A swap is an contractbetween two parties to trade two surges of cash flow. The purpose of swap is tochange the character of an advantage or obligation without liquidation Issuerof swap can contract to pay a floating rate and get a fixed rate, or the otherway around. Swap contracting as we probably am aware it today is a genuinelylate wonder. Swap market is originated from swap agreement negotiated in GreatBritain in the 1970s to dodge outside trade controls received by the Britishgovernment. The principal swaps were minor departure from cash swaps.
TheBritish government had a strategy of burdening outside trade exchanges thatincluded the British pound. This made it more troublesome for cash-flow toleave the nation, subsequently expanding household venture. After that in 1981 anoteworthy swap assention by Salomon Brothers in the interest of the World Bankand IBM and included a trade of cash flowdesignated out Swiss francs anddeutschemarks added brilliance to swap showcase.
Whyare swaps so popular? What is their economic rationale?Swapsare contractual agreements to exchange or swap a series of cash flows.Theseash follows are most commonly the interest payments associated with debtservice.· If the agreement is so for oneparty to swap its fixed interest rate payments for the floating interest ratepayments of another, it is termed as interest rate swap.
· If the agreement is to swapcurrencies of debt service obligation, it is termed a currency swap.· A single swap may combine elementsof both interest rate and currency swap.Economic rationale ofswap: When favorable stocksare less likely, the exposed firm chooses to issue long term debt and uses afloating for fixed interest rate swap to take advantage of declining interestrates. These results provide an economic rationale for the widespread use ofinterest rate swaps by nonfinancial firms.
Howwould you define currency swap?A currency swap shouldbe distinguished from a central bank liquidity swap.A currency swap is a foreign-exchangeagreement between two institute to exchange aspects of a loan in one currencyfor equivalent aspects of an equal in net present value loan in anothercurrency.Ø Mechanics of currencyswapThe swap agreement isa contract in which one party borrows one currency from, and simultaneouslylends another to, the second party. Each party uses the repayment obligation toits counterparty as collateral and the amount of repayment is fixed at theforward rate as of the start of the contract.
Ø Cash flow diagram Ø Role of credit ratingsin SWAPApproaching a creditrating agency is a good option for small and medium enterprises given theproblem they face in seeking finance. Rating agencies assess a firm’s financialviability and capability to honor business obligations, provide an insight intosales, operational and financial composition, thereby assessing the riskelement and highlights the overall health of enterprise, they also benchmarktheir operation within the industry as well and also plays a vital role in twocounterparties of SWAP contracts.Analyzea swap between two companiesInterest rate swapscan hedge companies against interest rate exposure.If a company makesfloating interest rate payments on its liability, it can enterinto a swap agreement with another company or financial institutionto hedge against the risk of interest rate fluctuations. In this scenario, thecompany should create a swap according to which it will make fixed interestrate payments to its counterparty, while it will receive the floating interestrate payments in exchange.
It can helpcompanies to leverage their comparative advantage in obtaining a liability. Byusing swaps, companies can leverage their comparative advantage in short-termor long-term borrowing and save money on interest payments.Imagine companies Aand B.
Company A is an AAA-rated company and it can obtain a long-term loanwith a 5% interest and a short-term loan with LIBOR+0.5% interest. Company B isa BBB-rate company and it can loan long-term with an 8% interest and loanshort-term with LIBOR+1% Company A Company B Quality Spread (QS) Credit Rating AAA BBB Long-term 5% 8% 3% Short-term LIBOR+0.5% LIBOR+1% 0.5% Obviously, Company A enjoys an absoluteadvantage in obtaining loans over Company B because in both cases, it canobtain loan money and pay lower interest rates. However, after the calculationof the quality spreads, we can say which companies demonstrate a comparativeadvantage; thus, the Company A should borrow long-term, while the Company Bshould borrow short-term.Therefore, if CompanyA needs a short-term loan and Company B needs a long-term loan, they can obtainloans in which they enjoy a comparative advantage and create a swap betweeneach other.
