter, usually the dealing are oriented through banks. Swaps can be used to hedge risk of various kinds which includes interest rate risk and currency risk. Currency swaps and interest rates swaps are the two most common kinds of swaps traded in the market. Types of Swaps

There are a wide variety of swaps that financial professionals trade in order to hedge against risk. Listed below are a few most common types of swap instruments traded in the market. Interest Rate Swap An interest rate swap is a contractual agreement between two counterparties to exchange cash flows on particular dates in the future. There are two types of legs or series of cash flows!. A fixed rate payer makes a series of fixed payments and at the outset of the swap, these cash flows are known. A floating rate payer makes a series of payments that depend on the future level of interest rates a "uoted index like L#$%& for example! and at the outset of the swap, most or all of these cash flows are not known. #n general, a swap agreement stipulates all of the conditions and definitions re"uired to administer the swap including the notional principal amount, fixed coupon, accrual methods, day count methods, effective date, terminating date, cash flow fre"uency, compounding fre"uency, and basis for the floating index.

An interest rate swap can either be fixed for floating the most common!, or floating for floating often referred to as a basis swap!. #n brief, an interest rate swap is priced by first present valuing each leg of the swap using the appropriate interest rate curve! and then aggregating the two results. Credit Default Swap A credit default swap is a contract that provides protection against credit loss on an underlying reference entity as a result of a specific credit event. A credit event is usually a default or, possibly, a credit downgrade of the entity. The reference entity may be a name, a bond, a loan, a trade receivable or some other type of liability. The buyer of a default swap pays a premium to the writer or seller in exchange for right to receive a payment should a credit event occur. #n essence, the buyer is purchasing insurance. Asset Swap An asset swap is a combination of a default able bond with a fixed'for' floating interest rate swap that swaps the coupon of the bond into the cash flows of L#$%& plus a spread. #n the case of a cross currency asset swap, the principal cash flow may also be swapped. #n a typical asset swap, a dealer buys a bond from a customer at the market price and sells to the customer a floating rate note at par. The dealer then enters into a fixed'for' floating swap with another counterparty to offset the floating rate obligation and the bond cash flows. (or a premium bond, the dealer pays the customer the difference of the bond price and its par. (or a discount bond, the customer pays the dealer the difference of the par and the bond price. #n the swap with the counterparty, the dealer pays a fixed bond coupon and receives L#$%& ) a spread. The spread can be determined from the cash that the dealer pays*receives and from the difference of the bond coupon and the par swap rate. +hen the bond redemption value is used for exchange of principal at maturity, the present value of the difference between the bond redemption value and its par value also contributes to the spread. Learn how to value an asset swap

Trigger Swap A Trigger Swap is an interest rate swap in which payments are knocked out if the reference rate is above a given trigger rate. (#,CA- provides analytics for two types of trigger swaps. periodic and permanent. (or a periodic trigger swap, the exchange of payments depends on the reference rate set for that period. #f the reference rate for a particular period is greater than the trigger rate, the fixed and floating payments are knocked out. #f the reference rate is below the trigger rate in a subse"uent period, regular fixed and floating payments are made. (or a permanent trigger swap, if the fixed and floating payments are knocked out for a particular period, then all subse"uent payments are knocked out as well. Commodity Swap A commodity swap is a swap in which one of the payment streams for a commodity is fixed and the other is floating. /sually only the payment streams, not the principal, are exchanged, although physical delivery is becoming increasingly common. Commodity swaps have been in existence since the mid'01234s and enable producers and consumers to hedge commodity prices. /sually, the consumer would be a fixed payer to hedge against rising input prices. The producer in this case pays floating i.e., receiving fixed for the product! thereby hedging against falls in the price of the commodity. #f the floating'rate price of the commodity is higher than the fixed price, the difference is paid by the floating payer, and vice versa. Foreign-Exc ange !F"# Swaps An (5 swap is where one leg4s cash flows are paid in one currency, while the other leg4s cash flows are paid in another currency. An (5 swap can be either fixed for floating, floating for floating, or fixed for fixed. #n order to price an (5 swap, first each leg is present valued in its currency using the appropriate curve for the currency!.

Total Return Swap A total return swap T&S! is a bilateral financial contract in that one counter party pays out the total return of a specified asset, including any interest payment and capital appreciation or depreciation, in return receives a regular fixed or floating cash flow. Typical reference assets of total return swaps are corporate bonds, loans and e"uities. A total return swap can be settled at the terminating date only or periodically, e.g., "uarterly. (or convenience we call the asset4s total return a T&'leg and the fixed or floating cash flow a non'T& leg. 6xamples. Commodity Swap Asia 6nergy the swap buyer! needs to buy 033,333 barrels of oil a month between 7anuary and 7une. #t wants to lock in a price for this purchase. The (irst $ank the swap provider! offers it a swap rate of 809 per barrel, based on daily fixings. #n theory, on each settlement date, Asia 6nergy pays (irst $ank the fixed rate and receives the floating rate. #n practice, only the actual cash difference is transferred. #f on a given settlement date. The average underlying the nearest future! for a barrel of gas oil turns out to be more than the fixed rate, Asia energy receives a cash amount e"ual to the difference between the two rates. This offsets their increased physical fuel costs, i.e., the fact that it will cost them more to buy oil in the market. The average underlying the nearest future! for a barrel of gas oil turns out to be less than the fixed rate, Asia 6nergy must pay a cash amount e"ual to the difference between the two rates. This loss is offset by the fact that it will cost them less to buy oil in the market.

Foreign Exc ange Swap $SD%&'( :ou need to buy /S- in exchange for ;$< value spot and sell /S- in exchange for ;$< in three months= time. Spot &ate is trading at 0.9203 The Three >onth (orward &ate is trading at 0.9233. The difference between the spot and the forward rate reflects the interest rate differentials between the two currencies. 0! :ou enter into a (oreign 6xchange Swap and buy /S- for ;$< at the fixed rate of 0.9203 spot and simultaneously sell the /S- for ;$< at 0.9233 for value three months forward. A $

?????????????#@@@@@@@@l@@@@@@@@@@@@ 0.9233 0.9203 A. Three >onth (orward 6xchange &ate $. Spot 6xchange &ate %utcome Spot :ou buy /S- for ;$< at a rate of 0.9203 %utcome in three months= time you sell /S- for ;$< at a rate of 0.9233 regardless of market rates