Financial Derivatives

UNIT-V-Swaps and Valuation of Swaps

Concept and Nature

Introduction

In the recent past, there has been integration of financial markets worldwide which has led
to the emergence of some innovative financial instruments. In a complex world of a variety
of financial transactions being taken place every now and then, there arises a need to
understand the risk factors and the mechanism to avoid the risks involved in these financial
transactions. The recent trends in financial markets show increased volume and size of
swaps markets.

Financial swaps are an asset liability management technique which permits a borrower to
access one market and then exchange the liability for another type of liability. Thus,
investors can exchange one asset to another with some return and risk features in a swap
market. In this lesson an attempt was made to get the students acquainted with the
mechanism of swaps markets and the valuation of the swap instruments.

Meaning of swaps

The dictionary meaning of „swap‟ is to exchange something for another. Like other
financial derivatives agreements are also agreement between two parties to exchange cash
flows. The cash flows may arise due to change in interest Rate or currency or equity etc.
In other words, swap denotes an agreement to exchange payments of two different kinds
in the future. The parties that agree to exchange cash flows are called „counter parties‟.

In case of interest rate swap, the exchange may be of cash flows arising from fixed or
floating interest rates, equity swaps involve the exchange of cash flows from returns of
stocks index portfolio. Currency swaps have basis cash flow exchange of foreign currencies
and their fluctuating prices, because of varying rates of interest, pricing of currencies and
stock return among different markets of the world.

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Features of Swap / Nature of Swaps

The following are features of financial swaps:

Counter parties: Financial swaps involve the agreement between two or more parties to
exchange cash flows or the parties interested in exchanging liabilities.

Facilitators: The amount of cash flow exchange between parties is huge and also the
process is complex. Therefore, to facilitate the transaction, an intermediary comes into
picture which brings different parties together for big deal. These may be brokers whose
objective is to initiate the counterparties to finalize the swap deal. While swap dealers are
themselves counter partied who bear risk and provide portfolio management service.

Cash flows: The present values of future cash flows are estimated by the counterparties
before entering into a contract. Both the parties want to get an assurance of exchanging the
same financial liabilities before the swap deal.

Less documentation: is required in the case of swap deals because the deals are based on
the needs of parties, therefore, fewer complexes and less risk consuming.

Transaction costs: Generating a very less percentage is involved in swap agreement.

Benefit to both parties: The swap agreement will be attractive only when the parties get
the benefits of these agreements.

Default-risk is higher in swaps than the option and futures because the parties may default
on the payment.

Evolution of swap market

Swaps were first introduced to the public in 1981 when IBM and the World Bank entered
into a swap agreement. Today, swaps are among the most heavily traded financial contracts
in the world: the total amount of interest rates and currency swaps outstanding was more
than $348 trillion in 2010, according to Bank for international settlements.

Most swaps are traded over the counter (OTC), "tailor-made" for the counterparties.
The Dodd Frank act in 2010, however, envisions a multilateral platform for swap quoting,
the swaps execution facility (SEF), and mandates that swaps be reported to and cleared
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through exchanges or clearing houses which subsequently led to the formation of swap
data repositories (SDRs), a central facility for swap data reporting and recordkeeping. Data
vendors, such as Bloomberg, and big exchanges, such as the Chicago Mercantile
Exchange, the largest U.S. futures market, and the Chicago Board Options Exchange,
registered to become SDRs. They started to list some types of swaps, swaptions and swap
futures on their platforms. Other exchanges followed, such as the Intercontinental
Exchange Frankfurt-based Eurex AG.

According to the 2018 SEF Market Share Statistics Bloomberg dominates the credit rate
market with 80% share, TP dominates the FX dealer to dealer market (46% share), Reuters
dominates the FX dealer to client market (50% share), Tradeweb is strongest in the vanilla
interest rate market (38% share), TP the biggest platform in the basis swap market (53%
share), BGC dominates both the swaption and XCS markets, Tradition is the biggest
platform for Caps and Floors (55% share)

Types of financial swaps

The swaps agreement provides a mechanism to hedge the risk of the counter parties. The
risk can be- interest rate, currency, or equity etc.

