Financial Swap

General meaning: Barter or exchange one or another. Business: a private arrangement between two parties to exchange cash flows in future according to a prearranged formula.

Definition
A transaction in which two parties agree to exchange a predetermined series of payments over time. An agreement between two parties to exchange interest payments for specific maturity on an agreed upon notional amount. An agreement whereby one party exchange one set of interest payment for another e.g. fixed for floating rate.

 A funding technique permits borrower to access one market exchange one liability to another. A device to obtain the desired form of financing indirectly, which otherwise may be inaccessible or too costly. Swap market exist because different companies have specific access to specific market.

Why Swap?
Credit rating. Capital structure. Market saturation. Goodwill of the company. Match with assets & liabilities.

Features
Counter party: Facilitator: Cash flow: Documentation: Transaction cost: Termination: Default risk: Duration:

Interest Rate Swap

A financial arrangement between two parties, wish to exchange interest payments or receipts. (no exchange of principal amount). The simplest example is to exchange fixed for floating rate of interest payment between two borrowers. Example of plain vanilla fixed-for-floating interest rate swap.

 Consider a 3 years swap initiated on March 2008, between Firm A and B on a principal amount of $40 million Firm A pays the fixed interest rate at 7% p.a. (and receives floating rate). The payment made semi-annually. Firm B receives fixed payment (pays floating rate) The floating rate is 6-months LIBOR. The swap originate date is March 5th 2008.
Date March 5th 2009 September 5th 2009 March 5th 2010 September 5th 2010 6-Months LIBOR rate (%) 6.5% 7.0% 7.3% 7.7%

March 5th 2011

September 5th 2011

7.0%
6.2%

How both the parties benefited through Swaps?

Firm X can raise funds in fixed market and floating market at 10.75% and LIBOR + 0.50% respectively. (interested in Fixed rate) Firm Y can raise funds in fixed market and floating market at 10% and LIBOR + 0.25% respectively. (interested in Floating rate) These rates are applicable for $100 million for 2 years.

Role of Intermediary
Arrange a counter party Market Maker.

CURRENCY SWAP
A contract involving exchange of interest payment on a loan in one currency for fixed or floating interest payment on equivalent loan in difference currency.

A plain vanilla currency swap is a fixed-fixed currency swap in which each party pays a fixed payment on the loan taken by them. The motivation behind currency swap is the actual need for funds denominated in different currency.

Example
Two firms A and B who are in need of Dollar fund and Euro fund respectively The exchange rate is 0.65 euro/$. A wants $100 million and B wants euro 65 million.
Firm A B Credit Rating BB AA Dollar 10.5% 8.5% Euro 11.8% 11%

Pricing of Swap
Swap can be priced by determining the value of each stream of cash flows. The value of each stream of cash flow is the NPV of cash flow. The price of the swap is the difference between values of two cash flows.

Valuation of Currency Swap (Fixed-for-Fixed) Suppose the term structure of Interest rate in US and France is 7% and 8% respectively. A French bank has entered into a currency swap where it receives 8%.p.a. on US dollar loan and pays 10% p.a. on Franc loan. Suppose the French firm is in need of $40 million for a foreign investment and U.S. firm needs a loan of FF 291.2 million for its French subsidiary. The swap period is 4 years and current exchange rate is 7.56FF/$.

 (i) (ii) (iii) (iv) (v)

Swap Risk: Interest rate risk. Currency exchange risk. Market risk. Credit risk. Sovereign risk.

 (i) (ii) (iii) (iv) (v)

Limitations of Swap Deal: Identification of counterparty. Termination. Inherent default risk. Not tradable in secondary market. Absolute & comparative advantages changes as credit rating changes.