interest rate swaps(final)

7/27/2019 Interest Rate Swaps(Final)

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INTEREST RATE SWAPS


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AGENDA

Swaps and its evolution-

Evolution of IRS

IRS

Why IRS-

Types

Mechanism

Examples

Pros and cons IRS in India. Why failed

Future of IRS in India


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DEFINITION

A contract which involves two counter parties to exchange over an agreed

period, two streams of interest payments, each based on a different kind of

interest rate, for a particular notional amount.

Interest rate swaps are used to hedge interest rate risks .

If a treasurer s view is that the interest rates will be falling in the future, he

may convert his fixed interest liability into floating interest liability; and also

his floating rate assets into fixed rate assets. If he expects the interest rates to go

up in the future, he may do vice versa.

Since there are no movements of principal, these are off balance sheet

instruments and the capital requirements on these instruments are minimal.


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Characteristics

Contractual agreement

Over a period of time

Exchange a series of interest cash flows

Only net cash flows exchanged on the maturity date

The size of the swap is referred to as the notional amount and

is the basis for calculation

Actual principal of the swap NOT exchanged


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Types of Interest Rate Swaps

Coupon Swap

If an interest rate swap involves the swapping of a stream of payments

based on the fixed interest rate for a stream of floating interest rate, then it

is called a coupon swap.

Counter parties to the Coupon Swap:

Payer of the fixed interest stream is called the Payer in the swap.

Receiver of the fixed interest stream is called the Receiver in the Swap

Generic swapA plain vanilla swap is a generic swap. It contain the simple characteristics,

such as a constant notional principal amount, exchange of fixed against

floating interest (coupon swap), an immediate start (i.e., on the spot date).


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Asset Swap

If in an interest rate swap, one of the streams of payments being exchanged

is funded with interest received on an asset, the whole mechanism is called

the asset swap. i.e. it is an interest rate swap, which is attached to an asset.

Asset swaps are used by investors.

If an investor anticipates a change in interest rates, he can maximize

his interest inflow by swapping the fixed interest paid on the asset for

floating interest, in order to profit from an expected rise in interest

rates.

Term Swaps

A swap with an original tenor of more than two years is referred to as a

term swap.


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Basis Swap

Two streams of payments can be calculated using different floating rate

indices. These are also called as floating-against-floating swaps.

It is possible to enter into a swap with a 3-month Libor against a 6

months LIBORIt is also possible to enter into a swap with a 91-Day T-Bill Yield against a

6-Month Libor.

Counterparties to a basis swap:

In a basis swap, each counter party is described in terms of both the intereststream it pays and the interest stream it receives.


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Money Market Swaps

Swaps with an original maturity of up to two years are referred to as

Money Market swaps.

IMM swaps come under this category. The tenor of the swaps matches

exactly with the short-term interest futures in the IMM (InternationalMonetary Market- Traded in the Chicago Mercantile Exchange).


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Participants

5. Scheduled commercial banks (excluding Regional Rural Banks), primary dealers (PDs) and

all-India financial institutions (FIs) are free to undertake FRAs/IRS as a product for their own

balance sheet management or for market making. Banks/Fls/PDs can also offer these products to

corporates for hedging their (corporates) own balance sheet exposures. No specific permission

from Reserve Bank would be required to undertake FRAs/IRS. However, participants when they

start undertaking such transactions, will be required to inform Monetary Policy Department

(MPD), Reserve Bank of India and abide by such reporting requirements as prescribed by the

Reserve Bank from time to time.

6. Participants undertaking FRAs/IRS are, however, advised that before undertaking market

making activity in FRAs/IRS, they should ensure that appropriate infrastructure and risk

management systems such as ability to price the product and mark to market their positions,

monitor and limit exposures on an ongoing basis, etc., are put in place.

Types of FRAs/IRS

7. Banks/PDs/FIs can undertake different types of plain vanilla FRAs/IRS. Swaps having


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Mechanism of an Interest Rate Swap:

Example:"plain vanilla" or the "coupon swap

Counter parties:: A and B

Maturity:: 5 years

A pays to B : 6% fixed p.a.

B pays to A : 6-month LIBOR

Payment terms : semi-annualNotional Principal amount: USD 10 million

Diagram:

PARTY A PARTY B

6% Fixed

6 m LIBOR


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USES

Originally created to allow multi-national companies to evade exchange controls.

