Swaps

A swap agreement is a contract entered into between two swap parties, whereby one party agrees to make to the other party a series of payments, the amount of which is to be computed based on the value of, or the return from, an asset, and to receive from the other party in exchange a series of payments the amount of which is to be computed based on the value or return from another asset.

Neither swap party makes any payment at the commencement of the contract.

The rationale behind a swap agreement is that one party to the transaction is willing to exchange a benefit that it enjoys in one market for the benefit enjoyed by another party in a different market.

A swap agreement is not a futures contract, nor is it a contract for the provision of loan or deposit facilities, nor does it create any right or obligation to purchase any asset. Swap agreements are over-the-counter derivatives.

A swap agreement is usually concluded with a bank acting as an intermediary, rather than directly between two companies. The effect of this structuring of the contractual relationships is that the bank concludes two contracts, one contract with each of the swap parties. The bank accordingly assumes credit risk that one of the parties may default, leaving the bank with one open contract in force with the non-defaulting party. Where a customer of a bank requests it to arrange a swap, the bank itself may assume the position of the counterparty to that party, until it is able to arrange the other side of the swap, in which case the bank is said to “warehouse” the swap.

Comparative advantage

The use of swaps is based on the theory of comparative advantage

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The basis of this theory, as it relates to interest rates, is that in any particular market, borrowers can either borrow at fixed rates or at floating rates. A borrower may, however, be at an advantage compared to other borrowers by being able to borrow more cheaply than those other borrowers. The reason for this is that a borrower with a low credit rating may pay a higher rate of interest in the fixed rate market than he does in the floating rate market, than the rate of interest that a highly rated borrower pays. For this reason, the comparative advantage in the floating rate market is held by lower rated borrowers, while higher rated borrowers hold a comparative advantage in the fixed rate market.

Although it is cheapest for a borrower to borrow in the market where he holds a comparative advantage, this form of borrowing may not meet his requirements. Thus a low rated borrower may wish to contract fixed rate borrowings, in order to avoid the risk of interest rate fluctuations, notwithstanding that it may be cheaper for him to borrow in the floating rate market, where he has a comparative advantage. By contracting an interest rate swap, he pays a fixed rate of interest to his swap counterparty, and receives in return floating rate interest, thereby transforming the floating rate loan into a fixed rate loan. For the borrower, this method may be more favourable than borrowing in the fixed rate market, because he can use his comparative advantage to borrow at the lower, floating, rate.

The same principle applies for borrows who wish to obtain finance at floating rates, but who have a comparative advantage in the fixed rate market.

Swap terminology

Swap agreements have their own unique terminology.

Uses of swaps

Swaps are used for trading or speculative purposes, for the hedging of risks, and to offset risks where a party is acting as an intermediary in a transaction between two other parties.

The main reason for using swaps is that they facilitate the transformation of the characteristics of assets or liabilities. Such characteristics include:

Transformation of characteristics results from the owner of the asset transferring the unwanted characteristic of the asset to the swap counterparty, who wishes to own that characteristic, and for the owner of the asset to receive in return an asset characteristic that is desired by him.

For example, if an asset owner does not wish to receive a fixed rate of return on his asset, he can transform that fixed rate into a floating rate through an interest rate swap.

As a result, the swap is an important method of managing risk for trading companies, and an important part of the business of banks.

When a bank acts as an intermediary, and it concludes a swap agreement with a customer, the bank hedges the risk by finding a counterparty with the opposite requirement to the customer, and the bank then concludes an offsetting swap with that counterparty. The bank calculates that it will receive payments from one swap party and will make payments to the other swap party, and will consequently earn a “spread” calculated as the difference between the receipts and the payments, without assuming any market risk from fluctuations in the value of the underlying items of the respective swaps. The swap counterparties are not aware of one another’s identities, because their direct counterparty is the intermediary bank. Both counterparties rely on the bank for performance of their contracts, and if one of them defaults the bank remains liable to the other. Any delay for the bank in finding another party for the other side of the swap results for the bank in a period during which it is uncovered and therefore at risk.

A bank or trading company may also use swaps to contract unhedged exposure to market risk, for trading or speculative purposes. This if a company took the view that forward interest rates were likely to rise, it could contract an unhedged swap agreement, providing for a fixed rate of interest to be paid by it, and in terms of which it would receive a floating rate of interest. A bank would not seek to offset the swap against another, but would leave it unhedged.

