There are four major components of a swap price.
• Benchmark price
• Liquidity (availability of counter parties to offset the swap).
• Transaction cost
• Credit risk
Swap rates are based on a series of benchmark instruments.
They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis.
In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP rates and PLR rates.
Liquidity, which is function of supply and demand, plays an important role in swaps pricing. This is also affected by the swap duration. It may be difficult to have counter parties for long duration swaps, specially so in India Transaction costs include the cost of hedging a swap.
Say in case of a bank, which has a floating obligation of 91 day T. Bill. Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must obtain funds.
The transaction cost would thus involve such a difference.
Yield on 91 day T. Bill - 9.5%
Cost of fund (e.g.- Repo rate) – 10%
The transaction cost in this case would involve 0.5%
Credit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated.
Say for e.g. it would be 0.5% for an AAA rating.
• Benchmark price
• Liquidity (availability of counter parties to offset the swap).
• Transaction cost
• Credit risk
Swap rates are based on a series of benchmark instruments.
They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis.
In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP rates and PLR rates.
Liquidity, which is function of supply and demand, plays an important role in swaps pricing. This is also affected by the swap duration. It may be difficult to have counter parties for long duration swaps, specially so in India Transaction costs include the cost of hedging a swap.
Say in case of a bank, which has a floating obligation of 91 day T. Bill. Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must obtain funds.
The transaction cost would thus involve such a difference.
Yield on 91 day T. Bill - 9.5%
Cost of fund (e.g.- Repo rate) – 10%
The transaction cost in this case would involve 0.5%
Credit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated.
Say for e.g. it would be 0.5% for an AAA rating.