Directory of Human Resource Management e.Publications June (2011) Vol.

1, Issue 1 ________________________________________________________________________

Emergence of SWAPS
AUTHOR(S): HASSAN DANIAL ASLAM AISHA RAFI

HASSAN DANIAL ASLAM FOUNDER PRESIDENT HUMAN RESOURCE MANAGEMENT ACADEMIC RESEARCH SOCIETY AISHA RAFI GENERAL SECTARY HUMAN RESOURCE MANAGEMENT ACADEMIC RESEARCH SOCIETY

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Emergence of SWAPS
Foreign exchange swaps have appeared for some time in the intervention toolkit of many central banks around the world, although their popularity seems to be on the wane. In a Bank for International Settlements survey taken in 1997, seven of fourteen industrial-country central banks surveyed listed foreign exchange swaps against either the U.S. dollar or the deutsche mark (or both) among the tools used to conduct open market intervention. Of those seven, fiveAustria, Belgium, Germany, Italy, and the Netherlandsdiscontinued foreign exchange operations when they became part of the European Monetary Union. Of the remaining two, Australia and Switzerland, only the latter has used foreign exchange swaps extensively, at some point as its main intervention tool, with the total amount of swaps hovering for years at about 40 percent of the monetary base. This use partly reflected the limited depth of domestic debt markets associated with limited fiscal deficits historically incurred by the Swiss government. Formally, a foreign exchange (FX) swap is a financial transaction whereby two parties exchange agreed-upon amounts of two currencies as a spot transaction, simultaneously agreeing to unwind the exchange at a future date, based on a rule that reflects both interest and principal payments. When the initiating agent is a central bank, the motivation for undertaking the swap is usually either to affect domestic liquidity or to manage foreign exchange reserves. (Rarely, central banks have been known to use currency swaps for the main purpose of hedging and asset liability management.) As described above, intervention through FX swaps can be thought of as a repurchase agreement (repo) with foreign currency as the underlying collateral instead of securities. When the forward leg of the operation is missing, the transaction becomes formally similar to an outright open market operation with foreign exchange as the underlying asset, and the operation is usually classified as FX intervention, rather than a swap. In parallel fashion, a distinction is often made with respect to the scope of the operation: While FX swaps are usually seen as aimed at controlling domestic liquidity, FX intervention is usually seen as aimed at influencing the exchange rate. By virtue of combining a spot and a forward transaction, FX swaps can also be priced easily, based on available forward quotations and, generally, satisfying the covered interest parity condition. Viewing swaps essentially as forward transactions also highlights requirements for their effective usenamely, price stability, depth of the underlying forward market, and ready availability of quotesrequirement that have led HRMARS, Pakistan www.hrmars.com 2

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ most central banks active in the swap market to undertake operations mostly in U.S. dollars or, until 1998, deutsche marks. From the viewpoint of central bank risk management, FX swaps are no riskier than standard repo operations, since the central bank is not assuming any of the underlying FX risk, by virtue of the covered nature of the swap position. However, FX swaps have been used in combination with spot FX intervention in a way that can lead to significant risk-bearing by the central bank: If the central bank uses the foreign currency obtained as collateral in the swap transaction to defend an exchange parity under pressure, it will incur losses if the defense fails before the forward leg of the swap transaction is unwound. A contributing reason why FX swaps have not been particularly popular as tools for monetary control is that FX transactions normally are settled on the second business day following the trade, in part because the transaction typically involves a transfer of liabilities between central banksso as to debit the sending partys account and credit the receiving partys accountand the two central banks may be in different time zones. This results in a delivery lag equal to at least the time difference plus the difference between each countrys local time for final settlement. This arrangement makes FX swaps ill-suited for swift action and has caused several countries using FX swaps to routinely renew them at maturity, leaving the burden for high frequency liquidity control to alternative instruments. The relative scarcity of banks sufficiently large and endowed with foreign currency on hand to act as counterparties has also contributed adversely to the diffusion of FX swaps as instruments for liquidity control.

CROSS CURRENCY SWAP

DESCRIPTION
Cross currency swap is similar to an interest rate swap but where each leg of the swap is denominated in a different currency. A Cross Currency Swap therefore has two principal amounts, one for each currency. Normally, the exchange rate used to determine the two principals is the then prevailing spot rate although for delayed start transactions, the parties can either agree to use the forward FX rate or agree to set the rate two business days prior to the start of the deal. With an Interest Rate Swap there is no exchange of principal at either the start or end of the transaction as both principal amounts are the same and therefore net out. For a Cross Currency Swap it is essential that the parties agree to exchange principal amounts at maturity. The exchange of principal at the start is optional. HRMARS, Pakistan www.hrmars.com 3

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ Like all Swaps, a Cross Currency Swap can be replicated using on-balance-sheet instruments, in this case loan and deposits in different currencies. This explains the necessity for principal exchanges at maturity as all loans and deposits also require repayment at maturity. While the corporate or investor counterparty can elect not to exchange principal at the start, the bank needs to. This initial exchange can be replicated by the bank by entering into a spot exchange transaction at the same rate quoted in the

Cross Currency Swap.

Loosely speaking, all foreign exchange forwards can be described as Cross Currency Swaps as they are agreements to exchange two streams of cash flows (in this case a stream of one) in different currencies. Many banks manage Long Term Foreign Exchange Forwards as part of the Cross Currency Swap business given the similarities. Like all FX Forwards, the Cross Currency Swap exposes the user to foreign exchange risk. The swap leg the party agrees to pay is a liability in one currency, and the swap leg they have agreed to receive, is an asset in the other currency. One of the major market users for Cross Currency Swaps are Debt issuers, particularly in the Euro-markets where issuers sell bonds in the "cheapest" currency and swap their exposure to their desired currency. A Cross Currency Swap where both legs are floating rate is part of the Basis Swap product family. Cross Currency Swaps are also known as a CIRCA (a Currency and Interest Rate Conversion Agreement).

