Description
Intro to Swap
SWAPS Introduction What is Swap? Exchanging things is called Swap. It can be anything you may be swapping your pen, mobile etc., with your friends. History of Swap? In ancient medieval period there was no currency or money. So people use to exchange things i.e. Farmer exchanging Rice with Cobbler for Shoes, this was called as Barter System. Swap has evolved from Barter system. Define - SWAP
A Swap is an agreement between two parties to Exchange Cash Flows based on underlying asset.
Demand & Supply Two Counterparties Mutual Agreement Rate of Interest Notional Amount Trade Date/Effective Date Settlement Date/Payment Date/ Maturity. Refix date Accrual Date & End of Accrual Date Coupon Interest
FEES FOR SWAP Brokerage / Consultancy Fee Loading Fee / Entry Fee Admin Fee Assignment Fee Exit Fee/Termination Fee
Types of Swaps:
Interest Rate Swap Cross Currency Swap Circus Swap
Callable Swap Putable Swap Credit Default Swap Equity Swap Equity Default Swap Commodity Swap Swaption Calculation of Coupon Interest Rate SWAP Definitions In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. Fixed Interest rate to Floating Interest rate Floating Interest rate to Fixed Interest rate Size of the Swap Market In 2001 the notational principal of: Interest rate swaps was $58,897,000,000. Currency swaps was $3,942,000,000 The most popular currencies are: U.S. dollar Japanese yen Euro Swiss franc British pound sterling
Advantages of Interest Rate Swap Swapping from fixed to floating may save issuer money. Protects against adverse movements in interest rates. No premium is paid to enter into a swap. No principal amount is exchanged. Cross Currency Swap Definitions In a Cross currency swap, two counterparties agree to a contractual arrangement wherein they agree to exchange their currencies. E.g. USD being exchanged with GBP AUD being exchanged with USD Example of Cross Currency Swap Circus Swap
In a Circus Swap ,two counterparties agree to a contractual arrangement wherein they agree to exchange their Notional Amount and Interest Rate.
Callable Swap:When a counterparty is receiving Fixed rate of Interest
Example of Circus Swap Callable & Putable Swap
Putable Swap:When a Counterparty is paying Fixed rate of Interest
Credit Default Swap (CDS) CDS – An Overview A credit default swap is an agreement by one party to accept a premium at regular intervals in return for making a larger payment if a specific company defaults, goes bankrupt, or suffers a negative credit event. It is an agreement between a protection buyer and a protection seller whereby the buyer pays a periodic fee in return for a contingent payment by the seller upon a credit event (such as a certain default) happening in the reference entity. A CDS is often used like an insurance policy, or hedge for the holder of a corporate bond. In a CDS the buyer of protection ("Buyer") typically pays a periodic fee in exchange for the seller of protection ("Seller") contracting to make a payment.
CDS – PROCESS FLOW CDS- An Example A pension fund owns 10 Mn Euros worth of a 5 year bond issued by X Corp. To manage the risk, they buy a CDS from Derivative Bank on a nominal of 10 million euros which trades at 200 basis points. The pension fund pays a premium of 2% of 10 million (200,000 euros per annum) as quarterly payments Derivative Bank. In case of no default PF receives 10 Mn Euros on completion of quarterly payments for 5 years. If X Corp. defaults on its debt 3 years into the CDS contract then the premium payments would stop and Derivative Bank would ensure that the pension fund is refunded for its loss of 10 million euros.
Types of Credit Events: Bankruptcy by the Reference Credit Restructuring
Credit events
Failure to Pay a pre-agreed asset or assets ("Reference Obligation") Settlement of CDS Cash Settlement - Reference obligation minus its post-default trading value as determined by a pre-agreed dealer poll mechanism. Physical Delivery - Transfer of a pre-agreed asset or assets ("Deliverable Obligation") to the seller in exchange for a payment equal to the notional of the contract.
