SDR Site Installation Standards for Telenor Vega Swap Project(V1.0) (1)
risk management project swap
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SWAP
Introduction
The implacable wave of credit crisis casualties has financial institutions
scrambling to protect their bottom line. In these uncertain times, once
solid investment vehicles are now looked upon as carrying great risk. A
derivative is a financial instrument that allocates the risks and price
exposures associated with a designated asset between the parties to an
instrument. Derivatives can provide price exposure or price insulation to
changes in the price or level of an open-ended range of assets, including
stocks, interest rates, currencies, bonds, commodities, insured risks, credit
risks, investment funds, property, the weather and more. Derivatives are
used in an infinite variety of ways by commercial, eleemosynary and
governmental entities to manage the commercial and financial risks they
confront. As the breadth and complexity of derivatives evolve, so too does
the complexity of associated documentation and legal issues.
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Meaning
In finance, a swap is a derivative in which counterparties exchange certain
benefits of one party's financial instrument for those of the other party's
financial instrument. The benefits in question depend on the type of
financial instruments involved. For example, in the case of a swap
involving two bonds, the benefits in question can be the periodic interest
(or coupon) payments associated with the bonds. Specifically, the two
counterparties agree to exchange one stream of cash flows against another
stream. These streams are called the legs of the swap. The swap
agreement defines the dates when the cash flows are to be paid and the
way they are calculated. Usually at the time when the contract is initiated
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.
The cash flows are calculated over a notional principal amount, which is
usually not exchanged between counterparties. Consequently, swaps can
be in cash or collateral. Swaps can be used to hedge certain risks such as
interest rate risk, or to speculate on changes in the expected direction of
underlying prices.
Swaps can be used to hedge certain risks such as interest rate risk, or to
speculate on changes in the expected direction of underlying prices.
Traditionally, the exchange of one security for another to change the
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maturity (bonds), quality of issues (stocks or bonds), or because
investment objectives have changed. If firms in separate countries have
comparative advantages on interest rates, then a swap could benefit both
firms. For example, one firm may have a lower fixed interest rate, while
another has access to a lower floating interest rate. These firms could
swap to take advantage of the lower rates
The first swaps were negotiated in the early 1980s.David Swensen, a Yale
Ph.D. at Salomon Brothers, engineered the first swap transaction
according to "When Genius Failed: The Rise and Fall of Long-Term
Capital Management" by Roger Lowenstein. Today, swaps are among the
most heavily traded financial contracts in the world: the total amount of
interest rates and currency swaps outstanding is more thn $426.7 trillion
in 2009, according to International Swaps and Derivatives Association.
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SWAPMARKET
Most swaps are traded over-the-counter (OTC), "tailor-made" for the
counterparties. Some types of swaps are also exchanged on futures
markets such as the Chicago Mercantile Exchange Holdings Inc., the
largest U.S. futures market, the Chicago Board Options Exchange,
IntercontinentalExchange and Frankfurt-based Eurex AG. The Bank for
International Settlements (BIS) publishes statistics on the notional
amounts outstanding in the OTC derivatives market. At the end of 2006,
this was USD 415.2 trillion, more than 8.5 times the 2006 gross world
product. However, since the cash flow generated by a swap is equal to an
interest rate times that notional amount, the cash flow generated from
swaps is a substantial fraction of but much less than the gross world
product³which is also a cash-flow measure. The majority of this (USD
292.0 trillion) was due to interest rate swaps. These split by currency as:
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The CDS and currency swap markets are dwarfed by the interest rate
swap market. All three markets peaked in mid 2008.
Currency End
2004
End
2005
End
2006
End
2007
End
2008
End
2009
End
2010
Euro 16.6 20.9 31.5 44.7 59.3 81.4 112.1
US dollar 13.0 18.9 23.7 33.4 44.8 74.4 97.6
apanese
yen
11.1 10.1 12.8 17.4 21.5 25.6 38.0
Pound
sterling 4.0 5.0 6.2 7.9 11.6 15.1 22.3
Swiss franc 1.1 1.2 1.5 2.0 2.7 3.3 3.5
Total 48.8 58.9 79.2 111.2 147.4 212.0 292.0
Usually, at least one of the legs has a rate that is variable. It can depend on
a reference rate, the total return of a swap, an economic statistic, etc. The
most important criterion is that it comes from an independent third party,
to avoid any conflict of interest. For instance, LIBOR is published by the
British Bankers Association, an independent trade body.
