January 7, 2013

IB0010 [International Financial Management] Set1 Q2

2. Define Swaps contracts. Write a note on forward swaps.

Ans.


Swap Contracts

A swap is a contract between two counter-parties to exchange two streams of payments for an agreed period of time.  These may be fixed or floating interest  rate of commitment (plain vanilla swap), one currency for another currency (currency swap) and both of these (cocktail swap). Also, these may be basis swap and asset swap.

Swaps are not debt instruments to raise capital, but a tool used for financial management.


Some other derivatives commonly used are:

An over-the-counter: A derivative that is not traded on an exchange but purchased from, say, an investment bank.  These can be more flexible than exchange-traded contracts and sometimes involve more unusual risk-transfers, achieved by the bank bundling together assorted swaps, forwards and exchange-traded futures and options to meet the precise needs of the buyer.
Leverage: The amount of money put at risk by a derivative is far bigger than the down payment made when it was traded.  The extent of leverage in a derivative is not always obvious.
Exotics: derivatives that are either complex or are available in emerging economies.  These tend to be contrasted with “plain-vanilla” derivatives, which are typically exchange-traded, relate to developed economies and are (relatively) uncomplicated.

Interbank forward dealing

Interbank quotations are given a bid and ask (also referred to as offer) price.
A  bid is the price (i.e., the exchange rate) in once currency at which a dealer will buy another currency.  An offer or ask is the price at which a dealer will sell the other currency.  Dealers generally bid (buy) at one price and offer (sell) at a slightly higher price, making their profit from the spread, i.e., the difference between the buying and selling prices.

Example 

All foreign exchange dealers are interested in making a profit out of each transaction.  Therefore, when a dealer in  India tries to sell foreign currency he will try to get as high a price as is possible for every unit of foreign currency sold.  But when the dealer is buying foreign currency, his aim will be to get the most reasonable price for every unit of the foreign currency he buys.
A dealer in New Delhi may give the following quotation
US $1 = Rs. 43.3000-43.7300
E1     =   RS. 69.9200-71.3100

This means that the dealer will buy dollars from the exporter at US $1 = Rs. 43.3000 and sell dollars to an importer at US $ = Rs. 43.7300.  Similarly, he will buy pounds at E1  = Rs. 69.9200 but sell punts at E1 = Rs.71.3100.  The lower rate in the quotation is the bid (buy) rate while the higher rate is the ask (selling) rate. The difference between the banks’ bid and ask rate is the spread.  The spread fluctuates in accordance with the level of stability in the market, the currency in question and the volume of the business.

Spread can be expressed in percentage as 
Percentage spread  = Ask price – Bid price/Ask price x 100
                                   = 43. 7300 – 43.3000/43.7300 x 100
                                  =  .9833

Generally, in transaction among dealers, only the last two digits are quoted and the rest is understood.  This is done to save time.


In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price.

The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.
Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement. Today, swaps are among the most heavily traded financial contracts in the world: the total amount of interest rates and currency swaps outstanding is more thаn $426.7 trillion in 2009, according to International Swaps and Derivatives Association (ISDA)

Types of swaps
The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also many other types.

Interest rate swaps
Main article: Interest rate swap

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an interest rate swap, the net result is that each party can 'swap' their existing obligation for their desired obligation. Normally the parties do not swap payments directly, but rather, each sets up a separate swap with a financial intermediary such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments.

The most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate is called variable, because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.

Currency swaps
Main article: Currency swap
A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps also are motivated by comparative advantage. Currency swaps entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction.

Commodity swaps
Main article: Commodity swap
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.

Equity Swap
Main article: Equity swap
An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do.

Credit default swaps
Main article: Credit default swap
A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure.


Forward swaps
A swap transaction (not to be confused with the swap rate) is a double-leg deal, in which one buys spot currency x selling currency Y and simultaneously sells forward currency X buying currency Y.  Let us give an example to show the rationale of such a transaction.  Assume that an American investor has a future receipt in DM.  In Addition, assume that he thinks that German bonds are presently a good investment.  So he has dollar assets abut does not hold cash in DM. In plain words, he needs Dm right now and cannot wait for the future receipt DM to come.  One solution would be to sell dollars and buy DM in the spot market.  However, suppose he does not wish to block money in a foreign exchange adventure for he cannot forecast the exchange value of the future receipt.  In this case he sells dollars against DM spot getting his DM and buying his bonds.  Simultaneously he buys dollars forward against DM matching the value date of the receipt. Upon expiration of the forward period, the investor cashes the receipt, pays back the DM that he owes and gets his original dollars.  Hence, he has been able to overcome the time lag problem.

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