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Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated)

directly between two parties, without going through an exchange or other intermediary. Products
such as swaps, forward rate agreements, exotic options and other exotic derivatives are
almost always traded in this way.

Definition of swaps market. A market in which a borrower with one type of loan exchanges it
with another borrower with a different type of loan. Each borrower is looking for an advantage
that the original loan did not have, for example that the loan is in a particular currency, has a
particular interest rate etc.

Swap
Exchange of one type of asset, cash flow, investment, liability, or payment for another. Common
types of swap include: (1) Currency swap: simultaneous buying and selling of a currency to
convert debt principal from the lender's currency to the debtor's currency. (2) Debt swap:
exchange of a loan (usually to a third world country) between banks. (3) Debt to equity swap:
exchange of a foreign debt (usually to a Third World country) for a stake in the debtor country's
national enterprises (such as power or water utilities). (4) Debt to debt swap: exchange of an
existing liability into a new loan, usually with an extended payback period. (5) Interest rate
swap: exchange of periodic interest payments between two parties (called counter parties)
as means of exchanging future cash flows.

Swap
An arrangement in which two entities lend to each other on different terms, e.g., in different cur
rencies, and/or atdifferent interest rates, fixed or floating.
swap
the bilateral (and multilateral) exchange of a product, business asset, interest rate on a financial
debt, orcurrency for another product, business asset, interest rate on a financial debt, or currency,
respectively;
a. product swaps: individual A offers potatoes to individual B in exchange for a bicycle. See
BARTER;
b. business asset swaps: chemical company A offers its ethylene division to chemical comp
any B in exchange for B'spaint division. This enables both companies to divest (see DIV

ESTMENT) parts of their business they no longer wishto retain while simultaneously ent
ering, or strengthening their position in, another product area;
c. INTEREST-RATE swaps on financial debts: a company that has a variable-rate debt, fo
r example, may anticipatethat interest rates will rise; another company with fixed-rate deb
t may anticipate that interest rates will fall. It thereforecontracts to make variable interestrate payments to the first company and in exchange is paid interest at a fixedrate. Interestrate swaps may be undertaken simultaneously on a variety of debt instruments thereby en
ablingcorporate treasurers to lower the company's total interest payments;
d. currency swap: the simultaneous buying and selling of foreign currencies. This can take t
wo main forms: aspot/forward swap (the simultaneous purchase or sale of a currency in t
he SPOT
MARKET coupled with an offsettingsale or purchase of the same currency in the FOR
WARD
MARKET); or a forward/forward swap (a pair of forwardcurrency contracts involving a
forward purchase and sale of a particular currency which mature at different futuredates).

Spot Transactions:
A spot transaction requires almost immediate delivery of foreign exchange.
In the interbank market, a spot transaction involves the purchase of foreign exchange
with delivery and payment between banks to take place, normally, on the second
following business day.
The date of settlement is referred to as the "value date."
Spot transactions are the most important single type of transaction (43 % of all
transactions).
Outright Forward Transactions:
A forward transaction requires delivery at a future value date of a specified amount of
one currency for a specified amount of another currency.
The exchange rate to prevail at the value date is established at the time of the agreement,
but payment and delivery are not required until maturity.
Forward exchange rates are normally quoted for value dates of one, two, three, six, and
twelve months. Actual contracts can be arranged for other lengths.
Outright forward transactions only account for about 9 % of all foreign exchange
transactions.
Swap Transactions:
A swap transaction involves the simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates.
The most common type of swap is a spot against forward, where the dealer buys a
currency in the spot market and simultaneously sells the same amount back to the same
back in the forward market. Since this agreement is executed as a single transaction, the

dealer incurs no unexpected foreign exchange risk.


Swap transactions account for about 48 % of all foreign exchange transactions.
A cross rate is an exchange rate between two currencies, calculated from their
common relationship with a third currency.

Currency Swaps
A currency swap involves exchanging principal and
interest payments in one currency for principal and
interest payments in another currency.
It requires the principal to be specified in each of the two
currencies.
Usually, the principal amounts are exchanged at the
beginning and at the end of the life of the swap.
The principal values are initially equivalent (using the
exchange rate) so that the swap is worth zero at inception.
We will only cover fixed-for-fixed currency swaps.
Currency Swaps
Just like interest rate swaps, currency swaps can
be used to transform loans and assets.
Loans: Transform borrowings in one currency to
borrowings in another currency.
Assets: Transform assets denominated in one
currency to assets in another currency.
Why should anyone use swaps?
Comparative Advantage. Currency Swaps
Just like interest rate swaps, currency swaps can
be used to transform loans and assets.
Loans: Transform borrowings in one currency to
borrowings in another currency.
Assets: Transform assets denominated in one
currency to assets in another currency.
Why should anyone use swaps?
Comparative Advantage.

