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A derivative is a financial contract which derives its value from some under lying assets. The underlying could be a Currencies, Shares, Commodity, Bonds etc
Derivative can be traded in
1) over the counter (OTC)- Buying or selling forward contract on currencies with bank
2) Exchange Traded- Currency Futures
let us look various derivative product one by one
1) Swap
Swap is a derivative product in which one parties exchange his series of cash flows with series of cash flows of the other party.
Types of swap
Currency swap: A Currency swap is a transaction in which one party swaps/exchange his cash flows in to cash flow of another currency with the other party at a specific date which to be converted in the original currency at the end of the swap period.
e.g.
1) REC Ltd. issuing a 100 mio 5% CHF bonds in the overseas market for 3 years
2) REC approaches UBS bank to swap the CHF received from issuing CHF bond in to INR at the current rate of 56 INR per CHF
3) REC pays 100 mio CHF to UBS bank and UBS pays 5600 mio INR to REC upfront.
4) REC as per agreement needs to pay 8% interest on INR for next three years to UBS and UBS will pay 5% interest on CHF for next 3 years to REC.
5) After 3 Years UBS pay 100 mio CHF to REC and REC pays 5600 mio INR to UBS
The above e.g. is just a simple illustration to understand the concept of currency swap
Interest rate swap (IRS): IRS is an arrangement whereby two parties swap their obligation at two different rates at predetermined dates for mutual benefit. One rate may be floating and other may be fixed.
e.g. of IRS
X and Y want to borrow while X want to borrow at floating rate, Y wants to borrow at fixed rate.
Following details are available.
X Y
Fixed rate 10% 12%
Floating rate Libor + 0.5% Libor + 1%
It can be observed that X has an advantage of 2% if he borrows in fixed rate over Y and 0.5% if he borrows in floating rate over Y. The net gain of 1.5% (2%-0.5%) can be availed by arranging a swap.
While X should borrow in fixed rate and Y should borrow in floating rate. As X has a comparative advantage in fixed rate. If the swap arranger charges 0.3%, then the net cost and benefit to each party is as follows.
The net actual benefit of 1.2% (1.5% -0.3%) will be equally shared by X and Y
Cost and benefit to X
Pays for borrowing 10.00%
Receives from swap arranger 10.60%
Pays to swap arranger Libor + 0.5%
Net cost to X Libor – 10%
Opportunity cost Libor +0.5%
Net saving 0.6%
Cost and benefit to Y
Pays for borrowing Libor + 1%
Receives from swap arranger Libor + 1.6%
Pays to swap arranger 12.00 % .
Net cost to Y 11.40%
Opportunity cost 12.00%
Net saving 0.6%
Swap arranger
Received from Y 12.00%
Paid to X 10.60%
Received from X Libor + 0.5%
Paid to Y Libor + 1.6%
Net received 0.3%
Swap rate
In IRS there is no initial exchange of cash. So to value the swap at the outset means to find a rate which will have a zero value at the outset, which is same as finding a fixed rate of interest having a zero initial value.
Swap rate = 1- Present Value Factor (PVF) for last payment x frequency of payment in
. a year
Sum of all PVF for different payment
This Formula can be used to find fixed rate when floating rates are given.
Generic/plain vanilla swaps
There are many variants of IRS one of them is fixed/floating swap also known as plain vanilla swap or Generic swap. In such swaps fixed rate payer makes payment based on long term interest rate to a floating rate payer, who in turn pays to fixed rate payer based on index of short term money market rate.
Non Generic swap: An IRS which specifies exchange payment based on two different variable rates is a non generic swap or basis swap. e.g. variable rates may be libor and prime rate or T-bill rate etc.
Day count convention
In swap market day count convention is important. Various conventions are as follows
a) actual/365
b) actual/360
c) 30/360
The convention in swap market is to quote the fixed interest rate as an All in Cost (AIC) means that fixed interest is quoted relative to a flat floating rate index.
For e.g. If a 5 year generic swap at an AIC is quoted by a swap dealer at 8.50/8.75 means the dealer is ready to buy the swap at 8.5% meaning pay fixed rate at 8.5% while receiving floating rate payment indexed to say 6 month Libor and is ready to sell the swap at 8.75%( Receive Fixed rate of 8.75%) while paying floating rate payment.
Fixed rate payments on Generic swap are calculated on 30/360 day count convention assuming 30 days a month and 360 days a year. And floating rate payments are calculated on actual/360 day count convention
Valuation of swap
IRS is an implicitly a mutual lending arrangement. In IRS one party may be holding a long position in fixed rate security and short in floating rate security. So valuation of swap simply boils down to valuing two notional securities viz. Fixed rate security and floating rate security having a redemption value or face value equal to notional principal amount of swap. We have to first discount the inflows and outflows at an appropriate rate. The difference between the discounted inflow and outflow is nothing but value of swap. Generally the prevailing Libor rate is used for discounting the cash flows of
floating rate and market quoted swap rate is used for discounting cash flows associated with fixed rate
Swaptions
A swaptions is simply an option on interest rate swap. It gives the buyer the right but not theobligation to receive/pay a fixed rate on specific date and pay/receive a floating rate. It allows the buyer to take the benefit of upside and downside risk in interest rate for an upfront premium/fee. It allows the buyer to select
a) The level of interest rate at which it want to enter in to swap called strike rate,
b) The length of the swap period
c) The floating rate index
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