MBA Financial Swaps 2nd Year Short 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 B

SHORT ANSWER QUESTIONS

 Ques.1. Give some important features of swap.

Ans. The important features of swap are as follows:

1. Flexibility: In the short term market, the lenders have the flexibility to adjust the floating interest Rate (short-term rate) according to the conditions prevailing in the market as well as the current financial positions of the borrower.
2. Necessity of an Intermediary: Swap requires the existence of the two counterpart opposite but matching needs. This has created a necessity for an intermediary to cancel both parties.
3. Settlements: Though a specified principal amount is mentioned in the swap agreement, then is no exchange of principal. On the other hand, a stream of fixed rate interest is exchanged for a floating m rate of interest and thus, there are streams of cash flows rather than single payment.
4. Long-term Agreement: Generally, forwards are arranged for a short period only. Long dated forward rate contracts are not preferred because they involve more risks, for example, risk of default risk of interest rate fluctuations, etc.
5. Basically a Forward: A swap is nothing but a combination of forwards. So, it has all the properties of a forward contract.
6. Comparative Credit Advantage: Borrowers enjoying comparative credit advantages in floating rate debts will enter into a swap agreement to exchange floating rate interest with the borrowers enjoying comparative advantages in fixed interest rate debt, like bonds. In the bond market, lending is done at a fixed rate for a long duration and therefore, the lenders do not have the opportunity to adjust rate according to the situation prevailing in the market.
7. Double Coincidence of Wants: Swap requires that two parties with equal and opposite needs must come into contact with each other, i.e. rate of interest differs from market to market and within the market itself.

QUES.2. Discuss about the functions of swap transactions.

Ans. There are following functions of swap transactions:

1. Arbitrage Function: Interest rate swaps can reduce borrowing costs for both parties by exploiting the differences in the interest that spreads in different segments. Similarly, currency swaps exploit the differences in interest spreads between different currency segments. The availability of swaps tends to:

(a) Increase demand or reduce supply in the under-priced segment; and

(b) Reduce demand or increase supply in the over-priced segment.

By doing so, it actually tends to narrow the gap between the two segments. Swaps, therefore, act as an arbitrage mechanism which helps market integration and reduces interest rate distortions.

2. Financing function: Swaps, by exploiting comparative advantage, make funds available to borrowers at cheaper rates than would otherwise be possible. They, therefore, perform a financing function by making investment capital cheaper.
3. Hedging function: It was shown that swaps are analytically equivalent to a strip of futures transactions and that they can act as a hedge. Because of this, swaps perform the hedging function. Also, whereas futures only provide a short-term (maximum two years) hedging facility, swaps provide a long-term hedging facility which is not available through other instruments.

Ques.3. What is the use of swap?

Ans. The following gains can be derived by a systematic use of swap:

1. Access to New Financial Markets: Swap is used to have access to new financial markets for funds by exploring the comparative advantage possessed by the other party in that market. Thus, the comparative advantage possessed by parties is fully exploited through swap. Hence, funds can be obtained from the best possible source at cheaper rates.
2. Borrowing at Lower Cost: Swap facilitates borrowings at lower cost. It works on the principle theory of comparative costas propounded by Ricardo. One borrower exchanges the comparative get possessed by him with the comparative advantage possessed by the other borrower. The net is that both the parties are able to get funds at cheaper rates.
3. To correct asset-liability mismatch: Swap can be profitably used to manage asset-liability match. For example, a bank has acquired a fixed rate bearing asset on the one hand and a floating e of interest bearing liability on the other hand. In case the interest rate goes up, the banks would be much affected because with the increase in interest rate, the bank has to pay more interest. This is because the interest payment is based on the floating rate. But, the interest receipt will not go up, since the receipt is based on the fixed rate. Now, the asset-liability mismatch emerges. This can be conveniently managed by swap. If the bank feels that the interest rate would go up, it has to simply swap the fixed rate with the floating rate of interest. It means that the bank should find a counterparty who is willing to receive a fixed rate interest in exchange for a floating rate.
4. Additional income: By arranging swaps, financial intermediaries can earn additional income in the form of brokerage.
5. Hedging of Risk: Swap can also be used to hedge risk. For instance, a company has issued fixed rate bonds. It strongly feels that the interest rate will decline in future due to some changes in the economic scene. So, to get the benefit in future from the fall in interest rate, it has to exchange the fixed rate obligation with floating rate obligation. That is to say, the company has to enter into a swap agreement with a counterparty, whereby it has to receive fixed rate interest and pay floating rate interest. The net result is that the company will have to pay only a floating rate of interest. The fixed rate it has to pay is compensated by the fixed rate it receives from the counterparty. Thus, risks due to fluctuations in interest rate can be overcome through swap agreements. Similarly, agreements can be entered into for currencies also.