Currency swaps can be divided into three categories: (a) fixed-to-fixed currency swap,
(b) floating-to-floating currency swap, and (c) fixed-to-floating currency swap.
A fixed-to-fixed currency swap is an agreement between two parties who exchange future
financial flows denominated in two different currencies. A currency swap can be
understood as a combination of simultaneous spot sale of a currency and a forward
purchase of the same amounts of currency. This double operation does not involve
currency risk. In the beginning of exchange contract, counterparties exchange specific
amount of two currencies. Subsequently, they settle interest according to an agreed
arrangement. During the life of swap contract, each party pays the other the interest
streams and finally they reimburse each other the principal of the swap. A simple
currency swap enables the substitution of one debt denominated in one currency at a
fixed rate to a debt denominated in another currency also at a fixed rate. It enables both
parties to draw benefit from the differences of interest rates existing on segmented
markets. A similar operation is done with regard to floating-to-floating rate swap.
A fixed-to-floating currency coupon swap is an agreement between two parties by which
they agree to exchange financial flows denominated in two different currencies with
different type of interest rates, one fixed and other floating. Thus, a currency coupon
swap enables borrowers (or lenders) to borrow (or lend) in one currency and exchange a
structure of interest rate against anotherfixed rate against variable rate and vice versa.
The exchange can be either of interest coupons only or of interest coupons as well as principal.
For example, one may exchange US dollars at fixed rate for French francs at
variable rate. These types of swaps are used quite frequently.

Participants in Swap Deals


Participants in swap markets are :
(a) financial institutions, (b) big enterprises, and (c) international organisations and
public sector institutions.
a) Financial institutions play a very important role in swap
operations. They influence, to a very great extent, the structure of operations and price of
swaps. Currency swaps are useful to financial institutions as they enable them to make
loans and accept deposits in the currency of their customers' choice. A financial
institution may participate in the swap deal either as a broker, a counterparty or an
intermediary.
When the financial institution acts as a broker only it is not a counterparty in the deal. It
should search for counterparties, facilitate negotiations, while preserving the anonymity
of counteiparties.
In the role of a counterparty, the financial institution incurs various riskscredit risk,
market risk and delivery risk. When the bank or financial institution is a counterparty to a
swap, it tries to arrange another swap having symmetrical features against another
company so as to balance its flows and reduce its own risk. Thus, if it has entered into a
Dollar-Euro fixed-to-fixed swap with a German company, it will try to find an American
company that would like a Euro-Dollar fixed-to-fixed swap involving the same amount

and for the same duration.


As an intermediary, the financial institution or the bank plays the role of a counterparty as
well as a broker at the same time. When the bank is a counterparty or an intermediary, it
is required to make quite complex arrangements m terms of several counterparties so as
to reduce its own risks.
Margins on swaps have diminished. They are lower even for currencies that are highly
traded. Depending on the currencies involved in a swap, a bank may gain 5 to 12 basis
points.
b) The second category of participants are enterprises. They are mostly multinationals, but
there may also be big and medium enterprises with good ratings. French Public
enterprises such as SNCF (French Railways) and EDF (French Electricity Company) take
recourse to swap markets in order to obtain more favourable interest rates. For example,
in May 1994, SNCF issued bonds worth 150 billion Italian lira on international capital
market which it exchanged with an American enteipnse for French francs through a swap
contract. Currency swaps involve a long position in one bond, combined with a short
position in another bond. They may also be considered as portfolio of forward contracts.
Enterprises use them when they have excess in one currency and shortage in another.
Sometimes, subsidized loans available for promoting exports may be swapped for a
desired foreign currency.
c) other institutions such as World Bank, and nation states also often take recourse
to currency swaps and currency coupon swaps.
Important Features of Swap Contracts
Minimum size of a swap contract is of the order of 5 million US dollar or its equivalent in
other currencies. But there are swaps of as large a size as 300 million US dollar, specially
in the case of Eurobonds. The US dollar is the most sought after currency in swap deals.
The dollar-yen swaps represent 25 per cent of the total while dollar-deutschemark
account for 20 per cent of the total. The swaps involving Euro are also likely to be widely
prevalent m European countries.
Life of a swap is between two and ten years. As regards the rate of interest of the
swapped currencies, the choice depends on the anticipation of enterprises. Interest
payments are made on annual or semi-annual basis.
Process of Swap Deals
If there are two enterprises which have symmetrical requirement of capital, in two
different currencies, a swap is possible.
Pricing a Currency Swap
As is clear from its definition, a swap is equivalent to borrowing and lending
simultaneously. So the value (or price) of a swap should be equal to the difference
between the present values of all inflows and all outflows. Pricing problem of a swap is
essentially to find out as to what rate should be quoted so that the two series of cashflows
have equal present value. For example, a bank is willing to swap 10 per cent fixed on
French franc with 8 per cent fixed on an equivalent US dollar principal for 3 years. This
means that the present value of franc payments at 10 per cent is equal to the present value
of the dollar payments at 8 per cent, both expressed in a common currency.
Reasons for Currency Swap Contracts
At any given point of time, there are investors and borrowers who would like to acquire
new assets/liabilities to which they may not have direct access or to which their access

