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Swaps

1. Swaps are derivative contracts where parties agree to exchange cash flows over a period of time, with the most common being interest rate swaps. 2. In a "plain vanilla" interest rate swap, one party pays a fixed interest rate on a principal while the other pays a floating rate, typically LIBOR, on the same principal. 3. Swaps have various uses like converting fixed rate liabilities/investments to floating rates and vice versa, and allow longer term hedging than futures or options.

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63 views

Swaps

1. Swaps are derivative contracts where parties agree to exchange cash flows over a period of time, with the most common being interest rate swaps. 2. In a "plain vanilla" interest rate swap, one party pays a fixed interest rate on a principal while the other pays a floating rate, typically LIBOR, on the same principal. 3. Swaps have various uses like converting fixed rate liabilities/investments to floating rates and vice versa, and allow longer term hedging than futures or options.

Uploaded by

Luvnica Verma
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Title 4

Chapter
Date
Swaps
Lifetime Learning… Building Success… Towards Globalization
Introduction

• Swaps are derivative instruments that involve an


agreement between two parties to exchange a series
of cash flows over a specific period of time

• Swaps do not trade on exchanges, and retail investors


do not generally engage in swaps. Rather, swaps are
over-the-counter contracts between businesses or
financial institutions.

• The most common kind of swap is an interest rate


swap
“Plain Vanilla” Interest Rate Swap
• The floating rate in most interest rate swap
agreements is the London Interbank Offered Rate
(LIBOR)

• Consider a hypothetical 3-year swap initiated on


March 5, 2012, between Microsoft and Intel. We
suppose Microsoft agrees to pay Intel an interest rate
of 5% per annum on a principal of $100 million, and

• In return Intel agrees to pay Microsoft the 6-month


LIBOR rate on the same principal.
“Plain Vanilla” Interest Rate Swap.....
• Microsoft is the fixed-rate payer; Intel is the floating
rate payer. We assume the agreement specifies that
payments are to be exchanged every 6 month

• Interest rate swap between Microsoft and Intel

LIBOR
Intel Microsoft
5%
Cash Flows to Microsoft

---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar.5, 2010 4.2%
5%
Sept. 5, 2010 4.8% +2.10 –2.50 –0.40
Mar.5, 2011 5.3% +2.40 –2.50 –0.10
Sept. 5, 2011 5.5% +2.65 –2.50 +0.15
Mar.5, 2012 5.6% +2.75 –2.50 +0.25
Sept. 5, 2012 5.9% +2.80 –2.50 +0.30
Mar.5, 2013 6.4% +2.95 –2.50 +0.45
Typical Uses of an Interest Rate Swap
• Converting a liability from
– fixed rate to floating rate
– floating rate to fixed rate

• Converting an investment from


– fixed rate to floating rate
– floating rate to fixed rate
Types of Swaps
1. Interest Rate Swaps
• most popular types of swaps
• They allow two parties to exchange fixed and floating
cash flows on an interest-bearing investment or loan.
• Generally, Principal amount is not exchanged

2. Currency Swaps
• A currency swap (or a cross currency swap) is a foreign
exchange derivative between two institutions to
exchange the principal and/or interest payments of a
loan in one currency for equivalent amounts, in another
currency.
Types of Swaps

3. Commodity Swaps
• A commodity swap is an agreement whereby a floating
(market or spot) price based on an underlying commodity
is traded for a fixed price over a specified period.
• It is similar to a Fixed-Floating Interest rate swap.
Types of Swaps
4. Credit Default Swap (CDS)
• It transfers the credit exposure between two or more
parties.
• In a credit default swap, the buyer of the swap makes
payments to the swap’s seller up until the maturity date
of a contract.
• In return, the seller agrees that, in the credit event, the
seller will pay the buyer the principal amount as well as
all interest payments that would have been paid
between that time and the security’s maturity date.
• A credit default swap is also often referred to as a credit
derivative contract.
Swaption
• A swaption (swap option) is the option to enter
into an interest rate swap or some other type of
swap.
• In exchange for an option premium, the buyer
gains the right but not the obligation to enter into
a specified swap agreement with the issuer on a
specified future date.
Advantages of Swaps
• Swap is generally cheaper. There is no upfront premium
and it reduces transactions costs.
• Swap can be used to hedge risk, and long time
period hedge is possible.
• It provides flexible and maintains informational
advantages.
• It has longer term than futures or options. Swaps will
run for years, whereas forwards and futures are for the
relatively short term.
• Using swaps can give companies a better match
between their liabilities and revenues.
Disadvantages of Swaps
• Early termination of swap before maturity may incur
a breakage cost.
• Lack of liquidity.
• It is subject to default risk.
Let’s Test Our Understanding

Q1. What are Swaps. Give one example

Q2. Interest Rate Swaps help in converting a liability from


fixed rate to floating rate (T/F)

Q3. Swaps are traded on exchanges by retail investors (T/F)

Q4. There is no possibility of default risk in Swaps (T/F)


Ans 2) True Ans 3) False Ans 4) False
Let’s Test Our Understanding
Q5. Swaps have longer term than futures or options (T/F)

Q6. Most Common type of swap is the commodity swap

Q7. ____________swap transfers the credit exposure


between two or more parties

Q8. ___________ is the option which gives buyer right not


obligation to enter into the swap agreement.
Ans 5) True Ans 6) False Ans 7) Credit Default Swap Ans 8)Swaption
Let’s Test Our Understanding

Q9. Principal is exchanged between the two parties in the


interest rate swap and it is not exchanged between them in
the currency swap (T/F)
Q10. What are the different advantages and disadvantages of
swaps
Q11. Write a short note on Plain vanilla interest rate swap
Q12. What is : a)Interest Rate Swap
b) Currency Swap c) Commodity Swap
d) Swaption e)CDS
Ans 9) False

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