The design of the swap may look like: In this case, bothcompanies will benefit from the swap: Company A Company B Loan 5% LIBOR+1% Swap (Pay) LIBOR 6% Swap (Receive) 6% LIBOR Net Interest LIBOR-1% 7% Gain from SWAP between parties Instead of payingLIBOR+1% for the short-term loan, Company A will pay LIBOR-1%, while Company Bwill pay an interest rate of 7% on its long-term loan, instead of 8%. Wheredo the gains from SWAPs arise from? Find three reasons?Acurrency SWAP allows the two counter parties to SWAP interest rate on borrowingin different currencies. However gains from SWAP arise from following reasonsü FlexibilityUnlike interest rateSWAP which allows companies to focus on their comparative advantage inborrowing in single currency in the short end of maturity spectrum, currencySWAP gives companies extra flexibility to exploit their comparative advantagein their respective in their respective borrowing markets. They also provide achance to exploit advantage across a network of currencies and maturity.The success of thecurrency swap market and the success of Eurobond market are explicitly linked.
ü ExposureCurrency swaps generatea larger credit exposure than interest rate swaps because of the exchange andre-exchange of notional principal amounts.Companies have to come up with thefunds to deliver the notional at the end of the contract, and are obliged toexchange one currency’s notional against the other at a fixed rate. The more actual marketrates have deviated from this contracted rate, the greater the potential lossor gain. This potential exposureis magnified as volatility increases with time. The longer the contract, themore room for the currency to move to one side or the other of the agreed uponcontracted rate of principal exchange.This explains why currency swaps tie upgreater credit lines than regular interest rate swaps.ü PricingCurrency swaps arepriced or valued in the same way as interest rate swaps using a discounted cashflows analysis having obtained the zero coupon version of the SWAP curves.Generally, a currencyswap transacts at inception with no net value.
Over the life of the instrument,the currency swap can go “in-the-money,” “out-of-the-money” or it can stay”at-the-money.” Whyinvestors use fixed and floating rates in setting up currency SWAP?Investorsuse fixed and floating rate swaps to convert financial exposure, to obtained comparativeadvantage, to speculate on interest rates on currencies.Let’ssuppose a risk seeker investor expect interest rate to rise and wants to lockin the fixed rate available for him/her.
So he chooses a swap contract thatprovide him fixed interest rate.Arisk averse investor expects interest rates to decline and wants floating rateborrowing. So he chooses a swap that provides him floating interest rate. Whatare the differences and similarities between FX and interest rate SWAP?The most widely recognized sortswap is interest rate swap in which Party A consents to make payments to PartyB in view of a fixed loan cost, and Party B consents to influence payments toParty To an in light of a floating financing cost. What’s more, Currency swapsis like a loan cost swap, aside from that in a cash swap, there is a trade ofimportant, while in a financing cost swap, the vital does not change hands.
Rather, on the exchange date, the counterparties trade notional sums in the twomonetary standards it is an agreement or understanding between two gatheringswherein one gathering trades the chief and enthusiasm for one cash with vital andenthusiasm for another money held by another gathering. They are additionallydone to fence danger of changing financing costs and danger of vacillation inoutside trade rates. The essential loan fee swap is afixed-for-floating rate swap in which one counterparty trades the intriguepayments of a fixed-rate obligation commitment for the floating-intriguepayments of the other counterparty. Both obligation commitments are named in asimilar cash. In a cash swap, one counterparty trades the obligation benefitcommitments of a bond named in one money for the obligation benefit commitmentsof the other counterparty which are named in another money. A swap bank is a nonexclusiveterm to portray a money related establishment that encourages the swap betweencounterparties. The swap bank fills in as either an agent or a merchant. Whenfilling in as a facilitate, the swap bank matches counterparties, however doesnot accept any danger of the swap.
