Chapter 05 SWAP

Understanding of Swaps

Think of swaps as a trade between two people. One person is better at handling a particular type
of risk, and the other person is more comfortable with a different kind of risk. By swapping their
responsibilities, both parties benefit by reducing the risks they’re less comfortable with. For
example:

If you have a fixed salary but want to be involved in the stock market, you might trade with
someone who has variable income (like a business owner) but wants the stability of fixed
payments. This way, both parties can achieve more predictability in their finances.

In very simple terms, a swap is like an agreement between two people or companies to trade
payments in the future, based on certain conditions. Each person or company takes on the other’s
risk to make their own situation more predictable or manageable.

Imagine two friends:

 Friend A prefers getting steady, predictable payments.

 Friend B doesn't mind if their payments go up and down but might get a reward if
they take a risk.
 They agree to "swap" their payment styles so that Friend A gets steady payments
and Friend B can take on the ups and downs, possibly earning more if things go
well.

Examples in Everyday Life:

1. Interest Rate Swap (Local Example)

Let’s say you're a small business owner in Pakistan, and you took a loan from a bank. The bank
charges you interest, but this interest rate can go up or down, depending on the market. You're
worried that if the interest rate goes up, you’ll have to pay more money each month.
A big company in the same city has a loan, but their loan has a fixed interest rate. This means
they always pay the same amount, no matter what happens in the market.

You and the big company can agree to a swap. You promise to pay the big company the fixed
amount every month, and they promise to cover whatever your variable amount is. Now, you
don’t need to worry about interest rates going up, because you’ll always be paying the fixed
amount. Local Example:

A textile company in Karachi might enter into a swap with a multinational company in Lahore.
The textile company wants to pay a fixed amount for its loan, while the multinational is okay
with taking the variable risk. By swapping, both companies get what they want.

2. Currency Swap (Local Example)

Imagine a local company in Pakistan that imports machinery from the U.S. The company has to
pay in U.S. dollars, but they make money in Pakistani rupees. They’re worried that the rupee
might weaken (lose value against the dollar), making it more expensive for them to buy U.S.
dollars in the future.

A U.S. company exports goods to Pakistan and earns Pakistani rupees, but it needs to pay its
workers and suppliers in U.S. dollars. The U.S. Company is worried about rupee volatility.

They can do a currency swap: The Pakistani Company pays the U.S. Company in rupees at a
set exchange rate, and the U.S. Company pays the Pakistani company in dollars. Now, both
companies can avoid the risk of fluctuating currency values.

Local Example: A Karachi-based manufacturer that imports from the U.S. might swap
currencies with an American exporter that sells in Pakistan. This helps both sides deal with the
uncertainty of exchange rates.

3. Commodity Swap (Local Example)

Imagine you’re an airline company in Pakistan, and your biggest cost is fuel. The price of fuel
can go up and down, making it hard to predict your expenses. You want to lock in a stable price
for fuel to manage your costs.

Meanwhile, a local oil supplier in Pakistan is happy to sell fuel at today’s price, even though the
price might go higher in the future.

You and the oil supplier make a commodity swap agreement. You agree to pay them a fixed
price for fuel, no matter how much the price changes in the future. In return, they take on the risk
of price fluctuations. Now, your fuel costs are predictable, and the supplier is protected from
falling prices.

Local Example: Pakistan International Airlines (PIA) might enter into a swap with a local oil
company like Pakistan State Oil (PSO) to lock in fuel prices. This allows the airline to manage
its costs better without worrying about fuel price increases.

Real-World Referenced Example:

Interest Rate Swap: You switch between paying a fixed or variable amount of interest on a loan
to make payments more predictable.

Currency Swap: You exchange one currency for another at an agreed rate to avoid risks from
currency fluctuations.

Commodity Swap: You fix the price of a commodity (like fuel) to avoid price jumps.

Swaps are simply tools to make financial situations less risky and more predictable. By trading
financial risks with someone else, companies and people can plan their future better, knowing
what they will pay or receive.