Trading companies and banks use swaps as an interest rate management tool, to hedge assets and liabilities.

For example, where the bank’s floating rate liabilities exceed its fixed rate liabilities, and a fall in interest rates would have a negative effect on its revenues, then, in order to hedge against this risk, the bank would conclude swap contracts that would have the effect of converting its fixed rate liabilities into floating rate liabilities. The swap would generate a profit for the bank if the interest rates were to go down, and would generate losses if interest rates were to go up. The swap would give the bank the assurance that its earnings will be stable, irrespective of the direction in which interest rates move. A bank may also hedge an entire portfolio of assets.

The background to the uses of swap agreements is as follows. The volatility of foreign exchange markets and interest rates has resulted in risks for companies from holding positions in foreign exchange or interest rates. A company’s funding resources usually consist of a mix of fixed and floating rate liabilities, possibly in a number of currencies. The company may prefer long term fixed rate funding in order to enable it to plan its investment decisions, but it might not be able to effect a public issuance of debt securities because of a poor credit rating, or because the amount that it requires to borrow is too small to justify public issuance, or because the costs of public issuance may be too high. Alternatively, the company may be able to effect a public issuance, but it might then be unwilling to accept the open interest rate risk that would result. If interest rates fell, the company would remain liable for the contracted rate of interest payments to investors, while if its other profits dropped, the result could be pressure on its margins. The swap would enable the company to resolve this difficulty, as it would effectively be arbitraging between the fixed and floating rate markets.

Other reasons for using swaps:

The use of swaps has drawbacks:

The swap market is finite, and as arbitrage opportunities are exploited, the result is a perfect market in which the swap no longer offers significant benefits.

A swap intermediary can be placed in a difficult position, because even if one of the swap counterparties failed to meet its obligations, the intermediary’s obligations would remain in place; the intermediary would thus have to cover its position in the market, at prevailing rates. The risk would be even greater in the case of a currency swap, where principal is exchanged.

Although interest rate swaps do not involve an exchange of principal, and currency swaps usually require funds to be simultaneously exchanged at predetermined rates of exchange, these instruments still give rise to the following forms of credit risk:

Application of swaps

Common applications of swap agreements are currency swaps, interest rate swaps, and debt-equity swaps.

A currency swap is an exchange of liabilities and related interest payment obligation denominated in different currencies.

For example, where A wishes to borrow dollars, and B wishes to borrow sterling, but the comparative advantages mean that B can borrow dollars more cheaply and easily, while A can borrow sterling more cheaply and easily, the parties would then borrow the principal amounts in the markets in which they have the advantage, and then exchange the principal amounts borrowed, and agree to pay the interest rates associated with the swapped principal amounts. At the end of the swap period, the parties would again swap the original principal amounts. The result would be that neither party would assume any exchange rate risk in connection with the swap. The exchange of the principal would be effected at the commencement of the swap at the then spot rate. The interest rate payments to be made during the life of the swap would be based on the rates of exchange then available. The parties thus exchange interest payments on a principal amount denominated in one currency, for interest calculated on a principal amount denominated in a second currency. The principal amounts are not notional, and are actually exchanged at the end of the swap period, at an exchange rate agreed in the agreement.

A currency swap thus enables a borrower to access funds on more favourable terms than would be possible by borrowing directly in the currency debt market. The principle of comparative advantage makes the currency swap attractive, because it is preferable for a company that requires foreign currency to fund the operations of a foreign business to borrow in the currency of the country in which that business is located, rather than to borrow in its home country currency and convert the loan principal into the currency of the foreign country. The cost of foreign borrowing, however, is likely to be higher than the cost of borrowing in the home country, where the company is known and will have a credit rating. In other words, the company has a comparative advantage, but not in its home country debt market. The currency swap resolves this problem, because each swap counterparty contracts a loan in the currency that is required by the other counterparty, and the parties then swap the loan principal, subject to their agreement to reswap it at a fixed future date and at a fixed future exchange rate. During the period of the swap, the counterparties make payments of interest to one another, calculated on the principal received in terms of the swap.

An interest rate swap is a contract between two parties in which they agree to exchange interest rate payments over an agreed period of time. It usually involves an exchange of fixed rate interest for floating rate interest. Principal amounts are not swapped, either at the inception of the swap, nor at its maturity. For that reason, principal is notional; only the net difference between the two interest cash flows that occur at periodic intervals is swapped.

