Explanation of Swaps Contract with a simple example

08/09/2022 1 By indiafreenotes

Types of Swaps in Finance

There are several types of Swaps transacted in the financial world. They are a commodity, currency, volatility, debt, credit default, puttable, swaptions, Interest rate swap, equity swap, etc.

For example, imagine ABC Co. has just issued $1 million in five-year bonds with a variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). Also, assume that LIBOR is at 2.5% and ABC management is anxious about an interest rate rise.

The management team finds another company, XYZ Inc., that is willing to pay ABC an annual rate of LIBOR​  plus 1.3% on a notional principal of $1 million for five years. In other words, XYZ will fund ABC’s interest payments on its latest bond issue. In exchange, ABC pays XYZ a fixed annual rate of 5% on a notional value of $1 million for five years. ABC benefits from the swap if rates rise significantly over the next five years. XYZ benefits if rates fall, stay flat, or rise only gradually.

EDU Inc. enters into a financial contract with CBA Inc. in which they have agreed to exchange cash flows making LIBOR as its benchmark wherein EDU Inc. will pay a fixed rate of 5% and receive a floating rate of LIBOR+2% from CBA Inc.

Now, if we see, in this financial contract, there are two legs of the transaction for both parties.

  • EDU Inc. is paying the fixed rate of 5% and receiving a floating rate (Annual LIBOR+2%), whereas CBA Inc. is producing a floating rate (Annual LIBOR+2%) and receiving a fixed percentage (5%).

In the above example, let’s assume that both the parties have entered into a swaps contract for one year with a notional principal of Rs.1,00,000/-(since this is an Interest rate swap, hence the principal will not be exchanged). And after one year, the one year LIBOR in the prevailing market is 2.75%.

To understand the comparative rate advantage, let’s assume that the EDU Inc. and CBA Inc. have their own borrowing capacities in both fixed as well as a floating market (as mentioned in the table below).

Company Fixed Market Borrowing Floating Market Borrowing
EDU Inc. 4.00% One year LIBOR-0.1%
CBA Inc. 5.20% One year LIBOR+0.6%

In the above table, we can see that EDU Inc. has an absolute advantage in both the market, whereas CBA Inc. has a comparative advantage in the floating rate market (as CBA Inc. is paying 0.5% more than EDU Inc.). Assuming both the parties have entered into a Swap agreement with the condition that EDU Inc. will pay one year LIBOR and receive 4.35% p.a.

The cash flows for this agreement are described in the table below for both the parties.

Cash Flows for EDU Inc.  
Receivable in a Swap agreement 4.35%
Payable in a Swap agreement LIBOR
Payable in fixed market borrowing 4.00%
Net Effect LIBOR-0.35%
Cash Flows for EDU Inc.  
Receivable in the Swap agreement LIBOR
Payable in the Swap agreement 4.35%
Payable in floating market borrowing LIBOR+0.6%
Net Effect 4.95%

Looking at the above cash flows, we can say that EDU Inc. has a net cash flow of LIBOR – 0.35% per annum, giving it an advantage of 0.25%, which EDU Inc. had to pay if it went directly in the floating market, i.e., LIBOR – 0.1%.

In the second scenario for CBA Inc., the net cash flow is 4.95% per annum, giving it an advantage of 0.25% in the fixed borrowing market if it had gone directly, i.e., 5.20%.