Equity SWAPS - An Overview Equity swap is a transaction between two parties in which each party agrees to make a series of payments to the other, with at least one set of payments determined by the return on a stock or stock index. The return is calculated based on a pre-determined notional principal and may or may not include dividends. The payments occur on regularly scheduled dates over a specified period of time. Equity swaps are offered by derivatives dealers in much the same manner as their offerings of interest rate, currency, and commodity swaps. Dealers typically charge a bid-ask spread and hedge any risk they have assumed by transacting in the underlying stock or index or another derivative on the stock or index. Type of Equity SWAPS There are three main types of equity swaps: An Equity Swap with the Equity Return An Equity Swap with the Equity Return paid against a Fixed Rate paid against a Floating Rate
EQUITY SWAP
An Equity Swap with the Equity Return paid against another Equity Return Example - Equity Return Paid Against a Fixed Rate
On December 15 of a given year, Dynamic Money Management enters into a swap to pay a fixed rate of 5% with payment terms of 30/360 and receive the return on the S&P 500 with payments to occur on March 15, June 15, September 15, and December 15 for one year. Payments will be calculated on a notional principal of $20 million. The counterparty is the swaps dealer Total Swaps, Inc. The S&P 500 is at 1105.15 on the day the swap is initiated. Example - Equity Return Paid Against a Fixed Rate On each settlement date, the return on the S&P 500 is calculated and applied to the $20 million notional principal to determine the payment to be received. The fixed payment is based on 5% and an adjustment factor of 90/360 applied to $20 million. As is customary in swaps, the difference in the two payments is determined and only the net, as indicated in the last column, is paid. Example - Equity Return Paid Against a Fixed Rate Example - Equity Return paid against a Floating Rate On December 15 of a given year, Dynamic Money Management enters into a swap to pay a floating rate of 90-day LIBOR with payment terms of 30/360 and receive the return on the S&P 500 with payments to occur on March 15, June 15, September 15, and December 15 for one year. Payments will be calculated on a notional principal of $20 million. The counterparty is the swaps dealer Total Swaps, Inc. The S&P 500 is at 1105.15 and 90day LIBOR is 4.75% on the day the swap is initiated. Example - Equity Return paid against a Floating Rate Example - Equity Return Paid Against Another Equity Return On December 15 of a given year Dynamic Money Management enters into a swap to pay the return on the NASDAQ Composite index and receive the return on the S&P 500 with payments to occur on March 15, June 15, September 15, and December 15 for one year. Payments will be calculated on a notional principal of $20 million. The counterparty is the swaps dealer Total Swaps, Inc. The S&P 500 is at 1105.15 and NASDAQ is at 1705.51. Example - Equity Return Paid Against Another Equity Return
Definition A swap where exchanged cash flows are dependent on the price of an underlying commodity. This is usually used to hedge against the price of a commodity. Types of commodity swaps Fixed-floating Fixed-floating swaps are just like the fixed-floating swaps in the interest rate swap market with the exception that both indices are commodity based indices. Commodity-for-interest Commodity-for-interest swaps are similar to the equity swap in which a total return on the commodity in question is exchanged for some money market rate. Example for Commodity Swap A large US refinery wants to launch a program that would allow the customers to lock in the price they pay the Refinery for a pre-specified quantity of oil products during the coming year. To protect itself from financial loss arising out of market fluctuation, the refinery enters into a one-year Fixed for Floating Swap with Sempra Energy Trading ® Corp. ("SET") to hedge 100,000 barrels of fuel oil per month at a fixed price of $22.00/bbl. Under the swap agreement, the Refinery makes a monthly fixed payment to SET equal to $22.00/barrel. SET, in exchange, makes a floating payment to the Refinery based on the arithmetic average of the daily settlement prices of the prompt NYMEX crude oil futures contract for each of the Pricing Periods for which the Reference Price is quoted. Example-cont. During the life of the swap, The Refinery continues to purchase crude it needs from its regular suppliers, which may include SET, at index prices. On each Settlement Date, the Refinery and SET exchange payments equal to the difference between the index price and the fixed $22.00/bbl swap price. The floating payment received from SET should closely approximate the payment the Refinery made to its suppliers for physical purchase of crude oil. The net result is that by combining the swap with its current physical crude oil contract, the End User pays $22.00/bbl for its crude oil purchase
COMMODITY SWAP Commodity Swap
Equity Default Swap Equity Default Swap Equity default swap is a vehicle for one party to provide another protection against some possible event relating to some company’s stock. The event being protected against is called the trigger event or knock-in event. For example, the equity default swap might provide protection against a 70% decline in the stock price from its value when the equity default swap was initiated.