EXAMPLE Investor
A fund manager is seeking to purchase 3 yr DEM assets with a minimum credit rating of AA and a yield in excess of LIBOR plus 12. A review of the DEM Floating Rate Note market and even the DEM fixed rate bond market swapped into floating rate using an Asset Swap, shows that no such assets exist in reasonable volume. A 3 yr GBP AA rated corporate bond can be purchased at a yield of GBP LIBOR plus 18bp for a total price of GBP 10,000,000. The prevailing exchange rate is 2.50. The fund manager can purchase the bond for GBP10,000,000 and simultaneously enter into a Cross Currency Swap agreeing to pay GBP LIBOR plus 18bp and receive DEM LIBOR plus 15bp. The spot rate is set at 2.50 and the fund manager elects to exchange principal at the start. The initial cash flows are as follows:

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Investor buys bond: Cross Currency Swap:

-GBP 10,000,000 +GBP 10,000,000 -DEM 25,000,000

The swap agreement nets out the initial GBP flow and replaces it with an equivalent DEM flow. Over the life of the bond, the fund manager pays the GBP coupons (LIBOR plus 18bp) to the bank counterparty and receives DEM LIBOR plus 15bp. At maturity, the following flows occur irrespective of the prevailing exchange rate: Bond Redeems to Investor: +GBP 10,000,000 Cross Currency Swap: -GBP 10,000,000 -DEM 25,000,000 Again, the GBP bond flows are cancelled out by the swap flows leaving DEM redemption to the investor. By using the Cross Currency Swap the fund manager has created a synthetic DEM Floating Rate Asset. The fund manager does not wear any currency exposure as the currency exposure created by the swap (i.e. the asset, GBP liability) is offset by the currency exposure created by the purchase of the GBP bonds (i.e. GBP asset), leaving a net position only in the base currency of DEM. Of course, the investor bears the full credit risk of the underlying bond and should the bond default, the investor is still obliged to make all remaining payments under the swap or reverse the swap at its then book value.

Issuer
A New Zealand company is looking to raise NZD 100 million by issuing 10 year bonds. In the New Zealand domestic market, it would issue at a yield of LIBOR plus 25bp. Alternatively it can issue in Australia where there is a shortage of quality bonds, at a yield of 7.50%. It can then enter into a 10 year Cross Currency Swap for a notional amount of NZD 100 million agreeing to receive AUD 7.50% and pay NZD LIBOR plus 20bp. The prevailing spot rate is 1NZD = 0.90AUD. The initial cash flows are as follows: Company issues bond: Cross Currency Swap: HRMARS, Pakistan +AUD 90,000,000 -AUD 90,000,000 www.hrmars.com 5

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+NZD 100,000,000 The swap agreement nets out the initial AUD flow and replaces it with an equivalent NZD flow which the company can use to fund its operations as planned. Over the life of the bond, the company receives the AUD coupons from the bank counterparty that it owes to the bond investors, and pays instead NZD LIBOR plus 20bp. At maturity, the company will receive the AUD bond principal amount it owes the Bond investors from the swap counterparty, and in return is required to pay NZD 100 million irrespective of the then spot rate. Using the Cross Currency Swap, the company has created a synthetic NZD liability.

Corporate
A multinational company uses USD as its base currency. The company has assets denominated in many different currencies, but the Board or Directors is particularly concerned about the assets denominated in Spanish Peseta, which represent over 20% of the company. While the assets are intended to be held for the long term the Board is concerned that any fluctuations in the spot rate will lead to an increase in the volatility of earnings. In total, there are ESP 120bn Spanish assets with no corresponding ESP liabilities. The majority of company liabilities are denominated in USD. The currency exchange rate is 1USD = 120ESP. The company has considered raising ESP debt in the Spanish market and repaying USD debt as a way to hedge this exposure, however the company is not well known in Spain and would need to pay LIBOR plus 45bp in order to do so. Alternatively, the company can enter into a Cross Currency Swap as follows:

ESP Principal: USD Principal: Tenor: Company pays: Company receives:

ESP 120 billion USD 1 billion 10 years (to match the long term nature of the assets) ESP LIBOR plus 5 bp USD LIBOR

In this situation, the company would like to create a synthetic ESP liability to offset the ESP assets it owns. There is no new requirement to generate cash and so the company HRMARS, Pakistan www.hrmars.com 6

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ elects not to exchange principal at the start of the deal, so there are no initial cash flows. In effect, the company has transferred some of its USD liabilities into ESP liabilities to offset the ESP assets it owns and thereby reduce its currency exposure. From this point on, any currency loss on the assets will be offset by a corresponding currency gain on the Cross Currency Swap. In this example, the Cross Currency Swap has been used as an effective Foreign Exchange hedge much like the use of an FX forward contract.

PRICING
The pricing in a Cross Currency Swap reflect that level where the market is indifferent to receiving the cash flows on either leg. Each leg of the swap can be considered on its own. At the inception of the swap, the present value of one leg (which is calculated using the prevailing zero coupon yield curve for that currency) must be equal to the present value of the other leg at the then prevailing spot rate. Using this simple logic, it would seem natural that stream of LIBOR flat payments in one currency could be exchanged for stream of LIBOR flat payments in another currency. This is not always true and the reason is generally a simple case of supply and demand. Where there is excessive demand for Cross Currency Swaps between two particular currencies (or FX Forwards for that matter), the price will tend to rise, and vice versa. This may or may not be to the advantage of the swap user. In general, the price difference is limited to plus or minus 10bp. Like FX forwards, three things influence the price and value of a Cross Currency Swap: (a) The yield on currency one (b) The yield in currency two (c) The spot exchange rate

TARGET MARKET
There are three clear target markets: (a) Investors who wish to purchase foreign assets but seek to eliminate foreign currency exposure (b) Debt issuers who can achieve more favourable rates by issuing debt in foreign currency (c) Liability managers seeking to create synthetic foreign currency liabilities

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INTEREST RATE SWAPS

Somewhat complex, innovative financing arrangement for corporations that can reduce borrowing costs and increase control over interest rate risk and foreign exchange exposure. Relatively new market, due to financial deregulation, integration of world financial markets, and currency and interest rate volatility. Market has grown significantly. Interest Rate Swap financing involves two parties (MNCs) who agree to exchange CFs, results in benefits for both parties. Single-currency interest rate swap is usually just called an Interest Rate Swap. Cross-currency interest rate swap is called a Currency Swap. Basic (plain vanilla) Interest Rate Swap involves exchanging (swapping) interest payments on Floating-rate debt for interest payments on Fixed-rate debt, with both payments in the same currency. One party actually wants fixed rate debt, but can get a better deal on floating rate; the other party wants floating rate debt, but can get a better deal on fixed rate. Both parties can gain by swapping loan payments (CFs), usually through a bank as a financial intermediary (FI), which charges a fee to broker the transaction.

Currency Swap
One party swaps the interest payments of debt (bonds) denominated in one currency (USD) for the interest payment of debt (bonds) denominated in another currency (SF or BP), usually on a "fixed-for-fixed rate" basis. Currency swap is used for cost savings on debt, or for hedging long term currency risk.