may be costly. For example, a company may retire its foreign currency loan prematurely
by swapping it with home currency loan. The same can also be achieved by direct access
to market and by paying penalty for premature payment. A swap contract makes it
possible at a lower cost. Some of the significant reasons for entering into swap contracts
are given below.
Hedging Exchange Risk
Swapping one currency liability with another is a way of eliminating exchange rate risk.
For example, if a company (in UK) expects certain inflows of deutschemarks, it can swap
a sterling liability into deutschemark liability.

6.4. Swaps
A swap is an agreement whereby two parties (called counterparties) agree to exchange
periodic payments. The cash amount of the payments exchanged is based on some
predetermined principal amount, which is called the notional principal amount or simply
notional amount. The cash amount each counterparty pays to the other is the agreed-upon
periodic rate times the notional amount. The only cash that is exchanged between the
parties are the agreed-upon payments, not the notional amount.
A swap is an over-the-counter (OTC) contract. Hence, the counterparties to a swap are
exposed to counterparty risk.
Swap can be decomposed into a package of derivative instruments, e.g. a package of
forward contracts. However, its maturity can be longer than that of typical forward and
futures contracts, it is negotiated separately, can have quite high liquidity (larger than
many forward contracts, particularly long-dated (i.e., long-term) forward contracts).
The types of swaps typically used by non-finance corporations are:
interest rate swaps,
currency swaps,
commodity swaps, and
credit default swaps.
Interest rate swap is a contract in which the counterparties swap payments in the same
currency based on an interest rate. For example, one of the counterparties can pay a fixed
interest rate and the other party a floating interest rate. The floating interest rate is
commonly referred to as the reference rate.
Currency swap is a contract, in which two parties agree to swap payments based on
different currencies.
Commodity swap is a contract, according to which the exchange of payments by the
counterparties is based on the value of a particular physical commodity. Physical
commodities include precious metals, base metals, natural gas, crude oil, food.
A credit default swap (CDS) is an OTC derivative that permits the buying and selling of
credit protection against particular types of events that can adversely affect the credit
quality of a bond such as the default of the borrower.
Although it is referred to as a swap, it does not have the general characteristics of a
typical swap. There are two parties in the CDS contract: the credit protection buyer and
credit protection seller. Over the life of the CDS, the protection buyer agrees to pay the

protection seller a payment at specified dates to insure against the impairment of the debt
of a reference entity due to a credit-related event. The reference entity is a specific issuer.
The specific credit-related events are identified in the contract that will trigger a payment
by the credit protection seller to the credit protection buyer are referred to as credit events.
If a credit event does occur, the credit protection buyer only makes a payment up to the
credit event date and makes no further payment. At this time, the protection buyer is obligated to
fulfill its obligation. The contract will call for the protection seller to
compensate for the loss in the value of the debt obligation.

A swap contract is an obligation to pay a fixed amount and receive a floating amount at the end
of every period for a pre-specified number of periods.
Each date on which payments are made is called a settlement date. If the fixed amount exceeds
the floating amount on a settlement date, the buyer of the swap pays the seller the difference in
cash. If the floating amount exceeds the fixed amount on a settlement date, the seller of the swap
pays the buyer the difference in cash. In either case, this difference is conveyed in the form of a
difference check.
A swap contract is equivalent to a portfolio of forward contracts with identical delivery prices
and different maturities. Consequently, swap contracts are similar to forwards in that:
at any date, swap contracts can have positive, negative, or no value.
at initiation, the fixed amount paid is chosen so that the swap contract is costless.
The unique fixed amount which zeros out the value of a swap contract is called the swap price.