Example: 01

Imagine two friends, Alex and Jordan, who have different types of loans:
Alex has a fixed-rate loan with a monthly payment of $1,000.
Jordan has a variable-rate loan with a monthly payment that can change based on market interest
rates, and currently, it's $800.
They decide to do an interest rate swap:
Alex agrees to pay $200 to Jordan each month.
Jordan agrees to pay $200 to Alex each month.
Here's what happens after the interest rate swap:

Alex's total monthly payment becomes $800 ($1,000 - $200 paid to Jordan).

Jordan's total monthly payment becomes $1,000 ($800 + $200 received from Alex).

So, in this simplified example, Alex effectively shifts to a lower variable-rate payment like
Jordan's, and Jordan adopts a fixed-rate payment similar to Alex's. This is how an interest rate
swap can help parties achieve their preferred payment structures.

Example 02

Let's consider two parties, Party A and Party B:

 Party A has a fixed-rate loan with a monthly payment of $1,000.

 Party B has a variable-rate loan with a monthly payment of $800.
They agree to do an interest rate swap, where Party A will pay $200 of Party B's variable-
rate loan, and Party B will pay $200 of Party A's fixed-rate loan.

After the swap:

Party A's effective monthly payment becomes $800 ($1,000 - $200).

Party B's effective monthly payment becomes $1,000 ($800 + $200).

So, Party A's payment becomes more like Party B's variable-rate payment, and Party B's
payment becomes more like Party A's fixed-rate payment. This is a simplified numerical
example of how an interest rate swap can work. In reality, interest rate swaps involve more
complex terms and are used for managing larger financial risks and exposures.
Here’s a simple numerical example of how an interest rate swap works:

Scenario:

Company A has a loan of $1 million with a floating interest rate (let's say LIBOR + 2%). This
means that their interest payments will change whenever LIBOR changes. Company A wants to
switch to a fixed interest rate to make their payments more predictable.
Company B has a loan of $1 million with a fixed interest rate of 5% per year. Company B
believes that interest rates may go down and would prefer to pay a floating rate to possibly
reduce their interest payments.
The Swap Agreement:
Company A and Company B agree to an interest rate swap.
Company A will pay Company B a fixed rate of 5%.
Company B will pay Company A the floating rate (LIBOR + 2%).
Step-by-Step Example:
Year 1:
LIBOR is 3%, so the floating rate is 3% + 2% = 5%.
Payments:
Company A will pay Company B 5% of $1 million, which is $50,000.
Company B will pay Company A the floating rate, which is also 5% of $1 million = $50,000.
Since the rates are the same, both companies effectively pay each other the same amount, so no
additional payment is made in Year 1.
Year 2:
LIBOR increases to 4%, so the floating rate becomes 4% + 2% = 6%.
Payments:
Company A will still pay Company B a fixed rate of 5% of $1 million = $50,000.
Company B will now pay Company A the floating rate, which is 6% of $1 million = $60,000.
Result:
Company B owes Company A the difference: $60,000 - $50,000 = $10,000.
Company B pays Company A $10,000 in Year 2 to settle the swap.
Year 3:
LIBOR decreases to 2%, so the floating rate is 2% + 2% = 4%.
Payments:
Company A still pays the fixed rate of 5% of $1 million = $50,000.
Company B pays Company A the floating rate, which is 4% of $1 million = $40,000.
Result:
Company A owes Company B the difference: $50,000 - $40,000 = $10,000.
Company A pays Company B $10,000 in Year 3 to settle the swap.
Summary of Payments:
In Year 1, no payment is made because the fixed and floating rates were the same.
In Year 2, Company B pays Company A $10,000 because the floating rate was higher.
In Year 3, Company A pays Company B $10,000 because the floating rate was lower.
Purpose:
Company A now has fixed payments, meaning they pay the same amount every year, regardless
of whether interest rates go up or down. This helps them manage their cash flow predictably.
Company B can take advantage of the floating rate, hoping that it will decrease and reduce their
interest payments.
This example shows how an interest rate swap can allow companies to exchange risks—one
prefers predictability (fixed rate), while the other is comfortable taking on some risk in hopes of
reducing costs (floating rate).

