Swaps & Applications: Equity, Interest, Currency, and Basis Swaps

Key Takeaways

• Swaps are OTC contracts to exchange cash flows (e.g., fixed vs. floating rates) without transferring underlying assets.
• Common types: Interest rate swaps, currency swaps, equity swaps, and basis swaps (floating vs. floating).
• Purpose: Hedging (e.g., banks locking rates), arbitrage (e.g., NEPSE investors), or tax optimization.
• Notional principal is fixed but cash flows vary; payments are net settled.
• Counterparty risk exists (no central clearing like exchanges).
• Exam focus: Definitions, swap mechanics, and numerical problems (e.g., calculating net payments).

1. Introduction to Swaps

Swaps are derivatives where two parties agree to exchange cash flows based on a notional principal. Unlike futures/options, swaps are customized OTC (over-the-counter) contracts, not traded on exchanges.

Key Features

mindmap:
  root((Swaps))
    - Customized: Tailored to counterparties' needs
    - OTC: No centralized exchange (unlike futures)
    - Notional Principal: Fixed amount (e.g., Rs 60M) for cash flow calculations
    - Net Settlement: Only net payment is exchanged
    - Counterparty Risk: Credit risk between parties
    - No Upfront Cost: Typically zero initial payment

Why Use Swaps?

• Hedging: Lock in rates (e.g., banks hedging loan risks).
• Arbitrage: Exploit rate/currency mismatches.
• Tax Efficiency: Shift income to lower-tax jurisdictions (e.g., currency swaps).

2. Types of Swaps

(A) Interest Rate Swaps (IRS)

Exchange floating-rate payments (e.g., LIBOR) for fixed-rate payments.

Example: Nepal Bank vs. Investor

• Nepal Bank (lender) wants to lock in floating rates (e.g., 6-month LIBOR).
• Investor (borrower) wants fixed rates (e.g., 5%).
• Swap: Bank pays investor 5% fixed; investor pays bank 6-month LIBOR.
  • If LIBOR > 5%, bank profits; if LIBOR < 5%, investor profits.

Visual: Cash Flow Diagram

(B) Currency Swaps

Exchange principal + interest in two currencies (e.g., USD/NPR).

Real-World Use: Nepalese Importers

• A Nepalese importer (NPR) needs USD for machinery.
• Swap: Borrow USD from a bank, pay NPR interest; bank borrows NPR, pays USD interest.
  • Reduces FX risk if NPR depreciates.

Example Calculation

flowchart TD
    A["Nepal Importer (NPR)"] -->|"Borrow USD 1M @ 5%"| B["USD Lender"]
    B -->|"Pay NPR 1M @ 3%"| A
    C["NPR Bank"] -->|"Borrow NPR 1M @ 2%"| A
    A -->|"Pay USD 1M @ 4%"| C

(C) Equity Swaps

Exchange equity returns for fixed/floating rates.

Example: NEPSE Investor Hedging

• An investor holds small-cap stocks (high risk) but wants fixed income.
• Swap: Pays dealer return on small-cap index; receives fixed rate (e.g., 4%).
  • If small-cap index drops, investor gains from fixed rate.

Cash Flow Table

| Period | Investor Pays (Small-Cap Return) | Dealer Pays (4%) | Net Payment |
|--------|----------------------------------|------------------|-------------|
| 0-1y   | -10% (loss)                       | 4%               | **Dealer pays Rs 6M** |
| 1-2y   | +15% (gain)                       | 4%               | **Investor pays Rs 11M** |

Notional = Rs 100M.

(D) Basis Swaps

Exchange two floating rates (e.g., 3-month LIBOR vs. 6-month LIBOR).

Why?

• Arbitrage between short-term and long-term rates.
• Example: A bank may prefer 6-month LIBOR over 3-month for funding.

Visual: Basis Swap Flow

sequenceDiagram
    participant Bank as Bank A
    participant Counterparty as Counterparty
    Bank->>Counterparty: Pays 3m LIBOR (Floating)
    Counterparty->>Bank: Pays 6m LIBOR (Floating)
    note right of Bank: Arbitrage between
    note right of Counterparty: short-term and long-term rates
    Bank-->>Counterparty: Net Settlement (if any)

3. How Swaps Work: Step-by-Step

1. Agreement: Parties define notional, rates, and payment dates.
2. Notional Principal: Fixed amount (e.g., Rs 60M) for calculations.
3. Cash Flow Exchange: Payments are net settled (only difference is exchanged).
4. Termination: Can be terminated early (with compensation) or at maturity.

