RISK MANAGEMENT AND DERIVATIVES

UNIT-V

RISK MANAGEMENT TECHNIQUES- SWAPS

SWAP/SWAP MARKETS:

 A Swap is an agreement between two counter parties to exchange cash flows in the future.
Terms like the dates when the cash flows are to be paid, the currency in which to be paid
and the mode of payment are determined and finalized by parties.
 The swap market is used extensively by major corporations, international financial
institutions and governments, and is an important part of the international bond market.

Types of swaps mainly include:

1) Basis Rate Swap. 2) Bond Swap.

3) Commodity Swap. 4) Credit Default Swap.

5) Volatility Swap. 6) Interest Rate Swap.

7) Currency Swap. 8) Forex Swap.

The primary features of swap contracts are:

 They involve the bartering of assets or liabilities between two parties.

 They are driven by a need to manage debt issues on both sides of the exchange.
 There is often a third party that oversees the terms of the exchange.
 They are driven by arbitrage that is deriving profit from capitalizing on a price
differential between two or more markets.

Evolution of swap market:

 Financial experts agree that the origin of the swap markets can be traced back to
1970s when many countries imposed exchange regulations and restrictions in order
to control cross border capital flows.
 Experts are of the opinion that swap markets owe their origin to the exchange rate
instability that followed the demise (failure) of Bretton Wood System during the
years 1971 to 1973.
 Most of the borrowers and investors at the international level wishing to diversify
their assets and liabilities compositions in varied currencies in order to control losses
arising due to fluctuations in exchange rate.
 In 1980s a few countries liberalize their exchange regulatory measures, as a result,
some of the MNCs treasurers structured their portfolios and brought out a new
financial product, known as swaps.
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 In 1980s, most of the MNCs and other corporate borrowers were approaching to the
investors directly rather than through banks, also encourage them to make financial
arrangement through swaps.
 First swap contract was negotiated in 1981 between Deutsche Bank and an
undisclosed counter party.
 Bankers were only acting as brokers in the swap markets to match the
complimentary requirement of the counter parties.
 Emergence of the large bank and performed as aggressive market makers specifically
in dollar interest rate swaps and provide bid/ offer quotes for both interest rate and
currency swaps.
 The banks started to find out a counter party with exactly or nearly matching
requirement to hedge the original swap by entering into a matching swap.
 The formation of the international Swap Dealers Association (ISDA) in 1984 was a
significant development to speed up the growth in the swap market by standardizing
swap documentation.
 In 1985, the ISDA published the first standardized swap code.. This code was revised
in 1986 and in 1987, published its standard form agreements.
 Currency swaps were first introduced in late 1970s, and then interest rate swap in
1981, equity and commodity swap in mid 1980s and credit derivatives in 1990, were
floated.

INTEREST RATE SWAPS:

 An interest rate swap is defined as a mutual agreement among different parties, to
exchange interest payments over a predetermined period.
 The most common IRS is a fixed for floating swap, whereby one party will make payments to
the other based on an initially agreed fixed rate of interest, to receive back payments based
on a floating interest rate index.
 Each of these series of payments is termed a "leg", so a typical IRS has both a fixed and a
floating leg.
 The primary motives behind the interest rate swaps are to lower the costs of borrowing and
to overcome the asset liability mismatch.

Types of interest rate swaps:

1) Fixed for Floating:

It is also known as Plain Vanilla swap.

 Customer receives cash flows at a fixed rate of interest and simultaneously pays cash flows at a
floating rate of interest or vice versa.

 The cash flows are calculated on a Notional Principal amount.

 The floating rate of interest is usually determined by reference to a transparent benchmark

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 In a fixed-for-floating swap agreement, one party agrees to pay the fixed leg of the swap, with
the other party agreeing to pay the floating leg of the swap.

 The fixed rate is the interest charged over the life of a loan and does not change.