Currency Swap: A currency swap involves the exchange of one currency for another with an
agreement to reverse the exchange at a specified future date. Currency swaps are used to manage
currency risk, especially when companies have exposure to foreign currencies in their business
operations.

A currency rate swap, also known as a currency swap, is a financial derivative in which two
parties agree to exchange a specified amount of one currency for another, often at different
exchange rates. Currency swaps are used to manage currency risk, access different currencies,
and optimize cash flows in international financial transactions.
Here's a simplified explanation of a currency rate swap

Parties Involved:

Party A: Usually needs a different currency.

Party B: Typically has the currency that Party A needs.

How It Works:

Party A and Party B agree to exchange a set amount of currency (e.g., USD for EUR).

They also specify the exchange rate at which this exchange will happen. This rate can be the
current market rate or a rate agreed upon between the two parties.

They set a maturity date, which can be short-term or long-term.

Example:01

Party A needs euros (EUR) to pay for imports in Europe.

Party B needs U.S. dollars (USD) for a project in the United States.

Currency Swap Agreement:Party A gives Party B $1 million (USD) and receives €850,000
(EUR) at the agreed exchange rate. Party A and Party B agree to reverse the exchange at a
specified date in the future, with the same exchange rate.

Bnefits:

 Party A can make euro payments for imports.

 Party B can use the U.S. dollars for their U.S. project.
 Both parties can hedge against currency exchange rate fluctuations.

Currency swaps are commonly used in international business to mitigate currency risk, facilitate
cross-border trade, and secure competitive financing rates. They help entities access the
currencies they need for their specific financial requirements.

Example 02

Two Friends' Currency Swap (Simplified):

Friends:

Alex (US-based)

Sophie (European-based)

Scenario:

Alex is planning a trip to Europe and needs euros (EUR).

Sophie is going to the United States and needs U.S. dollars (USD).

Currency Swap Agreement:

Initial Exchange (Before the Trip):

 Alex gives Sophie $1,000 (USD).

 Sophie gives Alex €850 (EUR) at an agreed exchange rate of 1 USD = 0.85 EUR.

Interest Component (During the Trip):

 Alex agrees to give Sophie a small gift or pay her an additional $20 (USD) after the trip.
 Sophie agrees to give Alex a small gift or pay him an additional €10 (EUR) after the trip.

End of the Trip:

After the trip, they exchange the leftover money.

Alex returns Sophie's €850 (EUR), and Sophie returns Alex's $1,000 (USD).

Result:

Alex got euros for his European trip.

Sophie got dollars for her U.S. trip.
They exchanged small gifts or paid each other after their trips.

This simplified example mirrors the basic idea of a currency swap. Two friends exchange
different currencies before their trips, with a small additional exchange afterward, just as a token
of goodwill. It helps them both get the currency they need for their travel.

Sure! Let’s break down a currency swap with a very simple numerical example.
Example 03 : Scenario:

Company A is a U.S. company that needs €1 million (euros) to do business in Europe.

Company B is a European company that needs $1 million (U.S. dollars) to do business in the
U.S.
Both companies decide to swap currencies to avoid the hassle of converting money through
banks and to protect against currency fluctuations.
Step-by-Step Example:
Initial Swap (Beginning of the Agreement):
Company A gives $1 million to Company B.
Company B gives €1 million to Company A.
Now, Company A has euros to conduct its European business, and Company B has U.S. dollars
to conduct its U.S. business.

Interest Payments (During the Swap):

Over the course of a year, both companies agree to pay each other interest on the borrowed
amount.
Let’s assume:

The U.S. interest rate is 4%.

The European interest rate is 3%.
Company A (U.S. company) owes Company B interest on €1 million:

3% of €1 million = €30,000.
Company B (European company) owes Company A interest on $1 million:
4% of $1 million = $40,000.
Final Swap (At the End of the Agreement):
After 1 year, both companies return the principal amounts to each other:
Company A gives back the €1 million to Company B.
Company B gives back the $1 million to Company A.
Interest Payment Settlement:
Company A pays €30,000 to Company B (interest on €1 million).
Company B pays $40,000 to Company A (interest on $1 million).
At the end of the swap period:

Company A has paid €30,000 in interest.