A basis (plain vanilla, or coupon) swap is the simplest of the interest rate swap structures, in which fixed and floating rates of interest are exchanged. This occurs where a party has contracted to receive interest calculated at a fixed rate, and wishes to receive interest calculated at a floating rate, and it contracts an interest rate swap. It contracts a floating rate loan, and concludes a swap contract under which it undertakes to pay an amount equal to a fixed rate of interest calculated on a notional principal amount, for which it is entitled to receive an amount calculated at a floating rate of interest and calculated on the same notional principal amount. In practice, only the net difference in the two interest payment liabilities is transferred from one party to the other.

Settlement of an interest rate swap may be either gross or net. If the agreement provides for gross settlement, then on each settlement date, each of the parties makes payment of its full obligation for interest to the other party. If the agreement provides for net settlement, the party whose obligation it is to pay the greater amount of interest makes a payment to the other party of the difference between the two liabilities, which is referred to as &ldquolpayment netting”.

An alternative form of netting is “netting by novation”, where a new contract replaces all previous contracts.

Parties to interest rate swaps often use an intermediary, who arranges the transaction, either by acting as a broker, so that the two parties will be in direct contact with each other, and will both pay the intermediary an arrangement fee when the transaction is signed, or by acting as a principal, in which case the parties contract with the intermediary, and need not know one another; the intermediary then passes all payments between the parties.

If the intermediary is contracting as a principal, he may contract one leg of the swap contract before he contracts the other leg of the contract, running an “open position” until another contracting party can be found. This is referred to as “warehousing”, and, instead of receiving an arrangement fee, the intermediary may earn a profit from the rates paid to or received from the parties.

In a debt-equity swap, the underlying asset is transferred, with the result that the parties’ asset or liability position is completely transformed.

For example:

Accounting

FRS 13 sets out rules for the disclosure of swap agreements. FRS 13 requires disclosure of an entity’s objectives, policies and strategies in using derivatives. It also requires numerical disclosure of items, including carrying values, notional values, an analysis of whether payments and receipts are made on a fixed or floating basis, the currency of receipts and payments, an analysis of contracts maturities, and disclosure of whether the contracts are held for trading or hedging purposes. The effect of interest rate and cross-currency swaps should be taken into account as far as possible, in preparing the numerical disclosures. FRS 13 thus makes provision for mandatory disclosure of swaps.

The main source of rules on accounting for swaps is the British Bankers Association’s SORP on Derivatives.

How the swap is accounted for depends on the purpose for which the swap was contracted, that is, either for trading or for hedging. The BBA SORP recommends that traded swaps should be measured at “fair value”, with changes in value being taken to the profit and loss account in the period during which they occur. “Fair value” is determined by using a net present value method. This applies to both “matched” swap and “open warehousing” swap positions. The net present value method takes all settlements to maturity into consideration, and it complies with the accruals concept, because the effect of marking a swap to market daily by the net present value method is to record profits and losses in the same way as if the swap were closed out daily. The result of this is to avoid adjustments being made pursuant to the accrual method when a swap is assigned or terminated prior to its maturity. Counterparty credit risk and other risks associated with a swap must also be considered, and marking to market using a net present value method, takes the credit risk into account.

Swap agreements that hedge income or expenditure, or that hedge assets or liabilities, should be accounted for on the same basis as the income or expenditure, or the assets and liabilities. The BBA SORP allows for changes that are required to be made to the value of swaps held for hedging purposes, to be deferred until the accounting period in which the profit or loss is realised or accounted for on the item being hedged.

There are two methods for accounting for an interest rate swap: the “accruals method” and the “mark to market” method.

Under the accruals method, the only accounting entry is to accrue interest over each settlement period. This only takes into account interest until the next settlement, and ignores any value whether positive or negative that is contained in subsequent settlements. This could result in large adjustments when a swap is assigned or terminated.

Under the mark to market method, the swap is valued at the reporting date, and revaluation profits and losses arising from future cash flows are taken to the profit and loss account.

Under both the accruals method and the mark to market method, the only balance sheet entry that is required is an entry to record the value of the swap as an asset or as a liability. The notional amount of the underlying asset of the swap is not shown in the balance sheet.

Interest rate swaps should be accounted for by taking into account the net payment or receipt under the swap in determining the interest charged or credited to the profit and loss account.