On the occurrence of trigger event , the equity default swap terminates and the protection seller makes a specified payment to the protection buyer. Equity Default Swap - cont. Equity default swap are quoted as spreads over Libor. Equity default swap truly behaves as a form of hybrid between a credit derivative and an equity derivative. An equity default swap is more likely to be triggered than a credit default swap, they generally trade at higher spreads than credit default swap. Advantages of Equity Default Swap Trigger events are more easy to define since there is less ambiguity over the stock price movement. Recovery rates are fixed for equity default swaps. Equity default swaps can be structured with various trigger levels loosely corresponding to various degrees of corporate impairment.
Swaption Swaption A swaption is a financial instrument granting the owner an option to enter swap agreement. agreement. To specify a swaption, there must be three basic parameters: The expiration date of the option. The fixed rate on the underlying swap. The tenor (time to maturity at exercise of the option) of the swap. There are two types of settlement possible for a swaption contract. Physical settlement, , in which case an option is actually entered into upon exercise. Cash settlement, in which case the market value of the underlying swap changes hands upon exercise.
Functioning of a Swaption The purchaser of the swaption pays an up front premium. The fixed rate specified for the swaption plays a role very similar to that of a strike price. The holder of the swaption will decide whether or not to exercise based on whether swap rates rise above or fall below that fixed rate. For this reason, the fixed rate is often called the strike rate. If the swaption is exercised, there is no strike price to pay. The two parties simply put on the prescribe swap Purpose of Swaption The primary purposes for entering into a swaption are: to hedge call or put positions in bond issues. to change the tenor of an underlying swap. to assist in the engineering of structured notes. to change the payoff profile of the firm. Types of Swaption American Swaption, in which the owner is allowed to enter the swap on any day that falls , Swaption within a range of two dates. Bermudan Swaption, in which the owner is allowed to enter the swap on a sequence of dates. Swaption, European Swaption, in which the owner is allowed to enter the swap on one specified date Thank You
doc_263788572.doc
Intro to Swap
SWAPS Introduction What is Swap? Exchanging things is called Swap. It can be anything you may be swapping your pen, mobile etc., with your friends. History of Swap? In ancient medieval period there was no currency or money. So people use to exchange things i.e. Farmer exchanging Rice with Cobbler for Shoes, this was called as Barter System. Swap has evolved from Barter system. Define - SWAP
A Swap is an agreement between two parties to Exchange Cash Flows based on underlying asset.
Demand & Supply Two Counterparties Mutual Agreement Rate of Interest Notional Amount Trade Date/Effective Date Settlement Date/Payment Date/ Maturity. Refix date Accrual Date & End of Accrual Date Coupon Interest
FEES FOR SWAP Brokerage / Consultancy Fee Loading Fee / Entry Fee Admin Fee Assignment Fee Exit Fee/Termination Fee
Types of Swaps:
Interest Rate Swap Cross Currency Swap Circus Swap
Callable Swap Putable Swap Credit Default Swap Equity Swap Equity Default Swap Commodity Swap Swaption Calculation of Coupon Interest Rate SWAP Definitions In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. Fixed Interest rate to Floating Interest rate Floating Interest rate to Fixed Interest rate Size of the Swap Market In 2001 the notational principal of: Interest rate swaps was $58,897,000,000. Currency swaps was $3,942,000,000 The most popular currencies are: U.S. dollar Japanese yen Euro Swiss franc British pound sterling
Advantages of Interest Rate Swap Swapping from fixed to floating may save issuer money. Protects against adverse movements in interest rates. No premium is paid to enter into a swap. No principal amount is exchanged. Cross Currency Swap Definitions In a Cross currency swap, two counterparties agree to a contractual arrangement wherein they agree to exchange their currencies. E.g. USD being exchanged with GBP AUD being exchanged with USD Example of Cross Currency Swap Circus Swap
In a Circus Swap ,two counterparties agree to a contractual arrangement wherein they agree to exchange their Notional Amount and Interest Rate.