SWAP BANK
Financial Institution (FI) in the swap business, either as dealer or broker, usually large commercial and investment banks. Broker bank: Arranges and brokers the deal, but does not assume any of the risk, just charges a commission/fee for structuring and servicing the swap. Dealer bank: Bank that is willing to take a position on one side of HRMARS, Pakistan www.hrmars.com 8

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ the swap or the other, and therefore assume some risk (interest rate or currency). Dealer would not only receive a commission for arranging and servicing the swap, but would take a position in the swap, at least until it sold its position later. Example: Banks trading currency forward contracts. If they always match shorts and longs, there is no risk, acting as brokers. For every party who want to buy BP forward from the bank, there is a party selling BP forward to the bank. If the bank has a client who wants to sell $10m forward (short position) in 6 months, and accepts the contract without a forward BP buyer (long), it is exposed to currency risk by taking the long position itself. As a trader-broker, the bank can do more business than just a broker, by assuming risk exposure.

EXAMPLE OF INTEREST RATE SWAP

Bank A is AAA-rated bank in PAKISTAN, and needs $10m cash inflow to finance floatingrate, 5-year Eurodollar term loans to its commercial clients. To minimize (eliminate) interest rate risk, bank would prefer to match floating-rate debt (CDs or notes) with its expected floating-rate assets (Eurodollar loans). It has two sources of debt available: a) 5-YR FIXED-RATE BONDS @ 10% or b) 5-YR FLOATING-RATE NOTES (FRNs) @ KIBOR With floating rate loans and fixed rate debt, there is interest rate risk. Therefore, bank prefers floating-rate debt, to match the floating rate loan (asset). Company B is a BBB rated MNC in Pakistan, needs $10m for 5 years to finance a capital expenditure (new project, investment in property/plant, replace worn out equipment, etc.). It has two sources of debt available: a) 5-YR FIXED-RATE BONDS @ 11.75% b) 5-YR FLOATING-RATE NOTES (FRNs) @ KIBOR + .50% With FRNs there is interest rate risk if interest rates. Therefore, MNC prefers fixed-rate debt to guarantee a fixed, stable interest expense. Swap Bank can broker an interest rate swap deal (for a fee) with Bank A and Company B that will benefit both counterparties. When structured properly all three parties will benefit (Bank A, Company B, and the swap bank "Risky" BBB HRMARS, Pakistan "Safe" AAA www.hrmars.com 9

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ Company B 11.75% Bank A 10% KIBOR Difference (11.75 - 10%) Risk Premium 1.75% .50%

Fixed-Rate

Floating-Rate

KIBOR +.5%

(KIBOR + .5%) - KIBOR QSD 1.25%

The key to an interest-rate swap is the QSD (Quality Spread Differential), the difference or spread between fixed interest rates (Risky - Safe), and variable interest rate (Risky Safe). Co. B would have to pay 1.75% more than Bank A for fixed rate debt, but only .5% more for variable rate. The QSD is 1.25% , reflecting the difference, or additional default risk premium on fixed rate debt. The yield curve (fixed rate) for risky debt is much steeper than for safe debt, since lenders will: 1) Not have an opportunity to adjust (raise) the rate. 2) Not have the opportunity to cancel the debt if the company gets in trouble 3) Not be able to change the terms of the loan. All of these would be possible under floating-rate agreements, and lenders therefore have to "lock-in" a high default risk premium for fixed-rate debt at the beginning of the loan. When a QSD exists, it represents the potential gains from trade if both parties get together, through the swap bank. Here is an example of how the 1.25% QSD can be split up as follows: .5% for each party (bank and MNC) in the form of interest rate savings and .25% profit for the bank to arrange the deal. For $10m, each party (Bank A and Co. B) can save $50,000/year for 5 years, and the bank will make $25,000/yr for 5 years (total of $625,000 to split). Without the swap, Bank A will pay variable-rate @ KIBOR, and Co. B will pay fixed-rate @ 11.75%. With the swap, each party will save .5%, as follows: Bank A will pay a all-incost (interest expense, transactions cost, service charges) interest expense of KIBOR .5% (saving .50%) and Co. B will pay all-in-cost interest expense of 11.25% (saving .50%). Here is how: Instead of actually issuing the type of debt they really want, each party issues the opposite of what they want, and then they swap CFs. Instead of variable debt at KIBOR, Bank A issues fixed-rate bonds at 10%. Instead of issuing fixed rate at 11.75%, Co. B issues variable-rate debt at KIBOR + .5%. The parties issue the debt that they don't want, and make interest payments directly to the bondholders for 5 years. The swap bank then arranges the following CF payments: HRMARS, Pakistan www.hrmars.com 10

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ 1. Co. B pays 10.50% fixed-rate interest (on $10m) to the Swap Bank, and the bank passes on 10.375% interest payment to Bank A in PAKISTANI (Swap bank makes the difference = 10.50% - 10.375% = .125%). 2. Bank A pays KIBOR - .125% on $10m to the Swap Bank and they pass on KIBOR - .25% to Company B. As a result, here is the net position of each party:

Bank A
Pays -10% Fixed-rate interest (on $10m) to bondholders Receives +10.375% fixed rate interest from Swap Bank (Net on fixed rate debt = +.375%) Pays variable -(KIBOR -.125%) rate to Swap Bank (Reduced by +.375% on fixed rate debt) NET INTEREST = KIBOR - .50% variable rate (w/swap), vs. KIBOR (w/o swap)

Company
Pays -10.50% Fixed-rate to Swap Bank Pays Variable-rate KIBOR + .5% to bondholders Receives KIBOR - .25% from Swap Bank (Net on variable-rate debt = -.75%) NET INTEREST = 11.25% Fixed Rate (w/swap), vs. 11.75% (w/o swap)

Swap

Bank

Receives 10.50% fixed-rate from Co. B Pays 10.375% to Bank A (Net of +.125% on fixed-rate debt) Receives KIBOR -.125% from Bank A Pays KIBOR -.25% to Co. B (Net of +.125% on variable-rate debt) NET INCOME = .25% (on $10m) Net result: Bank A borrows at KIBOR - .5% instead of KIBOR, gets a variable-rate, and saves 0.50%. Co. B borrows at 11.25% instead of 11.75%, gets a fixed rate, and saves .50%. Swap Bank makes .25% to arrange the deal.

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CFs

for

Co.

B:

Pay $1.050m to Swap Bank (10.50% x $10m) Receive $775,000 from Swap Bank (7.75% x $10m), (KIBOR - .25% = 7.75%) Net PMT to SWAP BANK = $275,000 Pay $850,000 to bondholders (KIBOR + .5%) x $10m. Total interest expense = $275k + $850k = $1.125m (or 11.25% of $10m), vs. $1.175m @ 11.75%, or a savings of $50,000 per year.

