History of Swaps in India

Swaps came into being in the early 1980s as a hedging and risk mitigation tool. A swap
could be used to take advantage of certain views that individual counterparties would hold
and is based on the Comparative Advantage Theory. Interestingly, the first swap that was
done involving any Indian counterparty was as early as 1984 when ONGC entered into a
swap contract with a consortium of foreign banks to hedge some of its foreign currency
exposure-this contract was negotiated and done under the jurisdiction of a foreign market.
However, swaps were not really heard of in Indian markets till the mid-1990s. The Reserve
Bank of India (RBI) started allowing the usage of swaps by counterparties in India from 1995
on a case-by-case basis In a sense, in those days, each single transaction needed to have
explicit RBI approval. However, with the market maturing and developing quite fast, RBI
started relaxing the rules, and by 1999 RBI has started allowing banks to enter in to swap
contracts and report such deals to RBI on a periodic basis (the periodicity of this reporting
from being every fortnight in the initial days increased to aggregate reporting every quarter).
Yet, there was a small legal issue that remained While RBI allowed the usage of swaps for
risk mitigation purposes, the legal framework required to ensure the smooth conduct of the
swap market was not created — in effect, the law governing securities trading (the Securities
Contract Regulation Act, 1956) had not been amended to make over-the-counter derivatives
legal in the country. Finally, in 2005, the finance minister through a special approval of the
parliament made swap-related transactions legal, With retrospective effect. The illegality,
rather non-legality, of all other OTC contracts is SHII existent in the Indian markets. In fact,
for a period of about 6 years, there was a scenario where swap contracts were being entered
into by banks and financial institutions (these contracts being allowed by RBI) but could have
been legally untenable had any default happened and the case brought before the judicial
system in India. It is a matter of great relief for the entire financial system that no such
default-related event happened, and the market developed in a spectacular manner.
Another point that needs to be noted in the Indian context is the absence of an active-term
market in India. This implies that many a times the liquidity of the 3 month and/or the 6-
month benchmark is in question. On the other hand, overnight markets are highly liquid in the
Indian context. Hence, initial players in the swap market in India came up with non-standard
swaps such as Overnight indexed swaps (OIS) swaps that are linked to overnight Mumbai
interbank offer rate (MIBOR). Further, these along with Mumbai interbank forward rate
(MIFOR) and constant maturity swaps account for nearly 100% of the traded volume in Indian
swap markets.
[Link] Swaps
Another popular type of swap is known as a currency swap. In its simplest form, this
involves principal and interest payments in one currency for principal and interest
payments in another.
The first currency swap was between the World Bank and IBM in which IBM swapped a
U.S. dollar loan with the World Bank's Swiss francs and Deutschemarks in 1981 for a
notional amount of USD 210 million over 10 years. Suppose a company in India wants to
borrow U.S. dollars to pay for its oil imports. It has to borrow at U.S. dollar interest rates,
which would be different from Indian rupee interest rates. In a currency swap, one party
borrows U.S. dollars at
A currency swap is an over-the-counter derivative. It is a foreign exchange agreement. It involves the
exchange of principal and/or interest payment on a loan or an asset in one currency for principal and/or
interest payment on an equivalent loan or an asset in another currency.
US. dollar interest rates and swaps the U.S. dollar with a loan based on Indian rupee
interest
 A currency swap agreement requires the principal to be specified in each of the two
currencies. The principal amounts are usually exchanged at the beginning and at the end
of the life of the swap. Usually, the principal amounts are chosen to be approximately
equivalent using the exchange rate at the swap's initiation. When they are exchanged at
the end of the life of the swap, their values may be quite different.
A currency swap is an over-the-counter derivative. It is closely related to interest rate
swap It involves the exchange of cash flows between counterparties which takes place in
two different currencies. In case of Interest Rate Swap, the parties swap only interest.
But in case of currency swap, the parties swap both interest and/or principal.
 Types of Currency Swaps

There are three types of currency swaps. These are as follows:

• Fixed Rate Currency Swap: In this currency swap agreement, the interest rates are fixed
for both the parties.

• Cross-currency Swaps: In this case, the interest rate on one leg is based on a floating
rate and the interest rate on other leg is based on the fixed rate.

• Currency Basis Swap: In this case, the interest rate on both legs are based on floating
rates.

Uses of a Currency Swap

A currency swap involves a service of exchanges of cash flow. These cash flows are made
in different currencies. These amounts of cash flows are determined on the basis of exchange
rates. Swap transactions are useful in the following ways:
(a) Hedging the exchange risk by way of converting a liability/asset in one currency into a
liability/asset in another currency - Currency swaps can be used to hedge against exchange
rate risks by converting liabilities or assets from one currency to another.
(b) Reduction of borrowing or financing cost (in case of foreign currency borrowing or
financing) through currency swaps - Mulånational firms need funds in different
currencies. They follow the principle of comparative advantage. As different countries
 have their own economic policies as well as distinct and separate financial markets, the
multinationals can avail maximum benefits through currency swap transactions.
(c) To transform assets and liabilities - A swap such as the one just considered can be used to
transform borrowings in one currency to borrowings in another. Suppose that IBM can issue $
18 million of US dollar-denominated bonds at 6% interest. The swap has the effect of
transforming this transaction into one where IBM has borrowed E 10 million at 5% interest. The
initial exchange of principal converts the proceeds of the bond issue from US dollars to sterling.
The subsequent exchanges in the swap have the
Ill. Equity Swaps

