Swaps in Finance

What are Swaps in Finance?

Swaps in finance involves a contract between two or more party on a derivative contract which involves exchange of cash flow based on a predetermined notional principal amount, which usually includes interest rate swaps which is the exchange of floating rate interest with fixed rate of interest and the currency swaps which is the exchange of fixed currency rate of one country with floating currency rate of another country etc.

Example

Let us understand it with the help of an example.

EDU Inc. enters into a financial contract with CBA Inc. in which they have agreed to exchange cash flows making LIBOR as its benchmark wherein EDU Inc. will pay a fixed rate of 5% and receive a floating rate of LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more+2% from CBA Inc.

Now, if we see, in this financial contract, there are two legs of the transaction for both parties.

  • EDU Inc. is paying the fixed rate of 5% and receiving a floating rate (Annual LIBOR+2%), whereas CBA Inc. is producing a floating rate (Annual LIBOR+2%) and receiving a fixed percentage (5%).

In order to understand this, let’s look into the numerical now.

In the above example, let’s assume that both the parties have entered into a swaps contract for one year with a notional principal of Rs.1,00,000/-(since this is an Interest rate swap, hence the principal will not be exchanged). And after one year, the one year LIBOR in the prevailing market is 2.75%.

We will analyze the cash flows for two scenarios:

  1. When the one year LIBOR is 2.75%,
  2. When the one year LIBOR increased by 50 bps to 3.25%

Scenario 1 (When one year LIBOR is 2.75%)

swaps-example-1

Scenario 2 (When one year LIBOR is 3.25%)

swaps-example-2

Looking at the above exchange of cash flows, an obvious question comes to our mind that why financial institutions enter into swaps agreement. It is clearly seen in scenario one that a fixed paying party is benefitted from the swaps. However, when the one year LIBOR increased by 50 bps to 5.25%, it was in loss from the same swap agreement.

The answer to this is a comparative rate advantage to both parties.

Comparative Rate Advantage

The comparative rate advantage suggests that when one of the two borrowers has a comparative advantage in either the fixed or floating rate market, the better of their liability by entering into swaps. It basically reduces the cost of both parties. However, a comparative advantage argument assumes that there is no credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more involved, and funds can be borrowed during the life of the Swap.

To understand the comparative rate advantage, let’s assume that the EDU Inc. and CBA Inc. have their own borrowing capacities in both fixed as well as a floating market (as mentioned in the table below).

CompanyFixed Market BorrowingFloating Market Borrowing
EDU Inc.4.00%One year LIBOR-0.1%
CBA Inc.5.20%One year LIBOR+0.6%

In the above table, we can see that EDU Inc. has an absolute advantage in both the market, whereas CBA Inc. has a comparative advantage in the floating rate market (as CBA Inc. is paying 0.5% more than EDU Inc.). Assuming both the parties have entered into a Swap agreement with the condition that EDU Inc. will pay one year LIBOR and receive 4.35% p.a.

The cash flows for this agreement are described in the table below for both the parties.

Cash Flows for EDU Inc. 
Receivable in a Swap agreement4.35%
Payable in a Swap agreementLIBOR
Payable in fixed market borrowing4.00%
Net EffectLIBOR-0.35%
Cash Flows for EDU Inc. 
Receivable in the Swap agreementLIBOR
Payable in the Swap agreement4.35%
Payable in floating market borrowingLIBOR+0.6%
Net Effect4.95%

Looking at the above cash flows, we can say that EDU Inc. has a net cash flow of LIBOR – 0.35% per annum, giving it an advantage of 0.25%, which EDU Inc. had to pay if it went directly in the floating market, i.e., LIBOR – 0.1%.

In the second scenario for CBA Inc., the net cash flow is 4.95% per annum, giving it an advantage of 0.25% in the fixed borrowing market if it had gone directly, i.e., 5.20%.

