Hedging With Swaps

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HEDGING WITH SWAPS

A swap is nothing but a barter or exchange but it plays a

very important role in international finance.

A swap is the exchange of one set of cash flows for

another. A swap is a contract between two parties in which the

first party promises to make a payment to the second and

the second party promises to make a payment to the first.


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HEDGING PURPOSESwaps can be used for hedging purpose and to

manage risks:

Swaps can be used to lower borrowing costs and generate

higher investment returns.

Swaps can be used to transform floating rate assets into

fixed rate assets, and vice versa.

Swaps can transform floating rate liabilities into fixed rateliabilities, and vice versa.

Swaps can transform the currency behind any asset or

liability into a different currency.


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INTEREST RATE SWAPSHedging against rising and falling Interest Rate :

An interest rate swap is an agreement between 2 parties

agreeing to exchange one regular stream of interest from a fixed

rate contract for another regular stream of interest from a

variable rate contract for a specific period and on the basis of a

predetermined amount.

To covert a fixed-rate obligation to a floating-rate obligation.

Therefore, the parties do not swap the notional amount, butonly the agreed interest rate structures.


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Example

Interest Rate Swaps can be used to make money or to hedge andprotect assets.

For example, if a bank has made a 5-year loan and is receiving a

fixed 3 percent return on that money, it could swap its revenue

stream against someone else's 5-year money earning a variable rate.

Each party to the transaction is making a play on the future ofinterest rates. If the rate increases, the variable rate income stream

will produce more revenue than the fixed rate stream, which

outperforms if rates decline.

The party swapping into the fixed rate, however, could simply be

creating the clarity of a fixed rate as a hedge for future investment,while the party swapping into a variable rate could be offsetting

other fixed rate investments.


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CURRENCY SWAPS

A currency swap involves two principal amounts, one for each currency.

There is an exchange of the principal amounts and the rate generally used

to determine the two principal amounts is the then prevailing spot rate.

To convert an obligation in one currency to an obligation in other

currency.

A currency swap is similar to a series of foreign exchange forward

contracts, which are agreements to exchange two streams of cash flows in

different currencies.

Like all forward contracts, the currency swap exposes the user to foreign

exchange risk.

The swap leg the party agrees to pay is a liability in one currency and theswap leg the party agrees to receive is an asset in the other currency.

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A Currency swap is viable whenever one counterparty has comparativelycheaper access to one currency than it does to another.

Types of currency swaps

Hedge both the principal & interest payments (preferred swap)

Hedge the principal payments only

Hedge the interest payment only

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Example

Suppose:

Firm B can borrow in $ at 8.0%, or in at 6.0%.

Firm A can borrow in $ at 6.5% or in at 5.2%.

If A wants to borrow , and B wants to borrow $, then they may beable to save on their borrowing costs if each borrows in the market in

which they have a comparative advantage, and then swapping into

their preferred currencies for their liabilities.


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COMMODITY SWAPS

A swap in which exchanged cash flows are dependent on the price of an

underlying commodity .

A commodity swap is usually used to hedge against the price of a

commodity.

In a commodity swap, the first counterparty makes periodic payments tothe second at a per unit fixed price for a given quantity of some

commodity. The second counterparty pays the first a per unit floating

price for a given quantity of some commodity.

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ExampleCommodity swaps are used for hedging against :

Fluctuations in commodity prices or

Fluctuations in spreads between final product and rawmaterial prices (E.g. Cracking spread which indicates the

spread between crude prices and refined product prices

significantly affect the margins ofoilrefineries)

The vast majority of commodity swaps involve oil


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EQUITY SWAPS

An equity swap is a financial derivative contract (a swap) where a set of

future cash flows are agreed to be exchanged between two counterparties

at set dates in the future.

The two cash flows are usually referred to as "legs" of the swap; one of

these "legs" is usually pegged to a floating rate such as LIBOR. This leg is

also commonly referred to as the "floating leg".

The other leg of the swap is based on the performance of either a share

of stock or a stock market index.

This leg is commonly referred to as the "equity leg".

Most equity swaps involve a floating leg vs. an equity leg, although some

exist with two equity legs

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INDEX SWAPS

Hedging arrangement in which one party exchanges one cash flow with

another partys cash flow on specified dates for a specified period.

These cash flows are associated with a debt index, equity(stock) index, or

any asset or price index. An index swap is a variant of the conventional fixed-rate swap, and its

term may range from 3 months to a year or more.

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DIFFERENTIAL SWAPS

A plain vanilla swap in which one of the legs is paid in a currency other

than the one in which it is calculated.

For example, the notional amount over which the interest rates are

calculated may be in U.S. dollars, but one of the payments may be madein yen. A differential swap may be entered in order to take advantage of a

favorable exchange rate.

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MISCELLANEOUS RISK MANAGEMENT

INSTRUMENTS

MORTGAGE SWAP

INNOVATIONS IN OVER-THE-COUNTER OPTIONS MARKET

DIVERSIFICATION

CREDIT RISK ENHANCEMENT

OVERCOLLATERISATION

ASSIGNMENT

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MORTGAGE SWAP

Mortgage swaps can be used to replicate a mortgage portfolio earningsstream without the need to hold the mortgage assets. They can also beused to hedge mortgage portfolios from variations in earnings

Cash flows based on a group of Government National MortgageAssociation (GNMA) mortgage backed securities of America are exchanged

for a floating rate of interest.

Upon termination of swap, a final cash settlement is made on the changein the market values of the mortgages.

In case of mortgage hedging, the standard prepayment assumption ,called the PSA (Public Securities Association) standard prepayment model

is used for prepayment pattern on the mortgages However, the mortgage swaps use the actual prepayment experience of

the index pool in determining the amortization of the principal on theswap.

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INNOVATIONS IN OVER-THE-COUNTER OPTIONS MARKET

A. PATH DEPENDENT OPTIONS

These are cash-settled options in which pay-off is based on an

average value of the underlying asset over some period of time as

opposed to the customary settlement based on the value of the

underlying asset at the time of the options expiry. These options

assist in hedging multi-period exposure with a single-period

option. Example : Cruise line fuel problem.

B. LOOK BACK OPTIONS

These are the cash settlement options that are settled on the basis

of the highest (or lowest) price of the underlying asset to prevail

over the course of the options life. These options command higher

premium than the options that settle based on the value of the

underlying asset.

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C. OPTION-LINKED LOANS

These are the loans denominated in one currency, requiring the

borrower to write an option that allows the lender to

redenominated in another currency.

In this case, the cost of the loan is less as it reflects the option

granted to the lender. Where the option is possessed by the borrower and borrowers are

multinational companies earning various foreign currencies, then

option-linked loans can be used by using the less profitable

currencies to payback the loan.

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DIVERSIFICATION

Diversification is an excellent and nearly costless way to eliminate the

unsystematic risks associated with various financial positions.

To illustrate, the junk bonds individually involve high risk.

However, portfolio of junk bonds where no single component represents

more than few percentage of overall portfolio have outperformed farmore conservative portfolios for extended periods even after allowing for

losses due to default.

This suggests that the risk-premiums on junk bonds may have been

excessive.

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CREDIT ENHANCEMENT

Credit Risk can be reduced by Credit Enhancement.

This technique offers the lenders an alternative means of collecting the

interest and the principal due to the lender in the event that the borrower

defaults.

For e.g.., the lender can recourse to bank guarantor in the event that theborrower is unable to meet its commitment to the lender.

This method was widely used by Japanese borrowers in the late 1980s.

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OVERCOLLATERIZATION

It facilitates in converting high risk loans or instruments into low risk loans

or instruments.

This is done by keeping the actual amount lent always some percentage

below the value of the collateral property.

Overcollaterization is used in both the securitization of mortgages andother assets (such as corporate receivables).

Most recently it has been used to convert the risk character of junk bonds.

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ASSIGNMENT

The holder of a position transfers both the rights and obligations

associated with that position to the third party.

This is widely used in the insurance industry in the form of reinsurance

where the risk is transferred by one insurer to another insurer. Insurers

shall write down policies that far exceed their risk-bearing capabilities. Then, they assign the risks to larger size insurance firms or farm out

portions of the policy to number of smaller insurers.

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Hedging With Swaps

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