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Need for swap?
The motivations for using swap contracts fall into two basic categories:
commercial needs and comparative advantage. The normal business
operations of some firms lead to certain types of interest rate or currency
exposures that swaps can alleviate. For example, consider a bank, which
pays a floating rate of interest on deposits (i.e., liabilities) and earns a fixed
rate of interest on loans (i.e., assets). This mismatch between assets and
liabilities can cause tremendous difficulties. The bank could use a fixed-
pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-
rate assets into floating-rate assets, which would match up well with its
floating-rate liabilities.
Some companies have a comparative advantage in acquiring certain types
of financing. However, this comparative advantage may not be for the type
of financing desired. In this case, the company may acquire the financing
for which it has a comparative advantage, then use a swap to convert it to
the desired type of financing.
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For example, consider a well-known U.S. firm that wants to expand its
operations into Europe, where it is less well known. It will likely receive
more favorable financing terms in the US. By then using a currency swap,
the firm ends with the euros it needs to fund its expansion.
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Types of Swaps
The five generic types of swaps, in order of their quantitative importance,
are:
i. Interest Rate Swaps
ii. Currency Swaps
iii. Credit Swaps
iv. Commodity Swaps And
v. Equity Swaps
Interest rate swaps
An interest rate swap is an exchange between two counter parties of interest obligations (payments of interest) or receipts (investment income),in the same currency on an agreed amount of notional principal for anagreed period of time. The agreed amount is called "notional principal"because, since it is not a loan or investment. The principal amount isneither exchanged at the outset nor rapid at maturity. The most commoninterest-rate swaps involve the exchange of interest from a fixed to a floating basis or vice versa.
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A is currently paying floating, but wants to pay fixed. B is currently paying
fixed but wants to pay floating. By entering into an interest rate swap, the
net result is that each party can 'swap' their existing obligation for their
desired obligation. Normally the parties do not swap payments directly,
but rather, each sets up a separate swap with a financial intermediary such
as a bank. In return for matching the two parties together, the bank takes
a spread from the swap payments.
The most common type of swap is a ´plain Vanillaµ interest rate swap. It
is the exchange of a fixed rate loan to a floating rate loan. The life of the
swap can range from 2 years to over 15 years. The reason for this
exchange is to take benefit from comparative advantage. Some companies
may have comparative advantage in fixed rate markets while other
companies have a comparative advantage in floating rate markets. When
companies want to borrow they look for cheap borrowing i.e. from the
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market where they have comparative advantage. However this may lead to
a company borrowing fixed when it wants floating or borrowing floating
when it wants fixed. This is where a swap comes in. A swap has the effect
of transforming a fixed rate loan into a floating rate loan or vice versa.
For example, party B makes periodic interest payments to party A based
on a variable interest rate of LIBOR +70 basis points. Party A in return
makes periodic interest payments based on a fixed rate of 8.65%. The
payments are calculated over the notional amount. The first rate is called
variable, because it is reset at the beginning of each interest calculation
period to the then current reference rate, such as LIBOR. In reality, the
actual rate received by A and B is slightly lower due to a bank taking a
spread.
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Currency Swaps
It is a swap that involves the exchange of principal and interest in one
currency for the same in another currency. It is considered to be a foreign
exchange transaction and is not required by law to be shown on the
balance sheet. Just like interest rate swaps, the currency swaps also are
motivated by comparative advantage.
Example
Suppose a U.S.-based company needs to acquire Swiss francs and a
Swiss-based company needs to acquire U.S. dollars. These two companies
could arrange to swap currencies by establishing an interest rate, an agreed
upon amount and a common maturity date for the exchange. Currency
swap maturities are negotiable for at least 10 years, making them a very
flexible method of foreign exchange.
Working
A currency swap agreement specifies the principal amount to be swapped,
a common maturity period and the interest and exchange rates
determined at the commencement of the contract. The two parties would
continue to exchange the interest payment at the predetermined rate until
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the maturity period is reached. On the date of maturity, the two parties
swap the principal amount specified in the contract.
The equivalent amount of the loan value in another currency is calculatedby using the net present value (NPV). This implies that the exchange of
the principal amount is carried out at market rates during the inception
and maturity periods of the agreement.
