Project on SWAPS-structure, IRS and how to hedgingSWAPS

Submitted to:- Prof. Deepak tendon Submitted by:- Anuradhasharma Group-1 Pg20082421

Swap () In finance, a is a in which two 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. 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 used to create unfunded exposures to an underlying asset, since counterparties can earn the profit or loss from movements in price without having to post the notional amount 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. The first swaps were negotiated in the early 1980s. David Swensen, a Yale Ph.D. at Salomon Brothers, engineered the first swap transaction according to "When Genius Failed: The Rise and Fall of Long-Term Capital Management" by Roger Lowenstein. Today, swaps are among the most heavily traded financial contracts in the world. Swap market

Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange, IntercontinentalExchange and Frankfurt-based Eurex AG. The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC . At the end of 2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross world product. However, since the cash flow generated by a swap is equal to an interest rate times that notional amount, the cash flow generated from swaps is a substantial fraction of but much less than the gross world product —which is also a cash-flow measure. The majority of this (USD 292.0 trillion) was due to interest rate swaps. These split by currency as: The CDS and markets are dwarfed by the market. All three markets peaked in mid 2008. Source: BIS Semiannual OTC derivatives statistics at end-December 2008

Notional outstanding in USD trillion

Currency End 2000 End 2001 End 2002 End 2003 End 2004 End 2005 End 2006

Euro 16.6 20.9 31.5 44.7 59.3 81.4 112.1

US dollar 13.0 18.9 23.7 33.4 44.8 74.4 97.6

Japanese yen 11.1 10.1 12.8 17.4 21.5 25.6 38.0

Pound sterling 4.0 5.0 6.2 7.9 11.6 15.1 22.3

Swiss franc 1.1 1.2 1.5 2.0 2.7 3.3 3.5

Total 48.8 58.9 79.2 111.2 147.4 212.0 292.0

Source: "The Global OTC Derivatives Market at end-December 2004", BIS, "OTC Derivatives Market Activity in the Second Half of 2006", BIS. Usually, at least one of the legs has a rate that is variable. It can depend on a reference rate, the total return of a swap, an economic statistic, etc. The most important criterion is that it comes from an independent third party, to avoid any conflict of interest. For instance, is published by the British Bankers Association, an independent trade body. 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

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 +70basis points. Party A in turn 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 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. Commodity swaps A 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 oil. An equity swap is a special type of , 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 have. Credit default swaps A (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 credit 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 Other variations There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures.A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then party A receives this amount from party B. The parties have exposure to the return of the underlying stock or index, without having to hold the underlying assets. The profit or loss of party B is the same for him as actually owning the underlying asset.

. An on a swap is called a . These provide one party with the right but not the obligation at a future time to enter into a swap. . A is an over-the-counter instrument that allows one to speculate on or hedge risks associated with the magnitude of movement, i.e. , of some underlying product, like an exchange rate, interest rate, or stock index. . A , also known as a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap. . An Amortising swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such LIBOR.

Valuation

The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap is worth zero when it is first initiated, however after this time its value may become positive or negative.[1] There are two ways to value swaps: in terms of bond prices, or as a portfolio of forward contracts.[1] Using bond prices While principal payments are not exchanged in an interest rate swap, assuming that these are received and paid at the end of the swap does not change its value. Thus, from the point of view of the floating-rate payer, a swap can be regarded as a long position in a fixed-rate bond (i.e. receiving fixed interest payments), and a short position in a floating rate note (i.e. makingfloating interest payments):

Vswap = Bfixed − Bfloating From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite positions. That is,

Vswap = Bfloating − Bfixed Similarly, currency swaps can be regarded as having positions in bonds whose cash flows correspond to those in the swap. Thus, the home currency value is:

