Assignment on Interest Rate SWAP

Submitted To:
Sir Mahmood Afzal
Submitted By:
M Waleed
BBFE-17-05
BBA 6th EVE

Interest rate SWAP

 Interest rate swaps are forward contracts where one stream of future interest payments
is exchanged for another based on a specified principal amount
 Interest rate swaps can be fixed or floating rate in order to reduce or increase exposure
to fluctuations in interest rates

Swaps are derivative contracts. The value of the swap is derived from the underlying value of
the two streams of interest payments. Swaps allow investors to offset the risk of changes in
future interest rates. The pricing of SWAP through the forward premium or discount is
determined by the differential in interest rate in the currency.
Example

ABC Company and XYZ Company enter into one-year interest rate swap with a nominal value
of $1 million. ABC offers XYZ a fixed annual rate of 5% in exchange for a rate of LIBOR plus 1%,
since both parties believe that LIBOR will be roughly 4%. At the end of the year, ABC will pay
XYZ $50,000 (5% of $1 million). If the LIBOR rate is trading at 4.75%, XYZ then will have to pay
ABC Company $57,500 (5.75% of $1 million, because of the agreement to pay LIBOR plus 1%).

Therefore, the value of the swap to ABC and XYZ is the difference between what they receive
and spend. Since LIBOR ended up higher than both companies thought, ABC won out with a
gain of $7,500, while XYZ realizes a loss of $7,500. Generally, only the net payment will be
made. When XYZ pays $7,500 to ABC, both companies avoid the cost and complexities of each
company paying the full $50,000 and $57,500.

USES of IRS

There are two reasons why companies may want to engage in interest rate swaps:

Commercial motivations

Some companies are in businesses with specific financing requirements, and interest rate
swaps can help managers meet their goals. Two common types of businesses that benefit
from interest rate swaps are:

 Banks, which need to have their revenue streams match their liabilities. For
example, if a bank is paying a floating rate on its liabilities but receives a fixed
payment on the loans it paid out, it may face significant risks if the floating rate
liabilities increase significantly. As a result, the bank may choose to hedge against
this risk by swapping the fixed payments it receives from their loans for a floating
rate payment that is higher than the floating rate payment it needs to pay out.
Effectively, this bank will have guaranteed that its revenue will be greater than it
expenses and therefore will not find itself in a cash flow crunch.
 Hedge funds, which rely on speculation and can cut some risk without losing too
much potential reward. More specifically, a speculative hedge fund with an
expertise in forecasting future interest rates may be able to make huge profits by
engaging in high-volume, high-rate swaps.

Comparative advantages

Companies can sometimes receive either a fixed- or floating-rate loan at a better rate
than most other borrowers. However, that may not be the kind of financing they are looking
for in a particular situation. A company may, for example, have access to a loan with a 5%
rate when the current rate is about 6%. But they may need a loan that charges a floating rate
payment. If another company, meanwhile, can gain from receiving a floating rate interest
loan, but is required to take a loan that obligates them to make fixed payments, then two
companies could conduct a swap, where they would both be able to fulfill their respective
preferences.
In short, the swap lets banks, investment funds, and companies capitalize on a wide range of
loan types without breaking rules and requirements about their assets and liabilities.
Modus Operandi &Characteristics of IRS
Swap is calculated by the below formula:

 Swap = – (Contract_Size × (Interest_Rate_Differential + Markup) / 100) / Days_Per_Year

Interest rate swap agreements have predetermined interest rates or spreads and

How it Works

Basically, interest rate swaps occur when two parties – one of which is receiving fixed-
rate interest payments and the other of which is receiving floating-rate payments (mutually
agree that they would prefer the other party’s loan arrangement over their own). The party
being paid based on a floating rate decides that they would prefer to have a guaranteed fixed
rate, while the party that is receiving fixed-rate payments believes that interest rates may rise,
and to take advantage of that situation if it occurs – to earn higher interest payments – they
would prefer to have a floating rate, one that will rise if and when there is a general uptrend in
interest rates.

The theory is that one party gets to hedge the risk associated with their security
offering a floating interest rate, while the other can take advantage of the potential reward
while holding a more conservative asset. It’s a win-win situation, but it’s also a zero-sum
game. The gain one party receives through the swap will be equal to the loss of the other
party. While you’re neutralizing your risk, in a way, one of you is going to lose some money.

Interest rate swaps are traded over the counter, and if your company decides to exchange
interest rates, you and the other party will need to agree on two main issues:
 1. Length of the swap. Establish a start date and a maturity date for the swap, and know
that both parties will be bound to all of the terms of the agreement until the contract
expires.

2. Terms of the swap. Be clear about the terms under which you’re exchanging interest
rates. You’ll need to carefully weigh the required frequency of payments (annually,
quarterly, or monthly). Also decide on the structure of the payments: whether you’ll
use an amortizing plan, bullet structure, or zero-coupon method.
Exiting a SWAP agreement

The process for exiting a swap is similar to exiting a futures or options contract. There are four
basic ways to do this.

1. Buy Out: In that, this would mean that exiting party pays the other party the market
value of the swap. In practice, however, a buy out must be a negotiated feature of any
swap. The easiest way to do this is to write it into the swap agreement, although it can
be done when the buy out is needed with the other party’s consent.
2. Negotiate an Offsetting Swap: In simple terms, if two companies had an interest rate
swap, the exiting party could enter into a swap with a different party that would allow
them to switch from a fixed rate to floating or vice versa.
3. Third Party Sale: In this example, the exiting party would sell the swap to a third party.
However, like the buy out option, this requires the consent of the other party.
4. Swaption: As the name implies, this is an option on a swap. Purchasing a swaption

allows a party to arrange, but not actually enter into, a swap that would offset their
original swap. This must be created at the time they execute the original swap and is
done to reduce the market risks that could come from having to negotiate an offsetting
swap in the middle of a contract.