Description
Describes the currency swaps in details.
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A swap is an agreement between two or more parties to exchange a sequence of cash flows over a period in the future. Example: A agrees to pay a fixed rate of interest on $1 mn each year for 5 years to B. In return, B might pay floating rate of interest on $1 mn each year for 5 years.
Swap Basics
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The parties that agree to swap are known as counterparties. The cash flows that are made are generally tied to the value of debt instruments or to the value of foreign currencies.
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Therefore, the two basic swaps are interest rate swaps and currency swaps.
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ISDA provides standard documentation for swap agreements and keeps records of swap activity. Limitations
– One potential counterparty must find a counterparty that is willing to take the opposite side of a transaction. – A swap agreement cannot be altered or terminated early without the agreement of both parties. – Swap market has “Has No Such Guarantor”
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In currency swap, one party typically holds one currency and desires a different currency. The swap arises when one party provides a certain principal in one currency to its counterparty in exchange for an equivalent amount of a different currency.
Example
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Party C may have German marks and wants US dollars. Similarly, Party D may hold US dollars and wants marks. They can enter into a swap agreement which will involve four possibilities for making interest payments
Options available
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•
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•
Party C pays a fixed rate on dollars received, and Party D pays a fixed rate on marks received. Party C pays a floating rate on dollars received, and Party D pays a fixed rate on marks received. Party C pays a fixed rate on dollars received, and Party D pays a floating rate on marks received. Party C pays a floating rate on dollars received, and Party D pays a floating rate on marks received.
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The two parties exchange cash Parties make periodic interest payments to each other during the life of the swap agreement, which is to be made in full without netting At the termination, the parties again exchange the principal
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Spot Rate $1 = 2.5 DM US interest rate = 10% German interest rate = 8% Party C has 25 mn marks Party D has $10 mn Tenor of the swap = 7 years
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Known as Plain Vanilla Swap
Parties exchange principal at the outset of the swap, but one party pays fixed rate on the foreign currency it receives and the other party pays floating rate on the currency it receives.
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Spot Rate $1 = ¥ 120 Notional amount = $10,000,000 and ¥1,200,000,000 Tenor of the swap = 4 years Fixed interest rate on yen borrowing = 7% Interest rate on dollars = LIBOR Current LIBOR = 5%
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One firm may have better access to the capital market than another firm.
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A party who assists in completion of Swaps When strictly a facilitator without taking any financial position – SWAP Broker When transacted for its own account – Dealer Facilitates to find out a counterparty with the same specific need in terms of – Currency, Quantum, Time Horizon, willingness to transact at the time desired, acceptable credit rating etc.
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Serves as an information intermediary Number of firms in its client base Superior knowledge in finding suitable C/P Protecting the identity till the C/P are found Not a party to the SWAP Contract as such As the market has matured SD lost importance Swap Dealers perform informational role as well as stand ready to act as a counterparty
SWAP Transactions are facilitated by dealers who are ready to accept either side of transaction (eg. Pay Fixed or Receive Fixed) as a counter party ? Matched book Cash Flows on numerous Swaps (SWAP Book) on both sides leads to a small risk exposure on one side of the market ? Dealer serve as a facilitating agent and collect a fee for the service, if the transactions are performed properly, they incur little risk on one side of the market
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Principal Risks that a Swap Dealer faces in managing a Swap Book are
? Default Risk (when a C/P fails to perform) ? Basis Risk (generally incase of interest rate swaps) ? Mismatch risk (unable to quickly offset through another swap) ? Interest Rate Risk (if Floating Paying Party – then rising interest rates is a risk and vice-versa)
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Seasonal (Importer of woolen clothes) CIRCUS Swap (Combined Interest and Currency Swap)
Plain Vanilla Currency Swap Firm
Fixed German Marks LIBOR Plain Vanilla Interest Rate Swap Fixed US Dollars
C/P 1
Firm
C/P 2
LIBOR
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Swap transactions between two forward dates. Forward swaps can be used to take a view on interest rate differentials with a minimum exchange rate risk.