Vswap = Bdomestic − S0Bforeign, where Bdomestic is the domestic cash flows of the

swap, Bforeign is the foreign cash flows of the swap, and S0 is the spot exchange rate. Using forward rate agreements Consider a three year interest rate swap with semiannual payments. The first cash flow is known at the time the swap is initiated, however the other five exchanges can be regarded as forward rate agreements. The payment for these other exchanges is the 6 month rate observed in the market 6 months earlier. Assuming that forward interest rates are realised, this method values the swap by firstly calculating the required forward rates using the LIBOR/swap curve, then calculating the swap cash flows using these rates, and then finally discounting these cash flows back to today. London Interbank Offered Rate (LIBOR) LIBOR is the rate of interest offered by banks on deposit from other banks in the eurocurrency market. One-month LIBOR is the rate offered for 1-month deposits, 3- month LIBOR for three months deposits, etc. LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just like the prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the International Market. Arbitrage arguments As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the NPV of these future cash flows is equal to zero. Where this is not the case, arbitrage would be possible. For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement the fixed rate would be such that the present value of future fixed rate payments by Party A are equal to the present value of the expected future floating rate payments (i.e. the NPV is zero). Where this is not the case, an Arbitrageur, C, could:

1. assume the position with the lower present value of payments, and borrow funds equal to this present value 2. meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding payments - which have a higher present value 3. use the received payments to repay the debt on the borrowed funds 4. pocket the difference - where the difference between the present value of the loan and the present value of the inflows is the arbitrage profit.

Subsequently, once traded, the price of the Swap must equate to the price of the various corresponding instruments as mentioned above. Where this is not true, an arbitrageur could similarly short sell the overpriced instrument, and use the proceeds to purchase the correctly priced instrument, pocket the difference, and then use payments generated to service the instrument which he is short.