 The floating rate is an interest rate pegged to an international reference rate index and is
subject to change. The most commonly used reference rate is London Interbank Offered Rate or
LIBOR.

2) Floating for Floating:

 In this kind of a swap, both the counter-parties exchange interest amounts based on two
different floating reference rates, through the life of the swap.

 In a floating-for-floating interest rate swap agreement, both parties agree to pay a floating rate
on their respective legs of the swap.

 The floating rates for each leg of the swap generally come from different reference rate indexes,
but can also come from the same index. If both parties choose the same index, generally they
then choose different payment dates.

 The two main indexes investors use in a floating for floating interest rate swap are the LIBOR and
the Tokyo Interbank Offered Rate or TIBOR

3) Fixed for Fixed:

 In fixed-for-fixed interest rate swaps, both parties agree to a fixed interest for their respective
legs of the swap.

 The interest rate does not change over the life of the loan for both parties. Investors most
commonly use fixed-for-fixed interest rate swaps when they are dealing with different
currencies. Companies often use fixed-for-fixed interest rate swaps when they are building or
expanding their business in a foreign country.

4) Off market Swap:

 An interest rate or other swap contract with a fixed rate payment materially different from
current coupon rates on bonds or notes of similar term.

 Ordinarily, this swap will have a net present value that requires the counterparties to exchange
an extra payment at the beginning or end of the swap tenor. Also called Adjustment Swap.

5) Callable Swaps & Putable Swaps:

 Fixed rate receiver has the right, but not the obligation to terminate the swap at one or more
pre-determined times during the life of the swap.

 A Swap where the fixed rate payer has the right to terminate is known as a Callable Swap. Both
the Putable and Callable Swaps are also known as Cancellable Swaps. 

 The foreign exchange version of a Cancellable Swap is called the Break Forward or

Cancellable Forward.
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Advantages of Interest rate swaps:

 Swapping from fixed to floating may save issuer money.
 Protects against adverse movements in interest rates.
 No premium is paid to enter into a swap.
 No principal amount is exchanged.

CURRENCY SWAPS:

A currency swap, also known as cross-currency swap, is a legal contract between two parties
to exchange two currencies at a later date, but at a predetermined exchange rate.

Usually, global banks operate as the facilitators or middlemen in a currency swap deal,but
they can also be counterparties in currency swaps as a way to hedge against their global
exposure, particularly to foreign exchange risk.

Types of Currency Swap Contracts:

Similar to interest rate swaps, currency swaps can be classified based on the types of legs
involved in the contract. The most commonly encountered types of currency swaps include
the following:

1) Fixed vs. float: One leg of the currency swap represents a stream of fixed interest
rate payments while another leg is a stream of floating interest rate payments.
2) Float vs. float (basis swap): The float vs. float swap is commonly referred to as basis
swap. In a basis swap, both swaps’ legs both represent floating interest rate
payments.
3) Fixed vs. fixed: Both streams of currency swap contracts involve fixed interest rate
payments.

Benefits of Currency Swaps:

 Currency swaps have always been very convenient in finance. They allow for the
redenomination of loans or other payments from one currency to the other.
 This comes with various advantages for both individuals and companies. There is the
flexibility to hedge the risk associated with other currencies as well as the benefit of
locking in fixed exchange rates for a longer period of time.
 For large corporations, currency swaps offer the unique opportunity of raising funds
in one particular currency and making savings in another.
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 The risk for performing currency swap deals is very minimal, and on top of that,
currency swaps are very liquid, and parties can settle on an agreement at any time
during the lifetime of a transaction.

EQUITY SWAPS:
 An equity swap is an exchange of future cash flows between two parties that
allows each party to diversify its income for a specified period of time while still
holding its original assets.
 An equity swap is similar to an interest rate swap, but rather than one leg being
the "fixed" side, it is based on the return of an equity index.
 The two sets of nominally equal cash flows are exchanged as per the terms of the
swap, which may involve an equity-based cash flow (such as from a stock asset,
called the reference equity) that is traded for fixed-income cash flow (such as
a benchmark interest rate).
 Most equity swaps are conducted between large financing firms such as auto
financiers, investment banks, and lending institutions.
 Equity swaps are typically linked to the performance of an equity security or
index and include payments linked to fixed rate or floating rate securities.

