Over the Counter Drivatives Market

Forward Contracts & Swaps are settled at the OTC (Over the Counter) market also known as “Telephone Market”). Over-the-counter (OTC) derivatives are private contracts negotiated between parties.. The chief advantage of OTC derivatives markets is limitless flexibility in contract design. The underlying asset can be anything, the size of the contract can be any amount, and the delivery can be made at any time and at any location. The only requirement of an OTC contract is a willing buyer and seller. Among the disadvantages of OTC markets, however, is that willing buyers and sellers must spend time identifying each other. Another disadvantage of OTC derivatives is credit risk, that is, the risk that a counterparty will renege on his contractual obligation.

By the 1800s, the pendulum had swung from undisciplined derivatives trading in OTC markets toward more structured trading on organized exchanges. The first derivatives exchange in the USA was the Chicago Board of Trade (CBT). While the CBT was originally formed in 1848 as a centralized marketplace for exchanging grain, forward contracts were also negotiated.

"The 1980s saw the re-emergence of OTC derivatives trading. As derivatives on financial assets became increasingly popular, investment banks began to think of new ways to tailor contracts to meet customer needs. Some innovations were minor changes in the standard terms of exchange-traded derivatives contracts (e.g., modifications to the expiration date and/or the contract denomination). In 1980, for example, the first OTC Treasury bond option was traded. Other contracts were new and seemingly different. They fall under the generic heading of “swaps”. A swap contract is a contract to “swap” a series of periodic future cash flows, where the terms of the swap are usually set such that the up-front payment is zero. The first interest rate swap was in 1981, when the Student Loan Marketing Association (i.e., “Sallie Mae”) swapped interest payments on intermediate-term fixed rate debt for floating-rate payments indexed to the three-month Treasury bill rate. The cash flows of the two legs of a swap can be linked to virtually any asset or index. A basis rate swap, for example, is an exchange of floating rate payments where the two floating rates are linked to, say, a three-month Treasury bill rate and a three-month Eurodollar time deposit rate. A currency swap is an exchange of interest payments (either fixed or floating) in one currency for payments (either fixed or floating) in another. An equity swap involves the exchange of an interest rate payment and a payment based on the performance of a stock index, while an equity basis swap involves an exchange of payments on option contracts, but they are not. Every swap can be decomposed into a portfolio of forwards and options. The benefit a swap provides is that several transactions are bundled into a single product."
[Source: From Article titled "Derivatives" published by Robert E. Whaley, Faculty, Fuqua School of Business, Duke University, USA]

"Swap" literally implies 'exchange' In Foreign exchange market the term 'Swap' connotes simultaneous spot purchase and forward sale of a foreign currency against another and vice versa.

The term has acquired a distinct usage in the financial market. Here Swap means an exchange of specific streams of payments over an agreed period of time between two parties. The Bank for International Settlements defines the term "a swap is a financial transaction in which two counterparties agree to exchange streams of payments over time". Swaps are thus derivative products which involve a private agreement between two parties to exchange cash flows in the future according to a prearranged formula. The underlying instruments are liabilities or assets with interest expenses or incomes. Swaps can be broadly classified into two types - interest rate swaps and currency swaps. The first recorded swaps were negotiated in 1981. Since then, the markets have grown very rapidly.

Swap, as mechanism for widespread use is a development of recent origin during the last two decades. This is due to the progressive elimination of exchange and capital controls and the revolutionary developments in telecommunication and computer technology, active 24-hour trading in foreign exchange has emerged. As a result of these innovations the process of liberalisation and consequent integration of markets has emerged. The high volatility of exchange rates and interest rates have opened up opportunities for large profit to market participants in the spot as well as in the forward markets, provided they are on the right side of the market. Trading is now increasingly guided by new decision techniques, particularly chart-based by sell recommendations, rather than considerations of the underlying economic factors as hitherto done. Such a move towards sophistication and globalization of markets in turn opened up arbitrage opportunities, which are increasingly availed through swaps and options in an effective manner.

The most commonly used types of Swaps are currency and interest rate swaps. The currency swap began in 1981, while interest rate swap started in 1982.