Uses
Currency swaps have two main uses:
y To secure cheaper debt (by borrowing at the best available rateregardless of currency and then swapping for debt in desiredcurrency using a back-to-back-loan)
y To hedge against (reduce exposure to) exchange rate fluctuations.
Benefits of Currency Swap
The benefits of currency swaps are:
Help portfolio managers regulate their exposure to interest rates.
Speculators can benefit from a favorable change in interest rates.
Reduce uncertainty associated with future cash flows as it enablescompanies to modify their debt conditions.
Reduce costs and risks associated with currency exchange.
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Companies having fixed rate liabilities can capitalize on floating-rate
swaps and vise versa, based on the prevailing economic scenario.
Currency swaps can be used to exploit inefficiencies in international
debt markets.
Limitations of Currency Swap
The drawbacks of currency swaps are:
Exposed to credit risk as either one or both the parties could
default on interest and principal payments.
Vulnerable to the central government·s intervention in the
exchange markets. This happens when the government of a
country acquires huge foreign debts to temporarily support a
declining currency. This leads to a huge downturn in the value of
the domestic currency.
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Commodity Swap
A commodity swap is an agreement whereby a floating (or market or spot)
price is exchanged for a fixed price over a specified period. It is a swap
where exchanged cash flows are dependent on the price of an underlying
commodity. This is usually used to hedge against the price of a
commodity. In this swap, the user of a commodity would secure a
maximum price and agree to pay a financial institution this fixed price.
Then in return, the user would get payments based on the market price
for the commodity involved. The vast majority of commodity swaps
involve oil.
Equity Swap
It is basically a strategy in which an investor sells a bond and at the same
time purchases a different bond with the proceeds from the sale. There
are several reasons why people use a bond swap: to seek tax benefits, to
change investment objectives, to upgrade a portfolio's credit quality or to
speculate on the performance of a particular bond.
An equity swap is a special type of total return swap, where the underlying
asset is a stock, a basket of stocks, or a stock index. Compared to actually
owning the stock, in this case you do not have to pay anything up front,
but you do not have any voting or other rights that stock holders do have.
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Equity Swaps also provide the following benefits over plain vanilla equity
investing:
1. An investor in a physical holding of shares loses possession on theshares once he sells his position. However, using an equity swap the
investor can pass on the negative returns on equity position without losing
the possession of the shares and hence voting rights. For example, let's say
A holds 100 shares of a Petroleum Company. As the price of crude falls
the investor believes the stock would start giving him negative returns in
the short run. However, his holding gives him a strategic voting right in the
board which he does not want to lose. Hence, he enters into an equity
swap deal wherein he agrees to pay Party B the return on his shares
against LIBOR+25bps on a notional amt. If A is proven right, he will get
money from B on account of the negative return on the stock as well as
LIBOR+25bps on the notional. Hence, he mitigates the negative returnson the stock without losing on voting rights.
2. It allows an investor to receive the return on a security which is listed in
such a market where he cannot invest due to legal issues. For example,
let's say A wants to invest on script X listed in Country C. However, A is
not allowed to invest in Country C due to capital control regulations. He
can however, enter into a contract with B, who is a resident of C, and ask
him to buy the shares of company X and provide him with the return on
share X and he agrees to pay him a fixed / floating rate of return.
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Credit default swap
A credit default swap (CDS) is a swap contract in which the buyer of the
CDS makes a series of payments to the seller and, in exchange, receives a
payoff if a credit instrument - typically a bond or loan - goes into default
(fails to pay). Less commonly, the credit event that triggers the payoff can
be a company undergoing restructuring, bankruptcy or even just having its
credit rating downgraded. CDS contracts have been compared with
insurance, because the buyer pays a premium and, in return, receives a
sum of money if one of the events specified in the contract occur. Unlike
an actual insurance contract the buyer is allowed to profit from the
contract and may also cover an asset to which the buyer has no direct
exposure.
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Uses
Credit default swaps can be used by investors for speculation, hedging and
arbitrage.
y Speculation
Credit default swaps allow investors to speculate on changes in CDS
spreads of single names or of market indices such as the North American
CDX index or the European iTraxx index. An investor might believe that
an entity's CDS spreads are too high or too low, relative to the entity's
bond yields, and attempt to profit from that view by entering into a trade,
known as a basis trade, that combines a CDS with a cash bond and an
interest-rate swap.
y Hedging
Credit default swaps are often used to manage the risk of default which
arises from holding debt. A bank, for example, may hedge its risk that a
borrower may default on a loan by entering into a CDS contract as the
buyer of protection. If the loan goes into default, the proceeds from the
CDS contract will cancel out the losses on the underlying debt.