In a (standard) currency swap, the buyer receives the


difference be-tween the dollar value of one foreign currency unit
(e.g., the dollar value of 1 pound) and a fixed amount of domestic
currency (e.g., 2 dollars) at every settlement date (e.g., every 6
months). Since the spot exchange rate at each settlement date is
random, the dollar value of the foreign currency unit is also
random. If this difference is negative, the swap buyer pays the
absolute value of the difference to the swap seller.

Similarly, in an equity index swap, the buyer receives the


difference between the dollar value of a stock index and a fixed
amount of dollars at every settlement date.
The most common type of swap is an interest rate swap. The
buyer of an interest rate swap receives the difference between
the interest computed using a floating interest rate (e.g., LIBOR)
and the interest computed using a fixed interest rate (e.g., 5% per
6 months) at every settlement date (e.g., every 6 months). The
interest is computed by reference to a notional principal (e.g.,
$100 mio.), which never changes hands. If the floating side of an
equity index or interest rate swap is calculated by reference to an
index or interest rate in a foreign country, then there is currency
risk, in addition to the usual equity or interest rate risk.
If the currency is negatively correlated with the underlying, this currency risk is
actually desirable. Nonetheless, many swap con-tracts are quoted with a fixed
currency component, so that only the equity or interest rate risk remains.
Swap transactions provide a means for the bank to mitigate the currency exposure in a forward
trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a
forward purchase (or sale) of an approximately equal amount of the foreign currency. To illustrate,
suppose a bank customer wants to buy dollars three months forward against British pound sterling. The
bank can handle this trade for its customer and simultaneously neutralize the exchange rate risk in the
trade by selling (borrowed) British pound sterling spot against dollars. The bank will lend the dollars for
three months until they are needed to deliver against the dollars it has sold forward. The British pounds

received will be used to liquidate the sterling loan.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those

in the opposite direction.


Swaptions: Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather than have
calls and puts, the swaptions market has receiver swaptions and payer swaptions. A
receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed and receive floating.

Swaptions

Swaptions are options on interest rate swaps.

Caps and Floors


An interest rate cap gives the buyer the right, not the obligation, to receive the
difference in the interest cost (on some notional amount) any time a specified index
of market interest rates rises above a stipulated cap rate.
Caps evolved from interest rate guarantees that fixed a maximum level of interest
payable on floating rate loans.
The advent of trading in over the counter interest rate caps dates back to 1985,
when banks began to strip such guarantees from floating rate notes to sell to the
market.
The leveraged buyout boom of the 1980s spurred the evolution of the market for
interest rate caps. Firms engaged in leveraged buyouts typically took on large
quantities of short term debt, which made them vulnerable to financial distress in
the event of a rise in interest rates. As a result, lenders began requiring such
borrowers to buy interest rate caps to reduce the risk of financial distress.
Similar in structure to a cap, an interest rate floor gives the buyer the right to
receive the difference in the interest cost any time a specified index of market
interest rates falls below a stipulated floor rate.

Swaptions and Caps

Caps and swaptions are generally

traded as separate products in the financial markets, and the


models used to value caps are typically different from those used
to value swaptions.