CFs

for

Bank

A:

Receive $1.0375m from Swap Bank (10.375% of $10m) Pay $787,500 to Swap Bank (7.875% of $10m) Net RECEIPT from SWAP BANK = $250,00 Pay $1m to bondholders ($10m x 10%) Total Interest Expense = $1m - $250,000 = $750,000 (7.5% of $10m, @KIBOR -.50%), vs. $800,000 @ KIBOR, or a savings of $50,000. Swap Bank Receives $275,000 from Co. B, and pays $250,000 to Bank A, profit of $25,000/year. Regardless of what happens to KIBOR, the Swap Bank will always receive $25,000 profit/year.

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Interest rate Swaps and assetliability management by commercial banks of Pakistan

Pakistani banks participation in Swaps has risen sharply in recent years. The total amount of interest rate, currency, commodity, and equity contracts at PAKISTANI commercial and savings banks soared from Rs 6.8 trillion in 2003 to Rs 11.9 trillion in 2006, an increase of 75 percent. A major concern facing policymakers and bank regulators today is the possibility that the rising use of Swaps has increased the riskiness of individual banks and of the banking system as a whole. Banks have long used one type of swaps instrument, namely interest rate futures, to manage interest rate risk. However, the development of newer instruments, such as swaps, caps, collars, and floors has greatly expanded the menu of financial technologies available to banks for asset-liability management. In particular, interest rate swaps have become the preferred tool. According to a recent market survey of swaps users, 92 percent of responding financial institutions report using interest rate swaps to manage the interest rate risk of their lending portfolios.

SWAPS as a settlement tools in Banks I. Interest Rate Risk and Gap Analysis
Banks use swaps products mainly to manage interest rate risk. The last 15 years have seen an increased volatility of interest rates, making the need for accurate measurement and control of interest rate risk particularly acute. At the same time, financial innovations in the field of interest rate Swaps have given banks new and effective instruments for managing that risk. Interest rate risk arises in bank operations because banks' assets and liabilities generally have their interest rates reset at different times. This leaves net interest income (interest earned on assets less interest paid on liabilities) vulnerable to changes in market interest rates. The magnitude of interest rate risk depends on the degree of mismatch between the times when asset and liability interest rates are reset. One way to measure the direction and extent of the asset-liability mismatch is through gap analysis, which derives its name from the dollar gap that is the difference between the dollar amounts of rate-sensitive assets and rate-sensitive liabilities. A maturity gap is HRMARS, Pakistan www.hrmars.com 13

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ calculated for a given time period and includes all fixed-rate assets and liabilities that mature in that period and all floating-rate assets and liabilities that have interest rate reset dates in that period. A bank that has a positive gap will see its interest income rise if market interest rates rise, since more assets than liabilities will exhibit an increase in the interest rate. Similarly, a bank with a negative gap will be hurt by rising rates but will benefit from falling rates. For example, a bank that issues a 3-month certificate of deposit, and uses the funds to buy a 2-year Treasury note, will see its net interest income eroded if interest rates rise after the first three months because it will have to roll over the CDs at a higher rate, while the rate on the Treasury note will remain the same. In general, [Delta]NII = (A - L) x [Delta]r, (1) Where NII is net interest income, A is rate-sensitive assets, L is rate-sensitive liabilities and r is the market interest rate. The problem with this simple gap measure is that unless the time interval chosen is very small, assets and liabilities will have their rates reset at different times within that interval. In an extreme case, if the chosen interval is three months, a bank that issues 3-month CDs and funds them by borrowing federal funds overnight will show a three-month gap of zero, even though that bank is exposed to a substantial interest rate risk. One refinement of a simple maturity gap measure calculates a sequence of periodic maturity gaps, such as a series of three-month gaps for five years. This method has the advantage of more precision, although periodic gaps may be difficult to interpret, especially if they result in a long sequence of alternating negative and positive gaps. On the quarterly Call Reports, banks are required to report the book value of all interestbearing assets and liabilities, classified according to whether they mature or have interest rate reset dates within the next three months, three months to one year, one to five years, or more than five years. Accordingly, one can calculate the book value of the corresponding periodic gaps for all reporting banks on a quarterly basis. Ideally, one would want to reduce the measure of interest rate exposure to one number, showing how net interest income would react to a given change in the market interest rate. To provide such an estimate, the concept of "duration" was developed. Duration represents an account's weighted average time to repricing, where the weights are discounted cash flows. The duration gap is the difference between the duration of assets, weighted by dollars of assets, and the duration of liabilities, weighted by dollars of liabilities. The larger the duration gap, the more sensitive the bank is to the changes in the market interest rate HRMARS, Pakistan www.hrmars.com 14

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However, duration gap is an accurate measure of the interest risk only if the term structure of interest rates shifts in parallel, or if any departures from parallel shifts are known in advance. To the extent these conditions are violated, as they often are, interest rate risk cannot be summed up simply in one number.

II. Managing Interest Rate Risk with Swaps Contracts

Traditionally, Pakistani banks controlled interest rate risk by adjusting the maturity or reprising schedules of their assets and liabilities. For example, a bank wishing to lengthen the duration of its assets can add long-term government bonds to its securities portfolio. More recently, however, many banks realized that they could accomplish the same goal more cheaply and efficiently by entering into plain-vanilla swaps, where they pay a floating rate, usually denominated in Karachi Interbank Offer Rate (KIBOR), and receive a fixed rate, usually the Treasury rate of equivalent maturity plus a premium. A liability-sensitive bank, on the other hand, can enter into a swap where it pays a fixed rate and receives a floating rate. The bank can also use a "basis" swap, where both sides pay floating rates but the index rates are tied to the bank's cost of funds and lending rate. Specifically, the bank would pay the prime rate and receive KIBOR. Alternatively, the liability-sensitive bank can buy a cap on KIBOR, so that if KIBOR rises above a certain predetermined level, the seller will pay the bank the difference between KIBOR and that level. A similar approach is a "costless" collar on KIBOR, where the bank buys a KIBOR cap from the dealer and at the same time sells a KIBOR floor to the dealer, with the premium on the bought cap exactly offsetting the premium on the sold floor. In this way, the bank reduces the cost of buying protection from a rise in KIBOR by giving up a potential benefit to its earnings from a fall in KIBOR. Swaps can also be used to create synthetic loan and deposit products. For example, a bank can transform a floating-rate loan into a fixed-rate loan by coupling new floatingrate financing with a plain-vanilla swap where the bank pays a floating rate in return for receiving a fixed rate. The advantage of Swaps over more traditional methods of asset-liability management, such as adjusting one's securities portfolio, is that Swaps can transform the duration of the balance sheet while neither increasing it nor incurring significant additional capital requirement. The presence of the equity-to-asset ratio and the standard measures of asset quality such as the ratios of nonperforming assets to assets, loan-loss reserves to HRMARS, Pakistan www.hrmars.com 15

