A brief introduction to Derivative Swaps

1. Financial Innovation
SWAPS
Sec G, Group 6
Sakshi Agarwal | Sukanya Sen | Syamantak Hazra
Tushar Tyagi | Vishwa Trivedi

2. Derivatives
Contingent
Claims
Options
Forward
claims
Forward
Contracts
Futures
Contracts
Swaps

3. WHAT ARE SWAPS?
• An agreement between two parties to exchange sequences of cash flows for a set
period of time
• 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
• Purpose is to change the character of an asset or liability without liquidation
Customized contracts traded in the
over-the-counter (OTAC) market
Risk of a counterparty
defaulting on the swap

4. TYPES OF SWAPS?
• Interest Rate Swap
• Credit Default Swap
• Basis Rate Swap
• Bond Swap
• Commodity Swap
• Volatility Swap
• Currency Swap
• Forex Swap

5. INTEREST RATE SWAPS
• Basically exchange of interest rates between 2 parties
• Party A agrees to pay Party B a predetermined, fixed rate of interest on a
notional principal on specific dates for a specified period of time
• Concurrently, Party B agrees to make payments based on a floating interest rate
to Party A on that same notional principal on the same specified dates for the
same specified time period
• No exchange of principal (Notional); coupon flows only
• Types : Floating for Fixed, Fixed for Floating, Floating for Floating (Basis Swap)

6. INTEREST RATE SWAPS - EXAMPLE
Company A
$ 1 million loan
@ LIBOR + 2%
Company B
$ 1 million loan
@ 8% fixed rate
Lender 1 Lender 2
P1 – LIBOR = 5%
Interest – 70 K
P2 – LIBOR = 4%
Interest – 60 K
P1 - Interest – 80 K
P2 - Interest – 80 K
7% on notional 1 million
LIBOR + 1% on notional 1 million
Interest Rate Swap Agreement

7. INTEREST RATE SWAPS – EXAMPLE (CALCULATIONS)
- Pay 70 K to lender 1
- Pay 70 K to Company B
+Get 60K from Comp. B
Net = Pay 80 K
Previously – 70 K
Company A
$ 1 million loan
@ LIBOR + 2%
Company B
$ 1 million loan
@ 8% fixed rate
7% on notional 1 million
LIBOR + 1% on notional 1 million
Period 1 – LIBOR = 5%
- Pay 60 K to lender 1
- Pay 70 K to Company B
+Get 50K from Comp. B
Net = Pay 80 K
Previously - 60 K
Period 2 – LIBOR = 4%
- Pay 80 K to lender 2
- Pay 60 K to Company A
+Get 70K from Comp. A
Net = Pay 70 K
Previously - 80 K
- Pay 80 K to lender 2
- Pay 50 K to Company A
+Get 70K from Comp. A
Net = Pay 60 K
Previously - 80 K

8. CREDIT DEFAULT SWAPS
• Credit derivative that provides the buyer with protection against default and other risks
• Similar to insurance but no collateral needed
Pension Fund
$ 1 bn to loan out
Company A
10 % annual interest
USD 1 bn loan
Credit Rating Agency
Insurer /
CDS Underwriter
Insurance :
$ 1 bn if A
defaults
1 % yearly on 1 bn BB Rating
AA Rating

9. WHAT HAPPENED IN 2008!
Pension
Fund 1
Financial Institutions
Selling CDOs -
Lehman Brothers
annual interest on CDOs
Buys CDOs from
Moody’s
AIG
Provided insurance
against CDOs
Funds believed
the CDOs are
AA rated
AIG kept getting premium from
Various funds for CDS BB Rating
AA Rating
Pension
Fund 2
…

10. USE OF SWAPS
• Hedging
• Speculation

11. Questions???