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Requirement of $ 1,000,000 after 12 months. Expect currency to appreciate after 6 months. Currency Rates:
? USD/INR Spot: 45.00/45.50 ? 6-months: 20/10 ? 12-months: 40/30
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Two swaps on Day 1:
? Buy USD Spot and sell 6 months forward ? Sell USD Spot and buy 12 months forward
Period
Spot
Rate
45.00/45. 50
6months
12months
20/10
40/30
• Planned cash flows are:
After 6 months USD INR - $ 1,000,000 Rs. 4,48,00,000 ($ 1,000,000 x Rs. 44.80) After 12 months $1,000,000 -Rs. 4,52,00,000 ($ 1,000,000 x Rs. 45.20)
• After 6 months the rates are:
– USD/INR Spot: 45.40/45.80 – 6-months: 30/50
Period
Spot
Rate
45.40/45. 80
6months
30/50
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Execute another swap to buy $ 1,000,000 spot and sell six months forward.
After 6 months from Day 1 USD INR $ 1,000,000 - Rs. 4,58,00,000 ($ outflow Rs. cash1,000,000 x at six 45.80) After 12 months from Day 1 - $1,000,000 Rs. 4,63,00,000 ($ 1,000,000 months: Rs. x Rs. 46.30)
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Net 10,00,000 Net cash inflow at twelve months: Rs. 1,00,000
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Buy a bond in one currency & simultaneously issue a bond in another currency Assume NP=50 million USD with tenor of 5 years with payments in Euro & receipts in USD USD/Euro (spot)=3,US interest rate=7% & Euro interest rate=6% Annual coupon payments
EUR 150 mn
USD 3.5 mn
USD 3.5 mn
USD 3.5 mn
USD 3.5 mn
USD 53.5 mn
Year
0
1
2
3
4
5
USD 50 mn
EUR 9 mn
EUR 9 mn
EUR 9 mn
EUR 9 mn
EUR 159 mn
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•
•
• •
Buy a bond in foreign currency & simultaneously issue a FRN in USD Issue a FRN for USD 20 million with tenor of 3 years at LIBOR Buy a Euro denominated bond trading at par with market value of ¥2.4 bn USD/Yen (spot)=120 Annual coupon payments of 5% with maturity of 5 years
USD 20 mn
¥ 120 mn
¥ 120 mn
¥ 120 mn
¥ 120 mn
¥ 2.52 bn
Year
0
1
2
3
4
5
¥2.4 bn
LIBOR *20 mn
LIBOR *20 mn
LIBOR *20 mn
LIBOR *20 mn
LIBOR *20 mn+ USD 20mn
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Assume 1 year interest rate in INR is 10% & in USD is 5% , USD/INR (spot)=40 As per theorem for zero arbitrage opportunity for unit currency: 1.05=(1.1*40)/F where F= 1 year forward USD/INR= 41.9047 If this condition doesn’t hold good, arbitrage opportunity exists If F>41.9047, invest in USD If F<41.9047, invest in INR Borrow in the currency where funds are cheaper & invest in currency where rates are higher
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• • • •
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Assume NP=USD 100 mn=EUR 250 mn USD payer promises a fixed rate of 8.5% EUR payer promises a fixed rate of 5.3% Term to maturity is 5 years Interest payable in year 1-5 is USD 8.5 mn & EUR 13.25 mn for the USD & EUR payer respectively USD/EUR forward rates for year 1-5 is constant at 1.5588 and hence can be viewed as a portfolio of off market foreign exchange transactions
USD 100 mn
EUR 13.25 mn 1 USD 8.5 mn
EUR 13.25 mn 2
EUR 13.25 mn 3
EUR 13.25 mn 4
EUR 263.25 mn 5 USD 108.5 mn
Year
0 EUR 250 mn
USD USD USD 8.5 mn 8.5 mn 8.5 mn Cash flows from the perspective of the USD payer.
USD 100 mn Year 0 USD 100 mn
USD 5.45 mn
USD 5.64 mn 2 USD 8.5 mn
USD 5.84 mn
USD 6.07 mn
USD 125.52 mn 5
1
USD 8.5 mn
3 USD 8.5 mn
4
USD 8.5 mn
USD 108.5 mn
Determined as per forward rates PV of all cash flows must be zero discounted at the USD zero coupon rates for the swap to be fairly priced
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Receive Fixed plain vanilla currency swap =USD payer fixed-for-fixed currency swap + Receive-fixed plain vanilla interest swap Pay Fixed plain vanilla currency swap = Forex payer fixed-for-fixed currency swap + Pay-fixed plain vanilla interest swap
doc_855732792.pptx
Describes the currency swaps in details.
?
?