A Currency swap enables contracting parties to exchange predetermined streams of payments denominated in another currency during an agreed period of time. Two types of Currency Swaps are commonly transacted:

1. Fixed/fixed Currency Swap (both terms 'fixed' refer to interest rates)

2. Cross currency Interest Rate Swaps.

In this type of swap contracts, fixed interest payments on a specified principal amount of one currency is swapped for fixed interest payment on an agreed equivalent principal amount of another currency. Unlike in the case of interest rate swap, where principal currency amount being in the same currency and therefore not exchanged on the final maturity exchanged, in a currency swap the principal amount may be exchanged on the final maturity date of the swap contract at pre-determined exchange rate. Sometimes the principal amount in the respective currency may be exchanged initially and then re-exchanged at the maturity of the contract.

An example will make clear the elements of fixded/fixed currency swap clear. Suppose Party A agrees to pay a Swap Bank 0 percent interest in Dollars payable at half-yearly rests for a three year period on a principal amount of $ 100 million. In return Party A received 5% interest in DM, on DM-180 Million payable half yearly during the 3-year contract period (the DM equivalent is calculated at the spot $/DM rate, say DM 1.00). On each 6 monthly interest payment date, A pays $ 4 million to Swap Bank and received in return DM 4.5 million. At the end of the 3-year period Party A pays $ 100 million to the Swap Bank and received DM 180 Million (at the agreed exchange rate of $/DM at 1.80

There are four main elements in a fixed/fixed currency swap

1. There are fixed interest payments on due dates in the respective currencies

2. There are specified principal amounts in two currencies on which interest payments at the specified interest rates are calculated

3. There is an exchange rate involved. In this case it is the spot rate on contract date. It can even be a mutually agreed forward rate. The same exchange rate is used for computing the principal amount for calculating the interest payments and also for the exchange of principal on the initial date and re-exchange on the maturity date of the swap contract.

4. There is a specified maturity period.

Often a currency swap may involve exchange of one currency at fixed interest rate in return for receipts on a floating interest rate on another currency during the contract period. This is termed as Cross Currency Interest Swap. The transaction works on the same way as fixed/fixed currency swap, except that one of the currencies involved will carry a floating interest rate in exchange for the fixed rate in the other. Similar to the fixed rate currency swap, cross currency interest rate involves a final exchange of principal at the agreed spot exchange rate (or at agreed forward rate) prevailing on the date of the swap contract. Most of the cross currency interest swaps involve the swapping of fixed rate deutsche mark or Swiss franc or Japanese Yen against floating (interest) rate US Dollars.

An interest rate swap is a transaction in which two parties agree to exchange interest payments on an underlying notional amount but carrying interest payments based on differing terms according to agreed rules, It is important to note two points:

1. There is no exchange of principal amount either initially or on maturity, as the notional principal amount is the same, And

2. On each interest payment date, only the net amount will be paid/received by the counterparties

Under the commonest form of interest rate swap, a series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. This is a fixed-for-floating interest rate swap. Alternatively, both series of cash-flows to be exchanged could be calculated using floating rates of interest but floating rates that are based upon different underlying indices. Examples might be LIBOR and commercial paper or Treasury bills and LIBOR and this form of interest rate swap is known as a basis or money market swap.

There are three types of interest rate swaps commonly prevalent in International Finance and Banking.

1. Coupon Swaps
   A coupon swap is a fixed or floating rate interest swap in which two parties exchange fixed interest payments with floating interest payments on an underlying principal amount denominated in the same currency. For example Party A agrees to exchange Fixed Interest rate at 10% on $ 10 million for floating interest rate based on 6 months LIBOR for $ 10 million with a swap Bank for a period of 3 years.

2. Basic Swaps
   A basic swap involves exchange of interest payments calculated on different terms, such as 6 month LIBOR and prime rate (or triple A commercial paper rate)

3. Cross Currency Interest Swaps
   In this type of swaps exchange of payment on different currencies is involved. For example Dollar 6 months floating rate with fixed yen interest rates for a specified period on equivalent not notional principal amounts, or fixed rate dollar with fixed rate yen.

The plain vanilla interest rate swaps are those swaps where fixed rate obligations are exchanged for floating rate obligations over a specific period of time on a notional principal. In an interest rate swap there is no exchange of principal between the parties involved. There is only exchange of interest obligations. The principal is notional because it is used only to compute the periodic interest rate payments between the parties.

There are three parties in a Interest Swap Deal, i.e. two parties who swap interest payment streams and a banker.