Ques.4. What is interest rate swap?

Ans. Interest Rate Swap: An interest rate swap, or simply a rate swap is an agreement between parties to exchange a series of interest payments without exchanging the underlying debt. In a Col fixed/floating rate swap, the first party promises to pay to the second at designated intervals a pulated amount of interest calculated at a fixed rate on the ‘notional principal. The second party promises to pay to the US the underlying debt mises to pay to the first at the same intervals a floating amount of interest on the notional principal Calculated according to a floating-rate index.

The first party in a fixed/floating rate swap, which pays the fixed amount of interest is known as the fixed rate payer, while the second party which pays the fixed amount of interest is known as the floating-rate payer. The notional principal is simply a reference amount against which the interest is calculated. Interest rate swaps can be used to take on fresh interest rate risk as well as to manage existing interest rate risk.

Interest rate swaps without offsetting underlying create interest rate risk. Each counterparty in an interest rate committed to pay a stream of interest payments and receive a different stream of interest payments. A payer of fixed interest rate payments is exposed to the risk of falling interest rates, while a payer of floating interest rate payments is exposed to the risk of rising interest rates. Similarly, a receiver of fixed interest rate payments is exposed to the risk of rising interest rates, while the receiver of floating payments is exposed to the risk of falling interest rates. In conclusion, interest rate swaps weate an exposure to interest rate movements, if not offset by an underlying exposure.

Ques.5. What are the elements of a currency swap?

Ans. Elements of a Currency Swap: There are several important elements in a currency swap that must be agreed between the two parties. These are:

Period of the Agreements: Swap are medium to long-term arrangements normally covering 2 to 10 years, at the end of which principal is exchanged. A five-year arrangement is probably the most common.

2. Currencies Involved: Most currency swaps involve the dollar and one other major currency (Euro, Sterling, Yen, Swiss Francs, Canadian Dollar or Australian Dollars). Swaps between two currencies other than the dollar are less common but can be arranged.
3. Receiver and Payer: Each counterparty to a currency swap can be described in terms of

(a) The type of interest (fixed or floating and the currency that he/she pays, and

(b) The type of interest and the currency that he/she receives.

4. Principal Amounts: Swaps are primarily instruments for large organisations only because the amount of currency involved in a cwan is large, usually between $ 7 mimon and Summon. Some swaps arranged in conjunction with bond issues have been for even large amounts:

Currency swaps strictly defined, involve an exchange of two fixed interest payment streams (ie. fixed against fixed swap). However, currency swaps also can involve:

(a) A fixed interest rate versus a floating rate index (e.g. LIBOR)

(b) Two floating rate indices (e.g. six months Sterling LIBOR versus six month dollar LIBOR)

A currency swap in which at least one payment stream is based on a floating rate index is sometimes called a cross currency swap.

(i) A fixed-against-floating swap is a cross currency interest rate swap.

(ii) A floating-against-floating swap is a currency basis swap.

Interest rates in a swap are determined by negotiation between the two parties and need not be the same as current market rates. Interest rate payments normally are exchanged at regular intervals six monthly or annually. The amount payable by each party must be specified in the agreement. This might be a fixed percentage (e.g. 10% annually or 5% every six months) or a floating rate (e.g. the dollar LIBOR rate for six months or 12 months).

 QUES.6 What are the benefits of currency swap?

Ans. Currency swaps are useful in the following respects:

1. Tax savings: Saving on tax payments may be another objective for engaging in a swap contract by transforming income into capital gains, especially where the capital gains are liable to be taxed.
2. Low cost: Reduction in transaction costs if an investor intends to reverse the transaction.
3. Equilibrium: Enables banks to arrive at an equilibrium position on the currency balances.
4. Benefits firms: Facilitates firms to take out a coupon loan in one currency and change the effective currency or denomination of the loan by one contract.
5. Hedge: Allowing banks to hedge any mismatch between forward sales and purchases of foreign currency, currency swap being a series of futures exchange of amounts of one currency for amounts of another
6. Choice: Enabling banks to make loans and to accept deposits in the currency of customer choice.