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ nonperforming loans, and loan-loss reserves to total loans and leases, are meant to capture the regulatory environment. An important reason why managing interest rate risk through Swaps may be preferable to on-balance-sheet management is that offbalance-sheet contracts entail lower capital requirements. Thus, banks with lower capital ratios may be expected to be bigger users of Swaps, other things being equal. Similarly, banks with relatively poor asset quality (as measured by high levels of nonperforming assets relative to total assets or low levels of loan loss reserves relative to nonperforming loans) will need to conserve capital and might find Swaps to be a more desirable, capital-efficient way to manage the balance sheet. On the other hand, the use of Swaps may be perceived by regulators as risky, and poorly capitalized banks and banks with weak asset quality or low loan-loss reserves would be subject to more scrutiny or restrictions by regulators when they attempt to use Swaps, thus discouraging the use of Swaps by such banks. The four "gap" measures are meant to represent a crude measure of the interest rate risk assumed by the bank before its swaps position is taken into account. Larger absolute values of the gap measures indicate a greater sensitivity to interest rate changes on the part of the bank. A bank can reduce its interest rate exposure by hedging with swaps positions.

Cross Currency Swap Mechanics in banking Industry & Practices in Pakistan

Cross currency swaps are agreements between counterparties to exchange interest and principal payments in different currencies. To understand the mechanics of a cross currency swap, it is helpful to begin with the simplest derivative in the foreign exchange market, the forward contract. A FX forward involves the exchange of one currency for another, on a future date and at a forward price established today. The forward price can be viewed as the sum of the spot rate and the forward points, which indicate the relative premium or discount of the future transaction based on the interest rates of the currencies. As such, a forward transaction can be said to be comprised of two componentsan exchange of principal and an exchange of interest payments both of which occur at expiry. The principal exchange is based on todays spot rate; the interest paymentsdepending on the yields for the tenor of the contractare determined at HRMARS, Pakistan www.hrmars.com 16

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ the beginning and paid in a lump sum along with the principal. The ratio of the total currency amounts exchanged at expiry is the forward price. Like a forward, a cross currency swap consists of the exchange of principal amounts (based on todays spot rate) and interest payments between counterparties. Unlike a forward, however, a cross currency swap involves multiple exchanges of interest (and even principal amounts). Often, the counterparties will exchange principal initially as well, although this exchange is optional. With the initial exchange, the cross currency swap is akin to a FX swap with spot and forward legs.

Figure 1 illustrates a structure in which the bank receives USD interest and pays EUR interest. The front and back exchanges of principal amounts are based on the current spot rate. The grey Euro cash flows are economically equivalent to issuing a Euro bond; the USD cash flows are equivalent to investing in a USD bond. If paired with a USD borrowing, the CCS converts the USD borrowings into a synthetic EUR one; if paired with a EUR investment, the CCS converts the EUR asset into a synthetic USD one.

Practices in Pakistani Banks: Fixed vs. Floating Cross Currency Swaps

In Pakistan many banks favor the use of cross-currency swaps because, as over the counter instruments, they are easy to customize. In addition to the frequency of interest exchanges, the reference interest rates used to determine the interest payments can be customized to reflect the specific needs of the user. Although the interest rates must correspond to the currencies involved in the principal exchange, the actual benchmark rates used are up to the parties entering into the swap. This means that banks can HRMARS, Pakistan www.hrmars.com 17

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ match the reference rates for these instruments to those of their specific liabilities/assets, whose interest flows may be tied rates other than, say, KIBOR rates1. Furthermore, these instruments allow the interest rates on either side of the transaction to be fixed or floating rates. For instance, if a bank has liabilities with floating interest payments, they can enter into a cross currency swap where they receive the floating interest payments from the counterparty and pay a fixed interest rate in return. Figure 2 illustrates four different combinations of cross currency swaps for a bank wishing to receive foreign currency flows.

Pricing and Valuation

This type of Swap is practiced rarely in Pakistan. At inception, the value of a typical, vanilla swap is zero. This implies that the two back-to-back bonds (i.e., cash flows in a single currency) being exchanged have equivalent NPVs, when valued in a common currency at the spot exchange rate. Floating-for-floating swaps are akin to a bundle of two floating rate coupon bonds, whereas fix-for-fix swaps are akin to a bundle of two fixed coupon bonds. In terms of quoting convention, whereas the pricing of forwards contracts are expressed in terms of points, CCS is expressed in terms of spreads to the benchmark rates. After inception, as the two yield curves shift and the spot exchange rate moves, the value of a CCS will tend to change. The swaps value is determined by revaluing the remaining contractual cash flows on each side of the swap at current market rates (i.e., discounting future flows to determine net present values) and then converting the NPVs to a common currency (the USD) at the current spot rate). The difference between the NPVs of the legs is the current value of the swap. For a floating-for-floating swap, because the respective-currency NPVs of each side of the swap remain unchanged as yield curves shift, changes in the value of the swap correspond only to changes in the spot exchange rate. For fix-for-fix swaps, since the interest payments are locked-in at initiation, changes in value reflect changes in yields as well as spot rates. As such variable rate structures tend to provide more stable mark-to-market profiles throughout their lives than fix-rate swaps of the same tenor.

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Using a Cross Currency Swap to Transform Loans and Assets

This is the most commonly type of SWAP used in Pakistani banks. Fundamentally, because CCS changes the currency denomination of assets and liabilities, they can be used to alter the expected interest earnings/costs and foreign currency risk associated with those assets and liabilities. For example, suppose that a bank has a USDdenominated bond. To reduce its expected borrowing cost (and, for the moment, ignoring risk considerations), the bank may wish to access the lower interest rate JPY market. To do this, it can use a CCS to create synthetic JPY-denominated debt. This is widely practiced by MCB in Pakistan that the initial exchange converts the USD bond proceeds to yen, and the subsequent cash-flows (i.e., the JPY payments to and USD receipts from the swap counterparty) convert the interest and principal payments from dollars to yen. Similarly, cross-currency swaps can be used to manage FX risk by, say, transforming the currency of an investment. Instead of moving cash physically across borders, swaps can be used as an overlay instrument to transform an assets currency denomination synthetically. A bank that is currently holding JPY assets, for instance, may have a strong view that JPY will weaken considerably against USD and prefer, therefore, to hold a USD-denominated asset. A CCS involving paying JPY and receiving USD would effectively convert the investment from yen into dollars.

