LOANS- FIXED & VARIABLE & SWAPS. Vikas Kr. Sinha Dy.FA&CAO/C/NR

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1 LOANS- FIXED & VARIABLE & SWAPS Vikas Kr. Sinha Dy.FA&CAO/C/NR

2 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.

3 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.

4 Example Consider 2 companies, one with a AAA rating and one with a BBB rating: Fixed Floating AAA Corp 10.00% 1Y INBMK % BBB Corp 11.20% 1Y INBMK % 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%

5 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.

6 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.

7 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.

8 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

9 SWAP DIAGRAM 5.3% Company A 1 Y INBMK Company B 1 Y INBMK+6% 1 Y INBMK+30 BPS 11% 5 % 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.

10 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.

11 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.

12 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.

13 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.

14 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.

15 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.

16 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.

MBF1243 Derivatives. L7: Swaps

MBF1243 Derivatives. L7: Swaps MBF1243 Derivatives L7: Swaps Nature of Swaps A swap is an agreement to exchange of payments at specified future times according to certain specified rules The agreement defines the dates when the cash