Swaps: complex structures Complex swap structures refer to non-standard swaps whose coupons,notional, accrual and calendar used for coupon determination and paymentsare tailored made to serve client’s perspectives and needs in terms of riskmanagement, accounting hedging, asset re-packaging, credit diversificationand or speculation rationale.Complex swap structure are often part of more complex structures issued viaa special purpose vehicle, referred to as an SPV, which combines a swap, abond, and many other potential elements, like credit related instruments. Thistotal package is called in structurers’ jargon a structured note.On the risk engineering side, exotic (also called non-generic) swapsstructures can be quite involving in terms of pricing risk management andproduct applications. Compared to vanilla interest rate swaps, exotic swapsoffer the additional challenge of modeling accurately the yield curve, the skew and correlation of the various forward Libor and longer maturity rates involvedin the product. Exact estimation of the number of factors needed to price agiven exotic swap is also crucial.The first generation of non-generic swap, which by today’s standards havebecome vanilla products, includes: Simple structures: Forward starting swap, for protection in the future. On the liability side,this allows to pre-hedge anticipated debt like a bond issue, or loanwhile on the asset side, to lock in the expected revenues of the sell ofan asset like in a and so on. Amortizing and rollercoaster swaps. Compared to vanilla swaps, thesestructures offer the additional advantage to match their notional withthe one of the liabilities or assets payment, following the sameschedule. A typical example is the case of a swap against a pool ofmortgages. Deferred coupon, predefined stepped coupon and zero coupon swaps,whose coupons are designed to provide additional pick-up to clients aswell as appropriate duration of cash flows. Non-generic cross currency swap: cross currency swap with off marketrates. Structures requiring some adjustment on the forwards like convexity correction and quanto correction: Constant Maturity Swaps (CMS) and Constant Maturity TreasurySwaps (CMT) swaps:designed to risk manage yield curve exposure,these swaps needs to be priced with appropriate convexity correctiondue to the mismatch between the payment and the swap rate . CMS, CMT caps/floors, . Compared to vanilla swaptions,these options are based on longer maturity rates to risk manage longmaturity interest rates risks. In-Arrears Swaps: swaps whose Libor rates reset and are paid at thesame time. Because of the mismatch between the payment scheduleof the Libor and the one of the swap, the pricing of the In-arrear Liborsare equal to the standard forward plus a convexity correction. Differential Swaps, which are quanto swap. The quanto featureenables to get exposure to foreign market without any foreignexchange exposure. The quanto risk depends on the joint movement ofthe Libor rates and the forward fx, hence the terminology of correlation product. Power swap:swap whose floating leg pays Libor square, Libor cubicand more generally a power function of the Libor rate. Non standardunderlyings like inflation related, equity and asset swap:CPI (Real Interest Rate) Swaps paying an inflation-linked index, oftenin a form. Asset swap: one leg pays the cash flows of a bond, while the floatingleg pays a spread over Libor to make the two legs equal. Equity swap: it follows a similar logic to an asset swap. Credit related swap like Credit default swap. Although this is a swap, it is often risk managed and traded by the deskof credit derivatives and not the swap and exotic swap desk. This first generation of non-generic swap has been widely used for asset andliability management as well as simple trading strategies1. However, interestrates derivatives dealers have developed more exotic swaps to answer aneed for higher sophistication of interest rates risk exposure. The secondgeneration refers to more requiring modeling of the evolution ofthe yield curve but also the correlation and the distribution between its various components (both conditional and terminal distributions). Index amortizing swaps, whose notional amortization schedule is linked toa floating rate. This swap are of great use when hedging pool of liabilitieswhose notional can amortize according to early redemption mainlyinfluenced by the overall level of the interest rate. This type of swaprequires a good modeling of the dependence between the different floatingrates. Bermudan structures: used for instance to hedge structured (callable,putable) bonds, as well as providing additional flexibility when to exercisethe Bermudan swaption (either receiver or payer Bermudan swaptions). Range accrual Swaps: swaps whose notional accretes when a certainfloating rate, often a different rate from the one used to pay, lies within arange. Accrual swaps are in fact a strip of digital options. Asian swap,whose Libor fixing are averaged to get smoother payment.Often used in combination of other exotic features. Digital (Binary) options: swap that pays a certain fix amount if the rates isabove or below a certain level. Binaries can be completely replicated.1Zero cost structures are very popular among investors. Typical example is zero cost collars where thepurchase of the call is financed by the sale of a put or vice versa.However, for practical hedging, one needs to aggregate the static hedgeacross a few instruments and get the best approximating hedge. structures, also referred to a trigger swaps and swaptions,whose payoff is activated or dis-activated when a certain floating rate goes above or below a certain threshold. The attractive cheaper premium is alogic consequence of the upside given up. Chooser swap/swaptions, where the option holder can choose to enter intoa receiver or a payer swap. Other forms of choose swap/swaptions allowthe user to specify when to fix the floating rate, during an observationwindow. Extendible and cancelable swaps(callable and putable swaps): verysimilar to Bermudan swaption, this structure allows extending orterminating a given swap. Useful to hedge liabilities whose terminationdate is uncertain. Complex swap structures are widely used for additional flexibility to matchbetter liabilities whose notional and payment dates can be very uncertain.Complex swap can be a combination of the above individual component, likefor instance power Libor, quanto, knock out swap. Complex swap structurescan be used to get additional leverages for relative value trading and quasiarbitrage on the yield curve.When designing a complex swap structure, structurers and financialengineers need to get a good understanding of the client’s situation andneeds and to perform a thorough analysis of the impact of the structuredproduct on her portfolio. To analyze risk, one decomposes the derivative intosimple hedgeable components to isolate the various optionality and risk. Thestructurer makes also the difference between asset and liability point of view,as investor and borrower strategies have very different needs.

What is an interest rate swap?

The interest rate swap is a very efficient instrument. It can be constructed at extremely low cost and is probably less expensive than taking out a new fixed rate loan and using the proceeds to buy an offsetting floating rate security paying LIBOR. Technically this would accomplish the same thing but it would surely be much more costly and time consuming to set up.

Interest rate swaps have several advantages over futures contracts. First, futures are only available two to four years out. Interest rate swaps can be arranged at any time. Secondly, futures contracts have to be marked to market every day, which could bring unexpected cash outflows. Interest rate swaps do not enact this often. Finally, and most importantly, the interest rate swap is cheaper and requires less monitoring. These are the reasons corporations are becoming involved more in interest rate swaps than futures as part of their treasury management.

(i) An interest rate swap is a contractual agreement entered into between two counterparties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. The principal amount is notional because there is no need to exchange actual amounts of principal in a single currency transaction: there is no foreign exchange component to be taken account of. Equally, however, a notional amount of principal is required in order to compute the actual cash amounts that will be periodically exchanged.