Creating Asset/Liability Currency Matches

Cross currency swaps can also be used strategically to alter, and thereby create more appropriate, currency matches within broad portfolios of assets and liabilities. By using them, banks can adjust the currency denomination of liabilities and cash outflows to match those of assets and cash inflows, creating natural offsets and hedges against currency movements on a strategic and portfolio basis. As a simple example, imagine a bank with a foreign-currency denominated funding but operations mostly in the US and cash flows in USD. If the foreign currency strengthens against the USD, the bank will be left with a larger liability position and larger USD cash outflows to service the foreign-currency denominated loan. Instead of leaving itself at risk to a strengthening of the foreign currency, however, the bank could swap the loan into US dollars. Changes in the value of the swap will provide a perfect offset to changes in the value of the loan, insulating financial statements from the impact of currency moves. Broadly, the bank has converted a foreign liability to match the land, equipments, and properties on the asset side. And on a cash flow basis, the CCS will leave net interest expenses in the same currency as firm revenues.

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Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ In practice, many Pakistani banks have global operations but a majority of their liabilities denominated in USD$. And as banks continue expanding globally and investing overseas, foreign revenue growth will lead to a widening currency mismatch if funding of that expansion remains largely in USD. Such a currency mismatch would leave the firm exposed to shortfalls in liquidity, should currency values change significantly. To prevent the emergence of such a mismatch, banks in this situation may wish to swap a portion of their USD debt into foreign currencies (those in which long-term revenue growth is considered the most promising). Such synthetic foreign currency debt will provide a natural hedge for growing non-USD assets, and allow foreign revenues to be used to service interest on the borrowings. Similarly, for banks whose funding is largely USD-based but whose overseas growth will occur via foreign operating entities in their respective markets, a CCS can be an effective tool for funding the foreign operation in its local currency and managing any subsequent lent to the foreign entities. Thereafter, inflows from the swap will mirror those from a USD bond, providing a match to the banks underlying USD-denominated funding. Concomitantly, outflows due to the swap will mimic those of foreign currency debt. With the swap, the US parent transforms the currency denomination of a share of its liabilities from USD to foreign currency, matching that of its growing overseas assets, while the subsidiary is left with an interbank liability denominated in the currency of its operations and income. Figure 3 above shows such interbank relationship and a bankwide asset/liability match of currency transactions.

Figure 3. Multi-national Corporate Structure

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Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ From a longer-term perspective, if the US parent illustrated in Figure 3 has designated the interbank loan as long term and therefore one that is re-measured through equity (or the funding of the foreign subsidiary has occurred via equity), then the US parent may choose to designate the cross-currency swap as a hedge of its foreign net investment. Designated as such, the swap would protect the USD value of the parents foreign equity investment, as well as future cash flows returned from the business (in the form of dividends and royalties). Ultimately, to minimize currency risk, firms may desire to localize their assets and liabilities, i.e., borrow in the markets where is to be used and assets are to be accumulated. In many circumstances, however, this may not possible or practical. In these cases, banks may find that CCS is an efficient tool for synthetically effecting portfolio adjustments.

Minimizing Interest Costs and Enhancing Interest Earnings

In addition to using CCS to manage FX risk, banks can utilize these flexible and efficient instruments to alter the expected interest costs or earnings of a portfolio. A firm managing a net debt portfolio, for instance, may find it more efficient to use cross currency swaps to transform the funds raised into the ultimate currencies of need, rather than to raise funds directly in the currencies needed. In the current interest rate environment, with USD interest rates higher than many others (such as EUR, CAD, and JPY), a Pakistani bank raising capital may find it attractive to consider alternative currencies. While interest rate differentials favor direct issuance in currencies other than the USD, similar (and even superior) funding advantages may be achieved by combining issuance in USD with a CCS. Moreover, the latter may allow the issuer to circumvent some of the additional challenges associated with a foreign issuance, such as limited market size and name recognition/investor appetite. Indeed, in some currencies/countries, a cross currency swap may provide the only means of securing long-term, fixed-rate financing (where borrowing needs may be too small or expensive to fund through capital markets, private placements or local bank lines). By enabling diverse currency requirements to be satisfied by a single, currency borrowing, cross currency swaps also may enable firms to realize borrowing economies of scale. For instance, instead of funding its diverse European operations by borrowing in multiple currencies, a firm may be able to secure more favorable pricing by raising its total requirement in a single currency (say the EUR) and then using CCS to swap portions of the borrowing into CHF, GBP, NOK and any other currencies required. Outside of the immediate capital raising period, changing market conditions can also provide firms with strong incentives to adjust existing capital structures, and cross currency swaps can be an efficient tool for implementing such adjustments. In recent HRMARS, Pakistan www.hrmars.com 21

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ years, when the Fed aggressively lowered its short-term interest rate target, banks sought pay-floating interest rate swaps to participate in the lower rates. More recently, with the Fed reversing its trend, banks may see opportunities to decrease interest expense, as well as debt-servicing costs on a cash basis, by swapping debt into foreign currencies with lower yields (such as JPY). Cross currency swaps transform USD debt into synthetic lower cost foreign currency debt, enabling firms to benefit from lower interest rates. Of course, such swaps may expose firms to FX risk, as changes in swap values due to currency fluctuations are recorded in income; in many instances, however, firms can avoid such risk to income by designating CCSs as net investment hedges. Like firms managing debt portfolios, banks with investment portfolios may identify opportunities to enhance returns by strategically shifting the currency compositions of portfolios, and CCS can again be used for this purpose. For portfolios of short-term assets, positioning is likely to be more efficiently managed through regular FX forwards and FX swaps. Cross currency swaps, on the other hand, can be used with long-term foreign investments to capture favorable interest rate differentials. Given the current rate environment, Pakistani banks with foreign subsidiaries in countries such as Japan and the Euro area, which have lower interest rates than those in the Pakistan, can use cross currency swaps to convert these investments into USD. In addition to enhancing earnings on these foreign assets, the swaps eliminate currency risk by synthetically converting the assets into USD.