Callable Swap:When a counterparty is receiving Fixed rate of Interest
Example of Circus Swap Callable & Putable Swap
Putable Swap:When a Counterparty is paying Fixed rate of Interest
Credit Default Swap (CDS) CDS – An Overview A credit default swap is an agreement by one party to accept a premium at regular intervals in return for making a larger payment if a specific company defaults, goes bankrupt, or suffers a negative credit event. It is an agreement between a protection buyer and a protection seller whereby the buyer pays a periodic fee in return for a contingent payment by the seller upon a credit event (such as a certain default) happening in the reference entity. A CDS is often used like an insurance policy, or hedge for the holder of a corporate bond. In a CDS the buyer of protection ("Buyer") typically pays a periodic fee in exchange for the seller of protection ("Seller") contracting to make a payment.
CDS – PROCESS FLOW CDS- An Example A pension fund owns 10 Mn Euros worth of a 5 year bond issued by X Corp. To manage the risk, they buy a CDS from Derivative Bank on a nominal of 10 million euros which trades at 200 basis points. The pension fund pays a premium of 2% of 10 million (200,000 euros per annum) as quarterly payments Derivative Bank. In case of no default PF receives 10 Mn Euros on completion of quarterly payments for 5 years. If X Corp. defaults on its debt 3 years into the CDS contract then the premium payments would stop and Derivative Bank would ensure that the pension fund is refunded for its loss of 10 million euros.
Types of Credit Events: Bankruptcy by the Reference Credit Restructuring
Credit events
Failure to Pay a pre-agreed asset or assets ("Reference Obligation") Settlement of CDS Cash Settlement - Reference obligation minus its post-default trading value as determined by a pre-agreed dealer poll mechanism. Physical Delivery - Transfer of a pre-agreed asset or assets ("Deliverable Obligation") to the seller in exchange for a payment equal to the notional of the contract.
Equity SWAPS - An Overview Equity swap is a transaction between two parties in which each party agrees to make a series of payments to the other, with at least one set of payments determined by the return on a stock or stock index. The return is calculated based on a pre-determined notional principal and may or may not include dividends. The payments occur on regularly scheduled dates over a specified period of time. Equity swaps are offered by derivatives dealers in much the same manner as their offerings of interest rate, currency, and commodity swaps. Dealers typically charge a bid-ask spread and hedge any risk they have assumed by transacting in the underlying stock or index or another derivative on the stock or index. Type of Equity SWAPS There are three main types of equity swaps: An Equity Swap with the Equity Return An Equity Swap with the Equity Return paid against a Fixed Rate paid against a Floating Rate
EQUITY SWAP
An Equity Swap with the Equity Return paid against another Equity Return Example - Equity Return Paid Against a Fixed Rate
On December 15 of a given year, Dynamic Money Management enters into a swap to pay a fixed rate of 5% with payment terms of 30/360 and receive the return on the S&P 500 with payments to occur on March 15, June 15, September 15, and December 15 for one year. Payments will be calculated on a notional principal of $20 million. The counterparty is the swaps dealer Total Swaps, Inc. The S&P 500 is at 1105.15 on the day the swap is initiated. Example - Equity Return Paid Against a Fixed Rate On each settlement date, the return on the S&P 500 is calculated and applied to the $20 million notional principal to determine the payment to be received. The fixed payment is based on 5% and an adjustment factor of 90/360 applied to $20 million. As is customary in swaps, the difference in the two payments is determined and only the net, as indicated in the last column, is paid. Example - Equity Return Paid Against a Fixed Rate Example - Equity Return paid against a Floating Rate On December 15 of a given year, Dynamic Money Management enters into a swap to pay a floating rate of 90-day LIBOR with payment terms of 30/360 and receive the return on the S&P 500 with payments to occur on March 15, June 15, September 15, and December 15 for one year. Payments will be calculated on a notional principal of $20 million. The counterparty is the swaps dealer Total Swaps, Inc. The S&P 500 is at 1105.15 and 90day LIBOR is 4.75% on the day the swap is initiated. Example - Equity Return paid against a Floating Rate Example - Equity Return Paid Against Another Equity Return On December 15 of a given year Dynamic Money Management enters into a swap to pay the return on the NASDAQ Composite index and receive the return on the S&P 500 with payments to occur on March 15, June 15, September 15, and December 15 for one year. Payments will be calculated on a notional principal of $20 million. The counterparty is the swaps dealer Total Swaps, Inc. The S&P 500 is at 1105.15 and NASDAQ is at 1705.51. Example - Equity Return Paid Against Another Equity Return