Furthermore, most Wall Street firms use a piecemeal approach to


calibrating their models for caps and swaptions, making it difficult
to evaluate whether these derivatives are fairly priced relative to
each other.
Financial theory, however, implies no arbitrage relations for the
cap and swaption prices.
A cap can be represented as a portfolio of options on individual
for-ward rates. In contrast, a swaption can be viewed as an option
on the forward swap rate, which is a portfolio of individual forward
rates.
This implies that the relation between cap and swaption prices is
driven primarily by the correlation structure of forward rates.
Interest Rate Swap: an interest rate swap is an agreement between two entities, whereby one
entity pays the long-term interest rate times a notional amount minus the short-term interest rate
times the notional amount. The other counterparty the entity on the other side does the
reverse.
SWAPS
A swap can be defined as the exchange of one stream of future cash flows with another stream of cash
flows with different characteristics.
A swap is an agreement between two or more people/parties to exchange sets of cash flows over a
period in future. Swaps can be divided into two types viz., (a) Currency Swaps, (b) Interest Rate Swaps.
Currency Swaps: The currency swap is an agreement between two parties to exchange (swap) payments
or receipts in one currency for payment or receipts in other currency. Suppose if two entities are trading in
currency, the rationale for currency swap between them lies in the fact that one borrower has a
comparative advantage in borrowing in one currency, while the other borrower has an advantage in
borrowing in another currency.
Interest Rate Swaps: An interest rate swap is an agreement whereby one party exchanges one set of
interest rate payment for another rate over a time period. The most common arrangement is an exchange
of fixed interest rate payment for another rate over a time period. The interest rates are calculated on
notional values of principals.
In finance, 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. Consequently, swaps can be used to create unfunded exposures to an underlying asset,
since counterparties can earn the profit or loss from movements in price without having to post the
notional amount in cash or collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the
underlying.
Most swaps are traded Over The Counter (OTC), tailor-made for the counter parties. Some types of
swaps are also exchanged on future markets, for instance Chicago Mercantile Exchange Holdings Inc.,
the largest US futures market, the Chicago Board Options Exchange and Frankfurt-based Eurex AG.
SWAPTION
A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap.
While options can be traded on a variety of swaps, the term swaption typically refers to options on
interest rate swaps.
Properties of Swaption
Unlike ordinary swaps, a swaption not only hedges the buyer against downside risk, also lets the buyer
take advantage of any upside benefits. Like any other option, if the swaption is not exercised by maturity,
it expires worthless.
If the strike rate of the swap is more favourable than the prevailing market swap rate, then the swaption
will be exercised as detailed in the swaption agreement.
It is designed to give the holder the benefit of the agreed upon strike rate if the market rates are higher,
with the flexibility to enter into the current market swap rate if they are lower.
The converse is true if the holder of the swaption receives the fixed rate under the swap agreement.
Investors can also use swaptions to trade the volatility of the underlying swap rate.

Swap Deals:
Swap contracts can be arranged across currencies. Such contracts are known as currency swaps and
can help manage both interest rate and exchange rate risk. Many financial institutions count the
arranging of swaps, both domestic and foreign currency, as an important line of business. This
method is virtually cheaper than covering by way of forward options. Technically, a currency swap is
an exchange of debt service obligations denominated in one currency for the service in an agreed
upon principal amount of debt denominated in another currency. By swapping their future cash flow
obligations, the counterparties are able to replace cash flows denominated in one currency with cash
flows in a more desired currency.
A swap deal is a transaction in which the bank buys and sells the specified foreign currency
simultaneously for different maturities. Thus a swap deal may involve:
(i) simultaneous purchase of spot and sale of forward or vice verse ; or
(ii) Simultaneous purchase and sale, both forward but for different maturities. For instance, the bank
may buy one month forward and sell two months forward. Such a deal is known as forward swap.
A swap deal should fulfill the following conditions:
There should be simultaneous buying and selling of the same foreign currency of same value for
different maturities; and
(i) The deal should have been concluded with the distinct understanding between the banks that it is a
swap deal.

A swap deal is done in the market at a difference from the ordinary deals. In the ordinary deals the
following factors enter into the rates:
(i) The difference between the buying and selling rates ; and
(ii) The forward margin, i.e., the premium or discount.
In a swap deal the first factor is ignored and both buying and selling are done at the same rate. Only
the forward margin enters into the deal as the swap difference.
In a swap deal, both purchase and sale are done with the same bank and they constitute two legs of
the same contract. In a swap deal, it does not really matter as to what is spot rate. What is important
is the swap difference which determines the quantum of net receipt of payment for the bank as a
result of the combined deal. But the spot rate decides the total value in rupees that either of the banks
has to deploy till receipt of forward proceeds on the due date. Therefore, it is expected that the spot
rate is the spot rate ruling in the market. Normally, the buying or selling rate is taken depending upon
whether the spot side is respectively a sale or purchase to the market-maker. The practice is also to
take the average of the buying and selling rates. However, it is of little consequence whether the
purchase or selling or middle rate is taken as the spot rate
Need for Swap Deals:
Some of the cases where swap deal may become necessary are described below:
(1) When the bank enters into a forward deal for a large amount with the customer and cannot find a
suitable forward cover deal in the market, recourse to swap deal may become necessary.
(2) Swap may be needed when early delivery or extension of forward contracts is effected at the
request of the customers. Please see chapter on Execution of Forward Contracts and Extension of
Forward Contract.
(3) Swap may be carried out to adjust cash position in a currency. This explained later in the chapter
on Exchange Dealings.
(4) Swap may also be carried out when the bank is overbought for certain maturities and oversold for
certain other maturities in a currency.
Swap and Deposit/Investment:
Let us suppose that the bank sells USD 10,000 three months forward, Instead of covering its position
by a forward purchase, the bank may buy from the market spot dollar and kept the amount in deposit
with a bank in New York. The deposit will be for a period of three months. On maturity, the deposit
will be utilized to meet its forward sale commitment. Such a transaction is known as swap and
deposit. The bank may resort to this method if the interest rate at New York is sufficiently higher
than that prevailing in the local market. If instead of keeping the amount in deposit with a New York
bank, in the above case, the spot purchased is invested in some other securities the transaction is
known as swap and investment.
Ready Transactions: In cases where the agreement to buy and sell the foreign exchange takes place
and actual settlement is finished (i.e., delivery of foreign exchange and the receipt of the price, i.e.,
exchange transaction proper is completed on that day itself, it is called ready transaction. It is also
known as Value today.
Spot Transactions: In some transactions, the deal will be struck; but the actual exchange of
currencies will take place, say, after two days from the date of contract. This type of transaction is

