Interest Rate Swaps - Explained in Hindi - YouTube

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Namaskar! my name is Mukul

and you are welcome to the Asset Yogi channel

Friends in this video,

we are going to talk about the interest rate swaps

which is a financial derivative.

I've already made a video about the basics of financial derivatives,

In fact, we've done two more videos, 'futures' and 'forwards'

You can watch those videos too, you will get links in the description below.

So in the basics, we had seen that

the financial derivative is a financial instrument by which

which derives its value from any other underlying asset.

So interest rate swap is also such financial instrument

which derives the value from the interest rate.

It is not for a retail investor like you and me.

Generally, those companies engage in this

which wants to reduce their interest rate

or they want to reduce their risk which we also called hedging.

How do they reduce the interest rate?

if any company wants to go from floating to fixed,

then it can engage any other such company

which wants to come in floating from fixed.

We call it interest rate swaps.

So how is its mechanics?

how does its calculation happen? what kind of cash flows are generated

for both the parties?

along with this, what kind of role do intermediaries have?

What do speculators do in the swaps?

We'll know all these things in this video,

so watch this video till the end.

Let's straight go to the blackboard.

To understand the interest swaps,

we assume there are two companies,

company A and company B, which have taken some loans from the market.

Let's say company A has taken a loan of rupees 1 crore,

from lender 1, this a bank which we are calling lender 1

or we can call l1 in sort form, to understand.

here if it has taken a loan of rupees 1 crore,

then it has to pay the interest rate of MIBOR + 2%.

MIBOR is Mumbai Inter-Bank Offer Rate.

The meaning of MIBOR is

the interest rate at which banks give loans to each other.

So in India, MIBOR is used popularly.

Whichever the prime customers are,

whichever is the average interest of the banks

which they give to their prime customers

the MIBOR is calculated by taking the average of those interest rates.

So you can say that it is the average rate of the prime customers.

And this 2% is the risk premium.

So for company A, the risk premium is set as 2%.

So company A has taken this loan of 1 crore at MIBOR + 2%.

On the other hand, company B has taken a loan of 1 crore,

from any other bank, we'll call it lender 2, we do this l2 here.

The requirements of both can be different.

Company A thinks that in the upcoming time MIBOR will increase

it wants to reduce its risk.

Let's assume the MIBOR at today's date is 8%.

So the current total interest rate is

8% + 2%, so the total interest is 10%.

So now the company thinks it would be better to pay the fixed interest

because we don't want to take this risk of going MIBOR up and down.

But if they go to the banks then the bank is not giving them a fixed interest rate.

So in this case, they have the option of swaps.

Company B has the other requirement,

it thinks our fixed interest rate is very high,

we want to reduce our interest rate,

and we don't care if we get variable interest,

and company B thinks in the upcoming time

it will decrease in the upcoming time,

that's why it is ready to take this risk,

it says we're ready to take the variable interest rates.

If we get any party that is interested to exchange this interest rate

then we are ready.

We call this thing interest rate swap.

So let's see how does the mechanics happen?

Company A will say we are ready to give a fixed interest rate of 10%

it is saying our variable is 10%.

Let's get this fixed, what's wrong with that.

It will give a fixed interest rate of 10% on 1 crore.

But this 1 crore will not be changed,

understand, this value of 1 crore is the notional value

This means they don't have to give 1 crore rupees,

they'll have to pay only the difference of the interest

I'll make you understand, how?

So as they said we're promising you a 10% fixed rate,

and company A is also saying we'll give you interest of MIBOR + 1%.

So company A is also agreed on this.

It say's okay

here is a little difference of 1%,

we're paying here 10%,

we can get 9% immediately also.

But we think this MIBOR will increase in upcoming time,

this is why we don't want to take this risk.

And let's say all these loans are for 5 years.

A and B have taken the loans from lenders 1 and 2 are for 5 years.

And both of these companies do back-to-back arrangements for 5 years.

So now see on the timeline,

how the payouts of interest and principal will be done?

Let's see this once,

how the cashflows will be created for the company A and B?

Now see, here I write MIBOR on the upper side,

We'll see if MIBOR fluctuates

then how much profits or losses will be to the companies A and B.

So let's assume in this portion,

they've signed the contract in the year 0,

let's say this swap agreement,

I write here,

We are putting it into the box like this.

And this is a swap agreement, which is done between companies A and B.

And let's say it is done in the year 0 on the 0 dates.

Now the MIBOR is 8% from year 0 to year 1,

and let's assume for year 1 to year 2 it becomes 10%.

So in this way, in upcoming times also cashflows will depend on the MIBOR.

If we understand for 2 years then we will understand the cashflows.

So now see, what will happen in year 1?

What kind of transactions will be between A and B?

How much A will give to B?

It will give the 10% fixed only, it is fixed.

So what is the 10% of 1 crore for one year

it is 10 lakh rupees.

And how much B will give to A?

Here it is MIBOR + 1%,

What is the MIBOR here? 8%

8% + 1% means 9%.