Under the commonest form of interest rate swap, a series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. This is a fixed-for-floating interest rate swap. Alternatively, both series of cash flows to be exchanged could be calculated using floating rates of interest but floating rates that are based upon different underlying indices. Examples might be Libor and commercial paper or Treasury bills and Libor and this form of interest rate swap is known as a basis or money market swap.

1. Pricing Interest Rate Swaps

If we consider the generic fixed-to-floating interest rate swap, the most obvious difficulty to be overcome in pricing such a swap would seem to be the fact that the future stream of floating rate payments to be made by one counterparty is unknown at the time the swap is being priced. This must be literally true: no one can know with absolute certainty what the 6 month US dollar Libor rate will be in 12 months’ time or 18 months’ time. However, if the capital markets do not possess an infallible crystal ball in which the precise trend of future interest rates can be observed, the markets do possess a considerable body of information about the relationship between interest rates and future periods of time. In many countries, for example, there is a deep and liquid market in interest bearing securities issued by the government. These securities pay interest on a periodic basis, they are issued with a wide range of maturities, principal is repaid only at maturity and at any given point in time the market values these securities to yield whatever rate of interest is necessary to make the securities trade at their par value.

It is possible, therefore, to plot a graph of the yields of such securities having regard to their varying maturities. This graph is known generally as a yield curve -- i.e.: the relationship between future interest rates and time -- and a graph showing the yield of securities displaying the same characteristics as government securities is known as the par coupon yield curve. The classic example of a par coupon yield curve is the US Treasury yield curve. A different kind of security to a government security or similar interest bearing note is the zero- coupon bond. The zero-coupon bond does not pay interest at periodic intervals. Instead it is issued at a discount from its par or face value but is redeemed at par, the accumulated discount which is then repaid representing compounded or "rolled-up" interest. A graph of the internal rate of return (IRR) of zero-coupon bonds over a range of maturities is known as the zero-coupon yield curve.

Finally, at any time the market is prepared to quote an investor forward interest rates. If, for example, an investor wishes to place a sum of money on deposit for six months and then reinvest that deposit once it has matured for a further six months, then the market will quote today a rate at which the investor can re-invest his deposit in six months’ time. This is not an in "crystal ball gazing" by the market. On the contrary, the six month forward deposit rate is a mathematically derived rate which reflects an arbitrage relationship between current (or spot) interest rates and forward interest rates. In other words, the six month forward interest rate will always be the precise rate of interest which eliminates any arbitrage profit. The forward interest rate will leave the investor indifferent as to whether he invests for six months and then re-invests for a further six months at the six month forward interest rate or whether he invests for a twelve month period at today's twelve month deposit rate.

The graphical relationship of forward interest rates is known as the forward yield curve. One must conclude, therefore, that even if -- literally -- future interest rates cannot be known in advance, the market does possess a great deal of information concerning the yield generated by existing instruments over future periods of time and it does have the ability to calculate forward interest rates which will always be at such a level as to eliminate any arbitrage profit with spot interest rates. Future floating rates of interest can be calculated, therefore, using the forward yield curve but this in itself is not sufficient to let us calculate the fixed rate payments due under the swap. A further piece of the puzzle is missing and this relates to the fact that the net present value of the aggregate set of cash flows due under any swap is -- at inception -- zero. The truth of this statement will become clear if we reflect on the fact that the net present value of any fixed rate or floating rate loan must be zero when that loan is granted, provided, of course, that the loan has been priced according to prevailing market terms. This must be true, since otherwise it would be possible to make money simply by borrowing money, a nonsensical result However, we have already seen that a fixed to floating interest rate swap is no more than the combination of a fixed rate loan and a floating rate loan without the initial borrowing and subsequent repayment of a principal amount. The net present value of both the fixed rate stream of payments and the floating rate stream of payments in a fixed to floating interest rate swap is zero, therefore, and the net present value of the complete swap must be zero, since it involves the exchange of one zero net present value stream of payments for a second net present value stream of payments. The pricing picture is now complete. Since the floating rate payments due under the swap can be calculated as explained above, the fixed rate payments will be of such an amount that when they are deducted from the floating rate payments and the net cash flow for each period is discounted at the appropriate rate given by the zero coupon yield curve, the net present value of the swap will be zero. It might also be noted that the actual fixed rate produced by the above calculation represents the par coupon rate payable for that maturity if the stream of fixed rate payments due under the swap are viewed as being a hypothetical fixed rate security. This could be proved by using standard fixed rate bond valuation techniques.

