Floating rate Payments 6m Libor. Fixed rate payments

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1 Introduction: Interest rate swaps are used to hedge interest rate risks as well as to take on interest rate risks. If a treasurer is of the view that interest rates will be falling in the future, he may convert his fixed interest liability into floating interest liability; and also his floating rate assets into fixed rate assets. If he expects the interest rates to go up in the future, he may do vice versa. Since there are no movements of principal, these are off balance sheet instruments and the capital requirements on these instruments are minimal. Definition: A contract which involves two counter parties to exchange over an agreed period, two streams of interest payments, each based on a different kind of interest rate, for a particular notional amount. Mechanism of an Interest Rate Swap: Take the case of an interest rate swap, in which Counter Party A and Counter Party B agree to exchange over a period of say, five years, two streams of semi-annual payments. The payments made by A are calculated at a fixed rate of 6% (Fixed rate) per annum while the payments to be made by B are to be calculated using periodic fixings of 6-month Libor (floating). The swap is for a notional principal amount of USD 10 million. The above swap is called the "plain vanilla" or the "coupon swap". Interest rates are normally fixed at the beginning of the contract period, but settled at the end of the period. The contract can be simplified as follows. Counter parties:: A and B Maturity:: 5 years A pays to B : 6% fixed p.a. B pays to A : 6-month LIBOR Payment terms : semi-annual Notional Principal amount: USD 10 million. Cash flows in the above swap are represented as follows: Payments at the end Half year period Fixed rate payments Floating rate Payments 6m Libor Net Cash From A to B

2 Typical Characteristics of the Interest Rate Swaps: 1. The principal amount is only notional. 2. Opposing payments through the swap are normally netted. 3. The frequency of payment reflects the tenor of the floating rate index. What is a Coupon Swap? If an interest rate swap involves the swapping of a stream of payments based on the fixed interest rate for a stream of floating interest rate, then it is called a coupon swap. Counter parties to the Coupon Swap: Payer of the fixed interest stream is called the Payer in the swap. Receiver of the fixed interest stream is called the Receiver in the Swap. What is a generic swap? The term generic is used to describe the simplest of any type of financial instrument plain vanilla. So, a plain vanilla swap can be called a generic swap. Typically, generic swaps contain the simple characteristics, such as a constant notional principal amount, exchange of fixed against floating interest (coupon swap), an immediate start (i.e., on the spot date). A simple coupon swap can be called a generic swap. What is a Basis Swap? Two streams of payments can be calculated using different floating rate indices. These are called basis swaps or floating-against-floating swaps. a. It is possible to enter into a swap with a 3-month Libor against a 6-month Libor. b. It is also possible to enter into a swap with a 91-Day T-Bill Yield against a 6-Month Libor. Basis index swaps come under the classification of non-generic swaps. Counterparties to a basis swap: In a basis swap, each counter party is described in terms of both the interest stream it pays and the interest stream it receives.

3 Asset Swap: If in an interest rate swap, one of the streams of payments being exchanged is funded with interest received on an asset, the whole mechanism is called the asset swap. In other words, it is an interest rate swap, which is attached to an asset. It does not however involve any change in the swap mechanism itself. Asset swaps are used by investors. If an investor anticipates a change in interest rates, he can maximize his interest inflow by swapping the fixed interest paid on the asset for floating interest, in order to profit from an expected rise in interest rates. Money Market Swaps Swaps with an original maturity of upto two years are referred to as Money Market swaps. IMM swaps come under this category. The tenor of the swaps matches exactly with the short-term interest futures in the IMM (International Monetary Market- Traded in the Chicago Mercantile Exchange). Term Swaps A swap with an original tenor of more than two years is referred to as a term swap. What does an Interest Rate Swap do? Interest rate swaps can be used to take on fresh interest rate risk as well as to manage existing interest rate risk. Interest Rate swaps without offsetting underlying create interest rate risk. : Each counter party in an interest rate swap is committed to pay a stream of interest payments and receive a different stream of interest payments. A payer of fixed interest rate payments is exposed to the risk of falling interest rates, while a payer of floating interest rate payments is exposed to the risk of rising interest rates. Similarly, a receiver of fixed interest rate payments is exposed to the risk of rising interest rates while the receiver of floating interest payments is exposed to the risk of falling interest rates. To summarize, interest rate swaps create an exposure to interest rate movements, if not offset by an underlying exposure. Interest rate swaps can be used to hedge interest rate risk: Floating rate loans expose the debtor to the risk of increasing interest rates. To avoid this risk, he may like to go for a fixed rate loan, but due to the market conditions and his credit rating, his fixed rate loans are available only at a very high cost. In that case, he can go for a floating rate liability and then swap the floating rate liability into a fixed rate liability. He can do the swap with another counter party whose requirements are the exact opposite of his or, as is more often the case, can do the swap with a bank. The following diagram illustrates the case in which an intermediary, e.g. a