Company B has paid $40,000 in interest.
Key Points:
Both companies swapped currencies at the beginning to get the currency they needed.
They paid each other interest based on the interest rates of their respective countries.
At the end of the swap, they exchanged back the principal amounts, and each company got back
the money it initially gave.
This simple example shows how a currency swap allows two companies to access foreign
currency without directly going to the market, while protecting themselves against currency
fluctuations.

A Credit Default Swap (CDS) is a type of financial contract that works like insurance against
the risk of a credit default. Essentially, it is an agreement between two parties where one party
(the buyer of the CDS) pays a periodic fee (like an insurance premium) to the other party (the
seller of the CDS) in exchange for protection against the risk that a third party (like a company or
government) will default on its debt (usually a bond or loan).

How a Credit Default Swap Works:

Buyer of CDS: This is usually an investor who owns bonds or loans and wants to protect
themselves against the possibility that the issuer of those bonds (the borrower) will default (fail
to pay).

Seller of CDS: This party, typically a financial institution, agrees to compensate the buyer if the
borrower defaults. In return, the seller receives regular payments from the buyer (like an
insurance premium).
Underlying Debt (Reference Entity): This is the company, government, or entity whose debt is
being insured. If this entity defaults on its debt, the CDS kicks in.

Example of a Credit Default Swap:

Investor A holds bonds issued by Company X. The investor is concerned that Company X might
default on its debt and not pay back the full amount.

To protect themselves, Investor A enters into a Credit Default Swap with Bank B.

Investor A pays Bank B a periodic fee (e.g., 2% of the bond's face value per year).

If Company X defaults on its bonds (can’t pay its debt), Bank B will compensate Investor A for
the losses, typically by paying the face value of the bonds.

Key Points:

CDS Buyer: The investor seeking protection against a default.

CDS Seller: The party providing the protection and receiving periodic payments.

Reference Entity: The company or government whose credit risk is being insured.

Why Credit Default Swaps are Used:

Hedging: Investors use CDS to hedge against the risk of default on bonds or loans they own. It’s
a way to protect against loss.

Speculation: Some traders buy CDS contracts without owning the underlying bonds to speculate
on the likelihood of default. They profit if the reference entity's credit situation worsens and the
value of the CDS rises.

CDS in Risk Management:

CDS help manage and spread the risk of a credit event (default).
However, during the 2008 financial crisis, CDS gained attention for amplifying risk because
many financial institutions used them to speculate rather than just hedge.

In short, a Credit Default Swap is like insurance for bondholders or lenders, protecting them in
case the borrower defaults on their debt.

Commodity Swap: Commodity swaps involve the exchange of a fixed price for a commodity,
such as oil or agricultural products, for a floating (market) price. These swaps help companies
hedge against price fluctuations in commodities they use or produce.

Parties involved:

 Party A: A company that produces and sells oil.

 Party B: A company that specializes in agriculture and produces and sells wheat.
Agreement:
 Party A and Party B decide to enter into a commodity swap.
 Terms of the Commodity Swap:

Duration: 1 year.

Exchange of Commodities: Party A agrees to give Party B 1,000 barrels of oil every quarter. In
return, Party B agrees to give Party A 10 metric tons of wheat every quarter.

Current Market Prices:

 The current market price for a barrel of oil is $60.

 The current market price for a metric ton of wheat is $300.

Calculation of Swap Payments:

Oil Payments from Party A to Party B:

1,000 barrels * $60/barrel = $60,000/quarter

$60,000 * 4 quarters = $240,000/year

Wheat Payments from Party B to Party A:

10 metric tons * $300/metric ton = $3,000/quarter

$3,000 * 4 quarters = $12,000/year

Net Payment:

 Party A pays Party B $240,000 for the oil.

 Party B pays Party A $12,000 for the wheat.

Purpose of the Swap:

 Party A might want to hedge against the risk of falling oil prices.
 Party B might want to hedge against the risk of rising wheat prices.