So here it is 9 lakh rupees.

So B will give 9 lakh rupees to A,

So A will give a net of 1 lakh rupees to B.

Let me write here itself,

under this swap agreement, A will basically give a net of 1 lakh rupees to B.

Now talk about year 2,

In year 2 MIBOR becomes 10%,

now again understand the transactions.

Between A and B how many and what kind of transactions will be at the end of year 2?

How much A will give to B, it is fixed 10%,

it will give 10 lakh only.

How much B will give to A?

Here MIBOR + 1%

MIBOR of 10% + 1% means 11 lakh rupees will give.

So what will be the net transaction here?

Here B gives 11 and from A to B it is 10 lakh

so B will give 1 lakh rupees net to A.

See what kind of cash flows will be here?

First, we see the cash flows of A,

so A basically pays 1 lakh to B

and second,

means 1 lakh is to give under this swap agreement.

It has to give interest to lender 1 also

So how much is this? 10%,

10% will be? 10 lakh,

so this 10 lakh is to give to l1.

So how much net money A will have to pay?

We write net payment here,

10 lakh and 1 lakh.

So we can say that the net payment is 11 lakh,

and the interest becomes almost 11%.

On the other hand, let's see the cash flows of B also.

We've seen cash flows of A now let's see cash flows of B also,

So you see basically B is getting 1 lakh rupees.

So here we write, B gets 1 lakh from A.

Right!

After that B has to do its payment also,

He has to do payment here, 11% fixed,

so how much does this become? 11 lakh.

And it is to give to l2.

So how much is the net payment?

We write net payment here,

1 lakh has gone from net payment 11 lakh

it gets 1 lakh from A,

So what is the net payment?

Sorry! it is not 12 lakh, it is 11 lakh - 1 lakh

payment of 10 lakh.

And basically, the effective interest for B is 10%.

Now see the transactions of year 2,

let me do a little separation here.

We take A first,

A basically pays,

Sorry! here pays will not come, gets will come

because here 1 lakh is coming from B to A.

So basically A gets 1 lakh, B pays.

And how much is to pay it to lender 1?

Here you see MIBOR becomes 10%,

10% + 2%, here it becomes 12 lakhs.

It is to be paid to l1.

So here the net payment comes out to be

we write net payment here

1 lakhs gone from 12 lakhs, it is 11 lakh

so you see, it becomes 11%, its effective interest rate.

Now we talk about B,

B has to pay 1 lakh rupees

so here 'pays' come, 1 lakh to A

and pays,

it has to give 11% fixed

11 lakhs to l2.

So the net payment of B becomes, 11 lakh + 1 lakh, 12 lakh.

Let's see the interpretation, what do we understand from these payments?

You see here, we were talking about company A.

whatever interest they were giving to lender1

this interest was variable.

Now you see here whatever the MIBOR becomes,

Its payment will be 11 lakh only.

In both cases, it is 11 lakh.

So what they've done?

by doing the swap, they have changed their the variable interest in fixed,

now it becomes a fixed interest rate.

On the other hand, if we see the payments of B

So here, their interest rate was fixed

but now it becomes variable.

What does it mean by variable?

That if this MIBOR goes up or down, then all the risk is of company B

Now you see here when MIBOR was less,

you see here MIBOR was only 8%,

then here, their payments get reduced, it was 10 lakh.

This means it becomes 10%, though actually, they had to give 11%.

But as the MIBOR increases, their payment will increase.

If we see in the second case,

then if they keep paying the fixed interest,

and don't do the swap agreement then their interest rate will be 11% only,

but now, in this case, it becomes 12 lakh means 12%.

So in this way, in a swap agreement, if two parties agree,

then they can go into a swap agreement.

Now let me tell you one more point in this,

how this company A will find company B?

It is not that easy!

So for this, there is an intermediary bank.

It can be this bank or this bank,

or it can be a third party's bank.

So in such cases, the bank becomes the dealer between company A and company B,

and it takes a little commission between company A and company B.

Like it will say to company A, you give us this 10% interest,

this is 10%,

and when it will pass this interest payment, it will pass only 9.75%

so it will keep 0.25% with itself.

Similarly, it is taking interest rate from company B,

then it will say to them you give us MIBOR + 1%,

and when it will pass this interest, it will pass MIBOR + 0.75% only,

so in this way, it earns 0.25% in both the payments.

So in this way, a swap agreement works.

Now see, we talked about the swap agreement,

two kinds of people use this swap agreement,

one is a speculator, who wants to earn money from this arrangement,

want to earn money from this fluctuation of interest rate or MIBOR,

then we can call it speculator or gambler.

The second is hedger, as we've seen in this case,

company A and B are going to swap agreements to reduce their risks.

So these both kinds of parties do interest rate swaps.

I hope you liked this video,

In this video, we had talked about interest rate swaps,

in an upcoming video, we'll talk about currency swaps.

So you must watch that video too.

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