Definition A swap where exchanged cash flows are dependent on the price of an underlying commodity. This is usually used to hedge against the price of a commodity. Types of commodity swaps Fixed-floating Fixed-floating swaps are just like the fixed-floating swaps in the interest rate swap market with the exception that both indices are commodity based indices. Commodity-for-interest Commodity-for-interest swaps are similar to the equity swap in which a total return on the commodity in question is exchanged for some money market rate. Example for Commodity Swap A large US refinery wants to launch a program that would allow the customers to lock in the price they pay the Refinery for a pre-specified quantity of oil products during the coming year. To protect itself from financial loss arising out of market fluctuation, the refinery enters into a one-year Fixed for Floating Swap with Sempra Energy Trading ® Corp. ("SET") to hedge 100,000 barrels of fuel oil per month at a fixed price of $22.00/bbl. Under the swap agreement, the Refinery makes a monthly fixed payment to SET equal to $22.00/barrel. SET, in exchange, makes a floating payment to the Refinery based on the arithmetic average of the daily settlement prices of the prompt NYMEX crude oil futures contract for each of the Pricing Periods for which the Reference Price is quoted. Example-cont. During the life of the swap, The Refinery continues to purchase crude it needs from its regular suppliers, which may include SET, at index prices. On each Settlement Date, the Refinery and SET exchange payments equal to the difference between the index price and the fixed $22.00/bbl swap price. The floating payment received from SET should closely approximate the payment the Refinery made to its suppliers for physical purchase of crude oil. The net result is that by combining the swap with its current physical crude oil contract, the End User pays $22.00/bbl for its crude oil purchase
COMMODITY SWAP Commodity Swap
Equity Default Swap Equity Default Swap Equity default swap is a vehicle for one party to provide another protection against some possible event relating to some company’s stock. The event being protected against is called the trigger event or knock-in event. For example, the equity default swap might provide protection against a 70% decline in the stock price from its value when the equity default swap was initiated.
On the occurrence of trigger event , the equity default swap terminates and the protection seller makes a specified payment to the protection buyer. Equity Default Swap - cont. Equity default swap are quoted as spreads over Libor. Equity default swap truly behaves as a form of hybrid between a credit derivative and an equity derivative. An equity default swap is more likely to be triggered than a credit default swap, they generally trade at higher spreads than credit default swap. Advantages of Equity Default Swap Trigger events are more easy to define since there is less ambiguity over the stock price movement. Recovery rates are fixed for equity default swaps. Equity default swaps can be structured with various trigger levels loosely corresponding to various degrees of corporate impairment.
Swaption Swaption A swaption is a financial instrument granting the owner an option to enter swap agreement. agreement. To specify a swaption, there must be three basic parameters: The expiration date of the option. The fixed rate on the underlying swap. The tenor (time to maturity at exercise of the option) of the swap. There are two types of settlement possible for a swaption contract. Physical settlement, , in which case an option is actually entered into upon exercise. Cash settlement, in which case the market value of the underlying swap changes hands upon exercise.
Functioning of a Swaption The purchaser of the swaption pays an up front premium. The fixed rate specified for the swaption plays a role very similar to that of a strike price. The holder of the swaption will decide whether or not to exercise based on whether swap rates rise above or fall below that fixed rate. For this reason, the fixed rate is often called the strike rate. If the swaption is exercised, there is no strike price to pay. The two parties simply put on the prescribe swap Purpose of Swaption The primary purposes for entering into a swaption are: to hedge call or put positions in bond issues. to change the tenor of an underlying swap. to assist in the engineering of structured notes. to change the payoff profile of the firm. Types of Swaption American Swaption, in which the owner is allowed to enter the swap on any day that falls , Swaption within a range of two dates. Bermudan Swaption, in which the owner is allowed to enter the swap on a sequence of dates. Swaption, European Swaption, in which the owner is allowed to enter the swap on one specified date Thank You
doc_263788572.doc