By entering into this commodity swap, both parties can manage their price risks. Party A secures
a fixed price for a portion of its oil, and Party B does the same for its wheat.

Please note that in a real-world scenario, commodity swaps can involve more complex terms,
and parties may also consider factors such as quality adjustments, delivery logistics, and other
terms in their agreements.

Total Return Swap (TRS): A total return swap is a contract in which one party agrees to pay
the total return (capital appreciation and income) of a specific asset or portfolio to another party
in exchange for a series of payments, often based on a benchmark interest rate. TRS can be used
to gain exposure to a particular asset or index without actual ownership.

A "swap bank" typically refers to a financial institution that specializes in facilitating and
managing various types of financial derivatives and swaps for its clients. Swaps are financial
instruments where two parties agree to exchange cash flows or financial assets over a specified
period. These agreements are often used to manage risk, speculate on market movements, or
optimize financial positions.

1. Swap banks play a pivotal role in the derivatives market by acting as intermediaries
between parties interested in engaging in swap transactions. Their primary functions may
include:
2. Matching Counterparties: Swap banks help connect entities or individuals looking to
enter into swap agreements. They identify counterparties with opposing needs or
objectives, such as interest rate swaps or currency swaps.
3. Risk Management: Swap banks may assist clients in assessing and managing the risks
associated with swap transactions. This can involve evaluating the potential risks and
rewards of a particular swap and structuring deals that align with the clients' risk
tolerance and financial goals.
4. Trade Execution: They execute and settle swap contracts, ensuring that the terms and
conditions are met according to the agreed-upon schedule.
5. Pricing and Valuation: Swap banks may provide pricing information and valuation
services for various swap transactions, helping clients understand the fair value and risks
associated with their swaps.
6. Compliance and Documentation: Swap banks often ensure that all swap agreements
comply with regulatory requirements and have proper documentation in place. This
documentation helps formalize the terms of the swap and outlines the responsibilities of
each party involved.
7. Market Research and Analysis: They provide market research and analysis to help clients
make informed decisions regarding swap transactions, taking into account market trends
and economic factors.

Hedging with Swap

Hedging: Imagine you're a farmer who wants to protect your crops from unpredictable weather.
You'd want to take some precautions, like buying insurance for your crops. This insurance is
your "hedge" because it helps you avoid losses if the weather turns bad.
Swaps: Now, think of "swaps" as a way to exchange something. In the world of finance, a
"swap" is like a deal where two people exchange things to help each other.
Hedging with Swaps: Suppose you're a company and you've borrowed money, but you're
worried about the interest rate changing and making your loan more expensive. So, you make a
deal with another company. You agree to exchange the interest payments on your loan with
them.
You may agree to pay them a fixed interest rate (like 3% per year).
They agree to pay you whatever the variable interest rate is (like the changing market rate).
If interest rates go up, you're protected because you're getting money from the other company to
offset your higher interest costs. It's like having insurance to cover your loan costs in case things
change.
In simple terms, hedging with swaps is like making a financial deal to protect yourself from
unexpected changes in interest rates or other financial factors. It's a bit like having an umbrella
for your money to shield it from the rain of financial uncertainty.
Imagine you're a business owner and you have a loan of $1,000,000 with a variable interest rate
tied to LIBOR, which is currently at 5%.

However, you're worried that if LIBOR increases, your interest payments will go up, and that
might hurt your business. So, to protect yourself, you decide to do a swap with another company,
Company B.
You and Company B agree on a simple interest rate swap:
You'll pay Company B a fixed interest rate of 4%.
Company B will pay you the variable interest rate based on LIBOR, which is currently 5%.
Now, let's see how this works:
Without the swap, if LIBOR goes up to 6%, your interest payments on the loan would be
$1,000,000 x 6% = $60,000 per year.
But, because of the swap, Company B pays you the variable rate, which is 5%, and you pay them
the fixed rate, which is 4%.
So, you receive $1,000,000 x 5% = $50,000 from Company B and pay them $1,000,000 x 4% =
$40,000.
Your net payment is $50,000 - $40,000 = $10,000.
With the swap, you're effectively paying only $10,000 in interest, even if LIBOR goes up. This
helps protect your business from rising interest rates and keeps your interest costs more
predictable.
Swaptions are financial contracts that give the holder the right, but not the obligation, to enter
into an interest rate swap. Essentially, a swaption is an option on a swap. It provides the holder
with the choice to either enter into a swap agreement or not, depending on what's most favorable.

