MBA Financial Swaps 2nd Year Long Sample Question Answer

MBA Financial Swaps 2nd Year Short Sample Question Answer

Financial swaps, managing interest rate exposure, Interest rate swaps, Currency swaps, Interest rate futures, Forward rate agreement.

Section C

LONG ANSWER QUESTIONS

QUES.1. What are the types of swap?

Ans. Types of Swap Following are the types of swap:

1. Interest Rate Swaps: A standard fixed-to-floating interest rate swap, known in the market terminology as a Plain Vanilla Coupon Swap (exchange borrowings), is an agreement between two parties in which each contracts to make payments to the other on particular dates in the future till a specified termination date.
2. Currency Swaps: A currency swap is an agreement between two parties to exchange a given amount in one currency for another and to repay these currencies with interest in the future. A currency swap is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and, after a specified period of time, to give back the original amount swapped.
3. Commodity Swaps: In commodity swaps, the cash flows to be exchanged are linked to commodity prices. Commodities are physical assets such as metals, energy stores and food including cattle. For example, in a commodity swap, a party may agree to exchange cash flows linked to prices of oil for a fixed cash flow.

Commodity swaps are used for hedging against

(a) Fluctuations in commodity prices, or

(b) Fluctuations in spreads between final product and raw material prices, e.g. cracking spread, which indicates the spread between crude prices and refined product prices, significantly affect the margins of oil refineries).

A company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity changes. In such cases, the company would enter into a swap, whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. A producer of a commodity may want to reduce the variability of his revenues by being a receiver of a fixed rate in exchange for a rate linked to the commodity prices.

4. Equity Swaps: Under an equity swap, the shareholder effectively sells his holdings to a bank promising to buy it back at market price at a future date. However, he retains a voting right on the shares.

In equity swap, at least one of the two streams of cash flows is determined by a stock price, the value of a stock portfolio, or the level of a stock index. The other stream of cash flows can be a fixed rate, a floating rate such as MIBOR, or it can be determined by the value of another stock, stock portfolio or stock index. In this manner, an equity swap can substitute for trading in an individual stock, stock portfolio, or stock index.

Equity swaps are certainly similar to interest rate and currency swaps, but they also differ notably One difference is that the swap payment is determined by the return on the stock. Since stock returns can be negative, the swap payment can also be negative, for example, party A agrees to pay party B the return on the underlying stock. If at a given payment date, the return on the stock is negative, then barty A effectively owes a negative return. This means that party B would have to pay the return to party A. Unless party B also owes a negative return, party B will end-up making both payments.

 Ques.2. Explain the types of risks in swap.

Ans. Types of Risks in Swap

The risks explained below are mainly types of risk that arise in situations of speculation or by entering into several swaps in many different markets and thus taking several different types of positions, i.e. holding entire portfolios of swaps. The main types of risks are as follows:

1. Interest Rate Risks as Spread Risk and Market Risk: Generally speaking, the interest rate risk emerges as a result of the inverse relationship between the yield and the price of fixed rate interest bearing debt, which consequently affects the debt management instrument. A change in the interest rate of a certain maturity will hence affect the instruments used to manage that debt. A decrease in the interest rate on debt might prove disastrous for a dealer whose strategy rests upon a steady swap spread over the underlying bond (used as the source for risk-free yield in hedging operations). A noreaction strategy and a reaction-but-not-enough fast strategy put the dealer in a position where he/she loses money as a result of the fluctuating interest rates. This specific interest rate risk resulting from yield curve movements is referred to as a spread risk.
2. Currency exchange rate risk: Currency risk is something that is a consequence of differences in the nominal currencies of the underlying interest bearing debt. In such a case, the interest rate risk is accompanied by the currency risk. International transactions might easily concern many different counterparties in many different countries whereby the currency risk becomes even more tangible and relevant to the actors involved. By using interest rate swaps or similar instruments to create hedges, one might lessen or totally eliminate the possible impacts of different currencies and different interest rate movements.
3. Credit risk: Credit risk is an investor’s risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Another term for credit risk is default risk.
4. Liquidity risk: This type of risk is characterised by the easiness by which one can transform the swap into liquid assets like cash. Consequently, this is highly dependent upon the structure of the secondary market for swaps as well as the structure of the swap itself and the independence of these A two factors. The less developed the secondary market, the harder it is to find a new counterparty in need of a contract under these specified conditions.
5. Mismatch risk: Mismatch risk is a type of risk which evolves around differences in notional principal, maturity, the swap coupon, the floating index, the reset dates for the floating index and the payment frequencies between parallel agreements. As the number of agreements increase and they become more and more complex, a treasurer faces an ever increasing risk that he might not be able to hedge every position taken by way of an identical agreement with opposite interest cash flows.
6. Basis risk: The basis risk is the difference between two prices and in the case of interest rate swaps, it is the difference between floating-rate indexes. The basis risk arises in two different ways:

(a) For example, a treasurer and counterparty agree on a floating-floating interest rate swap in which the parties pay floating interest rate according to different floating-rate indexes like LIBOR and BUBOR.

(b) In a matching pair of swaps, a treasurer might pay according to one floating-rate index (eg., LIBOR) and receive according to another (e.g., BUBOR). The risk arises as a result of the different characters of the two indexes and they fluctuate according to different economic environments.

7. Sovereign risk: The sovereign risk arises in cross-border interest rate swaps, in swaps that are concerned with parties in two different countries and that thus reflect the countries’ financial standings in the world community and, to some degree, it is a function of the countries’ political stability. In general, one could regard the sovereign risk as another aspect of credit risk with the exception that credit risk is specific for the counterparty while the sovereign risk is specific for the country in which the counterparty is operating. The sovereign risk might also be considered a political risk while viewed in this manner the risk is given a more concrete size and shape in that it is not only international events that affect the investment climate but also national taxes, restrictions, and other national policies. All these factors affect the price of the swap in that the higher is the risk involved, the higher will be the price of the swap.

Delivery/Settlement Risk: The delivery risk, also called counterparties who must effect their payment to each other at different times of the day owing to different settlement hours between the capital markets of the two parties. This most often occurs when payments are made between counterparties in two different countries.

Systematic Risk: The systematic risk considers the probablity that extensive disturbances which might affect other segments and institutions occur to the extent that the entire financial system crashes. This type of risk has its foundations in panic reactions and extensive loss of confidence in the current status quo as a consequence of a quickly changing reality. The construction of a mehod to comprise this kind of risk into the price of a swap is only relevant on a theoretical and philosophical level. In reality, if such a crisis would occur, the pricing strategy is most or less irrelevant to the outcome, this type of risk is always present in one way or another.

 QUES.3. What are the sources of interest rate risk? Explain.

Ans. Sources of interest Rate Risk As financial intermediaries, banks encounter interest rate risk in several ways. Broadly, these can be described:

1. Refinancing Risk: Refinancing risk is the risk that a borrower is not able to redeem an existing loan with the proceeds of a new loan and an extra equity payment) at loan maturity. The recovery risk relates to the loan being unable to be refinanced and the underlying properties need to be sold or foreclosed to provide for funds for redemption. The extension risk is the risk that redemption of the loan does not occur at maturity but later.

Refinancing risk is the uncertainty of the cost of a new source of funds that are being used to finance a long-term fixed-rate asset. This risk occurs when an FI is holding assets with maturities greater than the maturities of its liabilities.

 

For example, if a bank has a ten-year fixed-rate loan funded by a 2-years time deposit, the bank opot | faces a risk of borrowing new deposits, or refinancing at a higher rate in two years time deposit. Thus, interest rate increases would reduce net interest income. The bank would benefit if the rates fall as the cost of renewing the deposits would decrease, while the earning rate on the assets would not change In this case, net interest income would increase.

2. Reinvestment Risk: Re-investment or refunding risk arises when interest rates at investment maturities (or debt maturities) result in funds being reinvested (or refinanced) at current market rates that are worse than forecast or anticipated. The inability to forecast the roll over rate with certainty has the potential to impact overall profitability of the investment or project.

Reinvestment risk is the uncertainty of the earning rate on the redeployment of assets that have matured. This risk occurs when an FI holds assets with maturities that are less than the maturities of its liabilities.

For example, a short-term money market investor is exposed to the possibility of lower interest rates when current holdings mature. Investors who purchase callable bonds are also exposed to reinvestment risk. If callable bonds are called by the issuer because interest rates have fallen, the investor will have proceeds to re-invest at subsequently lower rates.

Similarly, a borrower that issues commercial paper to finance longer-term projects is exposed to the potential for higher rates at the rollover or refinancing date. As a result, matching funding duration to that of the underlying project reduces exposure to refunding risk. Re-investment from a given strategy due to changes in the market rates’.

Re-investment risk, a challenge all investors face when bond yields are falling, is the risk that future cash flows either coupons or the final return of principal, will need to be re-invested in lower-yielding securities.

3. Re-pricing Risk: This risk arises from holding assets and liabilities with different principal amounts, maturity or re-pricing dates, thereby creating exposure to unexpected changes in the interest mates. For example,

S.No	Liability	Asset	Result
1	3 months deposit	5 years bond	Liability sensitive as after every three months, deposits will have to be rolled over and every roll-over will be subject to interest rates prevailing at the time of roll – over
2	3 years deposit	3 years bond with 6 months reset, i.e. floating rate bond where interest will be fixed afresh every six months on a set date.	Asset sensitive. Cost of liabilities is constant for 3 year while earnings on asset are subject to vagaries of interest rate movement .
3	2 years deposit	364 days treasury bill	Asset sensitive. Treasury bills when rolled over after 364 days may give a different yield as roll –over will be subject to rates prevailling at that time.
4	5 years deposit	5 years term loan	Neutral as both assets and liabilities are properly matched.

4. Basis Risk: Even where asset and liabilities are properly matchedin terms of re-pricing risk, one is exposed to the risk that correlation between change in interest rate on assets may not be the same as change of interst rate on liabilities, thereby affecting the underlying spread at the time of re-pricing. Therefore, the risk that interest rate of different assets and liabilities may change in different magnitudes is called basis risk. To illustrate the point, let us take the following example:

S.no	Re-pricing liabilities	Re pricing assets	Result
1.	90 days certificates of deposits.	90 days commercial paper	At re-pricing, certificate of deposit rates may fall by just 0.5% p.a. while interest rates on C.P. may fall by 1% p.a.

When interest rates change, these differences can give rise to unexpected changes in the cash flows and earnings spread between assets, liabilities and off balance sheet instruments of similar maturities or, re-pricing frequencies.

5. Embedded Option Risk: Large changes in the level of interest encourage premature withdrawal of deposits on the liability side or, prepayment of loans on the asset side. Bonds with put and call option may also be redeemed before their original maturity as the holder will like to exercise put option if interest rates in the meantime have edged up while the issuer will exercise call option if interest rates have fallen. Every time a deposit is withdrawn or a loan is prepaid, it creates a mismatch and gives rise to repricing risk. Since customers on both sides of the balance sheet of the bank enjoy this embedded option, their abrupt decision/behaviour based on interest rate movement may give rise to repricing risk where it did not exist in that first instance. In order to protect themselves from this risk, banks impose penalties on premature withdrawal of deposits.
6. Yield Curve Risk: Yield curve risk is the risk of experiencing an adverse shift in market interest rates associated with investing in fixed income instruments. The risk is associated with either a flattening or steepening of the yield curve, which is a result of changing yields among comparable bonds with different maturities. When market yields change, this will impact the price of fixed-income instruments. When market interest rates, or yields, increase, the price of a bond will decrease and vice versa.

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