Financial Benefits Created By Swap Transactions

Consider the following statements:

(a) A company with the highest credit rating, AAA, will pay less to raise funds under identical terms and conditions than a less creditworthy company with a lower rating, say BBB. The incremental borrowing premium paid by a BBB company, which it will be convenient to refer to as a "credit quality spread", is greater in relation to fixed interest rate borrowings than it is for floating rate borrowings and this spread increases with maturity.

(b) The counterparty making fixed rate payments in a swap is predominantly the less creditworthy participant.

(c) Companies have been able to lower their nominal funding costs by using swaps in conjunction with credit quality spreads.

The Theory of Comparative Advantage

When we begin to seek an answer to the questions raised above, the response we are most likely to meet from both market participants and commentators alike is that each of the counterparties in a swap has a "comparative advantage" in a particular and different credit market and that an advantage in one market is used to obtain an equivalent advantage in a different market to which access was otherwise denied. The AAA company therefore raises funds in the floating rate market where it has an advantage, an advantage which is also possessed by company BBB in the fixed rate market.

The mechanism of an interest rate swap allows each company to exploit their privileged access to one market in order to produce interest rate savings in a different market. This argument is an attractive one because of its relative simplicity and because it is fully consistent with data provided by the swap market itself. However, as Clifford Smith, Charles Smithson and Sykes Wilford point out in their book MANAGING FINANCIAL RISK, it ignores the fact that the concept of comparative advantage is used in international trade theory, the discipline from which it is derived, to explain why a natural or other immobile benefit is a stimulus to international trade flows. As the authors point out: The United States has a comparative advantage in wheat because the United States has wheat producing acreage not available in Japan. If land could be moved -- if land in Kansas could be relocated outside Tokyo -- the comparative advantage would disappear. The international capital markets are, however, fully mobile. In the absence of barriers to capital flows, arbitrage will eliminate any comparative advantage that exists within such markets and this rationale for the creation of the swap transactions would be eliminated over time leading to the disappearance of the swap as a financial instrument. This conclusion clearly conflicts with the continued and expanding existence of the swap market.

It would seem, therefore, that even if the theory of comparative advantage does retain some force -- notwithstanding the effect of arbitrage -- which it almost certainly does, it cannot constitute the sole explanation for the value created by swap transactions. The source of that value may lie in part in at least two other areas.

Information Asymmetries

The much- vaunted economic efficiency of the capital markets may nevertheless co- exist with certain information asymmetries. Four authors from a major US money centre bank have argued that a company will -- and should -- choose to issue short term floating rate debt and swap this debt into fixed rate funding as compared with its other financing options if:

(1) It had information -- not available to the market generally -- which would suggest that its own credit quality spread (the difference, you will recall, between the cost of fixed and floating rate debt) would be lower in the future than the market expectation.

(2) It anticipates higher risk- free interest rates in the future than does the market and is more sensitive (i.e. averse) to such changes than the market generally.

In this situation a company is able to exploit its information asymmetry by issuing short term floating rate debt and to protect itself against future interest rate risk by swapping such floating rate debt into fixed rate debt.

Fixed Rate Debt and Embedded Options

Fixed rate debt typically includes either a prepayment option or, in the case of publicly traded debt, a call provision. In substance this right is no more and no less than a on interest rates and a right which becomes more valuable the further interest rates fall. By way of contrast, swap agreements do not contain a prepayment option. The early termination of a swap contract will involve the payment, in some form or other, of the value of the remaining contract period to maturity.