Advantages of Equity Swap Contracts:

Equity swap contracts provide numerous benefits to the counterparties involved, including:

1. Avoid transaction costs:

One of the most common applications of equity swap contracts is for the avoidance
of transaction costs associated with equity trades. Also, in many jurisdictions, equity swaps
provide tax benefits to the participating parties.

2. Hedge against negative returns:

Equity swap contracts can be used in hedging risk exposures. The derivatives are
frequently used to hedge against negative returns on a stock without forgoing the
possession rights on it.

3. Access more securities:

Finally, equity swap contracts may allow investing in securities that otherwise
would be unavailable to an investor. By replicating the returns from a stock through an
equity swap, the investor can overcome certain legal restrictions without breaking the law.
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COMMODITY SWAP:
 A commodity swap is a type of derivative contract that allows two parties to exchange (or
swap) cash flows which are dependent on the price of an underlying asset. In this case, the
underlying asset is a commodity.
 Commodity swaps are very important in many commodity-based industries, such as oil
and livestock.
 They are used to hedge against swings in the market price of the product in question.
These swaps allow commodity producers and end-users to lock in at a set price for the
underlying commodity.
 No commodities are exchanged during the ‘swap trade’, cash is exchanged instead.
 In commodity swaps, exchanged cash flows are dependent on the price
(floating/market/spot) of an underlying commodity.
 It’s more or less similar to a fixed-floating interest rate swap, the difference is the
floating leg is based on the price of the underlying commodity instead LIBOR or
EURIBOR.
 The advantage of being linked with a commodity swap is that the user can secure a
maximum price to the commodity and agree to pay a financial institution a fixed
amount. In return, he/she gets payments based on the market price of the
commodity.

Types of commodity swaps:

There are two types of commodity swaps that are generally used: fixed-floating commodity
swaps and commodity-for-interest swaps.

1) Fixed-Floating Commodity Swaps:

 Fixed-floating swaps are very similar to interest rate swaps. The difference is that
commodity swaps are based on the underlying commodity price rather than on
a floating interest rate. 
 In this type of swap contract, there are two legs, the floating-leg which is tied to the
market price of the commodity, and the fixed-leg which is the agreed-upon price
specified in the contract.
 The party looking to hedge their position will enter into the swap contract with a
swap dealer to pay a fixed price for a certain quantity of the underlying commodity
on a periodic basis. The swap dealer will, in turn, agree to pay the party the market
price of the commodity.
 These cash flows will net out each period, and the party who must pay more will pay
the difference. On the other side, the swap dealer will also find a party looking to pay
the floating price of the commodity.
 The swap dealer will enter into a contract with this party to accept the floating
market price and pay the fixed price, which will again net out.
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Here we can see that an end-user of a commodity and a swap dealer have entered into a
commodity swap. Often, end-users of a commodity, such as fuel-intensive industries, will
look to pay a fixed price. In this example, the end-user will pay a fixed price and receive the
market price of the commodity.

2) Commodity-For-Interest Swaps:

 A commodity-for-interest swap is very similar to an equity swap, however, the

underlying asset is a commodity.
 One leg will pay a return based on the commodity price while the other leg is tied to
a floating interest rate such as LIBOR, or an agreed-upon fixed rate.
 Like the fixed-floating swap, these periodic payments will net out against each other
and the party who must pay more based on the commodity return, interest rate, and
face value will pay the difference.