A swap is an agreement between two or more parties to exchange a sequence of cash flows over a period in the future. Example: A agrees to pay a fixed rate of interest on $1 mn each year for 5 years to B. In return, B might pay floating rate of interest on $1 mn each year for 5 years.
Swap Basics
?
The parties that agree to swap are known as counterparties. The cash flows that are made are generally tied to the value of debt instruments or to the value of foreign currencies.
?
?
Therefore, the two basic swaps are interest rate swaps and currency swaps.
•
•
ISDA provides standard documentation for swap agreements and keeps records of swap activity. Limitations
– One potential counterparty must find a counterparty that is willing to take the opposite side of a transaction. – A swap agreement cannot be altered or terminated early without the agreement of both parties. – Swap market has “Has No Such Guarantor”
?
?
In currency swap, one party typically holds one currency and desires a different currency. The swap arises when one party provides a certain principal in one currency to its counterparty in exchange for an equivalent amount of a different currency.
Example
?
Party C may have German marks and wants US dollars. Similarly, Party D may hold US dollars and wants marks. They can enter into a swap agreement which will involve four possibilities for making interest payments
Options available
•
•
•
•
Party C pays a fixed rate on dollars received, and Party D pays a fixed rate on marks received. Party C pays a floating rate on dollars received, and Party D pays a fixed rate on marks received. Party C pays a fixed rate on dollars received, and Party D pays a floating rate on marks received. Party C pays a floating rate on dollars received, and Party D pays a floating rate on marks received.
?
?
?
The two parties exchange cash Parties make periodic interest payments to each other during the life of the swap agreement, which is to be made in full without netting At the termination, the parties again exchange the principal
?
? ?
?
? ?
Spot Rate $1 = 2.5 DM US interest rate = 10% German interest rate = 8% Party C has 25 mn marks Party D has $10 mn Tenor of the swap = 7 years
?
Known as Plain Vanilla Swap
Parties exchange principal at the outset of the swap, but one party pays fixed rate on the foreign currency it receives and the other party pays floating rate on the currency it receives.
?
?
?
? ? ? ?
Spot Rate $1 = ¥ 120 Notional amount = $10,000,000 and ¥1,200,000,000 Tenor of the swap = 4 years Fixed interest rate on yen borrowing = 7% Interest rate on dollars = LIBOR Current LIBOR = 5%
?
One firm may have better access to the capital market than another firm.
?
?
? ?
A party who assists in completion of Swaps When strictly a facilitator without taking any financial position – SWAP Broker When transacted for its own account – Dealer Facilitates to find out a counterparty with the same specific need in terms of – Currency, Quantum, Time Horizon, willingness to transact at the time desired, acceptable credit rating etc.
?
?
? ?
?
?
?
Serves as an information intermediary Number of firms in its client base Superior knowledge in finding suitable C/P Protecting the identity till the C/P are found Not a party to the SWAP Contract as such As the market has matured SD lost importance Swap Dealers perform informational role as well as stand ready to act as a counterparty
SWAP Transactions are facilitated by dealers who are ready to accept either side of transaction (eg. Pay Fixed or Receive Fixed) as a counter party ? Matched book Cash Flows on numerous Swaps (SWAP Book) on both sides leads to a small risk exposure on one side of the market ? Dealer serve as a facilitating agent and collect a fee for the service, if the transactions are performed properly, they incur little risk on one side of the market
?
?
Principal Risks that a Swap Dealer faces in managing a Swap Book are
? Default Risk (when a C/P fails to perform) ? Basis Risk (generally incase of interest rate swaps) ? Mismatch risk (unable to quickly offset through another swap) ? Interest Rate Risk (if Floating Paying Party – then rising interest rates is a risk and vice-versa)
?
?
Seasonal (Importer of woolen clothes) CIRCUS Swap (Combined Interest and Currency Swap)
Plain Vanilla Currency Swap Firm
Fixed German Marks LIBOR Plain Vanilla Interest Rate Swap Fixed US Dollars
C/P 1
Firm
C/P 2
LIBOR
?
Swap transactions between two forward dates. Forward swaps can be used to take a view on interest rate differentials with a minimum exchange rate risk.
?
?
? ?
Requirement of $ 1,000,000 after 12 months. Expect currency to appreciate after 6 months. Currency Rates:
? USD/INR Spot: 45.00/45.50 ? 6-months: 20/10 ? 12-months: 40/30
?