When filling in as a merchant, the swap bankstands willing to acknowledge either side of a cash swap. In a case of an essential loancost swap, it was noticed that a fundamental condition for a swap to beattainable was the presence of a quality spread differential between thedefault-chance premiums on the fixed-rate and floating-rate financing costs ofthe two counterparties. Furthermore, it was noticed that there was not a tradeof important aggregates between the counterparties to a loan cost swap in lightof the fact that both obligation issues were named in a similar money. Loan feetrades depended on a notional main. After beginning the estimation of a loanfee swap to a counterparty ought to be the distinction in the present estimationsof the installment streams the counterparty will get and pay on the notionalprimary.
In a point by point case of anessential cash swap it was demonstrated that the obligation benefit commitmentsof the counterparties in a money swap are viably proportional to each other incost. Ostensible contrasts can be clarified by the arrangement of worldwideequality connections. After beginning, the estimationof a cash swap to a counterparty ought to be the distinction in the presentestimations of the installment stream the counterparty will get in one moneyand pay in the other cash, changed over to either cash group. Notwithstanding the fundamentalfixed-for-floating loan fee swap and fixed-for-fixed cash swap, numerousdifferent variations exist. One variation is the amortizing swap, whichconsolidates an amortization of the notional standards. Another variation is azero-coupon-for-floating rate swap in which the floating-rate payer influencesthe standard intermittent floating-to rate payments over the life of the swap,however the fixed-rate payer makes a solitary installment toward the finish ofthe swap. Another is the floating-for-floating rate swap. In this sort of swap,each side is fixing to an alternate floating-rate record or an alternate recurrenceof a similar file.
Explanations behind theadvancement and development of the swap market ought to be fundamentallyanalyzed. We contend that one must depend on a contention of market culminationfor the presence and development of financing cost swaps. That is, the loan feeswap advertise helps with fitting financing to the sort wanted by a specificborrower when a wide range of obligation instruments are not consistentlyaccessible to all borrowersHowmany types of swaps? The following types ofswap are:1. Basis Rate A basisswap is an interest rate swap which involves the exchange of twofloating rate financial instruments. A basis swap functions as afloating-floating interest rate swap under which thefloating rate payments are referenced to different bases2. Bond SwapIn simple terms, abond swap is when an investor chooses to sell one bond and subsequentlypurchase another bond with the proceeds from the sale in order to takeadvantage of the current market environment.
Investors may choose to swap abond for a wide variety of reasons3. Commodity SwapA commodityswap is a type of swap agreement whereby a floating (or marketor spot) price based on an underlying commodity is traded for a fixedprice over a specified period. A Commodity swap is similar to a Fixed-FloatingInterest rate swap.4. Credit Default Swap A financial contractwhereby a buyer of corporate or sovereign debt in the form of bonds attempts toeliminate possible loss arising from default by the issuer of the bonds. Thisis achieved by the issuer of the bonds insuring the buyer’s potential losses aspart of the agreement.5. Volatility SwapA volatility swap is a forwardcontract on future realized price volatility.
Similarly, avariance swap is a forward contract on future realized pricevariance, variance being the square of volatility. In both cases, atinception of the trade, the strike is usually chosen such that the fair valueof the swap is zero. 6. Forex Swap A forexswap is the interest rate differential between the two currencies of thepair you are trading, and it is calculated according to whether your positionis long or short.
The FxPro Swap Calculator can be used to determinewhat your swap fee will be for holding a trade open overnight.7. Interest rate swapInterest rate swap isa contact or agreement between two parties wherein one set of fixed future cashflows of interest payments is exchanged for another set of floating future cashflows of interest payments based on usually a same principal amount. Thepayment is not of principal amount but of the interest amount that is exchangedin order to hedge the risk of fluctuating interest rates or can be described asswapping of fluctuating interest rates and floating interest rates.8. Currency swapCurrency swaps is a contract oragreement between two parties wherein one party exchanges the principal andinterest in one currency with principal and interest in another currency heldby another party. They are also done to hedge risk of changing interest ratesand risk of fluctuation in foreign exchange rates.
9. Cross currency swapA cross currency swap is an overthe counter derivative in a form of an agreement between two parties toexchange interest payments and principals on loans denominated in two differentcurrencies.