SWAPS
SWAPS
A swap is a derivative contract where two parties exchange (swap)
cash flows over a period of time.
The true idea of a swap is that open person has a risk he doesn’t want
and that’s a risk another person can manage better.
They exchange the cash flows
TYPES OF SWAPS
• INTEREST RATE SWAPS
• CURRENCY SWAPS
• COMMODITY SWAP
• CREDIT DEFAULT SWAP
INTEREST RATE SWAPS
Two parties exchange interest payments on a fixed amount (called
notional principal), without exchanging the principal itself.
An Interest Rate Swap is a derivative contract where:
• One party pays fixed interest rate
• Other party pays floating interest rate
FIXED INTEREST RATE :
A fixed interest rate is a rate that never changes during the entire
period.
Eg: Paying 5000 every year for a 100000 worth loan at 5% fixed interest
rate
FLOATING INTEREST RATE:
A floating interest rate changes periodically based on a benchmark
index.
Benchmarks :
SOFR ( Secured Overnight Financing Rate ) (replace LIBOR)
MIBOR ( Mumbai Interbank Offered Rate )
RBI
How it actually works?
Swaps are done majorly between
• Banks
• Corporations
• Insurance Companies
• Pension Funds
• Hedge Funds
Institution Why They Use Swaps Type Mostly Used
Hedge balance-sheet risk, Interest rate swaps,
Banks
market making currency swaps
Lower borrowing cost, hedge Interest rate swaps,
Corporations
FX currency swaps
Long-term interest rate
Insurance Companies Match long-term liabilities
swaps
Interest rate swaps (long
Pension Funds Hedge pension obligations
duration)
Hedge Funds Speculation & arbitrage TRS, CDS, IRS, FX swaps
Why do they use swaps?
• Managing Risk
• Matching Assets and Liabilities
• Lowering Interest Rate Costs
• Speculation
INTEREST RATE SWAPS
• Using Interest rate Swaps to lower borrowing costs,
• hedge against risk of rising interest rates,
• hedge against risk of falling interest rates.
CURRENCY SWAPS
A currency swap is a contract where two parties exchange:
• Principal amount in two different currencies
• Interest payments on those principals
• They re-exchange the principal at the original exchange rate
Example:
Company A (India) needs USD.
Company B (USA) needs INR.
Instead of borrowing in foreign markets at high cost, they exchange:
• A gives ₹100 crore
• B gives USD 12.5 million
(Assume 1 USD = ₹80)
Then during the swap:
• A pays interest in USD
• B pays interest in INR
TYPES
• FIXED FOR FIXED
• FIXED FOR FLOATING
• FLOATING FOR FLOATING
• ANNUITY SWAPS
• DIFFERENTIAL SWAPS
FIXED TO FIXED CURRENCY SWAP
Two parties exchange fixed interest payments in two different currencies.
• Long-term foreign loans
• Currency swaps between big corporations or governments
Party A pays 5% fixed in USD
Party B pays 6% fixed in INR
WHY?
To borrow cheaply in a foreign currency.
Often, a company can borrow cheaply in its home country but very expensively abroad.
So they borrow locally and use a swap to “convert” the loan into another currency.
FIXED TO FLOATING SWAPS
One side pays fixed interest, the other pays floating (SOFR, MIBOR, LIBOR,
etc.).
Why its used:
REASON 1: HEDGE INTEREST RATE RISK
• If rates may go up, a company pays fixed to protect itself.
• If rates may go down, a company pays floating to benefit.
A pays 4% fixed in USD
B pays MIBOR + 1% floating in INR
FLOATING FOR FLOATING SWAP
Both parties pay floating interest in different currencies
A pays SOFR + 0.5% in USD
B pays EURIBOR + 0.3% in EUR
Purpose:
• Hedge floating exposure in a foreign currency
• Access cheaper floating funding abroad
ANNUITY SWAP
Payments are made as equal annuity-style amounts, not interest-only.
Like EMI payments (equal every month/year).
• One party pays a fixed annuity amount,
while receiving a floating payment based on interest rates.
• So instead of only interest payments,
the paying side pays fixed EMI-like amounts.
Example:
A pays: ₹50 lakh per year fixed (annuity)
B pays: floating MIBOR-based interest
DIFFERENTIAL SWAP
A Differential Swap is a swap where interest rate comes from one
country, but payment is made in another currency.
Interest rate from Country A
Payment in currency of Country B
Actual cash exchanged = only in one currency
You notice US interest rate = 5% but India interest rate = 3%.
You want to earn based on US interest rate (5%),
but you DON’T want to deal with USD or exchange rate risk.
So you enter a Swap:
• Interest rate used US rate (5%)
• Payment you receive in INR
• Payment you pay in INR
• Exchange rate NOT considered during settlement
COMMODITY RISK
Commodity risk refers to the uncertainty of future market values and
the potential for financial loss or gain caused by fluctuations in the
prices of raw materials or primary agricultural products
• FIXED – eg: Airline
• FLOATING – eg: Oil company
CREDIT DEFAULT SWAP
A Credit Default Swap (CDS) is essentially a financial insurance contract against the
risk that a borrower (like a company or government) will fail to repay its debt.
• The Buyer of Protection (The Insured): This is typically a bondholder or lender
(like a bank) who wants to reduce their risk exposure to the borrower's default.
They pay a regular, periodic fee (the premium or spread) to the seller, much
like paying insurance premiums
• The Seller of Protection (The Insurer): This is usually a financial institution or
investor willing to take on the risk in exchange for the regular premium payments
They agree to compensate the buyer if a specific "credit event" occurs (e.g.,
bankruptcy, failure to pay interest or principal).