known as Spot Transaction. For example, if the contract for certain amount of foreign exchange is
made on an agreed rate, say on Monday, the actual delivery, i.e., completion of transaction will take
place on Wednesday. If that day happens to be a holiday, the delivery will take place on the very next
day, i.e., Thursday, it is on this day, the contract is fulfilled by paying rupees and receiving dollars or
vice versa.
Forward Transaction: On the other hand, the deal will be struck on a particular day, wherein rate will
be agreed upon. But the actual transaction will take place at a specified future date. This is called
Forward Transaction. The Forward Transaction may be for one month, two months or even three
months. This means, the actual contract will take place on a particular day. This forward contract for
delivery of currencies will take place after one month, two months or three months decided according
to the contract.
The concept of the SWAPS:
The aim of swap contract is to bind the two counterparties to exchange two different payment stream
over time, the payment being tied, or at least in part, to subsequentand uncertainmarket price
developments. In most swaps so far, the prices concerned have been exchange rates or interest rates,
but they increasingly reach out to equity indices and physical commodities. All such prices have risk
characteristics in common, in quality if not degree. And for all, the allure of swaps may be expected
cost saving., yield enhancement, or hedging or speculative opportunity.
Portfolio management requires financial swaps which are simple in principle,
versatile in practice yet revolutionary. A swap coupled with an existing asset or
liability can radically modify effective risk and return. Individually and together
with futures, options and other financial derivatives, they allow yield curve and
currency risks, and liquidity and geographic market considerations, all to be
managed separately and also independently of underlying cash market stocks.
Growth of the SWAP Market:
In the international finance market most of the new products are executed in a physical market but
swap transactions are not. Participants in the swap market are many and varied in their location
character and motivates in exciting swaps. However, in general the activity of the participants in the
swap market have taken on the character of a classical financial market connected to , and integrating
the underlying money, capital and foreign exchange market.
Swap in their current form started in 1981 with the well-publicised currency swaps, and in the
following year with dollar interest rate swaps. The initial deals were characterized by the three
critical features.
1. Barter- two counterparties with exactly offsetting exposures were introduced by a third party. If the
credit risk were unequal, the third party- if a bank might interpose itself or arrange for a bank to do
so for a small fee.
2. Arbitrage driven- the swap was driven by a arbitrage which gave some profit to all three parties.
Generally, this was a credit arbitrage or market-access arbitrage.
3. Liability driven- almost all swaps were driven by the need to manage a debt issue on both sides.
The major dramatic change has been the emergence of the large banks as
aggressive market makers in dollar interest rate swaps. Major US banks are in the business of taking
credit risk and interest rate risk. They, therefore, do not need counterparties to do dollar swaps. The
net result is that spreads have collapsed and volume has exploded. This means that institutional
investors get a better return on their investments and international borrowers pay lower financing
costs. This, in turn, result in more competitively priced goods for consumers and in enhanced returns

