Unit 4: Swaps and risk management
International Finance and Financial Derivatives notes · PTU syllabus (MBA 915-18)
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Unit summary
Swaps and exposure management protect international businesses from currency, interest rate and country risks. This unit covers the meaning, types and pricing of swaps and swaptions, credit derivatives and hedging strategies, measuring and managing transaction, economic and translation exposure, country risk analysis, and currency futures and interest rate derivatives.
After this unit you can
- Explain swaps and swaptions and their pricing
- Explain credit derivatives and hedging strategies
- Measure and manage transaction, economic and translation exposure
- Explain country risk analysis and currency and interest rate derivatives
PTU syllabus topics
- Swaps and swaptions meaning
- types and pricing
- credit derivatives and hedging strategies
- measuring and managing transaction/economic/translation exposure
- country risk analysis
- currency futures and interest rate derivatives
Transaction
Value of existing contracts
Forwards, futures, options
Translation
Reported accounts of subsidiaries
Balance sheet hedge
Economic
Long-term cash flows and competitiveness
Operational: sourcing, location
Topic 1
Swaps
- Swap: an agreement to exchange streams of cash flows over time.
Interest rate swap
Fixed for floating payments in one currency on a notional principal
Currency swap
Exchange of principal and interest in two currencies
Basis swap
Floating for floating on different benchmarks
Commodity and equity swaps
Commodity price or index returns exchanged
- Uses: convert floating debt to fixed (or vice versa), exploit comparative advantage in borrowing, hedge currency liabilities, reduce cost of funds.
Example
Company A can borrow fixed at 8% or floating at MIBOR + 1%; B can borrow fixed at 9.5% or floating at MIBOR + 1.5%. A borrows fixed, B floating and they swap — the total saving of 1% (1.5% − 0.5%) is shared.
- Pricing: a swap's value = PV of fixed leg − PV of floating leg; at inception the fixed swap rate is set so the value is zero; Indian benchmarks — MIBOR OIS, and SOFR for dollar swaps after LIBOR's end.
Topic 2
Swaptions
- Swaption: an option to enter into a swap at a future date on pre-agreed terms.
- Payer swaption: right to pay fixed (gains when rates rise). Receiver swaption: right to receive fixed (gains when rates fall).
- Use: hedging future borrowing costs or callable debt.
Topic 3
Credit derivatives and hedging strategies
- Credit derivatives: contracts transferring credit risk without transferring the underlying loan.
Credit default swap (CDS)
Protection buyer pays a premium; seller pays on a credit event
Total return swap
Exchange of total return on an asset for a floating rate
Credit-linked note
Bond whose repayment depends on a reference credit
Collateralised debt obligation
Tranches of a pool of debt
- India: RBI's Credit Derivatives Directions, 2022 permit CDS on corporate bonds and other instruments with eligible market makers.
- Risk: opaque OTC markets and concentration contributed to the 2008 crisis (AIG).
Topic 4
Measuring foreign exchange exposure
Exposure is the sensitivity of a firm's cash flows, earnings or value to unexpected changes in exchange rates.
Transaction exposure
Effect on contracted foreign currency receivables and payables
Translation (accounting) exposure
Effect on consolidated financial statements of foreign subsidiaries
Economic (operating) exposure
Effect on future cash flows and competitive position
- Relevance: reduces volatility of cash flows, avoids distress costs, improves planning; critics argue shareholders can diversify — but market imperfections make hedging valuable.
Topic 5
Managing transaction exposure
Forward contract
Lock rate for future receipt/payment
Money market hedge
Borrow/lend in currencies to create offsetting position
Futures
Exchange-traded hedge
Options
Protection with upside
Internal techniques
Invoicing in home currency, leading and lagging, netting, matching, exposure netting
Example
Importer owes US$ 100,000 in 3 months. Spot ₹83, forward ₹83.60. Money market hedge: invest the PV of $100,000 at US rate (4% p.a. → 1% for 3 months) = $99,010; buy dollars now = ₹82,17,830; borrow this in India at 8% p.a. (2% for 3 months) → repay ₹83,82,187 — compare with forward cost ₹83,60,000 → forward is cheaper.
Topic 6
Managing translation and economic exposure
- Translation exposure management: balance sheet hedge (match exposed assets and liabilities in the same currency), funds adjustment, derivatives; not a cash flow issue, but affects reported earnings and covenants.
- Economic exposure management: diversify production and sourcing across countries, flexible pricing, product differentiation, financing in foreign currencies to match revenues, R&D for competitiveness.
Topic 7
Country risk analysis
- Country risk: risk that conditions in a foreign country reduce the value of investments or the ability to collect payments.
Political risk
Expropriation, war, instability, change in government policy, corruption
Economic risk
Recession, inflation, fiscal and current account deficits, debt levels
Transfer and convertibility risk
Restrictions on moving or converting funds
Legal and regulatory risk
Weak contract enforcement, sudden tax changes
- Assessment: checklist and weighted scoring, ratings (sovereign credit ratings, Euromoney, PRS), Delphi and expert opinion, scenario analysis.
- Management: adjust discount rates or cash flows, political risk insurance (MIGA), joint ventures with local partners, local financing, phased investment.
Topic 8
Currency futures and interest rate derivatives
- Currency futures in India: USD-INR, EUR-INR, GBP-INR, JPY-INR and cross-currency pairs on NSE and BSE; cash-settled in rupees; RBI and SEBI limits for participants.
- Interest rate derivatives: interest rate futures on government bonds and T-bills (NSE), forward rate agreements, interest rate swaps (MIBOR OIS), caps, floors and collars.
FRA settlement
Notional × (reference rate − FRA rate) × days ÷ 360, discounted to the settlement date
Example
A borrower buys a cap at 9% on a ₹10 crore loan. If MIBOR + spread rises to 10%, the cap pays 1% — ₹10 lakh a year — keeping the effective cost at 9% plus the premium.
Key terms
- Interest rate swap
- Exchange of fixed and floating interest payments
- Swaption
- Option to enter into a swap
- Credit default swap
- Protection against default of a reference entity
- Translation exposure
- Accounting effect of exchange rates on consolidated statements
- Country risk
- Risk from a foreign country's conditions
Quick revision
- Interest rate, currency, basis swaps; comparative advantage; pricing; MIBOR OIS, SOFR.
- Payer and receiver swaptions.
- CDS, TRS, CLN, CDO; RBI directions 2022.
- Transaction, translation, economic exposure; internal and external hedging.
- Country risk components and management; currency futures; IRFs, FRAs, caps, floors, collars.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.What is an interest rate swap?
- Q2.Distinguish payer and receiver swaptions.
- Q3.What is a credit default swap?
- Q4.Distinguish transaction and translation exposure.
- Q5.Name three components of country risk.
- Q6.What is an interest rate cap?
Long-answer questions
- Q1.Explain swaps and swaptions and how a swap is valued.
- Q2.Explain credit derivatives and their uses and risks.
- Q3.Explain the measurement and management of transaction, translation and economic exposure.
- Q4.Discuss country risk analysis and currency and interest rate derivatives.
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