Types of Swaps in Finance

There are several types of Swaps transacted in the financial world. They are a commodity, currency, volatility, debt, credit default, puttable, swaptions, Interest rate swap, equity swapEquity SwapEquity Swaps is defined as a derivative contract between two parties that involve the exchange of future cash flows. There are two basis of determining cash-flows, cash stream and equity stream.read more, etc.

We will look at Currency swaps in detail later in this article.

Valuation of Swaps in Finance

As we know that Swap is nothing but the series or a combination of bonds for both counterparties, and hence its valuation is also easy.

For example, suppose that two counterparties A and B enter into a Swaps agreement wherein A pays fixed and receive float (refer image: 2 below). In this arrangement, if we see, there is a package of two bonds for A.

  1. A is short on fixed coupon paying bond and
  2. Long on floating coupon paying a bond.

2016-10-20_12-42-51wqe
At any given point of time, a value of the Swap for a fixed ratepayer is the difference between the present value of the remaining floating-rate payment and the present value of the remaining fixed-rate payment (Bfloat – Bfixed). Whereas for a fixed-rate receiver, the value of the Swap is the difference between the present value of the remaining fixed-rate payment and the present value of the remaining floating-rate payment (Bfixed – Bfloat). We can calculate a value of Swap for either of the party and then find out for another easily as a swap is a derivative contract, and we are aware that derivative is a zero-sum game wherein profit for one party is equal and opposite to the loss of another. Hence, the formula for the value of swap agreement can be summarized as below:

  • Value of a Swap agreement (for a Floating ratepayer) = PV of remaining fixed-rate payment (Bfixed) – Value of remaining floating-rate payment (Bfloat) or Bfixed – B
  • Value of a Swap agreement (for a Fixed ratepayer) = PV of remaining float rate payment (Bfloat) – Value of remaining fixed-rate payment (Bfixed) or Bfloat – B

Here, one point is to be noted that at the date of settlement, a value of floating coupon bondCoupon BondCoupon bonds pay fixed interest at a predetermined frequency from the bond’s issue date to the bond’s maturity or transfer date. The holder of a coupon bond receives a periodic payment of the stipulated fixed interest rate.read more is always equal to the notional principal as at the date of settlement coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more is equal to YTM or the bond is par bond.

Example

Suppose A & B enters into a Swap Agreement for two years wherein A pays fixed (here A is short on a fixed coupon paying bond) at the rate of 4% and receives LIBOR from B. One year has already crossed, and both the party wants to terminate the agreement immediately.

A notional principal is Rs.1,00,000/- and two years LIBOR is 4.5%.

Scenario -1 (if party A pays fixed)

Here, since the swap agreement was supposed to end after two years but it is being terminated by the counterparties only after one year. Hence, we have to value the Swap at the end of one year.

As per the above formula, a value of Swap = Bfloat – Bfixed, Where,

Afloat = PV of all remaining float rate payment and,
Bfixed = PV of remaining fixed-rate payment.

Calculations:

Bfloat= since we are valuing the Swap at the date of settlement, the PV of floating-rate payment would be the notional principal, i.e., Rs.100000/-. Also, it is assumed that on the date of settlement, coupon payment has been made to a long party.

Hence, Bfloat = Rs.100000/-

Bfixed = The total fixed payment to be made by A for the second year is principal of Rs.100000/- and interest of Rs.4000/- (100000*0.04). This amount needs to be discounted with two years LIBOR, i.e., 4.5%.

(P+C)*e-r*t = (100000+4000)*e-0.045*1

= 99423.74

Hence, Bfixed = 99423.74

Value of Swaps = Rs.100000 – Rs.99423.74

= Rs.576.26

Scenario -2 (if party A pays float)

As per the above formula, the value of Swap = Bfixed – Bfloat,

Calculations:

Bfloat= Here also, the PV of floating-rate payment would be the notional principal, i.e., Rs.100000/- as we are valuing the Swap at the date of settlement.

Hence, Bfloat = Rs.100000/-.

Bfixed = The total fixed payment to be made by B for the second year is principal of Rs.100000/- and interest of Rs.4000/- (100000*0.04). We will discount this amount with two years LIBOR, i.e., 4.5%.