Returning, therefore, to our initial question as to why an interest rate swap can produce apparent financial benefits for both counterparties the true explanation is, I would suggest, a more complicated one than can be provided by the concept of comparative advantage alone. Information asymmetries may well be a factor, together with the fact that the fixed rate payer in an interest rate swap -- reflecting the fact that he has no early termination right -- is not paying a premium for the implicit embedded within a fixed rate loan that does contain a pre-payment rights. This saving is divided between both counterparties to the swap.

2. Reversing or Terminating Interest Rate Swaps

The point has been made above that at inception the net present value of the aggregate cashflows that comprise an interest rate swap will be zero. As time passes, however, this will cease to be the case, the reason for this being that the shape of the yield curves used to price the swap initially will change over time. Assume, for example, that shortly after an interest rate swap has been completed there is an increase in forward interest rates: the forward yield curve steepens. Since the fixed rate payments due under the swap are, by definition, fixed, this change in the prevailing interest rate environment will affect future floating rate payments only: current market expectations are that the future floating rate payments due under the swap will be higher than those originally expected when the swap was priced. This benefit will accrue to the fixed rate payer under the swap and will represent a cost to the floating rate payer. If the new net cashflows due under the swap are computed and if these are discounted at the appropriate new zero coupon rate for each future period (i.e. reflecting the current zero coupon yield curve and not the original zero coupon yield curve), the positive net present value result reflects how the value of the swap to the fixed rate payer has risen from zero at inception. Correspondingly, it demonstrates how the value of the swap to the floating rate payer has declined from zero to a negative amount.

What we have done in the above example is mark the interest rate swap to market. If, having done this, the floating rate payer wishes to terminate the swap with the fixed rate payer's agreement, then the positive net present value figure we have calculated represents the termination payment that will have to be paid to the fixed rate payer. Alternatively, if the floating rate payer wishes to cancel the swap by entering into a reverse swap with a new counterparty for the remaining term of the original swap, the net present value figure represents the payment that the floating rate payer will have to make to the new counterparty in order for him to enter into a swap which precisely mirrors the terms and conditions of the original swap.

Credit Risk Implicit in Interest Rate Swaps

To the extent that any interest rate swap involves mutual obligations to exchange cash flows, a degree of credit risk must be implicit in the swap. Note however, that because a swap is a notional principal contract, no credit risk arises in respect of an amount of principal advanced by a lender to a borrower which would be the case with a loan. Further, because the cashflows to be exchanged under an interest rate swap on each settlement date are typically "netted" (or offset) what is paid or received represents simply the difference between fixed and floating rates of interest. Contrast this again with a loan where what is due is an absolute amount of interest representing either a fixed or a floating rate of interest applied to the outstanding principal balance. The periodic cash flows under a swap will, by definition, be smaller therefore than the periodic cash flows due under a comparable loan.

An interest rate swap is in essence a series of forward contracts on interest rates.. In distinction to a , the periodic exchange of payment flows provided for under an interest rate swap does provide for a partial periodic settlement of the contract but it is important to appreciate that the net present value of the swap does not reduce to zero once a periodic exchange has taken place. This will not be the case because -- as discussed in the context of reversing or terminating interest rate swaps -- the shape of the yield curve used to price the swap initially will change over time giving the swap a positive net present value for either the fixed rate payer or the floating rate payer notwithstanding that a periodic exchange of payments is being made.

Users and Uses of Interest Rate Swaps Interest rate swaps are used by a wide range of commercial banks, investment banks, non- financial operating companies, insurance companies, mortgage companies, investment vehicles and trusts, government agencies and sovereign states for one or more of the following reasons:

1. To obtain lower cost funding

2. To hedge interest rate exposure

3. To obtain higher yielding investment assets

4. To create types of investment asset not otherwise obtainable

5. To implement overall asset or liability management strategies

6. To take speculative positions in relation to future movements in interest rates.

The advantages of interest rate swaps include the following:

1. A floating-to-fixed swap increases the certainty of an issuer's future obligations.

2. Swapping from fixed-to-floating rate may save the issuer money if interest rates decline.

3. Swapping allows issuers to revise their debt profile to take advantage of current or expected future market conditions.