Currency swaps by major Pakistani banks

The use of currency swaps has grown rapidly during the 1990s. These off-balance-sheet instruments, whose market value (and cash flow) changes with that of an underlying variable (such as an interest rate, a foreign currency exchange rate, an equity price, or a commodity price), are a powerful tool for companies in managing their exposure to risk. The increasing importance of swaps to financial institutions (including banks that are dealers of these instruments), as well as to other enterprises, has heightened the need to understand them better. Public awareness of these instruments has also grown a consequence of highly publicized losses by some large businesses and municipalities that had entered into currency swaps. In a few instances, the losses were blamed on swaps even though they had in fact resulted from the trading of traditional financial instruments. Nevertheless, HRMARS, Pakistan www.hrmars.com 22

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ these events illustrate the need for firms entering into contracts, shareholders of these firms, policymakers, and the public to understand derivative instruments more fully. The risks associated with swaps are no different from the risks that firms have always had to recognize and control. All financial contracts carry some degree of risk. Noncurrency swaps, in fact, can be riskier and more complex than swaps. For example, a junk-rated bond that is tied to a foreign interest rate and is convertible into the issuer's common stock carries credit and market risk that would be difficult to quantify. In contrast, the risks of some swaps, such as futures contracts, can be easily assessed because prices are observable from trading on exchanges and cash changes hands daily to maintain collateral, mitigating credit risk. Nonetheless, swaps can be highly complex in their design, and their pricing can be opaque, making their risks difficult to understand, measure, and manage. One approach to increasing public understanding of swaps has been the implementation of more comprehensive accounting practices and disclosure requirements. In particular, these two tools are helpful in characterizing more accurately the effects of these instruments on firms' financial performance and in explaining those effects through public financial reporting. The benefits of these tools are not limited to swaps, however. They should also lead to better understanding of how firms manage risks arising from non-derivative financial contracts as well as from other sources. The goals are to demystify swaps, to facilitate the assessment of firms' swaps activities by readers of financial statements, and thereby to help improve the allocation of capital by financial markets. Many groups have been involved in bringing about changes in swaps accounting and reporting: authorities that set accounting standards, regulators and bank supervisors, and industry associations. These groups have set various regulatory requirements and have made numerous recommendations. As a result, the nature of the information publicly disclosed by firms has been evolving in several ways, including the amount and type of information disclosed and the way information is presented. The published annual reports to shareholders and other public financial reports of banks and other companies play an important role in disseminating information to investors, creditors, and other stakeholders in the enterprises. The information they convey about swaps has improved significantly in the past few years. A survey of the annual reports of the top ten Pakistani banks that deal in swaps showed that their 2006 reports were substantially more "transparent" than their IN@ reports, with more discussion and analysis of, and more quantitative information about, their use of these instruments. This research follows up on the previous survey by reviewing the 2005 annual reports of the top ten banks that deal in swaps. Although disclosure requirements did not change HRMARS, Pakistan www.hrmars.com 23

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ during the intervening period, banks nonetheless improved their reporting of swaps activities in 2006 compared with 2005. In particular, they expanded their discussions of swaps activities and provided more quantitative information. The vastly greater amount of information presented in the 2006 reports is especially evident when they are compared with the financial statements issued for 2003, in which banks typically disclosed little more than the total value of their trading assets and liabilities, their total trading profits, their overall net credit exposure across all counterparties, and the notional amounts of their currency swaps. Regulators and industry groups that have advocated fuller disclosure have clearly had significant influence in improving the overall quality of reporting about swaps activities.

Review of 2006 annual reports

The institutions whose annual reports were surveyed for this research were the ten Pakistani Commercial banks having the greatest credit risk exposure from swaps on June 31, 2006 (taking into account the effects of netting agreements). Nine of the ten banks were also included in the survey of 2005 annual reports. Banks Credit Risk Amount (bln) 336 280 194 121 83 73 33 30 6 6 Traded Amount 3,403 4,728 2,301 1,742 1,515 801 1,006 268 58 56

National Bank of Pakistan MCB Bank Pakistan Habib Bank Limited United Bank Limited Allied Bank Limited Askari Commercial Bank Bank Alhabib Pakistan Soneri Bank Limited MyBank Pakistan Prime Bank Limited

As a result of minor changes in generally accepted accounting principles, the 2005 annual reports contained clearer, more understandable information about the fair value of the financial instruments in the firms' portfolios. Firms were required to disclose the fair value of financial assets and liabilities carried at historical cost separately from the fair value of swaps used to hedge these instruments. This approach makes it much more obvious whether an instrument was favorable (that is, an asset from which the bank could expect to receive cash) or unfavorable (a liability on which the bank probably HRMARS, Pakistan www.hrmars.com 24

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ would pay cash), given year-end prices or interest rates. The 2006 reports showed little change in how this information was presented.

Disclosures about Earnings

For 2006, all ten banks disaggregated their trading revenues: Nine reported their results according to line of business or risk exposure with little differentiation between derivative and other instruments, and one reported about swaps only. These numbers compare favorably with the 2005 reports, in which most banks gave only the minimum required information (that is, they reported only about swaps). As a result, the 2006 reports gave a more complete picture of profits and risks from trading both derivative and no derivative financial instruments. Under a floor contract, the borrower writes an option in which he agrees to pay the difference between the strike price and the interest rate index specified in the contract. The premium received offsets a portion of the overall interest expense of the obligation; however, the debtor retains exposure to higher interest rates and forgoes the benefit of lower interest rates on his floating-rate obligation.

Risks Associated with Swaps

The risks associated with currency swaps are no different from those associated with other bank financial instruments. The major categories of risk are described here. Credit risk is the possibility of loss from the failure of counterparty to fully carry out its contractual obligations. The types of information about credit risk associated with swaps that institutions might disclose include the following: * Gross positive market value - the gross replacement cost of a contract, excluding the effects of any netting arrangements * Current credit exposure fair value on a given date of contracts that are favorable to the holder (that is, are assets) * Potential credit exposure - a statistical measure of the possible future value of contracts held today if prices or rates move favorably for die holder before the contracts mature * Credit risk concentrations - indicators of diversification by geographic area or industry group * Collateral and other credit enhancements that may reduce credit risk HRMARS, Pakistan www.hrmars.com 25

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* Counterparty credit quality, nonperforming contracts, and actual credit losses. Market risk is the possibility that the value of a financial contract (or of a real asset, for that matter) will adversely change before the contract can be liquidated or offset with other positions. The value of these contracts may change because of changes in interest rates (interest rate risk), foreign exchange rates (foreign exchange rate risk), or commodity prices or other indexes. For some larger institutions, disclosure of information about internal value-at-risk measures and methodology can help financial statement readers understand the institution's exposure to market risk. Using value-at-risk methods involves die assessment of potential losses in portfolio value resulting from adverse movements in market risk factors for a specified statistical confidence level over a defined holding period. Liquidity risk has two broad types. Market liquidity risk and funding risk. Market liquidity risk arises from the possibility that a position cannot be eliminated quickly either by liquidating it or by establishing offsetting positions. Funding risk arises from the possibility that a firm will be unable to meet die cash requirements of its contracts. Operational risk is the possibility that losses may occur because of inadequate systems and controls, human error, or mismanagement. Legal risk is the possibility of loss that arises when a contract cannot be enforced because of, for example, poor documentation, insufficient capacity or authority of the counterparty, or uncertain enforceability of the contract in a bankruptcy or insolvency proceeding.

