INTRODUCTI
ON TO SWAPS
VIDUSHI VERMA
17120
WHAT ARE DERIVATIVES?
• Derivatives are types of contracts whose value is derived from any underlying asset.
• An underlying asset can be anything like Stocks, Currencies, Interest rates, Indexes or
commodities.
• Derivatives comes under the domain of ‘Securities’
DERIVATIVE PRODUCTS
FORWARDS FUTURES SWAPS OPTIONS
INTEREST RATE CURRENCY SWAPS
SWAPS
SWAPS
IT IS AN AGREEMENT TO EXCHANGE CASHFLOWS AT SPECIFIED FUTURE TIME
ACCORDING TO CERTAIN SPECIFIED RULES.
A swap has a pre-
determined life
Bilateral agreement between
two counter-parties
Includes specified cashflows Over-the counter i.e. done
at fixed periodic intervals directly between the parties
Exploit the comparative without the supervision of any
advantage of different third party like exchanges
players in different markets
FIXED EXCHANGE RATE VS FLOATING EXCHANGE RATE
• Fixed Exchange Rate is fixed for a specified principal amount for any duration.
• Floating Interest Rates are variable rates that are reset at fixed intervals, say overnight, monthly, semi-
annually, annually etc.
• MIBOR (Mumbai Inter-Bank Offer Rate) • LIBOR (London Interbank Offer Rate)
is an official floating rate for Interest Rate is an globally accepted benchmark
Swaps and Foreign Rate Agreements Interest Rate
• It is transparent, market-determined, • It is an average interest rate offered by
mutually acceptable to counter-parties as a specified group of multinational
reference banks in London for US dollar
deposits of a stated maturity
INTEREST RATE SWAPS/PLAIN VANILLA SWAP
it is a financial contract between two parties, exchanging or swapping a stream of interest payments for a
notional principal amount during a specified duration.
Expecting Expecting that
that MIBOR MIBOR will rise
will increase
A will give fixed interest amount to B • Loan amount Rs. 1
• Loan amount Rs. lakh
1 lakh • Floating rate of
• Fixed Interest MIBOR
Rate B will give interest amount at MIBOR to A
MR. A MR. B
CHARACTERISTICS OF AN INTEREST SWAP
• Fixed principal amount also called as ‘Notional
Amount’ does not change hands
• It is used to hedge against adverse movements of
interest rates.
• It is based on exploiting comparative advantages of
both the parties.
• It is an over the counter instrument.
EXAMPLE
10% Fixed Interest on Rs. 1 Crore
Firm A Firm B
Interest amount at MIBOR on Rs. 1 Crore
This is a Swap agreement between • Notional Amount : Rs. 1
• Notional Amount : Rs. 1 Crore Firm A and Firm B. Firm A Crore
• Life : 1 year exchanged its Fixed Interest rate • Life : 1 year
• Fixed interest rate at 10% with B as it expects MIBOR to • Interest Rate: MIBOR
increase further. Whereas, Firm B
did vice versa. Both Firm A & B
reduced their risk this way.
CASHFLOWS
• 6 month MIBOR is taken so interest amounts will be exchanged twice a year
• After 6 Months,
A to pay - Rs. 1 crore X (10/100) X (6/12) = Rs. 5 Lakhs
Notional Principal
Amount For 6
Fixed Interest months
6 Month MIBOR = 8% rate
B to pay – Rs. 1 cr X (8/100) X (6/12) = Rs. 4 Lakhs
• At Maturity/ after 1 year
A to pay - Rs. 1 crore X (10/100) X (6/12) = Rs. 5 Lakhs
6 Month MIBOR = 9.5%
B to pay – Rs. 1 cr X (9.5/100) X (6/12) = Rs. 4.75 Lakhs
• Final Payments
A to pay- Rs. 10 lakhs
B to pay – Rs. 8.75 lakhs
CURRENCY SWAPS
• A financial contract for exchange of
principal and fixed rate of interest
payments on a loan in one currency for
another currency.
• Principal amount is also exchanged in
currency swaps along with Interest
Payments
EXAMPLE
CP1 wants to transform its $100 million USD floating rate debt into fixed rate GBP loan:
CP 1 CP 2
• $100 Million • 74 million pounds
loan loan
• USD Floating • Fixed Interest
Rate (LIBOR) Rate @ 10%
Here, Exchange is assumed to be 1.35GBP/USD
CASHFLOWS
• AT T0 (TIME ZERO)
$100 million
CP 1 74 million pounds CP 2
• AFTER 6 MONTHS
10% on 74 million pounds
CP 1 LIBOR on $100 million CP 2
• AT MATURITY
10% on 74 million pounds + 74 million
pounds
CP 1 LIBOR on $100 million + $100 million CP 2
INTEREST RATE CAPS
• INTEREST RATE CAP IS A LIMIT ON HOW HIGH AN INTEREST RATE CAN RISE ON
VARIABLE RATE DEBT
• A PREMIUM AMOUNT IS PAID ON BUYING INTEREST RATE CAPS
• THEY CAN BE INSTITUTED ACROSS ALL TYPES OF VARIABLE RATE PRODUCTS
• THERE ARE 2 TYPES OF INTEREST RATE INSTRUMENTS:
- INTEREST RATE CAPS
- INTEREST RATE FLOOR
CAPS
• IF FIRM D BORROWS AT FLOATING RATE AND IT EXPECTS THAT INTEREST RATES
WILL RISE
Firm A Buy Interest Rate Cap
• IF RATE INCREASES, FIRM D WILL EXERCISE THE CAP
• IF INTEREST RATE WILL FALL, THE OPTION WILL NOT BE EXERCISED AND FIRM D
WILL INCUR A LOSS EQUAL TO THE PREMIUM AMOUNT
• IT PROTECTS THE RISK OF RISING INTEREST RATE
FLOORS
• IF FIRM B INVESTS AT FLOATING RATE AND IT EXPECTS THAT INTEREST RATES
WILL FALL
Firm B Buy Interest rate floor
• IF INTEREST RATE FALLS, FIRM B WILL EXERCISE THE CAP
• IF INTEREST RATE WILL INCREASE, THE OPTION WILL NOT BE EXERCISED AND
FIRM B WILL INCUR A LOSS EQUAL TO THE PREMIUM AMOUNT
• IT PROTECTS THE RISK OF FALLING INTEREST RATES
COLLARS
• IT IS A COMBINATION OF CAP AND FLOOR
• IF WE EXPECT INTEREST RATE TO RISE, WE BUY CAP AT HIGHER STRIKE PRICE
AND IN ORDER TO COVER THE PREMIUM AMOUNT WE WILL SELL FLOORS AT
LOWER STRIKE PRICE
• THIS STRATEGY IS CALLED ‘COLLARS’
Sell
Mr. A FLOOR
Receive premium amount
Buy
Mr. A CAP
Receive premium amount
THANK YOU