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y Arbitrage
Capital Structure Arbitrage is an example of an arbitrage strategy that
utilizes CDS transactions.This technique relies on the fact that a
company's stock price and its CDS spread should exhibit negative
correlation; i.e. if the outlook for a company improves then its share price
should go up and its CDS spread should tighten, since it is less likely to
default on its debt. However if its outlook worsens then its CDS spread
should widen and its stock price should fall. Techniques reliant on this
are known as capital structure arbitrage because they exploit market
inefficiencies between different parts of the same company's capital
structure; i.e. mis-pricings between a company's debt and equity. An
arbitrageur will attempt to exploit the spread between a company's CDS
and its equity in certain situations.
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Naked credit default swaps
In the examples above, the hedge fund did not own debt of Risky Corp. A
CDS in which the buyer does not own the underlying debt is referred to
as a naked credit default swap, estimated to be up to 80% of the credit
default swap market. There is currently a debate in the United States and
Europe about whether speculative uses of credit default swaps should be
banned. Legislation is under consideration by Congress as part of
financial reform.
Critics assert that naked CDS should be banned, comparing them to
buying fire insurance on your neighbor·s house, which creates a huge
incentive for arson. Analogizing to the concept of insurable interest, critics
say you should not be able to buy a CDS-insurance against default when
you do not own the bond. Short selling is also viewed as gambling and the
CDS market as a casino. Another concern is the size of CDS market.
Because naked credit default swaps are synthetic, there is no limit to how
many can be sold. The gross amount of CDS far exceeds all ´realµ
corporate bonds and loans outstanding. As a result, the risk of default is
magnified leading to concerns about systemic risk.
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Forex swap
In finance, a forex swap (or FX swap) is a simultaneous purchase and sale
of identical amounts of one currency for another with two different value
dates (normally spot to forward).
Structure
A forex swap consists of two legs:
y a spot foreign exchange transaction, and
y a forward foreign exchange transaction.
Constant maturity swap
A constant maturity swap, also known as a CMS, is a swap that allows the
purchaser to fix the duration of received flows on a swap.
The floating leg of an interest rate swap typically resets against a published
index. The floating leg of a constant maturity swap fixes against a point on
the swap curve on a periodic basis.
A constant maturity swap is an interest rate swap where the interest rate
on one leg is reset periodically, but with reference to a market swap rate
rather than LIBOR. The other leg of the swap is generally LIBOR, but
may be a fixed rate or potentially another constant maturity rate. Constant
maturity swaps can either be single currency or cross currency swaps.
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Therefore, the prime factor for a constant maturity swap is the shape of
the forward implied yield curves. A single currency constant maturity swap
versus LIBOR is similar to a series of differential interest rate fix (or
"DIRF") in the same way that an interest rate swap is similar to a series of
forward rate agreements. Valuation of constant maturity swaps depends
on volatilities and correlations of different forward rates and therefore
requires an interest rate model or some approximated methodology like a
convexity adjustment, see for example Brigo andMercurio (2001).
Example
A customer believes that the difference between the six-month LIBOR
rate will fall relative to the three-year swap rate for a given currency. To
take advantage of this, he buys a constant maturity swap paying the six-
month LIBOR rate and receiving the three-year swap rate.
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Other variations
There are myriad different variations on the vanilla swap structure, which
are limited only by the imagination of financial engineers and the desire of
corporate treasurers and fund managers for exotic structures.
y A total return swap is a swap in which party A pays the total return
of an asset, and party B makes periodic interest payments. The total
return is the capital gain or loss, plus any interest or dividend
payments. Note that if the total return is negative, then party A
receives this amount from party B. The parties have exposure to the
return of the underlying stock or index, without having to hold the
underlying assets. The profit or loss of party B is the same for him
as actually owning the underlying asset.
y An option on a swap is called a swaption. These provide one party
with the right but not the obligation at a future time to enter into a
swap.
y A variance swap is an over-the-counter instrument that allows one to
speculate on or hedge risks associated with the magnitude of
movement, a CMS, is a swap that allows the purchaser to fix the
duration of received flows on a swap.y An Amortising swap is usually an interest rate swap in which the
notional principal for the interest payments declines during the life
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of the swap, perhaps at a rate tied to the prepayment of a mortgage
or to an interest rate benchmark such as the LIBOR.