Interest rate swaps

It is a financial agreement to exchange interest payments or receipts for a predetermined

period of time traded on the OTC market. The swap may be on the basis of fixed interest
rate for floating interest rate. This is the most common swap also called „plain vanilla
coupon swap‟ which is simply in agreement between two parties in which one party
payments agrees to the other on a particular date a fixed amount of money in the future till
a specified termination date. This is a standard fixed-to-floating interest rate swap in which
the party (fixed interest payer) makes fixed payments and the other (floating rate payer)
will make payments which depend on the future evolution of a specified interest rate index.

The fixed payments are expressed as a percentage of the notional principal according to
which fixed or floating rates are calculated supposing the interest payments on a specified
amount borrowed or lent. The principal is notional because the parties do not exchange this

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amount at any time but is used for computing the sequence of periodic payments. The rate
used for computing the size of the fixed payment, which the financial institution or bank
are willing to pay if they are fixed ratepayers (bid) and interested to receive if they are
floating rate payers in a swap (ask) is called fixed rate.

A US dollar floating to fixed 9-year swap rate will be quoted as:8 years Treasury (5.95%)
+ 55/68.It means that the dealer is willing to make fixed payments at a rate equal to the
current yield on 8-years T-note plus 55 basic points (0.55%) above the current yield on T-
note (i.e. 5.95

+ 0.45 = 6.40%) and willing to receive4fixed rate at 68 basis points above (i.e. 5.95 + 0.68
= 6.63%) the Treasury yield.

Another example to understand the concept: Suppose a bank quotes a US dollar floating to
a fixed 6-years swap rate as: Treasury + 30 BP/Treasury + 60 BP vs. six months LIBOR
Here this quote indicates that the bank is willing to pay fixed amount at a rate equal to the
current yield on 6-years T-note plus 30 basis point (0.30%) in return for receiving floating
payments say at 9 six months LIBOR.

The bank has offered to accept at a rate equal to 6-year T-note plus 60 BP (0.60%) in return
for payment of six-month LIBOR. Similarly floating rate is one of the market indices such
as LIBOR, MIBOR, prime rate, T-bill rate etc. and the maturity of the underlying index
equal the time period/interval between payment dates. The fixed rate payments are
normally paid semi- annually or annually.

Currency swaps

In these types of swaps, currencies are exchanged at specific exchange rates and at
specified intervals. The two payments streams being exchange dare dominated in two
different currencies. There is an exchange of principal amount at the beginning and a re-
exchange at termination in a currency swap. Basic purpose of currency swaps is to lock in
the rates (exchange rates).As intermediaries large banks agree to take position in currency
suppose „pounds‟ and the other party raises the funds at fixed rate in currency suppose US
dollars.

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The principal amount is equivalent at the spot market exchange rate. In the beginning of
the swap contract, the principal amount is exchanged with the first party handing over
British Pound to the second, and subsequently receives US dollars as return. The first party
pays periodic dollar payment to the second and the interest is calculated on the dollar
principal while it receives from the second party payment in pounds again computed as
interest on the pound principal. At maturity the British pound and dollar principals are re-
exchanged on a fixed-to-floating currency swaps or cross-currency-coupon swaps, the
following possibilities may occur: One payment is calculated at a fixed interest rate while
the other in floating rate.

(a) Both payments on floating rates but in different currencies.

(b) There may be contracts without and with exchange and exchange of principals.

The deals of currency swaps are structured by a bank which also routes the payments from
one party to another. Currency swaps involve the exchange of assets and liabilities. The
structure of a currency swap agreement can be understood with the help of the following
illustration. Suppose a company „A „operating in US dollar wants to invest in EUR and the
company „B‟ operating in EUR wants to invest in US dollars. Since company „A‟ having
revenue in EUR and both have opposite investment plans. To achieve this objective, both
the companies can enter into a currency swap agreement. The following structure describes
the investment plans of the company A and B Operations

Equity Swaps

An equity swap is a contract for the exchange of future cash flows between two
parties based on pre-set conditions. The cash flows are linked to the performance of an
equity asset or a benchmark equity index over a specific period of time, with the exchange
based on a notional nominal amount.

Basically, with an equity swap, two parties agree to exchange two cash flows. One is based
on the performance of the equity or equity index chosen and the other linked to a fixed or
floating interest rate. Swaps are private agreements between parties who enter into a

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contract and agree to abide by its terms. As such they are traded in the over the counter
(OTC) market.