Equity swaps are similar to interest rate swap contract. are two counterparties, Elbey e to
exchange a set of future cash flows at get date, in future, An Equity Swap is the exchange of
two payment streams between two counterparties over an agreed period where the first party
makes makes payments payments that of are either based a fixed on amount the returns or a
on floating a stock amount or a stock or payments index and the returns of a stock or a stock
index.
In other words, an equity swap is a transaction in which one party agrees to make a series
of payments determined by the return on a stock, a group of stocks, or a stock index to
another party in return for a cash flow that could be based on a fixed rate, a floating rate, or a
return on another stock or stock index. For example, one party can promise to receive the
return on the CNX Nifty index to another party in return for paying 120/0 fixed

The two cash flows are usually referred as 'legs' of the swap. The figure 2 illustrates this.

Floating leg

Figure 6 - Legs in an Equity Swap

(i) Floating Leg: The leg of an equity swap which is usually pegged to a floating rate such
as MIDOR or LIBOR is known as "floating leg"
(ii) Equity Leg: This is the other leg of a swap which is based on the performance of either
a share of a stock or a stock market index. It is commonly referred to as equity leg.
IV. Credit Default Swaps
A credit default swap is a credit derivative contract between two counterparties. The
buyer of a CDS is known as protection buyer and seller of a CDS is known as protection
seller. The protection buyer makes a series of payments (often referred to as the CDS fee or
spread) to the protection seller and in exchange receives a pay-off if an underlying financial
(credit) instrument defaults or experiences a similar credit event.
Features of a CDS
1. Bilateral Contract: A credit default swap is a bilateral contract between the buyer
and seller of protection.
2. Reference Entity- The CDS may refer to a specified loan or bond obligation of a
corporation or government. Such corporation or government is known a Reference
Entity or Reference Obligor who is not a party to the swap contracts.
3. Regular Premium Payments by the Protection Buyer - The buyer of protection will
make regular premium payments to the protection seller. If the associated cred it
instrument suffers no credit event, the protection buyer will continue the payment till
the maturity of the contract.
4. Termination of Contract on Default- If the Reference Entity defaults on its
debt, then the investor (the protection buyer) will cease paying premium and
the protection seller will pay the buyer for the loss.
 settlement - In case the Reference Entity defaults, one of two kinds of settlement
can
- physical Settlement: The protection buyer delivers a defaulted asset to
the (€cur rotection seller for payment of the par value, which is known as
physical settlement cash Settlement: The protection seller pays the protection
buyer the difference
or
between the par value and market price of the specified debt obligation, which is known
as cash settlement.
6. Risk: In a Credit Default Swap, both the buyer and seller of credit protection are
exposed to counterparty risks.

Commodity Swaps
A commodity swap is an agreement between two counterparties to exchange cash flows
riding upon the price of a given commodity. Essentially, it is an agreement whereby a price is
exchanged for a fixed price. One party will pay a fixed price for the given commodity
(notional underlying), while the counterparty will pay floating price for the same commodity
on the settlement date. Commodity swaps are used to lock-in the price of a commodity.
Commodity swaps are in essence a series of forward contracts on a commodity with different
maturity dates and the same delivery prices.

Features of Commodity Swap

1. It is equivalent to a series of forward contracts on a commodity.

2. Both the counterparties determine the Notional Principal in terms of the commodity.
For example, 5 kg gold. They also determine the fixed price of the commodity.
3. The Notional Principal is not exchanged.

4. In a commodity swap, the counterparties determine the settlement dates or the dates on
which the commodity price is recorded. On these dates, only cash flows are exchanged
by comparing the actual price of the commodity.

Types of Commodity Swaps

There are two types of commodity swaps. These are:
(i) Fixed-for-floating swap — This is just like the fixed-for-floating interest swap. Here,
floating rate a specified commodity is based on commodity index.
 (ii) Commodity for interest swap — These are similar to the equity swap in which a total
return on the commodity in question is exchanged for some money market rates.

VI. Debt-equity Swap

There can be different structure of swap contracts but the basics are fairly simple. In
debtequity swap, a firm buy's a country's debt on the secondary loan market at a discount and
swaps it into local equity. In other words, the debts are exchanged for equity by one firm with
the other
VI'. Options embedded in Swaps
Sometimes there are options embedded in a swap agreement. For example, in an
extendable swap, one party has the option to extend the life of the swap beyond the
specified period. Ina puttable swap, one party has the option to terminate the swap early.
Options on swaps, or swaptions, are also available. These provide one party with the
right at a future time to enter into a swap where a predetermined fixed rate is exchanged
for floating.
Vlll. Volatility Swaps and Other Exotic Instruments
In a volatility swap there are a series of time periods. At the end of each period, one
side pays a pre -agreed volatility, while the other side pays the historical volatility realized
during the period. Both volatilities are multiplied by the same notional principal in
calculating payments.
Swaps are limited only by the imagination of financial engineers and the desire of
corporate treasurers and fund managers for exotic structures. In Chapter 32, we will
describe the famous 5/30 swap entered into between Procter and Gamble and Bankers
Trust, where payments depended in a complex way on the 30-day commercial paper rate, a
30-year Treasury bond price, and the yield on a 5-year Treasury bond.