(P+C)*e-r*t = (100000+4000)*e-0.045*1

= 99423.74

Hence, Bfixed = 99423.74

Value of Swaps = Rs.99423.74 – Rs.100000

= – Rs.576.26

In the above-explained scenarios, we have seen the valuation of Swaps on the date of settlement. But what if the contract is not terminated on the date of settlement?

Valuation of Swaps – Before the date of settlement

Let’s see how valuation is done in case the contract is not terminated on the date of settlement.

The valuation for fixed leg payment shall remain the same as explained above. But the valuation for the floating leg is slightly changed. Here, since we are not standing on the date of settlement, the discounting for floating-rate payment shall be Notional Principal + Floating rate payment for the remaining period.

Let’s look at the example.

Suppose A & B enters into a Swap Agreement for two years wherein A pays fixed (here A is short on a fixed coupon paying bond) at the rate of 4% and receives LIBOR from B. After one and half years both the party wants to terminate the agreement immediately.

A notional principal is Rs.1,00,000/- and two years LIBOR is 4.5%.

Value of Swaps = Bfloat – Bfixed, Where,

Bfloat = PV of all remaining float rate payment and,
Bfixed = PV of remaining fixed-rate payment.

Bfloat= since valuation is happening six months prior to the settlement, the PV of floating-rate payment would be the notional principal, i.e., Rs.100000/- plus the floating rate coupon payment, which is due in the next six months. The same can be found out using two years of LIBOR curveLIBOR CurveLIBOR curve represents graphically, the values of the LIBOR rate at various maturity intervals such as one-month rate, two-month rate, etc. and it is used by various banks and other financial institutions for determining the interest rate for debt-based products and other financial products.read more.

(P+C)*e-r*t = (100000 + 4500)* e-0.045*0.5

= 102175.00

Hence, Bfloat = Rs.102175.00

Bfixed = Total fixed payment to be made by A for the second year is principal of Rs.100000/- and interest of Rs.4000/- (100000*0.04). This amount needs to be discounted with two years LIBOR, i.e., 4.5% for six months as six months are left to expire the contract.

(P+C)*e-r*t = (100000+4000)*e-0.045*0.5

= 101686.12

Hence, Bfixed = 101686.12

Value of Swaps = Rs.102175 – Rs.101686.12

= Rs.488.88

What are Currency Swaps in Finance?

Like an Interest rate swapInterest Rate SwapAn interest rate swap is a deal between two parties on interest payments. The most common interest rate swap arrangement is when Party A agrees to make payments to Party B on a fixed interest rate, and Party B pays Party A on a floating interest rate.read more (as explained above), Currency Swaps (also known as Cross Currency Swaps) is a derivative contract to exchange certain cash flows at a predetermined time. The basic difference here is, under currency swaps, the principal is exchanged (not obligatory) at inception as well as at maturity of the contract, and cash flows are in the different currencies, therefore, generate a larger credit exposure.

Another difference between these types of swaps are, in Interest Rate swap, cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more are netted at the time of settlement whereas, in the currency swap, the same is not netted but exchanged in actual between parties.

Mechanics of currency swaps

Suppose two companies EDU Inc. (based in the US) and CBA Inc. (based in India), entered into currency swaps, wherein EDU Inc. pays 5% in INR and receives 4% in USD (and CBA Inc. pays 4% in USD and receives 5% in INR) every year for the next two years (refer Image: 3). At the beginning of the contract, both the parties exchanged a certain amount of principals (EDU Inc. exchanged USD 80000, and CBA Inc. exchanged INR 100000). The current spot rate is INR 65/USD.

Here, at each settlement dateSettlement DateThe settlement date is the date on which the cash and assets that have been exchanged or traded are settled by netting out a process that happened a few days ago. Commonly for shares, it is two business days after the trade.read more, EDU Inc. shall pay INR 5000 (100000*0.05) to CBA Inc. and receives USD 3200 (80000*0.04) from CBA Inc., respectively. Further, at the end of the contract, both the parties shall exchange the principal amount, i.e., EDU Inc. shall pay INR 100000, and CBA Inc. shall pay USD 80000.