Equity swaps can be tailored to the needs of traders, can help to better diversify a portfolio,
and also offer some potential tax benefits. Through an equity swap, you can hedge certain
positions and assets in a portfolio, but you must assess the risk that the person you contract
with (your counterparty) could default on your agreement.

How do equity swaps work?

Equity swap transactions are quite complex; however, think of them in terms of
a contractually bound share swap. As a rule, the equity swap involves a party with a long
position in shares and a counterparty wanting to replicate the returns on those shares
without necessarily having to buy them..

The equity swap contract is then realized, with one side of the future cash flows to be
exchanged tied to a reference interest rate (usually LIBOR) and the other to the future
performance of the shares (or share index) chosen during the reference period.

No transactions take place at the beginning of the contract or at the end, only during the
reference period of the equity swap, based on the interest rate and the performance of the
shares (or share index).

Index Swap

An index swap refers to a hedging contract in which a party exchanges a predetermined

cash flow with a counter-party on a specified date. A debt, equity, or other price index is
used as the agreed exchange for one side of this swap.

An overnight index swap applies an overnight rate index such as the federal funds or
London Interbank Offered Rate (LIBOR) rates. Index swaps are specialized groups of
conventional fixed-rate swaps, with terms that can be set from three months to more than
a year.

Credit Risks in Swap

Types of Credit Risk

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1. Default Risk

It is a scenario where the borrower is either unable to repay the amount in full or is already
90 days past the due date of the debt repayment. Default risk influences almost all credit
transactions—securities, bonds, loans, and derivatives. Due to uncertainty, prospective
borrowers undergo thorough background checks.

2 . Concentration Risk

When a financial institution relies heavily on a particular industry, it is exposed to the risk
associated with that industry. If the industry suffers an economic setback, the financial
institution incurs massive losses.

3. Country Risk

Country risk denotes the probability of a foreign government (country) defaulting on its
financial obligations as a result of economic slowdown or political unrest. Even a small
rumor or revelation can make a country less attractive to investors. The sovereign
risk mainly depends on a country’s macroeconomic performance.

4 .Downgrade Risk

It is the loss caused by falling credit rating. Looking at the credit ratings, market analysts
assume operational inefficiency and a lower scope for growth. It is a vicious cycle; the
speculation makes it even harder for the borrower to repay.

5. Institutional Risk

Borrowers may fail to comply with regulations. In addition to the borrower, contractual
negligence can be caused by intermediaries between the lenders and borrowers.

Using Swaps to Manage Risk

Hedging Interest Rate Risk

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Interest rate swaps are used to hedge interest rate risk, as they allow parties to lock in a
fixed interest rate or obtain exposure to a floating interest rate, depending on their needs.

Speculation

Market participants can use interest rate swaps to speculate on future interest rate
movements, with the expectation of profiting from changes in interest rates.

Funding and Investment in Foreign Markets

Companies and financial institutions can use currency swaps to obtain funding or invest in
foreign markets while mitigating the risk of currency fluctuation.

Managing Liabilities

Companies and financial institutions can use interest rate swaps to manage their liabilities,
such as converting fixed-rate debt to floating rate debt or vice versa.

Balance Sheet Management

Currency swaps can help organizations manage their balance sheets by matching assets and
liabilities in different currencies.

Valuation of interest rate swap

At the initiation stage the worth of an interest swap is zero or nearly zero. With the
passage of time, this value may be positive or negative. The fixed rate interest swap is
valued by treating the fixed rate payments as cash flows on a traditional bond and the
floating rate swap value is quite equivalent to a floating rate note (FRN). If there is no
default risk, the value of an interest swap can be computed either as a long position in
one bond combined with a short position in another bond or as a portfolio of forward
contracts.
Since in a swap agreement the principal is not exchanged. Some financial
intermediaries act as market makers and they are ready to quote a bid and an offer for
the fixed rate which they will exchange for floating. The is the fixed rate in a contract
where the market maker will pay fixed and receive floating while the offer rate in a
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swap the market maker will receive fixed and pay floating. These rates are quoted for
the number of maturities and number of different currencies.

Valuation of a currency swap

The currency swaps can be valued as the difference between the present values of
the conventional bonds. The computation of a currency swap is just equivalent to the
valuation of interest rate swaps. currency interest payments, is the discount rate for
various periods to cash flow, the length of those time periods to cash flows, S' is the
exchange P is the principal expressed in foreign currency converted into equivalent
domestic currency principal.