Requirements and Recommendations for Public Disclosure

Although authorities that set accounting standards, regulators, and industry groups have long recognized that there are deficiencies in accounting practices for and disclosure of financial instruments in general, the growing use of swaps has brought these deficiencies into sharp focus. The Financial Accounting Standards Board (FASB), the organization that sets accounting standards, in 1997 created a task force on financial instruments to address these deficiencies. After some study, the FASB decided that the accounting issues surrounding swaps would be best addressed by first establishing minimum disclosure requirements and then devising consistent accounting methods. The FASB has so far published three statements of accounting standards (SFAS) affecting disclosures about swaps and other financial instruments. Financial statements that conform to generally accepted accounting principles necessarily follow these standards. HRMARS, Pakistan www.hrmars.com 26

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* End-user activities. Firms must explain their objectives in using swaps for hedging or other risk-management purposes and must discuss their strategies for achieving those objectives. They must also indicate where, in their financial statements end-user swaps are presented and give certain details about swaps used to hedge anticipated transactions (such as the amount of gains or losses that were deferred). The fair values of end-user swaps must be disclosed separately from the fair values of items hedged by the swaps. Encouraged but not required is the disclosure of quantitative information that managers use as a basis for controlling risk exposure. Proposed Requirements Disclosures in the 2006 annual reports were influenced by requirements formally proposed in January 2006 by the Securities and Exchange Commission Pakistan (SECP), the agency responsible for administering federal securities laws and for regulating accounting and disclosure by publicly traded companies. The SECP has delegated much of its authority for setting accounting standards for publicly traded companies to the Financial Accounting Standards Board, but it also occasionally issues supplemental guidance. The proposed amendments to current requirements focus on the disclosure of market risk. If adopted, they would become effective for 1996 annual reports. The SECP proposal requires more detailed disclosure of quantitative and qualitative information about the market risks associated with swaps. The SECP proposal also requires that companies disclose more detail than currently required by the FASB about their procedures for accounting for swaps, including information about the accounting methods used, the types of swaps to which each method was applied, and the criteria for choosing which method to apply.

Recommendations
In the past two years, several industry groups and regulators, either individually or in association with other agencies, have called for additional disclosure of swaps activities. These groups have generally stressed the advisory nature of their recommendations, in an effort to encourage firms to develop better ways of informing readers of financial statements and of enhancing market discipline. Their recommendations, though nonbinding, appear to have influenced disclosures in the 2005, and 2006 annual reports.

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Euro-currency Standing Committee

We recommend a working group of the Euro-currency Standing Committee of the Group of Ten central banks (ECSC) recommended that firms disclose quantitative information about their market and credit risk exposures and their success at managing those risks, to provide a framework for their qualitative discussions. At a minimum, quantitative information about the market risk of the trading portfolio should be disclosed; also desirable is similar disclosure about the consolidated portfolio that is, about swaps and financial instruments relating to traditional banking activities as well as to trading). The information should reveal the portfolio's riskiness by indicating the volatility of its market value. We also recommended that firms increase the transparency of their disclosures about credit risk. Suggestions include the reporting of current and potential credit exposure and the quantification of the variability of credit exposure over time. Reporting of actual credit losses. Arrangements for collateral, and other credit enhancements were suggested to give an indication of the quality of the firm's risk-management practices.

Sum up Comments
Available to the Public
Regulators have long required that banking organizations report notional amounts and fair values of the derivative instruments they hold or have issued. Since 2006, the Federal Reserve and the other federal banking agencies, under the auspices of the Federal Financial Institutions Examination Council (FFIEC), have required that notional amounts and fair values be reported by risk exposure and management objective. Information about trading revenues and the effects of end-user swaps on accrual-basis income has also been required since 2006, as has the past-due status of currency swaps and actual credit losses. This information is available to the public. The information required in these regulatory reports appears to have influenced the disclosures made by the largest of the top ten banks in their 2006 annual reports.

Accounting for Currency swaps

Derivative instruments, like some other financial instruments such as traditional loan commitments, are executor contracts. That is, the two parties to the contract have made mutual promises but have not carried out all die obligations specified in the contract. Under generally accepted accounting principles, an executor contract is reported in a financial statement only after some economic performance (in what may be a series of requirements) has taken place - under a firm commitment to lend, for HRMARS, Pakistan www.hrmars.com 28

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ example, when funds are drawn. The commitment is "off balance sheet" until some performance occurs. When the cash disbursement is reported as a loan, the financial contract can be said to be "on balance sheet." In keeping with this accounting principle for executor contracts, the accounting treatment of derivative instruments may reflect only the next required contractual performance during the period covered by the financial statement (such as the accrual of a cash receipt or disbursement characterized as income or expense). Under this procedure, an example of accrual accounting, even though a party to a currency swaps an interest rate swap, for example - could be obligated to make a series of cash payments over a number of years if interest rates change adversely, these potential future obligations are not reflected on the balance sheet. Hence, the derivative contract is "off balance sheet," and its potential risks and rewards are obscure. Also, when currency swaps are used as hedges, losses or gains on them may be deferred to match revenue from loans or interest expenses on deposits or other items being hedged. Future benefits or obligations associated with off-balance-sheet contracts, then, are not well captured in financial statements and therefore lack transparency. Although executor contracts may not he recognized for accounting purposes, they nonetheless have economic value. For example, an interest rate swap entitling a firm to receive a fixed rate of percent is more valuable than one entitling the firm to receive 7 percent, even though the comparative benefit does not appear on the balance sheet. In some financial reporting situations (such as in reporting trading activities), using economic value is more relevant than using accrual accounting, conventions to represent swaps. The accounting practice of estimating economic value, called marking to market, involves determining the fair value of the contract (by market quote, if available; otherwise through estimation techniques), recording that value on the balance sheet, and recognizing the change in value as a gain or a loss. When currency swaps are marked to market, their fair value is reflected in accounting statements at a point in time (the balance sheet date) and their volatility is demonstrated through the change in fair value reported in earnings. Accountants may disagree about which procedure - marking to market or accruing cash flows - more faithfully represents a particular transaction. However, they do agree that more thorough disclosure of the contractual terms of currency swaps and discussion by management of their hedging programs and the results of those efforts improve the transparency of off-balance-sheet instruments. The notional amount is the face amount of a contract to which an interest rate, a price, or a rate of exchange is applied to determine the contractual cash payments or receipts. In general, the notional amount is not exchanged and does not reflect the risk of a HRMARS, Pakistan www.hrmars.com 29

Directory of Human Resource Management e.Publications June (2011) Vol.1, Issue 1 ________________________________________________________________________ transaction. In this research, "bank" refers to a banking organization, comprising bank holding companies, their banking affiliates, and other subsidiaries that are consolidated for purposes of public financial reporting.

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