Mechanics of currency swaps

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For eg:
Source: Swaps in Finance (wallstreetmojo.com)

Valuation of Currency Swaps in Finance

Currency swaps are valued in the same way as interest rate swaps, using DCF (bond method). Hence,

Value of Currency Swaps (long on one bond) = Blong on a currency – So*Bshort on currency,

Value of Currency Swaps (short on one bond) = Bshort on a currency – So*Blong on currency, where

S0 = Spot rate of the currency

Let’s understand this through a numerical.

Taking the above example into consideration, assume that the interest rate in India is 6%, and in the USA, it is 4%. Assume that the interest rate remains constant throughout the life of Swaps agreement in both the economy. Exchange rates for the currencies are INR 65/USD.

Before proceeding to value the swap contract, first look at the cash flows in the below table:

current-example

* Discounting factorDiscounting FactorDiscount Factor is a weighing factor most often used to find the present value of future cash flows, i.e., to calculate the Net Present Value (NPV). It is determined by, 1 / {1 * (1 + Discount Rate) Period Number}read more has arrived through formula e-r*t

# PV of Cash flows have arrived through formula Cash Flows*Discounting Factor

As mentioned above, the valuation of currency swaps is also done through discounted cash flow. Therefore, here we will calculate the total PV of Cash flows in both the currencies.

PV of INR Cash Flows = INR 53820.36

PV of USD Cash Flows = USD 28182.30

Since EDU Inc. is long on USD and short on INR, therefore,

Value of Swaps = BUSD – S0*BINR

= 28182.30 – (1/65)*53820.36

= 28182.30 – 828.01 = 27354.49

In a Nutshell

  • It is an OTC derivative contract between two parties exchanging a sequence of cash flows with another at a predetermined rate for a set period of time.
  • Under the Swaps agreement, one party exchanges fixed cash flows in return for floating cash flows exchanged by the other counterparty.
  • The most common kind of swaps in finance are Interest rate and Currency Swaps.
  • A plain vanilla interest rate swap exchanges fixed-rate payment for floating-rate payment over a period of swaps.
  • A swap contract is equivalent to a simultaneous position in two bonds.
  • The comparative rate advantage suggests that when one of the two borrowers has a comparative advantage in either the fixed or floating rate market, the better of their liability by entering into the Swap.
  • The value of the Swap for a fixed-rate receiver is the difference between the present value of the remaining fixed-rate payment and the present value of the remaining floating-rate payment, and for a floating rate, the receiver is the difference between the present value of the remaining floating-rate payment and the present value of the remaining fixed-rate payment.
  • Currency swaps exchanges cash flows in different currencies along with the principal amount at inception and at maturity, though not obligatory.

This has been a guide to swaps in finance and its definition. Here we discuss examples, different types of swaps along with valuation and mechanics. You may also have a look at the following articles –

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Comments

  1. Austin LYNCH says

    I was trying to understand the whole concept of Swap Rate and couldn’t find a good explanation on swap rate. If you could tell me what actually Swap Rate Is? It will be very helpful.

    • Dheeraj Vaidya says

      Swaps are those derivatives where counterparts exchange fixed payment against floating rate payments. A Swap is an agreement between two parties where future interest payments are exchanged for another based on a specified principal amount. Final answer to your question is that the fixed rate which you agree to pay is called the Swap Rate.

  2. Noah HENRY says

    Hey Nice job!! I found this article very helpful, I intend to do finance business in future so if you could tell me how do I start a finance business and so that I can get started with finance business. Thanks

    • Dheeraj Vaidya says

      Thanks Noah! I am glad that you found my blog useful, well if you are about to start a Finance business. I must tell you Making money through financing takes time, but you can start many types of financing business, if you are thinking to start any kind of finance firm license is an essential requirement to start any finance firm.
      If you want to know anything more I’ll be glad to comment further.

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