pensioners. Swap therefore, have an effect on almost all of us yet they remain an arcane derivative
risk management tool, sometimes suspected of providing the international banking system with tools
required to bring about destruction.
Although the swap market is now firmly established , there remains a wide divergence among current
and potential users as to how exactly a given swap structure works, what risks are entailed when
entering into swap transactions and precisely what the swap market is and, for that matter is not.
The basic SWAP Structures
The growth and continued success of the swap market has been due small part to the creativity of its
participants. As a result, the swaps structures currently available and the future potential structures
which will in time become just another market norm are limited only by the imagination and
ingenuity of those participating in the market. Nonetheless, underlying the swap transactions seen in
the market today are four basic structures which may now be considered as fundamental . These
structures are:
- the Interest Rate Swap
- the Fixed Rate Currency Swap
- the Currency Coupon Swap
- the Basis Rate Swap
The Currency SWAP Market: Main Features
The oldest and the most creative sector:
The currency swap market is the oldest and most creative sector of the swap market. This is not
distinguished in market terms between the fixed rate currency swap and the currency coupon swap.
There is no distinction in market terms between these two types of currency swaps because the only
difference is whether the counter currency receipt/payment is on a fixed or floating basis- in structure
and result, the two types of swaps are identical and it is a matter of taste (or preference) for one or
both counterparties to choose a fixed or floating payment. When the dollar is involved on one side of
a given transaction, the possibility to convert a fixed rate preference on one side to a floating rate
preference on the other side through interest rate swap market makes any distinction even more
irrelevant. However, for those who like fine distinctions, there is a tendency in the market to regard
the fixed rate currency swap market as more akin to the long date forward foreign exchange market
(because when one is executing a fixed currency swap one may often be competing with the longdate FX market) and the currency coupon swap market as more akin to the dollar bond/
swap market (because the dollar bond issuer compares the below LIBOR spread
available in the dollar market to that available, say, through tapping the Swiss
Franc market.)
The fixed rate currency Swap:
A fixed rate currency swap consists of the exchange between two counterparties of fixed rate interest
in one currency in return for fixed rate interest in another currency.
Following are the main steps to all currency swaps:
1. Initial Exchange for the Principal:
The counterparties exchange the principal amounts on the commencement of the swap at an agreed
rate of exchange. Although this rate is usually based on the spot exchange rate, a forward rate set in
advance of the swap commencement date can also be used. This initial exchange may be on a
notional basis of alternatively a physical exchange. The sole importance of the initial exchange on
being either on physical or notional basis, is to establish the quantum of the respective principal

amounts for the purpose of (i) calculating he ongoing payments of interest and (ii) the re- exchange
of principal amounts under the swap.
2. Ongoing Exchanges of Interest:
Once the principal amounts are established, the counterparties exchange interest payments based on
the outstanding principal amounts at the respective fixed interest rates agreed at the outset of the
transaction.
3. Re-exchange of the Principal Amounts:
On the maturity date the counterparties re-exchange the principal amounts established at the outset.
This straight forward, three-step process is standard practice in the swap market and results in the
effective transformation of a debt raised in one currency into a fully-hedged fixed-rate liability in
another currency.
The Currency Coupon SWAP:
The currency coupon swap is combination of the interest rate swap and the fixed-rate currency swap.
The transaction follows the three basic steps described for the fixed rate currency swap with the
exception that fixed-rate interest in one currency is exchanged for floating rate interest in another
currency. By using the currency coupon swap the benefit which can be obtained, can be explained
with the following example. Suppose an Indian corporate wished to enter a major leasing contract for
a capital project to be sited in Japan. The corporate wanted to obtain the advantage of funding
through a Japans lease which provided lower lease rentals due to the Japan tax advantages available
to the Japan lessor. However, the Corporate was concerned by both the currency and interest rate
exposure which would result from the yen based leasing contract. The structure provided by Hankers
Trust enabled the Corporate to obtain the cost benefits available from the Japan lease and at the same
time convert the underlying lease finance into a fully hedged fixed-rate yen liability. Under the
structure Bankers Trust paid, on a quarterly basis, the exact payments due on the Corporates yen
based Japan lease in return for the Corporate paying an annual amount of fixed Japanese Yen to
Bankers Trust. The amount for fixed Japanese Yen payable reflected the beneficial level of the
Japanese Yen lease payments.
Swaps:
Swaps are agreements to exchange one series of future cash flows for another. Although the
underlying reference assets can be different, eg equity or interest rate, the value of the
underlying asset will characteristically be taken from a publicly available price source. For
example, under an equity swap the amount that is paid or received will be the difference
between the equity price at the start and end date of the contract.
Swaptions:
These are non-standard contracts giving the owner the right but not the obligation to enter into an underlying swap.
The most common swaptions traded are those dependent on interest rates which allow funds to create bespoke
protection. Contracts can be preconfigured to provide both upside and downside protection if an event occurs. For
example, a party can purchase a swaption to protect itself from the 10-year interest rate swap rate going below 1% in
3 months time.

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.

