Pricing of Swaps, Back to Back Loan

08/09/2022 0 By indiafreenotes

Pricing of Swaps

A swap is an agreement between two parties to exchange a series of cash flows, which can also be viewed as a series of forward contracts. Swap pricing is the determination of the initial terms of the swap at the inception of the contract. On the other hand, swap valuation is the determination of market value during the life of the swap contract.

Swaps are equivalent to a series of forward contracts, each created at the swap price. If the present value of the payments in a swap or forward contract is not zero, then the party who will receive the greater stream of payments must pay the other party the present value of the difference, i.e., the net value.

Interest Rate Swaps

An interest rate swap is an agreement to exchange one stream of interest payments for another, based on a specified principal amount, over a specified period of time. Here is an example of a plain vanilla interest rate swap with Bank A paying the LIBOR + 1.1% and Bank B paying a fixed 4.7%:

As in most financial transactions, a swap dealer is between the two parties taking a commission on the trade.

At inception, the value of an interest rate swap is zero. Therefore, the fixed rate on the swap has to be such that the present value of the fixed payments is equal to the present value of the floating payments. A received fixed-rate swap should be treated as buying a fixed-rate bond and issuing a floating rate bond:

Value of swap (receiving fixed) =Value of fixed-rate bond (long)–Value of floating-rate bond (short)

Back to Back Loan

A back-to-back loan, also known as a parallel loan, is when two companies in different countries borrow offsetting amounts from one another in each other’s currency as a hedge against currency risk. While the currencies and interest rates (based on the commercial rates of each locale) remain separate, each loan will have the same maturity date.

Companies could accomplish the same hedging strategy by trading in the currency markets, either cash or futures, but back-to-back loans can be more convenient. These days, currency swaps and similar instruments have largely replaced back-to-back loans. All the same, these instruments still facilitate international trade.

Normally, when a company needs access to money in another currency it trades for it on the currency market. But because the value of some currencies can fluctuate widely, a company can unexpectedly wind up paying far more for a given currency than it had expected to pay. Companies with operations abroad may seek to reduce this risk with a back-to-back loan.

The benefits of back-to-back loans include hedging in the exact currencies needed. Only major currencies trade in the futures markets or have enough liquidity in the cash markets to facilitate efficient trade. Back-to-back loans most commonly involve currencies that are either unstable or trade with low liquidity. High volatility in such trading creates greater need among companies in those countries to mitigate their currency risk.

Back-to-Back Loan Risks

In pursuing back-to-back loans, the biggest problem companies face is finding counterparties with similar funding needs. And even if they do find appropriate partners, the terms and conditions desired by both may not match. Some parties will enlist the services of a broker, but then brokerage fees have to be added to the cost of the financing.

In India, the states directly cannot borrow from external agencies such as IDA. The Union Government plays a role of intermediary. Before 2004, the states in India received all the external assistance on the terms as decided by the Union Budget. The loans were transferred to India states as per the below flowchart:

External AgencyGovernment of IndiaState Governments.

The External agency here means the banks such as World Bank etc. We should know that India has been a “blend borrower” in the World Bank. This means that it used to borrow on 50:50 rations of IBRD Loans and IDA Credits. The ratio could change also. Now the Government of India passed the funds to states on basis of 70:30 Loans to Grant ratio. This means that this loan to grant ratio was regardless of the loan: credit composition from the World Bank.

The States argued that the Central Government was pocketing the concessional components of the loans borrowed from the external agencies and they should be allowed to approach the market directly. The Central Government argued that since it (central government) is bearing the currency risks too, the pocketing of concessional component was a fair trade. On this matter, the 12th Finance Commission recommended passing loans on ‘Back-to-Back’ basis to State Governments. This implied that

  • States are encouraged to approach the market directly
  • States would face same terms and conditions as that of Union Government such as concessional interest rates, grace period and maturity profile, commitment charges and amortization schedules on account of their access to finance from bilateral and multilateral sources.
  • States would be exposed to uncertain movements in international rates of interest and currency exchange rates.

This means that though now states enjoy the same conditions as the Union enjoys, they are also exposed to the exchange risks. This recommendation was accepted by the Government of India for general category states and the arrangement came into effect from April 1, 2005. For special category states (Northeastern states, Uttarakhand, Himachal and J&K), external borrowings are in the form of 90 per cent grant and 10 per cent loan from the Union Government.

Passing loans on ‘Back-to-Back’ basis to State Governments implies that States would face identical terms and conditions (including concessional interest rates, grace period and maturity profile, commitment charges and amortization schedules) on account of their access to finance from bilateral and multilateral sources, as is faced by the Union Government.