Swap

A swap is a contract in which two parties agree to exchange something on a future date — in the workbook's words, "a specified exchange on a future date". Swaps are common in the interest rate and currency markets.

The easiest way to picture one is a borrower who does not like the kind of interest he is paying. His loan charges a floating rate that moves with the Treasury bill rate, but his business wants a steady, predictable outgo. He cannot easily renegotiate the loan. What he can do is find a swap dealer who will take his floating payments off his hands in return for a fixed payment.

Nothing about the underlying loan changes. The swap sits on top of it and changes what the borrower effectively pays.

Swaps are one of the four commonly used derivative products named in Chapter 6 — forwards, futures, options and swaps.

The workbook's example has three moving parts:

The floating amount the borrower receives from the dealer is exactly what he owes his lender, so those two legs cancel. What remains is the fixed payment to the dealer. By using the swap market, the borrower "has converted his floating rate borrowing into a fixed rate obligation".

Three features to hold on to:

• The principal is only a reference. The amount on which interest is computed is agreed between the counterparties, but only the interest on it is exchanged on each settlement date.
• Swaps are OTC. They are not listed on Indian exchanges. The workbook notes that though swap transactions are over the counter, they are governed by rules and regulations accepted by swap dealer associations.
• In India, swap markets for interest rates are available in the OTC markets, alongside forward markets for agricultural commodities — they do not appear in the list of exchange-traded derivative products.

Borrower's net cost = Floating paid on loan − Floating received from dealer + Fixed paid to dealer
                    = Fixed rate paid to dealer

Interest for one quarter on the notional principal:

Quarterly interest = Principal × Annual rate ÷ 4

Illustrative numbers. Meera Textiles has a Rs 50 crore loan at T-bill rate + 2 per cent, interest paid quarterly. It enters a swap: pay 9 per cent fixed to a swap dealer, receive T-bill + 2 per cent, on the same Rs 50 crore.

Quarter 1 — T-bill rate 6.5 per cent (floating rate 8.5 per cent):

Quarter 2 — T-bill rate jumps to 8 per cent (floating rate 10 per cent):

The company's cost is Rs 1.125 crore every quarter, whatever the T-bill rate does. In quarter 1 the swap cost it Rs 6.25 lakh more than staying floating; in quarter 2 it saved Rs 12.5 lakh. That trade-off is the price of certainty. And the Rs 50 crore principal never moved — only interest did.

Chapter 6 (Derivative Markets) lists swaps among the four common derivative products in section 6.3, explains them in section 6.3.4 through the floating-to-fixed borrower, and in section 6.4 notes that interest rate swap markets in India are OTC. Chapter 6 also opens with an interest rate swap as one of its four examples of risk transfer. Expect a definition question, a question on what is exchanged (interest, not principal), and an "OTC or exchange-traded?" question.

• Only the interest is exchanged, not the principal, in the workbook's interest rate swap. A choice saying the Rs 50 crore changes hands is wrong.
• Swaps are OTC, not exchange-traded — but they are not unregulated in practice: the workbook says they are governed by rules accepted by swap dealer associations.
• The swap does not alter the original loan. The borrower still pays floating to his lender; the swap offsets it.
• Fixed-for-floating removes rate uncertainty; it does not guarantee a lower cost. When rates fall, the fixed payer pays more than he would have.
• Swaps are common in interest rate and currency markets — do not confine the idea to interest rates alone.
• The exchange-traded list in section 6.4 includes interest rate futures and options, not swaps.