Hedging

To alter exposure to interest-rate fluctuations.

Swapping fixed-rate obligations for floating rate obligations, or vice versa.

Speculation

Used by hedge funds to change in interest rates or the relationship between them.

Arbitrage opportunities.

Insurers with long term assets and shorter term liabilities can enter a swap in whichthey pay a fixed rate and receive a floating rate

This swap provides cash inflows if interest rates rise
http://en.wikipedia.org/wiki/Exchange_controlshttp://en.wikipedia.org/wiki/Exchange_controlshttp://en.wikipedia.org/wiki/Exchange_controls


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Risk Involved Interest Rate Risk

- Interest rates might move against the swap bank after it has only gottenhalf of a swap on the books, or if it has an unhedged position.

Basis Risk- If the floating rates of the two counterparties are not pegged to the same

index.

Tax Risk

-The risk created by potential tax events that could affect the relationshipof the swap index with the interest rate on our variable rate bonds.

Counterparty Risk-The failure of the counterparty to make required payments or otherwise

comply with the terms of the swap agreement.


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Termination Risk- The risk that there will be a mandatory termination of the swap. A termination

will almost always result in our either owing or being due to receive a terminationpayment.

Rollover Risk

- The mismatch of the maturity of the swap and the maturity of the underlyingbonds

Liquidity Risk

- The risk that liquidity is unavailable when needed for future renewals or that theprice for the liquidity is unattractive at that time.

Credit Risk

- The occurrence of an event modifying the credit quality or credit rating ofthe swap provider or its credit support provider.


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Dealing and Quotations

Trade date : The date on which the swap isentered

Effective date/ : The date on which the swapValue date becomes effective i.e. when theinterest obligations start to

accrue

Maturity date : The date on which the swap stopsaccruing interest and

terminates


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A quote of 9.75% - 10.25% against 3

month MIBOR means

One Party agrees to pay (bid) 9.75% fixed and

receives INR 3 month MIBOR.

Another Party agrees to receive (ask/offer)

10.25% fixed and pay the 3 month MIBOR

determined 3 months from today.


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Who can enter into IRS

For Rupee IRS

Banks, primary dealers and financial institutionsfor hedging & market making

Other corporate can enter only for hedging theinterest rate risk on an underlying asset/liability


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For Non-Rupee IRS

All participants are allowed to enter into thesetransactions only for the purposes of hedging

an underlying exposure.


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A Closer Look at Interest Rate Swaps

One party pays a fixed interest rate while

receiving a floating rate payment

Typical contract:

Floating rate is LIBOR (note, this has credit risk)

Settlement is quarterly

However, interest rate swaps are privately

negotiated so anything goes


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A Closer Look at Interest Rate Swaps (p.2)

Assume a quarterly settlement

At the first settlement date (in three months),the floating rate is (current) spot 3-month

LIBOR For future periods, the floating side is

determined by the future level of LIBOR

At settlement, the payment is based on thedifference of LIBOR and the fixed rate timesthe notional principal


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Interest Rate Swap

NP*Rfix NP*Rfix NP*Rfix NP*Rfix

NP*Rfloat NP*Rfloat NP*Rfloat NP*Rfloat

Cash flows for fixed rate receiver

Time

0 1 2 T-1 T


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Why Use Interest Rate Swaps?

Essentially translates a fixed cash flow into afloating cash flow (or vice versa)

Companies with interest rate exposure can

adjust their interest rate risk Insurers with long term assets and shorter

term liabilities can enter a swap in which theypay a fixed rate and receive a floating rate

This swap provides cash inflows if interest ratesrise


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Copyright Prof Kian-Guan Lim SMU 24

PRICING INTEREST RATE SWAPS

INTEREST RATE SWAPS

Trade Start (1R) 2nd Reset 3rd Reset 4th Reset Maturity

Date Date Date Date Date Date

Notional principal = amount on which interest is computedCash settlement = payment of loss by one counterparty to the other

Start Date = date on which the first floating rate is set (usually the Trade Date or Contract Date except for forward

start IRS)

Value (Effective) Date = date on which the interest rate payments start to accrue; could be start date

