AFM 2: Interest Rate Swaps

S Krishnamoorthy: [email protected], Cell:9821461488

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XIMR AFM2 2010
 Swaps
In finance, a swap is a derivative in which counterparties exchange certain
benefits / stream of cash flows based on an underlying financial
instrument/commitment of the counterparties to the swap

The benefits in question depend on the type of financial instruments involved. For
example, in the case of a swap involving two bonds, the benefits in question can
be the periodic interest (or coupon) payments associated with the bonds

Specifically, the two counterparties agree to exchange one stream of cash flows
against another stream

These streams are called the legs of the swap

The swap agreement defines the dates when the cash flows are to be paid and
the way they are calculated

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Swaps
Usually at the time when the contract is initiated at least one of these series of
cash flows is determined by a random or uncertain variable such as an interest
rate, foreign exchange rate, equity price or commodity price

The cash flows are calculated over a notional principal amount, which is usually
not exchanged between counterparties

Consequently, swaps can be in cash or collateral

Swaps can be used to hedge certain risks such as interest rate risk, or to
speculate on changes in the expected direction of underlying prices

The counterparties to the swap should compulsory execute International Swap

Swaps are dealt over the counter [OTC] and/or in Exchanges

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Interest Rate Swaps [IRS]
In an IRS there is contractual agreement between the two counterparties
to make periodic payment to the other for an agreed period of time based upon a
notional amount of principal

The principal amount is notional because there is no need to exchange actual amounts
of principal in a single currency transaction and there is no foreign exchange
component to be taken account of

However, a notional amount of principal is required in order to compute the actual cash
amounts that will be periodically exchanged

Under the commonest form of IRS a series of payments calculated by

This is a fixed-for-floating IRS

 When both series of cash flows to be exchanged are based upon different underlying
floating indices for example upon 6 month LIBOR and 90 days MIBOR the swap is
known swap is known as a basis or money market swap

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Typical Interest Rate Swap [IRS]
Bank has extended floating rate loan of Rs 100 cr to Corporate
Term is one year with bullet repayment
Interest is payable monthly based on average rate of 1 month Mibor + a spread
of 30 bps
Corporate
Mibor + 30 bps

Pay Mibor
Bank Swap Bank
Receive Fixed 6%

The Bank to manage interest rate risk has signed IRS deal with Swap Bank
The notional principal amount is Rs 100 cr
The term is for 1 yr
In exchange for Swap Bank paying monthly fixed 6% the Bank will pay
monthly based on average 1 month Mibor rate
By doing IRS bank has managed interest rate risk and also retained and
served a customer who wanted floating rate interest loan

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 Pricing IRS
In a generic fixed-to-floating interest rate swap the difficulty to be overcome in pricing such a
swap would seem to be the fact that the future stream of floating rate payments to be made by
one counterparty is unknown at the time the swap is being priced

Neither counterparty know with absolute certainty what the 6 month Libor/Mibor rate will be in
12 months time or 18 months time

However money markets do possess a considerable body of information about the relationship
between interest rates and future periods of time

In many countries, for example, there is a deep and liquid market in interest bearing securities
issued by the government

 These securities pay interest on a periodic basis, they are issued with a wide range of
maturities, principal is repaid only at maturity and at any given point in time the market values
these securities to yield whatever rate of interest is necessary to make the securities trade at
their par value

It is possible to plot a graph of the yields of such securities having regard to their varying
maturities. This graph is known generally as a yield curve i.e. the relationship between future
interest rates and time

And a graph showing the yield of securities displaying the same characteristics as government
securities is known as the par coupon yield curve (Example GOI bond or T-bill Yield Curve)
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 Pricing IRS based on Yield Curves
A different kind of security to a government security or similar interest bearing note
is the zero-coupon bond and a graph of the internal rate of return (IRR) of zero-
coupon bonds over a range of maturities is known as the zero-coupon yield curve

Also at any time the market is prepared to quote an investor forward interest rates

If, for example, an investor wishes to place a sum of money on deposit for six
months and then reinvest that deposit once it has matured for a further six months,
then the market will quote today a rate at which the investor can re-invest his
deposit in six months time

The six month forward deposit rate is a mathematically derived rate which reflects
an arbitrage relationship between current (or spot) interest rates and forward
interest rates

 In other words, the six month forward interest rate will always be the precise rate
of interest which eliminates any arbitrage profit

The graphical relationship of forward interest rates is known as the forward yield
curve

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 Pricing IRS: NPV of Cash Flows is “ZERO”
Thus the market does possess a great deal of information concerning the yield
generated by existing instruments over future periods of time and future floating
rates of interest can be calculated using the forward yield curve

The issue with regard to calculating the fixed rate payments due under the swap can
be resolved based on the fact that the net present value (NPV) of the aggregate set of
cash flows due under any swap is at inception ZERO

The NPV of the complete swap must be zero, since it involves the exchange of one
zero net present value stream of payments for a second zero NPV stream of
payments

Since the floating rate payments due under the swap can be calculated as explained
above, the fixed rate payments will be of such an amount that when they are deducted
from the floating rate payments and the net cash flow for each period is discounted at
the appropriate rate given by the zero coupon yield curve, the NPV of the swap will be
zero ( In options pricing the Black Scholes model and a process called Boot Strapping
is used)

The pricing picture is now complete

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 Users and Uses of IRS

IRS are used by a wide range of commercial banks, investment banks, non-
financial operating companies, insurance companies, mortgage companies,
investment vehicles and trusts, government agencies, sovereign states and
corporate for the following reasons:
1. To obtain lower cost funding
2. To hedge interest rate exposure
3. To obtain higher yielding investment assets
4. To create types of investment asset not otherwise obtainable
5. To implement overall asset or liability management strategies
6. To take speculative positions in relation to future movements in interest
rates

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 Advantages of IRS

The advantages of interest rate swaps include the following:

1.A floating-to-fixed swap increases the certainty of an issuer's future

2. Swapping from fixed-to-floating rate may save the issuer money if

3. Swapping allows issuers to revise their debt profile to take advantage of

4. IRS are a financial tool that potentially can help issuers lower the amount
of debt service

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Other Types of Swaps
A Currency Swap involves exchanging principal and fixed rate interest payments
on a loan in one currency for principal and fixed rate interest payments on an
equal loan in another currency. Just like interest rate swaps, the currency swaps
also are motivated by comparative advantage

A commodity swap is an agreement whereby a floating (or market or spot) price

An equity swap is a special type of total return swap, where the underlying asset
is a stock, a basket of stocks, or a stock index. Compared to actually owning the
stock, in this case you do not have to pay anything up front, but you do not have
any voting or other rights that stock holders do have

A credit default swap (CDS) is a swap contract in which the buyer of the CDS
makes a series of payments to the seller and, in exchange, receives a payoff if a
credit instrument - typically a bond or loan goes into default /fails to pay. Unlike an
actual insurance contract the buyer is allowed to profit from the contract and may
also cover an asset to which the buyer has no direct exposure
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