Ques.7. What are the features of interest rate futures?

Ans. Salient features of exchange-traded interest rate futures are as follows:

1. Delivery of underlying asset is possible on an exchange platform.
2. Futures contract available on Notional 7% coupon 10 year Government of India Security as the underlying asset.
3. Large number of informal participants can trade using online electronic trading systems, leading to efficient price discovery.
4. Exchange-trade IRF ensure robust systems for risk management

and surveillance, thereby capable of eliminating any kind of market manipulation.

5. Greater transparency due to automated anonymous rate futures are used to e order matching systems and settlement.
6. Uniform standards and well-established procedures IRF market allow symmetry of treatment to various participants.
7. IRF expands the set of hedging tools available to financial as well as non-financial entities to manage interest rate risk.
8. IRF are standardised products that allow for gauging the utility and effectiveness of different positions and strategies.
9. Online real-time dissemination of prices.
10. Exchange-traded IRF provides credit guarantee by the clearing corporation and hence eliminates counterparty risk, thereby increasing the capital efficiency of the market participants.
11. Increased market reach enables higher liquidity.
12. Exchange platform ensures protection against counterparty defaults risk, due to novation by clearing house of the exchange.

Ques.8. What do you understand by forward rate agreements (fra)?

Ans. Forward rate agreements (fra): A Forward Rate Agreement (FRA) is an interest purchase or sale contract. Under FRA, the interest differential between the FRA contract rate and the market interest rate on the settlement date on the notional principal is paid or received.

In addition to the contract, FRA rate valuation model requires the future rate (i.e. the zero coupon government bond rate for the period from the valuation date to the final maturity date.) A forward rate agreement is a contract between the two parties, (usually one being the banker and other a banker’s customer or independent party) in which one party (the banker) has given the other party (customer)a guaranteed future rate of interest to cover a specified sum of money over a specified period of time in the future.

FRAs are over the Counter (OTC) instruments which are typically issued by investment banks to end-users and are not traded on exchanges. Thus, the terms of the FRA can be set according to the end-user’s requirements but they tend to be illiquid as they can only be sold back to the issuing investment bank.

QUES.9. Give the characteristic of FRAs.

Ans. Characteristic of FRAS: A FRA is an off-balance sheet instrument having the following characteristics:

1. FRAs mature in a certain number of days and are based on a rate that applies to an instruments maturing in a certain number of days, measured from the maturity of the FRA
2. The contract covers a notional amount but only interest rate payments on that amount are considered.
3. It is important to note that even though the FRA may settle in fewer days than the underlying rate (i.e. the number of days to maturity in the underlying instrument) the rate that dealer quotes has to be evaluated in relation to the underlying rate.
4. The structure is the same for all currencies. The structure is as follows. The short party or the dealer and the long party or end-user will agree on an interest rate, a time interval and a ‘hypothetical contract amount. The end-user benefits if rates increase (she has locked-in a lower rate with the dealer). Because the end-users are long, the dealer must be short the interest rate and will benefit if rates decrease.
5. Because there are two-day figures in the quotes, participants have come up with a system of quotes such as 3 x 9, which means that the contract expires in three months and in six months, or the nine months from the formation of the contract, interest will be paid on the underlying Euro dollar time deposit upon which the contract’s rate is based.
6. Other examples include 1 x 3 with the contract expiring in one month based on a 60 days LIBOR or 6 x 12 which means the contract expires in six months based on the underlying rate of a 180 days LIBOR.

Ques.10. Discuss about various types of interest rate swaps.