Valuation
The value of a swap is the net present value (NPV) of all estimated future
cash flows. A swap is worth zero when it is first initiated, however after this
time its value may become positive or negative. There are two ways to
value swaps: in terms of bond prices, or as a portfolio of forward
contracts.
a) Using bond prices
While principal payments are not exchanged in an interest rate swap,
assuming that these are received and paid at the end of the swap does not
change its value. Thus, from the point of view of the floating-rate payer, a
swap can be regarded as a long position in a fixed-rate bond (i.e. receiving
fixed interest payments), and a short position in a floating rate note (i.e.
making floating interest payments):
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V swap = Bfixed Bfloating
From the point of view of the fixed-rate payer, the swap can be viewed as
having the opposite positions. That is,
V swap = Bfloating Bfixed
Similarly, currency swaps can be regarded as having positions in bonds
whose cash flows correspond to those in the swap. Thus, the home
currency value is:
V swap = Bdomestic S0Bforeign, where Bdomestic is the domestic cash flows of the
swap, Bforeign is the foreign cash flows of the swap, and S0 is the spot
exchange rate.
b) Using forward rate agreements
Consider a three year interest rate swap with semiannual payments. The
first cash flow is known at the time the swap is initiated, however the other
five exchanges can be regarded as forward rate agreements. The payment
for these other exchanges is the 6 month rate observed in the market 6
months earlier. Assuming that forward interest rates are realised, this
method values the swap by firstly calculating the required forward ratesusing the LIBOR/swap curve, then calculating the swap cash flows using
these rates, and then finally discounting these cash flows back to today.
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c) London Interbank Offered Rate (LIBOR)
LIBOR is the rate of interest offered by banks on deposit from other
banks in the eurocurrency market. One-month LIBOR is the rate offeredfor 1-month deposits, 3-month LIBOR for three months deposits, etc.
LIBOR rates are determined by trading between banks and change
continuously as economic conditions change. Just like the prime rate of
interest quoted in the domestic market, LIBOR is a reference rate of
interest in the InternationalMarket.
d) Arbitrage arguments
As mentioned, to be arbitrage free, the terms of a swap contract are such
that, initially, the NPV of these future cash flows is equal to zero. Where
this is not the case, arbitrage would be possible.
For example, consider a plain vanilla fixed-to-floating interest rate swap
where Party A pays a fixed rate, and Party B pays a floating rate. In such
an agreement the fixed rate would be such that the present value of future
fixed rate payments by Party A are equal to the present value of the
expected future floating rate payments (i.e. the NPV is zero). Where this
is not the case, an Arbitrageur, C, could:
1. assume the position with the lower present value of payments, and
borrow funds equal to this present value
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2. meet the cash flow obligations on the position by using the
borrowed funds, and receive the corresponding payments - which
have a higher present value
3. use the received payments to repay the debt on the borrowed funds
4. pocket the difference - where the difference between the present
value of the loan and the present value of the inflows is the arbitrage
profit.
Exiting a Swap Agreement
Sometimes one of the swap parties needs to exit the swap prior to the
agreed-upon termination date. This is similar to an investor selling an
exchange-traded futures or option contract before expiration. There are
four basic ways to do this.
1) Buy Out the Counterparty
Just like an option or futures contract, a swap has a calculable
market value, so one party may terminate the contract by paying the
other this market value. However, this is not an automatic feature,
so either it must be specified in the swaps contract in advance, or the
party who wants out must secure the counterparty·s concent
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2) Enter an Offsetting Swap
For example, Company A from the interest rate swap example
above could enter into a second swap, this time receiving a fixed rate
and paying a floating rate.
3) Sell the Swap to Someone Else
Because swaps have calculable value, one party may sell the contract
to a third party. As with Strategy 1, this requires the permission of
the counterparty.
4) Use a Swaption
A swaption is an option on a swap. Purchasing a swaption would
allow a party to set up, but not enter into, a potentially offsetting
swap at the time they execute the original swap. This would reduce
some of the market risks associated with Strategy 2..