Lump sum payments receivable or payable under a swap should be time apportioned over the life of the swap, and where such treatment might have a materially different impact, by taking account of the fact that lump sum payments receivable or payable (other than arrangement fees) are usually determined on a net present value basis.

Foreign currency swaps should be valued on an equivalent basis to the asset or liabilities being hedged.

Where a swap has been contracted as part of a trading portfolio or for speculative purposes, it should be marked to market, by determining the net present value of future cash flows expected to arise under the swap at the current market interest rate. A zero coupon yield is an appropriate basis for determining such an interest rate. Part of the net present value of any expected future profits should then be spread over the life of the transaction to take account of all likely costs and risks.

If swaps are entered into as part of a trading portfolio or for speculative purposes, and if marking to market results in an overall net loss on the whole portfolio, and the portfolio is not regarded as part of a larger trading portfolio containing other off-balance sheet instruments, then the loss should be recognised immediately. In such cases, all anticipated costs should be accrued.

The critical issue, therefore, is whether the swap is part of the dealing portfolio or part of the investment portfolio, because this determines the accounting treatment.

In establishing whether a swap forms part of an investment portfolio, the criteria are, firstly, whether the swap was contracted for the purpose of including it in the investment portfolio, and secondly, whether there is evidence as to whether or not the swap was transacted for asset and liability management. A swap which is part of the investment portfolio may be a hedge, because it is intended to reduce the risk arising in the investment portfolio.

In marking a swap to market, the object is to take account of the cost of replacing the cash flows associated with the swap at the current market price. The current price of a swap is therefore achieved by discounting those cash flows back to their net present value, typically using a zero coupon yield curve for discounting purposes.

A swap is marked to market if it forms part of a dealing portfolio, on at least a monthly basis, but usually on a daily basis. The mark to market variations are then take to the profit and loss account as “swap income”. Receipts and payments of swap interest are not taken directly to the profit and loss account as interest income or charges. The mark to market calculation made prior to the interest being paid or received will already have taken into account the profit impact the of the relevant cash flow, and is accordingly a further variation to the mark to market account.

The most common method of marking a swap to market is to use the net present value approach. This means calculating the present value of the expected future cashflows resulting from each leg of the swap. The value of the swap is taken to be the present value of the receipts less the present value of the payments. This value is positive and thus an asset where the swap is “in the money”, that is, where interest rates have moved in favour of the position. If interest rates have moved against the position, the swap will be “out of the money” and it will have a negative value, and be a liability.

Taxation

Swap agreements are not covered directly by FA 2002 Schedule 26.

With regard to debt swaps, an Inland Revenue letter dated 1 February 1991 stated that where a debt is exchanged for another debt, for tax purposes the disposal constitutes the disposal of the original debt and the acquisition of a new debt. Based on the decision in Gold Coast Selection Trust Ltd v Humphrey 30 TC 209, the value of one debt that is exchanged for another debt is the fair value of the debt that is received in return, and that value is taken to be the cost for tax purposes of the debt received. In addition, the debts are valued at the end of the accounting period in which they are received, and not on the date on which the swap takes place. If the swap results in the receipt of cash as well as an asset, the proceeds of the debt that is swapped are taken to be the value of the debt received, plus the sum of cash received. If a debt plus cash is swapped for a debt, the realisation proceeds of the debt that is swapped is the value of the debt that is received, less the cash paid. The base cost of the debt received will thus be its value.

ESC C17 applied to fees earned from interest rate and currency swaps, but is now obsolete.

ESC C28 deals with debt–equity swaps. It notes that the anti-avoidance provisions in FA 1996, which deal with loan relationships between connected companies, provide that where companies are “connected” in terms of FA 1996 section 87, the creditor company is denied bad debt relief for amounts owed by the debtor company. This can have the effect of discouraging corporate rescues effected by the swapping of debts for shares in the debtor company. To lift this potential obstacle to corporate rescues through debt-equity swaps, Inland Revenue issued ESC C28, which states that it will allow bad debt relief under defined circumstances, even where the debtor and creditor are “connected” for purposes or section 87 of FA 1996. Thus where a company carries on the business of the provision of finance through making loans and subscribing for shares, and the company acquires preference shares as a result of a debt-equity swap, the shareholding will be ignored in determining whether it is “connected” with the debtor company. The effect of this concession is that the creditor company will be granted bad debt relief in respect of amounts owed by the debtor company, and for any loss incurred on the disposal of the loans. To qualify for the concession: