LOANS- FIXED & VARIABLE SWAPS - IRAS Times · LOANS – FIXED & VARIABLE Interest rates attached to...
Transcript of LOANS- FIXED & VARIABLE SWAPS - IRAS Times · LOANS – FIXED & VARIABLE Interest rates attached to...
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LOANS- FIXED & VARIABLE &
SWAPS
Vikas Kr. Sinha
Dy.FA&CAO/C/NR
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LOANS – FIXED & VARIABLE Interest rates attached to a variable rate loan are dictated by the wider economic situation, and may rise or fall considerably over the course of a loan’s lifespan.
While variable rate loans, offer a number of options that fixed loans do not, they also involve a greater element of risk for borrowers.
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LOANS – FIXED & VARIABLE
• Main advantage of Fixed rate – payments are pegged at a set amount, typically allowing for easier budgeting than with a variable interest rate loan.
• Primary downside - repayments will never fall either, even if the wider interest rates do
• Fixed rate loans are ideal for those who tend towards conservatism and risk avoidance in fiscal matters.
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Example
Consider 2 companies, one with a AAA rating and one with a BBB rating:
Fixed Floating AAA Corp 10.00% 1Y INBMK + 0.30% BBB Corp 11.20% 1Y INBMK + 1.00% Difference 1.20% 0.700% • Clearly, BBB Corp has a comparative advantage in floating-rate
markets. • AAA Corp has a comparative advantage in fixed markets. • Expected gains if the enter into a swap = 1.20% - 0.7% = 0.5%
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The Comparative Advantage Argument
• Some companies have a comparative advantage when borrowing in fixed-rate markets.
• Other companies have a comparative advantage in floating-rate markets.
• Companies should borrow in the markets where they have a comparative advantage and then use a swap to advantage, and then use a swap to transform their liabilities if so wanted.
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3-year swap initiated between AAA Corp and BBB Corp
Notional principal: Rs. 100 Crs.
AAA Corp. pays fixed at 5% annually compounded annually.
BBB Corp. pays floating at One year INBMK.
Payments: Annually.
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FLOATING FIXED
AAA Corp could use a swap to transform a floating rate loan into a fixed rate loan.
Assume that AAA Corp has borrowed Rs. 100 Crs. at 1 year INBMK +
30 bps. This is a floating rate loan. When AAA Corp enters into the swap, it will face 3 sets of Cash
Flows: 1. Payment of 1 Y INBMK + 30bps to outside lenders. 2. Inflow of 1 Y INBMK under the terms of the swap. 3.Payment of 5% under the terms of the swap. NET CF = 5.3% FIXED Thus, AAA Corp has been able to switch from a 1 Y INBMK+30bps floating loan to a 5.3% fixed loan.
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FIXED FLOATING
On the other hand, BBB Corp. could transform a fixed rate loan into a floating rate loan.
Assume that BBB Corp. has borrowed Rs. 100 Crs. at 11.0 %. This is
a fixed rate loan. When BBB Corp. enters into the swap, it will face 3 sets of CFs: 1. Payment of 11.0 % to outside lenders. 2. Inflow of 5% under the terms of the swap. 3.Payment of 1Y INBMK under the terms of the swap. NET CF = 1Y INBMK + 6%. Thus, BBB Corp. has been able to switch from a 11.0 % fixed loan to
a 1Y INBMK + 6%. floating loan
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Company A Company B
1 Y INBMK+30 BPS 11%
The swap in effect transforms a fixed rate liability or asset to a floating rate liability or asset (and vice versa) for the firms respectively.
5.3%
1 Y INBMK
5 %
1 Y INBMK+6%
SWAP DIAGRAM
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FEATURES OF SWAPs
• An agreement between two parties to exchange cash flows in the future.
• The agreement specifies the dates that the cash flows are to be paid and the way that they are to be calculated.
• In the case of a swap the cash flows occur at several dates in the future. The CFs are usually dependent on the value of a market variable (i.e. interest rates, currencies, etc.)
• Swaps are generally OTC. • A forward contract is an example of a simple swap. With a
forward contract, the result is an exchange of cash flows at a single given date in the future.
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PLAIN VANILLA SWAP
• The most commonly used swap agreement is an exchange of cash flows based upon a fixed and floating rate.
• Often referred to a “plain vanilla” swap, the agreement consists of one party paying a fixed interest rate on a notional principal amount in exchange for the other party paying a floating rate on the same notional principal amount for a set period of time.
• In this case the currency of the agreement is the same for both parties. The agreed amount is called "notional principal" because, since it is not a loan or investment.The principal amount is neither exchanged at the outset nor rapid at maturity.
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DIFFERENT TYPES OF SWAP…
• Forward Swap :Involves an exchange of interest payments that does not begin until a specified period of time.
• Callable swap : It is also called swaptions.
A callable swap provides the party making the fixed payment with the right to terminate the swap prior to its maturity.
• Puttable swap : It provides the party making the floating rate payment with the right to terminate the swap prior to its maturity.
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DIFFERENT TYPES OF SWAP…
• Extendable swap : It contains a feature that allows the fixed for floating party to extend the swap period.
• Zero Coupon for Floating Swap : Under this type, the fixed rate payer makes upfront payment , i.e. the fixed leg is prepaid.
• Rate capped swap :Floating rate payment is capped.
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DIFFERENT TYPES OF SWAP… • Currency swap: Means for exchange of interest
obligations or interest receipts between two different currencies .
• Typically, a fixed rate of interest is quoted in one currency against a floating rate of interest (generally in the US $).
• A rate of exchange between the two currencies must be established at the outset .
• This produces principal amounts in the 2 currencies upon which payments of interest will made.
• At the final maturity - final periodic payment of interest & exchange the principal amounts of the two currencies.
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DIFFERENT TYPES OF SWAP…
• Commodity Swap : This is a swap where payments are based on the prices of commodities. One party pays a fixed price for the good over life of the swap while the other pays a floating price for the good, depending on current market prices.
• Equity Swap : With an equity swap, payments are made based on a notional principal, which is an equity portfolio. The payments are fixed & floating. The floating rate sum is based on the return on the relevant index for the period while the fixed rate sum is agreed in advance.
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BEYOND PLAIN VANILLA SWAPS
• Amortizing Swap - The notional principal is reduced over time. This decreases the fixed payment. Useful for managing mortgage portfolios and mortgage backed securities.
• Accreting Swap – The notional principal increases over the life of the swap. Useful in construction finances. For example is the builder draws down an amount of financing each period for a number of periods.
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