1. Dr.P.krishnaveni/MBA/Financial Derivatives
SWAPS
Dr.P.krishnaveni/MBA/Financial Derivatives

2. Dr.P.krishnaveni/MBA/Financial Derivatives
SWAP
A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time.
Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a variable, such as an interest rate, foreign exchange rate, equity price or commodity price.
Dr.P.krishnaveni/MBA/Financial Derivatives

3. Dr.P.krishnaveni/MBA/Financial Derivatives
The Swaps Market
Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments.
Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties.
Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating.
Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap.
Dr.P.krishnaveni/MBA/Financial Derivatives

4. Dr.P.krishnaveni/MBA/Financial Derivatives
What is a swap?
A swap is an agreement between two counter-parties to exchange cash Flows at specified future times, according to specified rules.
The swap can be considered as a portfolio of forward/futures contracts with a sequential series of delivery times.
Dr.P.krishnaveni/MBA/Financial Derivatives

5. Dr.P.krishnaveni/MBA/Financial Derivatives
Facts about Swaps
The first major swap transaction was made in 1981 between IBM and World Bank (currency swap).
The majority of the swaps are traded over-the-counter (OTC).
In fact, more that 70% of the global OTC derivatives markets is swaps.
Swaps are mainly used by banks to convert their long-term fixed rate assets to floating rate in order to match their short term liabilities.
Dr.P.krishnaveni/MBA/Financial Derivatives

6. Dr.P.krishnaveni/MBA/Financial Derivatives
The setup clarification
The interest payments are exchanged at the same time.
The floating interest rate is the one that prevails at the beginning of the
period.
The fixed rate remains constant until the end of the swap life.
The notional principal is there to measure the size of the swap and it is not exchanged.
The Interest rate swap (IRS) market
The outstanding amount of the interest rate swap is above 55% of all the international OTC derivative market (according to the BIS, June 2009).
It is one of the largest and most liquid global financial markets.
It is closed related to other interest rate derivatives traded in organized exchanges.
Dr.P.krishnaveni/MBA/Financial Derivatives

7. Dr.P.krishnaveni/MBA/Financial Derivatives
Definitions
In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals.
There are two types of interest rate swaps:
Single currency interest rate swap
“Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps.
Cross-Currency interest rate swap
This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.
Dr.P.krishnaveni/MBA/Financial Derivatives

8. Dr.P.krishnaveni/MBA/Financial Derivatives
Size of the Swap Market
The most popular currencies are:
U.S. dollar
Japanese yen
Euro
Swiss franc
British pound sterling
Dr.P.krishnaveni/MBA/Financial Derivatives

9. Dr.P.krishnaveni/MBA/Financial Derivatives
The Swap Bank
A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.
The swap bank can serve as either a broker or a dealer.
As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap.
As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.
Dr.P.krishnaveni/MBA/Financial Derivatives

10. Swap Market Quotations
Swap banks will tailor the terms of interest rate and currency swaps to customers’ needs
They also make a market in “plain vanilla” swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.
Dr.P.krishnaveni/MBA/Financial Derivatives

11. Interest Rate Swap Quotations
Euro-€
£ Sterling
Swiss franc
U.S. $
Bid
Ask
1 year
2.34
2.37
5.21
5.22
0.92
0.98
3.54
3.57
2 year
2.62
2.65
5.14
5.18
1.23
1.31
3.90
3.94
3 year
2.86
2.89
5.13
5.17
1.50
1.58
4.11
4.13
4 year
3.06
3.09
5.12
1.73
1.81
4.25
4.28
5 year
3.23
3.26
5.11
5.16
1.93
2.01
4.37
4.39
6 year
3.38
3.41
2.10
2.18
4.46
4.50
7 year
3.52
3.55
5.10
5.15
2.25
2.33
4.55
4.58
8 year
3.63
3.66
2.45
4.62
4.66
9 year
3.74
3.77
5.09
4.48
2.56
4.70
4.72
10 year
3.82
3.85
5.08
2.64
4.75
4.79
3.82–3.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving euro LIBOR or it will receive fixed-rate euro payments at 3.85% against receiving euro LIBOR
Financial Times March 4, 2005
Dr.P.krishnaveni/MBA/Financial Derivatives