4. Interest rate swaps are a financial tool that potentially can help issuers lower the amount of debt service.

“Typical transactions would certainly include the following, although the range of possible permutations is almost endless.”

(a) Reduce Funding Costs. A US industrial corporation with a single A credit rating wants to raise US$100 million of seven year fixed rate debt that would be callable at par after three years. In order to reduce its funding cost it actually issues six month commercial paper and simultaneously enters into a seven year, Nona mortising swap under which it receives a six month floating rate of interest (Libor Flat) and pays a series of fixed semi- annual swap payments. The cost saving is 110 basis points.

(b) Liability Management. A company actually issues seven year fixed rate debt which is callable after three years and which carries a coupon of 7%. It enters into a fixed- to- floating interest rate swap for three years only under the terms of which it pays a floating rate of Libor + 185 bps and receives a fixed rate of 7%. At the end of three years the company has the flexibility of calling its fixed rate loan -- in which case it will have actually borrowed on a synthetic floating rate basis for three years -- or it can keep its loan obligation outstanding and pay a 7% fixed rate for a further four years. As a further variation, the company's fixed- to- floating interest rate swap could be an "arrears reset swap" in which -- unlike a conventional swap -- the swap rate is set at the end and not at the beginning of each period. This effectively extends the company's exposure to Libor by one additional interest period which will improve the economics of the transaction.

(c) Speculative Position. The same company described in (b) above may be willing to take a position on short term interest rates and lower its cost of borrowing even further (provided that its judgment as to the level of future interest rates is correct). The company enters into a three year "yield curve arbitrage swap" in which the floating rate payments it makes under the swap are calculated by reference to a formula. For each basis point that Libor rises, the company's floating rate swap payments rise by two basis points. The company's spread over Libor, however, falls from 185 bps to 144 bps. In exchange, therefore, for significantly increasing its exposure to short term rates, the company can generate powerful savings.

(d) Hedging Interest Rate Exposure. A financial institution providing fixed rate mortgages is exposed in a period of falling interest rates if homeowners choose to pre- pay their mortgages and re- finance at a lower rate. It protects against this risk by entering into an "index-amortizing rate swap" with, for example, a US regional bank. Under the terms of this swap the US regional bank will receive fixed rate payments of 100 bps to as much as 150 bps above the fixed rate payable under a straightforward interest rate swap. In exchange, the bank accepts that the notional principal amount of the swap will amortize as rates fall and that the faster rates fall, the faster the notional principal will be amortized.

A less aggressive version of the same structure is the "indexed principal swap". Here the notional principal amount continually amortizes in line with a mortgage pre- payment index such as PSA but the amortization rate increases when interest rates fall and the rate decreases when interest rates rise.

(e) Creation of New Investment Assets. A UK corporate treasurer whose company has substantial business in Spain feels that the current short term yield curves for sterling and the peseta which shows absolute interest rates converging in the two countries is exaggerated. Consequently he takes cash currently invested in the short term sterling money markets and invests this cash in a "differential swap". A differential swap is a swap under which the UK Company will pay a floating rate of interest in sterling (6 mth. Libor) and receive, also in sterling, a stream of floating rate payments reflecting Spanish interest rates plus or minus a spread. The flows might be: UK Corporation pays six month sterling Libor flat and receives six month Peseta Mibor less 210 bps paid in sterling. Assuming a two year transaction and assuming sterling interest rates remained at their initial level of 5.25%, peseta Mibor would have to fall by 80 bps every six months in order for the treasurer to earn a lower return on his investment than would have been received from a conventional sterling money market deposit.

(f) Asset Management.A German based fund manager has a view that the sterling yield curve will steepen (i.e. rates will increase) in the range two to five years during the next three years he enters into a "yield curve swap "with a German bank whereby the fund manager pays semi- annual fixed rate payments in DM based on the two year sterling swap rate plus 50 bps. Every six months the rate is re- set to reflect the new two year sterling swap rate. He receives six monthly fixed rate payments calculated by reference to the five year sterling swap rate and re- priced every six months. The fund manager will profit if the yield curve steepens more than 50 bps between two and five years.