1. SWAPS

2. Definition of SWAP
A swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap.
The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the underlying prices.

3. BACKGROUND
Swaps first evolved in 1981, in the form of currency swaps, (IBM and the World Bank for$210 million dollars and a term of over ten years)
Interest rate swaps emerged, which offered an alternative method to overcome asset-liability mismatches and to lower the cost of borrowing.
Swaps provide a level playing field for risk management but still struggle to find a future, especially in developing countries

4. TYPES OF SWAP Interest Rate Swaps Currency Swaps Commodity Swaps
Equity Swaps

5. INTEREST RATE SWAPS
An interest rate swap is defined as a mutual agreement among different parties, to exchange interest payments over a predetermined period.
 The primary motives behind the interest rate swaps are to lower the costs of borrowing and to overcome the asset liability mismatch.

6. INTEREST RATE SWAPS – Eg
Take the case of a plain vanilla fixed-to-floating interest rate swap. Here party A makes periodic interest payments to party B based on a variable interest rate of LIBOR +50 basis points.
Party B in turn makes periodic interest payments based on a fixed rate of 3%. The payments are calculated over the notional amount. The first rate is called variable, because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR.

7. TYPES OF INTEREST RATE SWAPS
Fixed for Floating
Also known as Plain Vanilla swap
Customer receives cash flows at a fixed rate of interest and simultaneously pays cash flows at a floating rate of interest or vice versa.
The cash flows are calculated on a Notional Principal amount.
The floating rate of interest is usually determined by reference to a transparent benchmark

8. Fixed for Floating – CONT.
Investors call the parts of interest swap agreements “legs.”
In a fixed-for-floating swap agreement, one party agrees to pay the fixed leg of the swap, with the other party agreeing to pay the floating leg of the swap.
The fixed rate is the interest charged over the life of a loan and does not change.
The floating rate is an interest rate pegged to an international reference rate index and is subject to change. The most commonly used reference rate is London Interbank Offered Rate or LIBOR.

9. An Example of a Plain Vanilla Fixed-for-Floating Interest
Party A- (Receives Floating Rate)Party B- (Pays the Floating Rate)
Notional Principal- $40 million.
Fixed rate day count method is 30/360 day basis.
Floating rate is Six- Month LIBOR, determined on a 30/360 day basis.
Swaps origination: July 20, 1999.
Swaps termination: July 20, 2000.
First payment: January 20, 2000
Semiannual payments will be made on each July 20 and January 20.

10. TYPES OF INTEREST RATE SWAPS
Floating for Floating
In this kind of a swap, both the counter-parties exchange interest amounts based on two different floating reference rates, through the life of the swap.
In a floating-for-floating interest rate swap agreement, both parties agree to pay a floating rate on their respective legs of the swap.

11. Floating for Floating - CONT
The floating rates for each leg of the swap generally come from different reference rate indexes, but can also come from the same index.
If both parties choose the same index, generally they then choose different payment dates.
The two main indexes investors use in a floating for floating interest rate swap are the LIBOR and the Tokyo Interbank Offered Rate or TIBOR

12. TYPES OF INTEREST RATE SWAPS
Fixed for Fixed
In fixed-for-fixed interest rate swaps, both parties agree to a fixed interest for their respective legs of the swap.
The interest rate does not change over the life of the loan for both parties.
Investors most commonly use fixed-for-fixed interest rate swaps when they are dealing with different currencies.
Companies often use fixed-for-fixed interest rate swaps when they are building or expanding their business in a foreign country.

13. TYPES OF INTEREST RATE SWAPS
Index Amortization Swap
A swap whereby the notional principal amount of the agreement is amortized according to the movement of an underlying rate.
Forward Swaps
A swap agreement created through the synthesis of two swaps differing in duration for the purpose of fulfilling the specific time-frame needs of an investor. Also referred to as a "forward start swap," "delayed start swap," and a "deferred start swap."

14. TYPES OF INTEREST RATE SWAPS
Off market Swap
An interest rate or other swap contract with a fixed rate payment materially different from current coupon rates on bonds or notes of similar term. Ordinarily, this swap will have a net present value that requires the counterparties to exchange an extra payment at the beginning or end of the swap tenor. Also called Adjustment Swap

15. TYPES OF INTEREST RATE SWAPS
Callable Swaps & Putable Swaps
Fixed rate receiver has the right, but not the obligation to terminate the swap at one or more pre-determined times during the life of the swap.
A Swap where the fixed rate payer has the right to terminate is known as a Callable Swap. Both the Putable and Callable Swaps are also known as Cancellable Swaps.
  The foreign exchange version of a Cancellable Swap is called the Break Forward or Cancellable Forward

16. LIMITATIONS OF SWAP DEALS
Counter Party Risk
Fund Requirement
Cordial Relationships
Information Network

17. CURRENCY SWAPS

18. DEFINITION
A currency swaps (or cross currency swap) is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and, after a specified period of time, to give back the original amounts swapped.
Currency swaps were originally done to get around exchange controls.