Ans. Following are the types of interest rate swaps

1. Zero Coupons to Floating: The holders of zero-coupon bonds get the full amount of loan and interest accrued at the maturing of the bond. Hence, in this swap, the fixed rate player makes a bullet payment at the end and the floating rate player makes the periodic payment throughout the swap period.
2. Forward swap: This swap involves an exchange of interest rate payment that does not begin until a specified future point in time. It is also a kind of swap involving fixed or floating interest rate.
3. Libor: London Interbank Offered Rate (LIBOR) quote by a particular bank is the rate of interest at which the bank is prepared to make a large wholesale deposit with other banks. Large banks and other financial institutions quote LIBOR in all major currencies for maturities up to 12 months. 1-month LIBOR is the rate at which 1-month deposits are offered, 3-month LIBOR is the rate at which 3-month deposits are offered, and so on.
4. Rate-capped Swap: In this type of swap, there is exchange of fixed rate payments for floating rate payments, whereby the floating rate payments are capped. An upfront fee is paid by the floating rate party to the fixed rate party for the cap.
5. Plain vanilla swap: Plain vanilla swap is also known as fixed-for-floating swap. In this swap, one party with a floating interest rate liability is exchanged with fixed rate liability. Usually swap period ranges from 2 years to over 15 years for a predetermined notional principal amount. Most deals occur within a four years period.
6. Alternative floating rate: In this type of swap, the floating reference can be switched to other alternatives as per the requirement of the counterparty. These alternatives include three months MIBOR, one-month commercial paper, T-Bill rate, etc.
7. Floating-to-Floating Swap: In this swap, one counterparty pays one floating rate, such as LIBOR while the other counterparty pays another, such as prime for a specified time period. These swap deals are mainly used by the non-US banks to manage their dollar exposure.
8. Mibor: The interest rate at which banks can borrow funds in marketable size from other banks in the Indian interbank market.

The Mumbai Interbank Offered Rate (MIBOR) is calculated everyday by the National Stock Exchange of India (NSEIL) as a weighted average of lending rates of a group of banks, on funds lent to first-class borrowers.

Ques.11. Give the structure of interest rate swaps.

Ans. Structure of Interest Rate Swaps: The most common form of swap is the interest rate swap. In an interest rate swap, a fixed interest rate loan is exchanged for a floating interest rate loan. Figure illustrates the basic structure of this form of a swap when one company transacts a swap in order to hedge its floating rate loans:

The company takes out a floating rate loan with the base rate adjusted to the three-months rate. Since the actual interest amount will depend on the three interest amounts and will depend on the three-months bill rate, the interest amount will vary. To hedge this variability in the interest payments. Be this variability in the interest payments, the company swaps the floating rate loan with a swap counterparty for a fixed rate loan, unterparty for a fixed rate loan, which would provide a constant interest rate during the life of the loan.

Suppose the Swap has a two-year maturity, then an exchange of the current two-year swap rate for the market’s three-month bill rate will occur every three months to

For example, assume that the two-year swap rate is 9% at the start of the swap arrangement and the three-months bill rate is 8%. This means that the company will pay 0.25% on the notional principal at the end of the first three months. Note that the principal is not exchanged in an interest rate swap. Since the company is swapping a floating rate loan for a fixed rate loan, the company will need to pay at 9% for the three-months loan under the swap, whereas the floating rate loan would have cost only 8%.

Thus, the company has to pay 1% higher interest on a yearly basis, or 0.25% on a three-month basis to the swap counterparty.

After three months, assume that the three-months bill rate increases to 10%. Since the fixed rate is 9%, the swap counterparty will pay the company 0.25% of the notional principal at the end of six months. This additional payment from the swap counterparty will provide sufficient funds to pay the interest on the floating rate loan at 10%.

Ques.12. Give various types of currency swaps.

Ans. Following are the types of currency swaps:

1. Fixed rate currency swap:A fixed rate currency swap consi counterparties of fixed rate interest in one currency in return for fixed rate interest in another currency.

(a) Fixed-to-Fixed Currency Swan: In this category, the currencies are exchanged at a fixed rate. rap works like this. One firm raises a fixed rate liability in currency X, for example, US while the other firm raises fixed rate funding in currency Y, for exam fixed rate funding in currency Pound (£). The principal amounts are equivalent at the current market rate of exchange. the first party will get pounds whereas the second party gets dollars. Subsequently, the will make periodic (pound) payments to the second, in turn gets dollars computed at interes at a fixed rate on the respective principal amount of both currencies. At maturity, the dollar and pound principal are re-exchanged.

(b) Fixed-to-Floating Currency Swaps: This swap is a combination of fixed-to-fixed currency swap and floating swap. In this, one party makes the payment at a fixed rate in currency, for example, X while the other party makes the payment at a floating rate in currency, for example, Y. Contracts without the exchange and re-exchange of principals do exist. In most cases, a financial intermediary (a swap bank) structures the swap deal and routes the payments from one party to another party.