Example: 6-Month Equity Swap (Exam Question)

• Pension Fund (Rs 60M notional) receives index return; pays fixed 3%.
• Index return: +5% (90 days), -2% (180 days).
• Calculations:
  • 90d: Fund receives 5% × Rs 60M = Rs 3M; pays 3% × Rs 60M × 0.5 = Rs 0.9M. Net: Fund receives Rs 2.1M.
  • 180d: Fund receives -2% × Rs 60M = -Rs 1.2M; pays 3% × Rs 60M × 0.5 = Rs 0.9M. Net: Fund pays Rs 0.3M.

Total Net Payment: Rs 2.1M (90d) – Rs 0.3M (180d) = Rs 1.8M received.

4. Advantages and Disadvantages

5. Swaps vs. Other Derivatives

| Feature          | Swaps               | Futures/Options          | Forwards             |
|------------------|---------------------|--------------------------|----------------------|
| **Market**       | OTC                 | Organized exchange       | OTC                  |
| **Standardized** | No                  | Yes                      | No                   |
| **Liquidity**    | Low                 | High                     | Low                  |
| **Settlement**   | Net                 | Physical/daily           | Physical             |
| **Counterparty Risk** | High          | Low (exchange guarantees)| High                 |

6. Real-World Applications

(A) Nepalese Banks (Interest Rate Swaps)

• Problem: Banks lend at floating rates (e.g., NPR) but borrow in USD.
• Solution: Use currency swaps to hedge FX risk.
  • Example: NMB Bank swaps USD liabilities for NPR assets to stabilize profits.

(B) NEPSE Investors (Equity Swaps)

• Problem: Investors want exposure to large-cap stocks but hold small-cap.
• Solution: Enter equity swaps to receive large-cap returns while keeping small-cap holdings.
  • Example: A pension fund swaps small-cap returns for NEPSE Large-Cap Index returns.

(C) Daraz (Supply Chain Swaps)

• Problem: Daraz faces currency risk from international suppliers (USD).
• Solution: Use currency swaps to lock in NPR rates for USD payments.
  • Example: Daraz swaps USD payments for NPR, reducing FX volatility.

7. Exam-Style Questions (Worked Examples)

Question 1: Interest Rate Swap Calculation

A pension fund enters a 1-year interest rate swap with a notional of Rs 50M. It pays 4% fixed and receives 3-month LIBOR. LIBOR rates are 4.5% (0-3m), 4.2% (3-6m), 4.8% (6-9m), 5.1% (9-12m). Calculate net payments.

Solution:

| Period | Fund Pays (4% Fixed) | Fund Receives (LIBOR) | Net Payment |
|--------|----------------------|----------------------|-------------|
| 0-3m   | Rs 5M (4% × 50M × 0.25) | Rs 5.625M (4.5% × 50M × 0.25) | **+Rs 0.625M** |
| 3-6m   | Rs 5M                 | Rs 5.25M (4.2% × 50M × 0.25) | **+Rs 0.25M** |
| 6-9m   | Rs 5M                 | Rs 6M (4.8% × 50M × 0.25) | **-Rs 1M**   |
| 9-12m  | Rs 5M                 | Rs 6.375M (5.1% × 50M × 0.25) | **-Rs 1.375M** |
| **Total** | **Rs 20M**           | **Rs 23.25M**         | **-Rs 3.25M** (Fund pays Rs 3.25M) |

Question 2: Currency Swap (Nepal Importer)

A Nepalese importer borrows USD 1M for 1 year at 5%. The bank offers a currency swap: borrow NPR 1M at 3% and pay USD 1M at 4%. What’s the net cost?

Solution:

• USD Borrow: 5% × USD 1M = USD 50k.
• Swap: Pay USD 4% (USD 40k) + borrow NPR 1M at 3% (NPR 30k).
• Net USD Cost: 50k – 40k = USD 10k (savings of USD 10k).

8. Common Exam Mistakes

1. Misidentifying Swap Types: Confusing interest rate swaps with currency swaps.
   • Fix: Memorize definitions (e.g., "currency swap = exchange principal + interest").
2. Incorrect Notional Application: Forgetting notional is fixed but cash flows vary.
   • Fix: Always calculate payments as (Rate × Notional × Time).
3. Ignoring Net Settlement: Assuming gross payments are exchanged.
   • Fix: Only the difference is settled.
4. Overlooking Counterparty Risk: Assuming swaps are risk-free.
   • Fix: Note swaps are OTC (no exchange guarantee).

9. Exam Tip

• Focus on:
  • Definitions (e.g., "equity swap = exchange equity returns for fixed/floating rates").
  • Numerical problems (calculate net payments using notional and rates).
  • Real-world links (e.g., banks using IRS, NEPSE investors using equity swaps).
• Avoid:
  • Describing swaps as "futures" or "options" (they are OTC and customized).
  • Forgetting to label periods (e.g., "90 days" vs. "180 days").
• Formula to Remember: $$\text{Net Payment}=(\text{Received Rate}-\text{Paid Rate})\times \text{Notional}\times \text{Time}$$