Here's a simple way to think about swaptions:

Imagine you have a ticket to a concert, but you're not sure if you want to go. You have the option
to decide later whether you want to use the ticket or not. A swaption is like that ticket. It's a
financial ticket that gives you the choice to get into a deal (an interest rate swap) in the future if
it's beneficial for you, but you're not forced to do it.

So, a swaption is like having a financial "maybe" ticket for a future financial arrangement. It
gives you flexibility and control over whether you want to enter into a specific financial deal or
not.

Hedging with swaptions involves using these financial contracts to protect against potential
interest rate or financial market risks. Swaptions are options on interest rate swaps, which
provide the holder with the right, but not the obligation, to enter into a swap agreement at a later
date. Here's an explanation of how hedging with swaptions works:

1. Understanding Swaptions:

A swaption is like having a financial "ticket" or option that allows you to decide later whether
you want to enter into an interest rate swap. It's an instrument that provides flexibility in
managing financial risks.
2. Interest Rate Swap Reminder:
An interest rate swap is a financial agreement where two parties exchange interest rate payments.
One party typically pays a fixed interest rate, while the other pays a variable (floating) interest
rate, often tied to a benchmark like LIBOR.
3. How Hedging with Swaptions Works:
Imagine you're a company concerned about potential interest rate fluctuations, and you want to
protect yourself from rising interest rates. You can use a swaption to hedge this risk.
You buy a swaption, which gives you the right, but not the obligation, to enter into an interest
rate swap at a later date. This means you can decide to do the swap or not, depending on market
conditions.
If interest rates go up, you can exercise the swaption and enter into a swap where you receive a
fixed interest rate and pay a floating rate.
This effectively locks in a fixed interest rate, which protects you from rising rates. Your interest
costs become predictable, and you avoid potential increases.
If interest rates stay the same or go down, you might choose not to exercise the swaption and
continue with your existing loan or investment, as it may be more cost-effective.

4. Advantages of Hedging with Swaptions:

Hedging with swaptions offers a range of advantages for risk management. These financial
options provide flexibility, allowing holders to choose when and if to enter into an interest rate
swap, effectively guarding against interest rate volatility. Swaptions can be tailored to suit
specific risk management needs and are a cost-efficient solution for protecting against rising
interest rates. They are particularly valuable for mitigating complex interest rate structures,
reducing basis risk, and enhancing portfolio management by fine-tuning interest rate exposure.
Overall, swaptions balance flexibility with stability, offering a powerful tool for businesses and
investors to shield themselves from potential adverse interest rate movements while maintaining
control over their financial strategies.

5. Risks and Considerations:

In summary, hedging with swaptions involves using these financial options to protect yourself
from interest rate risks. It's like having a "future decision" ticket that lets you choose to lock in a
fixed interest rate if it becomes advantageous, while still giving you the flexibility to maintain
your existing position if rates are more favorable. It's a strategy that offers a balance between
stability and adaptability in a changing financial environment.
Valuating swaptions is a critical aspect of using these financial instruments effectively. The
valuation process involves determining the fair market value of the swaption, which helps market
participants make informed decisions. Swaption valuation relies on factors such as the current
and expected future interest rates, the time to expiration, the notional amount, and the terms of
the underlying swap. Accurate swaption valuation aids in assessing the cost and potential
benefits of using swaptions for hedging or investment purposes. Additionally, it contributes to
risk management by enabling market participants to evaluate the trade-offs involved in
exercising the option and entering into an interest rate swap or, alternatively, selling the swaption
in the market. Accurate valuation is, therefore, a fundamental component of effective financial
decision-making when dealing with swaptions.