2. Currency coupon swap: The currency coupon swap is a combination of the interest rate swap and the fixed-rate currency swap. Currency swap involves exchange of affixed rate obligation in one currency for a floating rate obligation in another currency. This is known as ‘Fixed-to-Floating Currency Swap, or ‘Circus Swap, or ‘Currency Coupon Swap’.

The most important currencies in the currency swap market are the US Dollar, the Swiss Franc, the Deutsche Mark, the ECU, the Sterling Pound, the Canadian Dollar and the Japanese Yen. The currency swap is an important tool to manage currency exposures and cost benefits at the same time. These are often used to provide long-term financing in foreign currencies. This function is important because in many foreign countries, long-term capital and forward foreign exchange markets are notably absent or not well developed. However, if the international financial markets were fully developed from all the angles, then the incentive to swap would be not so much due to availability of arbitrage opportunities.

3. Diff swap: Another variation of the swap family is the differential swap also commonly known as diff swap or quanto swap. This product was first developed in the early nineties in order to suit the needs of customers who had strong views on the spread between interest rates in different countries, For example, the treasurer of company A, a US based company, gets today’s market data for US and Japan’s yield curves. He thinks that due to the strong growth in the US economy relative to Japan’s, the US interest rates are likely to rise faster than what the market suggests now, i.e. the spread between US interest rates and Japan interest rates would widen even further than today’s prediction.

Ques.13. How will you manage the currency risk by currency swaps?

Ans. Currency risk is managed by currency swaps in the following ways:

Using Currency Swaps to Lower Borrowing Costs in Foreign Countries: Inte can be mutually beneficial if there is a comparative advantage for the two parts over another. The rationale for currency swaps is similar: one party has a comparative advantage for the two parties in one market over another The rationale for currency swaps is similar: one party has a comparative advantage in borrowing in one currency while another has an advantage in the other. For example, suppose a prominent Indian company ( say, TISCO) wants to raise funds in the USA. At the same time, a prominent American company, say, Jacobs Engineering wants to borrow in Indian rupees for a project in India. TISCO, though a blue chip in India. It would be beneficial to both companies if TISCO borrows in rupees, Jacobs in dollars and the two then swap the liabilities.

Sometimes, comparative advantage could run in the opposite direction. A British company might have already borrowed heavily in the Sterling bond market. As a result, the market may demand a premium on further borrowings, as they would not prefer a concentration of holdings in one company. On the other hand, say because it is a well-known multinational, it may be able to raise funds relatively cheaply in the Indian rupee debt market because it has no previous exposure.

Ques.14. Describe the functions of fra.

Ans. Functions of FRA: FRA has the following functions:

1. A customer enters into an agreement with his bank to either buy or sell an FRA. The FRA defines an interest rate for the principal of a deposit or a loan for a defined interest period that will start at a future date. The interest rate on which they agree, also known as FRA rate, is the price of the FRA as it is quoted by the market.
2. By doing so, the bank has not committed itself to lend or take money at this rate. Instead, the customer and the bank agree to compare the fixed FRA rate to a reference interest rate (e.g., LIBOR) two days (exception: GBP) before the defined interest period (fixing date). The  reference rate is defined on the fixing date and is also called settlement rate.
3. Who receives or pays the due amount depends on whether the customer or the bank bought or sold the FRA and whether the FRA rate is higher or lower than the reference rate at settlement date.

A large company wishes to fix the interest rate for a loan of USD 20 million for 3 months, beginning two months. The company might buy an FRA from a bank that is trading such instruments. The bank tes an FRA rate. This FRA rate is applied to the principal (USD 20 million), but not to the three oth loan itself. Thereby, the FRA rate serves as the fixed rate that the company wanted to secure for a three month term of interest (from the end of the 2nd until the end of the 5th month). This fixed is known to both of the counterparties on trading day, but they do not know the future level of the month loan’s reference rate.

Ques.15. Give the advantages and disadvantages of fra.

Ans. Advantages of FRA: The advantages of FRA are as follows:

1. Very liquid market so small bid/offer spreads.
2. Customised dates and amounts.
3. Can be reversed at any time at the then prevailing rate.
4. No premiums or payments upfront.

Disadvantages of FRA: The disadvantages of FRA are as follows:

1. The FRA market is not very liquid.
2. Only cover short-term interest rates.
3. If an FRA is to be adapted to a client’s underlying asset, which often does not coincide with the standard periods of three or six months, this will add to the client’s costs.

4. It is more expensive for clients to trade small amounts.

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