19. EXAMPLE
For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange.

20. Types of currency swaps
Fixed for fixed
Fixed for floating
Floating for fixed
Floating for floating

21. RISKS OF INTEREST RATE AND CURRENCY SWAPS
Sovereign Risk
Mismatch Risk
Credit Risk
Exchange rate Risk
Basis Risk
Interest Rate Risk

22. RISKS OF INTEREST RATE AND CURRENCY SWAPS
Interest Rate Risk
Interest rates might move against the swap bank after it has only gotten half 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 to the same index.

23. RISKS OF INTEREST RATE AND CURRENCY SWAPS
Exchange rate Risk
In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.
Credit Risk
This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap.

24. RISKS OF INTEREST RATE AND CURRENCY SWAPS
Mismatch Risk
It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.
Sovereign Risk
The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.

25. ROLE OF FINANCIAL INTERMEDIARY

26. MEANING
In the financial markets, a company with the need for swapping a fixed rate liability may not easily find another company with a matching need in the reverse direction (same notional principal, maturity period, fixed rate and floating rate)

27. MEANING
In such cases, the company needing an interest rate swap may approach a financial intermediary such as a bank which is prepared to enter into swap agreement with the company.
The intermediary would then find out a party or a combination od parties with the matching need in the reverse direction

28. ROLE OF FIs IN INTEREST RATE SWAP
Two limitations,
There is a cost of time and resources associated with searching for a suitable swap candidate and negotiating the swap terms
Each swap participant faces the risk that the counter participant could default on payments

29. ROLE OF FIs IN INTEREST RATE SWAP- eg
Company A has borrowed Rs.5 lac from the lender X on fixed interest rate at 12%. The company wishes to convert the fixed rate liability into floating rate liability and approaches a bank(FI) for a swap deal. The bank agrees to receive interest at floating rate from company A in exchange for interest payment at fixed rate to company A.

30. ROLE OF FIs IN INTEREST RATE SWAP- eg
Meanwhile company B has borrowed Rs.5 lac from lender Y at floating interest rate specified as LIBOR+0.50%. It wants to exchange this floating rate liability into fixed rate liability. The financial intermediary would enter into a swap deal with company B agreeing to pay interest at floating rate to company A and receive interest at fixed rate from company A

31. ROLE OF FIs IN CURRENCY RATE SWAP
A currency swap can be used to transform a loan in one currency into a loan in another currency. A typical situation that necessitates currency swap is when a firm has liability denominated in one currency and an income stream denominated in another currency

32. ROLE OF FIs IN CURRENCY RATE SWAP- eg
An Indian firm may have borrowed Japanese yen to finance the acquisition of equipment from Japan. This firm engaged in exporting goods to the U.S and would therefore be receiving its income in U.S dollars. Thus, the firm has to make payments in Japanese yen to meet its loan commitment when it receives its income in U.S dollars.

33. ROLE OF FIs IN CURRENCY RATE SWAP- eg
The U.S dollars would have to be converted to Japanese yen whenever interest payments and principal repayments have to be made. This firm is exposed to forex risk as there is a possibility that the U.S dollar may weaken against the Japanese yen in the future. The firm would then suffer a loss in conversion of U.S dollar into yen as more dollars would have to be converted into yen to meet its loan commitment

34. WAREHOUSING

35. MEANING
One of the problems with swaps is the difficulty of finding a potential counterparty with matching needs.
This problem is resolved by swap dealers, working for invt banks, commercial bans and merchant banks, who take one side of the transaction themselves, this is called positioning the swap or booking the swap.

36. Positioning of swaps is also called warehousing swaps.
MEANING
Positioning of swaps is also called warehousing swaps.
Swap dealers becomes counterparty to the swap. For its services, the dealer earns a pay-receive spreads.
It is also known as bid-ask spreads

37. They do this exchange for commission
MEANING
The problem of finding a suitable counterparty can also be solved by employing a swap broker.
Brokers match counterparties without themselves becoming counterparties to swap.
They do this exchange for commission

38. Two types of facilitators,
MEANING
Two types of facilitators,
BROKERS: financial institutions first became involved in the role of swap brokers to find counterparties with matched needs.
Its role is limited to that of agent.

39. Two types of facilitators,
MEANING
Two types of facilitators,
SWAP DEALERS: he plays a role similar to that of dealers in other financial markets.
He helps counterparties to complete swap transaction
He may serves a broker or dealer