4 bank, is involved in a swap deal between two counter parties. Borrower A has a floating rate loan, but would prefer a fixed rate loan. There is another borrower B who has a fixed rate loan, but would prefer a floating rate loan. The intermediary can now match these two borrowers as described in the following diagram. Example: A manufacturing company embarks on a project for which it borrows USD 4 million working capital on a floating interest rate basis, payable quarterly for two years. Since the treasurer of the company felt that the floating rate payments will involve serious risks, he decides to enter into a swap with a bank and convert the same into a fixed rate loan. The bank now swaps the floating rate payments into a fixed rate at 12%. The resultant cash flow arising out of the transaction is illustrated below. Quarter Floating rate Floating rate payments Fixed rate payments Net cash paid by Co Getting comparative advantage in different markets: Various segments of the capital markets differ in terms of how sensitive they are to differences in the creditworthiness of the issuers. Particularly, in bond markets, where retail investors play an important role and tend to be averse to default risk, disproportionately higher yields are offered to them to invest in less creditworthy bonds. Issuers with a lower rating find themselves paying more than the issuers enjoying a stronger rating. Often, we find that cost of funds is higher in the bond markets than in the credit markets. Whenever, these differences occur in different markets, it would be possible

5 to arbitrage between the markets. Let us take the following example Consider two companies, rated AAA and BBB. AAA has a higher credit rating than BBB. Both companies can raise funds either by issuing fixed-interest bonds or by taking bank loans (at a floating interest rate). Their borrowing costs are: Cost of Funds to AAA and BBB Fixed rate bonds Floating rate loans< AAA 10.00% p.a. Libor+100bp BBB 12.00% pa Libor+160bp Differential 200 bps 60bps Assume now that AAA wants to raise floating rate money and BBB wants to raise fixed rate money. It will be realized that the advantage (200 basis points) of AAA raising fixed rate money in the bond market as against BBB, which is, is greater than the disadvantage (60 basis points) of letting BBB raise floating rate money in the credit market. There is a comparative advantage of 140(200-60) basis points. Both the parties can share the difference and reduce their borrowing costs. A Banker normally acts as an intermediary and arranges most of these deals. A share of the advantage is passed on to the banker. In this case, if the three parties agree to share the difference as 80:40:20 basis points, then AAA will receive 9.80% fixed from the bank in exchange for Libor, while paying 10.00% on his bonds. The net outcome for AAA is a floating rate liability at Libor+20 bps. This represents a gain of 80 basis points, than if he had borrowed at Libor+100 bp. Similarly Borrower BBB receives Libor in lieu of 10.00% fixed while paying Libor+160 bp to his creditor. The net effect is equivalent to paying 11.60% fixed, which represents a 40 basis points gain over fixed rate borrowing at 12.00%. The intermediary bank receives 10.00% fixed from BBB and pays 9.80% fixed to AAA in effect gaining 20 basis points on this transaction. The following diagram illustrates the transaction. Interest Rate Swaps in India: With a view to deepening the money market and also to enable banks; primary dealers and all-india financial institutions to hedge interest rate

6 risks, the Reserve Bank of India has allowed scheduled commercial banks, primary dealers and all-india financial institutions to make markets in Interest Rate swaps from July However, the market which has taken off seriously so far, is the one based on Overnight Index Swaps(OIS). Benchmarks of tenor beyond overnight have not become popular due to the absence of a vibrant inter bank term money market. The NSE publishes MIBOR(Mumbai Interbank Offered Rate) rates for three other tenors viz., 14- day, 1month and 3 month. The other longer tenor benchmark that is available is the yield based on forex forward premiums. This is called MIFOR(Mumbai Interbank Forward Offered Rate). Reuters published 1m,3m,6m 1yr MIFORs are the market standard for this benchmark. Definition and Mechanism of Overnight Index Swap: The Overnight Index Swap (OIS) is an INR interest rate swap where the floating rate is linked to an overnight inter bank call money index. The swap will be flexible in tenor i.e. there is no restriction on the tenor of the swap. The interest would be computed on a notional principal amount and settled on a net basis at maturity. On the floating rate side, the interest amounts are compounded on a daily basis based on the index. At the moment, the NSE O/N Mibor is the most widely used floating rate index, the Reuters O/N Mibor being the other used. Example: Bank A is a fixed rate receiver for INR 5 crores for a period of one week at 10% and Bank B is a receiver of floating rate linked to the Overnight index. The NSE Mibor rates for the seven days are taken and settled at the end of the swap period. At the end of the period of one week, i.e., the 8th day, Bank B will have to pay to Bank A Rs /- (being interest on Rs. 5 crores for 7 days at 10%) and has to receive from A Rs /-. The payments are netted and the only payment that takes place is a payment by A of Rs. 1,608 ( ) to B. NSE Mibor Index Notional Principal Amount Interest for One day 1st day 10.25% nd day 10.00% rd day 9.75% th day % & %

7 day 7th day 10.50% Disclaimer : Nothing contained in this publication shall constitute an offer to sell/purchase or an invitation/ solicitation to do so for any currency, security, commodity or equity. Mecklai Financial Services Ltd. accepts no liability whatsoever for any loss, howsoever arising, from any use of this document, its contents or otherwise arising in connection therewith. No part of this document can be circulated or reproduced in any form without prior approval of Mecklai Financial Services Limited.

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