Reset Date = date on which the floating rate is reset (includes the first set date at start date)

Reset Frequency = number of times per year floating rate is reset e.g. quarterly or semi-annually

Reset period = 1/(reset frequency) year

Maturity Date = date when swap matures, the last day on which interest accrues for usual swap in-fine wheresettlement takes place at the end of the accruing period

Tenor* = total period in years from value date to maturity date

Front stub period = time from value date to first payment

Note:* For interest rate caps, tenor sometimes refer to the reset period, i.e. time length between two adjacent payments.

t3 #dayst2 #dayst1 #dayss #days


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Mechanism of Interest Rate SWAPS

In an interest rate swap, each counterparty

agrees to pay either a fixed or floating rate

denominated in a particular currency to the

other counterparty

The fixed or floating rate is multiplied by

a notional principle amount


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Mechanism of Interest Rate SWAPS

For example : one counterparty A pays a fixed

rate (the swap rate) to counterparty B, while

receiving a floating rate. So here

A pays fixed rate to B (A receives variable rate)

B pays variable rate to A (B receives fixed rate)


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Interest Rate SWAP between Alfa Corp.

and Strong Financial Corp.

Terms:

Fixed rate payer: Alfa Corp

Fixed rate: 5 percent, semiannualFloating rate payer: Strong Financial Corp

Floating rate: 3-month USD Libor

Notional amount: US$ 100 millionMaturity: 5 years


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Alfa Corp agrees to pay 5.0% of $100 million on a

semiannual basis to Strong Financial for the next

five years

That is, Alfa will pay 2.5% of $100 million, or $2.5

million, twice a year

Strong Financial agrees to pay 3-month Libor (as a

percent of the notional amount) on a quarterly

basis to Alfa Corp for the next five years

That is, Strong will pay the 3-month Libor rate,divided by four and multiplied by the notional

amount, four times per year


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Advantages

Asset-Liability Mismatch Correction

Opens up Diverse Avenues of Funding

Hedging Floating Rate Risks

Taking advantage of low floating rate borrowings Low Credit Risk

Decouple Funding and Duration Decisions

Can be CustomizedFlexibility in the Management of Interest

Rates Improve Funding Cost


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Interest Rate Swaps In The Indian Market According to RBIs, Mid-Term Review of Monetary and Credit Policy for

1998-99, it would facilitate introduction of Interest Rate Swaps as a step

towards liberalizing and deepening the Indian Money Markets.

Banks and Financial Institutions are permitted to make a market in IRS

without any restrictions on the size of the notional principal and the tenor

of the agreement.

Corporates are allowed to enter into IRS agreements only to hedge

underlying exposures.

Banks and financial institutions must observe capital adequacy for IRS, as

per the stipulations contained in Annexure 1. Primary dealers should follow

the norms as indicated in Annexure 2.

Benchmark rate for the floating side of the swap can be any domestic

money or debt market rate which is market determined, provided the

methodology of computing the rate was objective, transparent and mutually

acceptable to counterparties.

Majorly used Benchmarks used in the Indian MarketMIFOR, MIBOR


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Rupee Interest Rate Swaps

Swap market is now four years old

FY 03 has seen tremendous growth in volumesand outstanding contracts

Increasing volumes have led to lower bid-offerspreads for some of the price points

No of market players have increased More banks and PDs have joined the market

Corporate activity has also increased

Emerging consensus about benchmark rates OIS and MIFOR have emerged as two key swap curves


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Reasons for failure of IRS in India

Interest rate swaps Lack of credible term money benchmark

Lack of participation large players with interest rate risk - PSU Banks,

MFs and Insurance companies

Absence of cash market for floating rate products

Legality of OTC derivatives

Transparency availability of price and volume data

MTM and valuation framework


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Remedies

Measurement and management of credit risk inOTC derivative transactions

Robust mark-to-market and valuation framework

Accounting and disclosure guidelines (IAS 39)

Minimisation of taxation and regulatory arbitrageacross products and institutions


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Reasons of entering into IRS

To obtain lower cost funding

To hedge interest rate exposure

To obtain higher yielding investment assets

To create types of investment asset not otherwise obtainable To implement overall asset or liability management strategies

To take speculative positions in relation to future movements

in interest rates.

interest rate swaps(final)

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