Currency Swaps
A currency swap involves exchanging
principal and
interest payments in one currency for
principal and
interest payments in another currency.
It requires the principal to be specified
in each of the two
currencies.
Usually, the principal amounts are
exchanged at the
beginning and at the end of the life of the
swap.
The principal values are initially
equivalent (using the
exchange rate) so that the swap is worth
zero at inception.
We will only cover fixed-for-fixed
currency swaps.

Valuation of
Currency Swaps
Two ways of valuing a
fixed-for-fixed
currency swap:
Difference between 2 bonds
(one foreign bond
and one local bond).
A portfolio of forward contracts.

value of 1 pound) and a fixed amount of domestic currency (e.g., 2 dollars) at every settlement
date (e.g., every 6 months). Since the spot exchange rate at each settlement date is random, the
dollar value of the foreign currency unit is also random. If this difference is negative, the swap
buyer pays the absolute value of the difference to the swap seller.
Similarly, in an equity index swap, the buyer receives the difference between the dollar value of
a stock index and a fixed amount of dollars at every settlement date.
The most common type of swap is an interest rate swap. The buyer of an interest rate swap
receives the difference between the interest computed using a floating interest rate (e.g., LIBOR)
and the interest computed using a fixed interest rate (e.g., 5% per 6 months) at every settlement
date (e.g., every 6 months). The interest is computed by reference to a notional principal (e.g.,
$100 mio.), which never changes hands. If the floating side of an equity index or interest rate
swap is calculated by reference to an index or interest rate in a foreign country, then there is
currency risk, in addition to the usual equity or interest rate risk.
If the currency is negatively correlated with the underlying, this currency risk is actually
desirable. Nonetheless, many swap con-tracts are quoted with a fixed currency component, so
that only the equity or interest rate risk remains.

Forward Premium and Forward Discount


A foreign currency is said to be a premium currency if its interest rate is lower than the domestic
currency. On the other hand, a foreign currency is said to be a discount currency if its interest
rate
is higher than the domestic currency. Forwards will exceed the spot for a premium currency and
will be less than the spot for a discount currency. For example, on November 9, 1994 (see
Example
I.6 below), the (forward) British pound was a discount currency. That is, the British pound is
cheaper in the forward market.
It is common to express the premium and discount of a forward rate as an annualized percentage
deviation from the spot rate. When annualized, the forward premium is compared to the interest
rate differential between two currencies. The forward premium, p, is calculated as follows:
p = [(Ft,T - St)/St] x (360/T).
Note that p could be a premium (if p > 0), or a discount (if p < 0).
Example I.6: Using the information from Example I.7 below, we obtain the 180-day USD/GBP
forward rate and the spot rate. The 180-day forward rate is 1.6167 USD/GBP, while the spot rate
is 1.62 USD/GBP. The forward premium is:
p = [(1.6167 - 1.62)/1.62] x (360/180) = -.0041.
The 180-day forward premium is -.41%. That is, the GBP is trading at a .41% discount for
delivery in 180
days.
The Foreign Exchange Swap Market
As mentioned above, in a foreign exchange swap transaction, a trader can simultaneously sell
currency for spot delivery and buy that currency for forward delivery. A foreign exchange swap
involves two transactions. For example, a sale of GBP is a purchase of USD and a purchase of
GBP is a sale of USD. A foreign exchange swap can be described as a simultaneous borrowing of
one currency and lending of another currency.

Cross-Exchange Rate (Cross-rate)


Exchange rate between two currencies based
on each of their exchange rates with a third
currency
5-12
U.S. perspective:
You have $/ and $/ exchange rates
Cross rate would be / calculated using $
exchange rates
/ = (/$) x ($/)

Cross Rates
Suppose that ($/) = 1.50
i.e. $1.50 = 1.00
and that S($/) = 0.01
i $0 01 1 00
5-13
i.e. 0.01 = 1.00
What must the / cross rate be?
0.006667
= 1.00 1.00 $0.01
$1.50 1.00
or, 1.00 = 150

The forward rate for a currency, say the dollar, is said to be at premium with respect to the spot
rate when one dollar buys more units of another currency, say rupee, in the forward than in the
spot rate on a per annum basis.
The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot
rate when one dollar buys fewer rupees in the forward than in the spot market. The discount is
also usually expressed as a percentage deviation from the spot rate on a per annum basis.
The forward exchange rate is determined mostly be the demand for and supply of forward
exchange. Naturally when the demand for forward exchange exceeds its supply, the forward rate
will be quoted at a premium and conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand
for forward exchange, the forward rate will tend to be at par.