# CA FINAL STRATEGIC FINANCIAL MANAGEMENT FINANCIAL SWAPS AND FUTURES

## CA FINAL STRATEGIC FINANCIAL MANAGEMENT FINANCIAL SWAPS AND FUTURES

Financial Swap

A financial swap is a portfolio of forward contracts. It involves multiple time betting. It is also defined as an exchange stream of cash flows.

A plain vanilla interest rate swap involves swapping floating payment v/s fixed payment based on notional principal and with netting features.

For example- On 01.01.2018, A and B entered into a one-year quarterly pay labor v/s fixed swap as shown below.

A is betting LIBOR Rise above 10% every 3 months, while B is betting otherwise.

Suppose 3 Months LIBOR on various reset dates happened to be

 DATES 3 MONTHS LIBOR 01.01.2018 9% 01.04.2018 13% 01.07.2018 8% 01.10.2018 15%

Find out net payments at the end of each quarter:

Solution:-

Quarter 1:        Relevant LIBOR=9%<10%, therefore, B wins and receives (10-9)% of \$800M X 3/12=\$2M at the end of March.

Quarter 2:        Relevant LIBOR=13%>10%, therefore, A wins and will receive (13-10)%X3/12= \$6M.

Quarter3:         Relevant LIBOR=8%<10%, therefore, B wins and will receive (10-8)%X800X3/12=\$4M

Quarter4:         Relevant LIBOR=15%>10%, therefore, A wins and will receive (15-10)%X3/12*800=\$10M

Swap Quotations:

Bank act as market and provide Bid/Ask quotes. The quotes represent fixed rate v/s a floating rate say LIBOR. The fixed quotes are generally expressed as spread over treasure yield.

Suppose a bank quotes 5 years fixed to floating swap at a spread at 30/80 basis points, over 5 years treasure v/s LIBOR.

5-year treasury presently yields 9%. So quote is 9.30%/9.80% V/s LIBOR.

This means that the bank is willing to enter into following two types of the swap.

1. Bank pays 9.30% fixed and receives LIBOR.
2. Bank receives 9.80% fixed and pays LIBOR.

So if the bank is equally struck on both sides of two quotes. It locks in a spread of .50% subject to counterparty default risk.

Problems based on swap quotations:

1. Swap can be used to reduce the cost of the proffered form of funding.
2. Swap can be used to convert nature of funding.

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Futures:

Definition:       Futures are standardized forward contracts traded on an exchange with daily marked to market feature, stringent margin requirements, high liquidity, heavy regulations and virtually no counterparty default risk.

Position in the futures market:

Long (F+):        Upside betting or contract to buy.

Short (F-):        Downside betting or contract to sale.

Margin Requirement:

Sept 1:  on 1st January A goes Long (F+) and B goes short (F-) on SBI Future for maturity 26th March. As soon as the contract is entered the clearinghouse steps in i.e. it splits contract into two parts one Sales to A and buyer to B.

So we find that the clearinghouse has not directional exposure. Instead, it is exposed double counterparty default risk. A may default if the price falls. And B may default if the price rise. Hence A and B need to pay an initial margin.

Note:   Calculation of initial martin

Clearing-house is worried about maximum daily change that can take place in the value of fixed cost.

Example:

 Days Closing Price Value of Future Contract (Lot Size 100) Daily absolute Change 1 1950.00 1950X100 195000.00 2 1980.00 1980×100 198000.00 3 1920.00 1920X100 192000.00 400 2100.00 2100X100 210000.00

Mean of X = 15000

SD of X = 8000

According to the concept of normal distribution, a variable can deviate from its means maximum to extent of 3 times of Standard deviation.

Hence initial margin = Mean+3SD

= 15000+3(8000) =39000.00

Rs. 39000.00 funds to be deposited as initial margin. This amount to be deposited by both A and B and credited in their respective margin Account.

Step2:  The future contract will be re-priced based on closing future price, every day. Thus if A and B have entered into a contract at 2200 and closing price happens to be 2280, A margin account will be credited, while B margin account will be debited to extent of Rs. 8000.00.

So account balance for A=39000+8000=47000.00

B= 39000-8000= 31000.00

Note 1: Any amount above initial margin can be withdrawn as in case of A is allowed. However, problems are solved assuming no withdrawal.

Note 2: There is a minimum margin called maintenance margin which should not be bridged. If margin balance falls below maintenance there will be a margin call and client has to furnish variation margin call and has to bring margin balance back to initial.

Step 3: Whenever A or B wish to close out their position. They can enter into a reverse trade i.e. A may sale future, while B may buy future. On such squaring off, margin balance after last marked to market will be returned.

Of course, there is no squared off in futures till maturity. Some exchange especially commodity exchange required physical delivery i.e. long has to and short has to actually deliver. However, while doing problem we ignore physical delivery contract deemed to have been squared off.

This is all about swaps and futures. Hopefully, this will help a lot build an understanding of the topic.

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May 8, 2021