Two swaps on Day 1:
? Buy USD Spot and sell 6 months forward ? Sell USD Spot and buy 12 months forward
Period
Spot
Rate
45.00/45. 50
6months
12months
20/10
40/30
• Planned cash flows are:
After 6 months USD INR - $ 1,000,000 Rs. 4,48,00,000 ($ 1,000,000 x Rs. 44.80) After 12 months $1,000,000 -Rs. 4,52,00,000 ($ 1,000,000 x Rs. 45.20)
• After 6 months the rates are:
– USD/INR Spot: 45.40/45.80 – 6-months: 30/50
Period
Spot
Rate
45.40/45. 80
6months
30/50
?
Execute another swap to buy $ 1,000,000 spot and sell six months forward.
After 6 months from Day 1 USD INR $ 1,000,000 - Rs. 4,58,00,000 ($ outflow Rs. cash1,000,000 x at six 45.80) After 12 months from Day 1 - $1,000,000 Rs. 4,63,00,000 ($ 1,000,000 months: Rs. x Rs. 46.30)
?
?
Net 10,00,000 Net cash inflow at twelve months: Rs. 1,00,000
?
?
?
?
Buy a bond in one currency & simultaneously issue a bond in another currency Assume NP=50 million USD with tenor of 5 years with payments in Euro & receipts in USD USD/Euro (spot)=3,US interest rate=7% & Euro interest rate=6% Annual coupon payments
EUR 150 mn
USD 3.5 mn
USD 3.5 mn
USD 3.5 mn
USD 3.5 mn
USD 53.5 mn
Year
0
1
2
3
4
5
USD 50 mn
EUR 9 mn
EUR 9 mn
EUR 9 mn
EUR 9 mn
EUR 159 mn
•
•
•
• •
Buy a bond in foreign currency & simultaneously issue a FRN in USD Issue a FRN for USD 20 million with tenor of 3 years at LIBOR Buy a Euro denominated bond trading at par with market value of ¥2.4 bn USD/Yen (spot)=120 Annual coupon payments of 5% with maturity of 5 years
USD 20 mn
¥ 120 mn
¥ 120 mn
¥ 120 mn
¥ 120 mn
¥ 2.52 bn
Year
0
1
2
3
4
5
¥2.4 bn
LIBOR *20 mn
LIBOR *20 mn
LIBOR *20 mn
LIBOR *20 mn
LIBOR *20 mn+ USD 20mn
•
• • • • • •
Assume 1 year interest rate in INR is 10% & in USD is 5% , USD/INR (spot)=40 As per theorem for zero arbitrage opportunity for unit currency: 1.05=(1.1*40)/F where F= 1 year forward USD/INR= 41.9047 If this condition doesn’t hold good, arbitrage opportunity exists If F>41.9047, invest in USD If F<41.9047, invest in INR Borrow in the currency where funds are cheaper & invest in currency where rates are higher
•
• • • •
•
Assume NP=USD 100 mn=EUR 250 mn USD payer promises a fixed rate of 8.5% EUR payer promises a fixed rate of 5.3% Term to maturity is 5 years Interest payable in year 1-5 is USD 8.5 mn & EUR 13.25 mn for the USD & EUR payer respectively USD/EUR forward rates for year 1-5 is constant at 1.5588 and hence can be viewed as a portfolio of off market foreign exchange transactions
USD 100 mn
EUR 13.25 mn 1 USD 8.5 mn
EUR 13.25 mn 2
EUR 13.25 mn 3
EUR 13.25 mn 4
EUR 263.25 mn 5 USD 108.5 mn
Year
0 EUR 250 mn
USD USD USD 8.5 mn 8.5 mn 8.5 mn Cash flows from the perspective of the USD payer.
USD 100 mn Year 0 USD 100 mn
USD 5.45 mn
USD 5.64 mn 2 USD 8.5 mn
USD 5.84 mn
USD 6.07 mn
USD 125.52 mn 5
1
USD 8.5 mn
3 USD 8.5 mn
4
USD 8.5 mn
USD 108.5 mn
Determined as per forward rates PV of all cash flows must be zero discounted at the USD zero coupon rates for the swap to be fairly priced
?
?
Receive Fixed plain vanilla currency swap =USD payer fixed-for-fixed currency swap + Receive-fixed plain vanilla interest swap Pay Fixed plain vanilla currency swap = Forex payer fixed-for-fixed currency swap + Pay-fixed plain vanilla interest swap
doc_855732792.pptx