Here we
see an example of a commodity-for-interest swap. The commodity-producer will pay a rate
based on the return of the commodity and receive a floating rate such as LIBOR. This can
help the commodity-producer reduce the downside risk of a poor return based on the
commodity market price.
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SWAPTIONS:
A swaption, also known as a swap option, refers to an option to enter into an interest
rate swap or some other type of swap.

 The participants in the swaption market are predominantly large corporations,

banks, financial institutions and hedge funds.
 End users such as corporations and banks typically use swaptions to
manage interest rate risk arising from their core business or from their financing
arrangements.
 For example, a corporation wanting protection from rising interest rates might buy
a payer swaption. A bank that holds a mortgage portfolio might buy a receiver
swaption to protect against lower interest rates that might lead to early
prepayment of the mortgages.

Swaptions includes:

Payer swaption:

In a payer swaption, the purchaser has the right but not the obligation to enter into
a swap contract where they become the fixed-rate payer and the floating-rate receiver. 

Receiver swaption:

A receiver swaption is the opposite i.e. the purchaser has the option to enter into a
swap contract where they will receive the fixed rate and pay the floating rate.

There are three main styles that define the exercise of the Swaption:

European swaption: in which the owner is allowed to enter the swap only at the start of the
swap. These are the standard in the marketplace.

Bermudan swaption: in which the owner is allowed to enter the swap on multiple specified
dates, typically coupon dates during the life of the underlying swap.

American swaption: in which the owner is allowed to enter the swap on any day that falls
within a range of two dates.

Purpose of swaption:

 To hedge call or put positions in bond issues.

 To change the tenor of an underlying swap.
 To assist in the engineering of structured notes.
 To change the payoff profile of the firm.
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How swaption works:

 Two parties agree to the previously mentioned components, the contract holder decides at
some date (or multiple dates, depending on the structure of the contract) whether or not
they would like to enter the contract before the swap begins or at some point a certain time
period into the swap.
 If the holder elects to exercise, a swap contract begins, and if not then the only exchange of
payments is the premium.
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Features of Swaps:

Counter parties:

 Swap involves the exchange of a series of periodic payment between at least two
parties.
 Example, a firm having a loan of ten crore payable at ten percent fixed coupon rate
for five years, wants to exchange for a floating interest rate with that party who is
also interest to exchange its liability from floating to fixed.

Facilitators:

 Swap agreements are arranged through an intermediary which is usually a large

international financial institution/ bank having network of its operation in major
countries.
 These intermediaries play a significant role in bringing closer the various parties
for such deals.
 Facilitator will note down the requirement of the parties and try to match and
fulfil these with other parties.
 Swap facilitators can be classified into two :
1) Brokers -- -function as agent that identify and bring the counter parties on the
table for the swap deal.
 Initiate the counter parties to finalize the swap deal according to their
respective requirement.
2) Swap dealers :
 They themselves become counter parties and takeover the risk. Swap dealer
are the part of the swap deal, they face two problems.
 First, how to price swap to provide for his service. Second problem is to
manage this portfolio.

Cash flows:

 Swap deal is an exchange of two financial obligation in future, both the parties
would desire to have same financial liabilities as before the swap deal.
 In swap deal, the present value of future cash streams are examined, and then
appropriate decision is taken.

Documentations:

 Swap transaction may be set up with great speed , their documentations and
formalities are much less in comparable to loan deals.
 It is an evaluation of various future cash stream arisen out in various contract
done in past.
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 The terms of different contract suit the interested firms requirements, the deal
will be enacted.  Transaction cost:
 It is observed that the transaction cost are relatively low in swap in comparison
to loan agreement.
 Unlikely to exceed half percent of the total sum involved in the swap
agreement.

Benefits to parties:

 Swap agreement will be done only when the parties will be benefited by such
agreement, otherwise such deals will not be excepted.

Termination:

 Swap is an agreement between two parties, it cannot be terminated at one’s

instance.
 Termination also requires to be accepted by counter parties.

Default risk:

 Swap deals are bilateral agreement; the problems of potential default by either of
the counter party exist.