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5a. Types of Swaps | Introduction to Swaps | Interest rate Swap | Commodity Swap | Debt-Equity Swap - YouTube
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Hello everyone, today we are going to discuss
the next type of derivative i.e. the Swap.
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A swap is basically an exchange
of one cash flow for another.
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E.g. Mr Fin exchanges the return generated
by his shares of Facebook with the return
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generated by the shares of Microsoft
held by Mr. Toon at the end of the year.
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Both of them hold shares worth $10,000.
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If Facebook gives a return of 5%
and Microsoft gives a return of 2%,
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Mr. Fin will give $500 to Mr. Toon
and Mr. Toon will pay $200 to Mr. Fin.
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Thus, both of them are able to get a return on
the others’ share without actually owning it.
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However, like any other derivative contract, only
one of them will experience a favorable outcome.
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In this case, Mr. Fin is a net loser and
was better off without the swap contract.
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Swaps are OTC contracts and
do not trade on exchanges.
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These contracts are customized to
suit the needs of both parties.
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Such contracts are usually used only
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by large businesses and institutions
for hedging or speculation.
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The transaction could be done with the help
of an intermediary, who would charge a fee.
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In most swaps, parties do not make
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any initial payments to each other
when they enter into the agreement.
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As these contracts are not regulated,
the risk of default is a major concern.
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The most common swap is the interest rate swap.
Other types are - commodity swaps, currency swaps,
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debt-equity swaps, total return
swaps & credit default swaps.
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Let us understand these swaps in detail.
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Interest rate swap –
Suppose X Corp has a bank loan
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of $1mn on which it pays a floating rate of
interest. As the floating rate keeps fluctuating,
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today it could be 4% and a year
later it could be higher or lower.
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If the interest rate increases, the Co. would
have to pay a higher interest. X Corp wants
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to hedge this risk and wants to convert this
uncertain liability into a predictable one.
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LIBOR is commonly used as
the benchmark floating rate.
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LIBOR is the interest rate at which
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major global banks lend unsecured
short-term loans to one another.
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LIBOR is quoted for 5 major
currencies i.e. U.S. dollar, the euro,
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the British pound, the Japanese yen, and the
Swiss franc, for seven different maturities.
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However, LIBOR could soon be replaced
by a new alternative reference rate
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such as the secured overnight financing rate.
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On the other hand, let us assume Y Corp has
issued a fixed coupon paying bonds worth $1mn.
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Every year it has to pay a fixed
interest of 5% to its bondholders.
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Y Corp speculates that floating
interest rates will fall in the future
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and will be lower than 5%. If it could
convert the existing fixed-rate liability
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into a floating rate liability,
the interest cost will reduce.
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X Corp and Y Corp enter into a swap contract,
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in which X Corp agrees to pay the fixed rate of 5%
and Y Corp agrees to pay the floating rate LIBOR.
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The notional principal is taken as
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$1mn and the swap will be settled
annually for the next 5 years.
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The notional principal is theoretical
and is not exchanged between the parties.
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Suppose during the 1st settlement
period, the LIBOR was 4% -
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X has to pay 50,000$ to Y and
Y has to pay 40,000$ to X.
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This payment can be netted and X will pay
10000$ to Y and the transaction is settled.
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Let us take a moment to understand
the cash flow for both parties.
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This scenario has worked favorably for Y, as
it was able to bring down the interest cost.
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If during the 2nd settlement
period, the LIBOR becomes 6.5% -
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X has to pay 50000$ to Y and
Y has to pay 65000$ to X.
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This can also be netted
and Y will pay 15000$ to X.
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Let us take a moment to understand
the cash flow for both parties.
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This scenario is favorable to X, as it
is able to save 15000$ in bank interest.
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Under this Swap contract, X will
always owe 50,000$ to Y and is thus
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able to convert an uncertain liability
into a fixed amount of expense.
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This is a plain vanilla interest swap.
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As swaps are customized contracts,
payments can be made monthly,
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quarterly, annually, or at any
interval determined by the parties.
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The payment dates are known as settlement dates,
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and the time between them
is the settlement period.
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As the same currency is used in both fixed and
floating cash flows, the payments can be netted.
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The transactions are netted
on a settlement to reduce
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default risk. But some risks will
always remain in OTC agreements.
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Floating-rate payer believes that floating rates
will fall and will be lower than fixed rates.
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Fixed-rate payer believes that floating rates will
increase and will be more than the fixed rates.
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Commodity Swaps
In a commodity swap, one party pays the
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fixed agreed-upon rate of a commodity in exchange
for the floating price of the same commodity.
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The terms used are fixed-leg and floating-leg.
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Usually, these swaps are made on
crude oil and related components.
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Similar to an interest rate
swap, the cash flows are netted
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and the party who must pay
more will pay the difference.
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E.g. An airline has entered into a
commodity swap on 1000 barrels of fuel
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with a dealer and has agreed to pay a fixed
rate of $80 per barrel of fuel i.e. $80,000
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to the dealer for the next 4 quarters.
The Dealer has agreed to pay the floating
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rate i.e. the actual market price
of fuel on the settlement date.
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If at the end of the first quarter, the
actual market price per barrel is $78,
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the airline will pay $80000 and
will receive $78000 from the dealer.
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This payment can be netted and the airlines
pays the difference of $2000 to the dealer.
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At the end of 2nd quarter, if
the price per barrel is $81,
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the airline will receive the net
value of $1000 from the dealer.
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Using the swap contract, the airline is able to
maintain a fixed expenditure of $80000 towards
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the quarterly consumption of fuel.
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Fixed-leg payer feels that
commodity prices will increase
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Floating-leg payer feels that
commodity prices will decrease
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Debt-Equity Swaps
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A debt-equity swap involves exchanging
repayment of debt for equity.
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Suppose Zee Ltd. has a $5mn
debt. Due to financial distress,
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it is unable to make the interest
and principal repayments.
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Q Corp. is willing to repay the debt directly
in return for a 30% equity ownership of Zee Ltd.
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No cash is paid to the counterparty in this swap.
It is used by financially distressed companies to
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refinance their debt or reallocate their capital
structure and keep it within a target range.
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