"For example, BPL refinery is contemplating an expansion plan for which it needs Rs. 100 crore. It is an AA rated company and it can raise funds at 12 percent fixed or at a floating rate of MIBOR + 30 basis points.

Well Housing is a housing finance company that requires the same sum for deployment for its business. It can raise funds in the fixed rate market at 15 percent or in the floating rate market at MIBOR + 80 basis points.

In the fixed rate interest structure, the Oil Company has an advantage over the Housing Company by 300 basis points. In the floating rate market it has an advantage of 50 basis points only. We call this as comparative advantage of B over A in the floating rate market. The difference between the fixed rate spread and the floating rate spread is known as "quality spread differential" (QSD). This QSD is important in arranging a swap deal. It is this spread that makes the swap advantageous to the parties involved.

The oil refinery has absolute advantage in both the markets. As it has more comparative advantage it opts for fixed rate funds. If the oil refinery is expecting a decrease in MIBOR rates in the next 1 year then it would like to benefit from its forecast by shifting its fixed rate exposure to that of floating rates. It approaches a bank with its proposal to exchange its fixed rate payments to floating rate payments. The housing finance company gets floating rate funds only 50 basis points higher than the rate available to the 'a' rated company. It has a comparative advantage in the floating rate. If the Housing finance company holds the view that floating rate is likely to go up it would prefer to shift to fixed rate of interest. It will also approach the bank to arrange for swap counter party to covert its floating rate liability to fixed rate liability if possible. It would also prefer to reduce its cost of funding in the fixed market. The bank that arranges the swap is called the swap bank. The swap bank takes a fee for arranging the swap if it can strike a deal between these two parties. The deal will be arranged as follows"

[Source: The above example is quoted from website of The Association of Certified Treasury Managers (http://www.actmindia.org/pages/drhedge1.htm) article titled - "On Interest Rate Swaps"]

The advantages of swaps are numerous. They are:

1. The corporates will be able to obtain cheaper finance than would be possible by borrowing directly in the market.

2. The corporates will have an access to the markets in which it is impossible to raise debt directly. For instance, the companies with lower credit rating may not have access to fixed rate funds but can arrange fixed rate funds through swaps. A company with the highest credit rating, AAA, will pay less to raise funds under identical terms and conditions than a less creditworthy company with a lower rating, say BBB. The incremental borrowing premium paid by a BBB company, which it will be convenient to refer to as a "credit quality spread", is greater in relation to fixed interest rate borrowings than it is for floating rate borrowings and this spread increases with maturity. It may also be that each of the counterparties in a swap has a "comparative advantage" in a particular and different credit market and that an advantage in one market is used to obtain an equivalent advantage in a different market to which access was otherwise denied. The AAA company therefore raises funds in the floating rate market where it has an advantage, an advantage which is also possessed by company BBB in the fixed rate market. The mechanism of an interest rate swap allows each company to exploit their privileged access to one market in order to produce interest rate savings in a different market.

3. Swaps can be used as a long term hedge instruments.

4. Use of swaps provides an opportunity to restructure a firm's capital profile without physically redeeming debt or raising new debt. For example, the proportion of debt on which fixed and floating interest rate is paid can be altered by use of swaps without incurring an extra cost associated with redemption or new issue of debt.

5. A floating-to-fixed swap increases the certainty of an issuer's future obligations.

6. Swapping from fixed-to-floating rate may save the issuer money if interest rates decline.

7. Swapping allows issuers to revise their debt profile to take advantage of current or expected future market conditions.

In the next article we will discuss about pricing of Swap transactions and in the subsequent pages about the advent and development of Interest Rate Swaps(IRS) and Forward Rate Agreements(FRA) in India in the late Nineties and the current thinking of RBI to introduce Rupee Derivatives, both OTC and exchange-traded interest rate derivatives to regulate and strengthen the operations of Banks and Financial Institutions in India

MIBOR - Mumbai Inter Bank Offer Rate
MIFOR - Mumbai Inter-Bank Forward Offered Rate
MIOCS - Mumbai Inter-Bank Offered Currency Swaps
MIOIS - Mumbai Inter-Bank Overnight Index Swaps
FEDAI - Foreign Exchange Dealers Association of India
FIMMDA - Fixed Income Money Market & Derivatives Association of India