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Types of Swaps
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This post is in continuation of our series on Introduction To Swap.

Let us now understand some basic swap arrangements such as currency swaps and interest rate swaps.

Currency Swaps

It is a transaction between two parties in which one party promises to make a series of payments to other party at specific dates in exchange for a payment from the other party in different currencies. So, in currency swaps, the cash flows of different currencies are swapped (exchanged).

Currency swaps can be used by firms that operate in one currency but need to borrow in another currency.

For example, X Ltd. and Y Ltd. can borrow USD and GBP, respectively. But X Ltd. can borrow GBP at a cheaper rate than Y Ltd. while Y Ltd. can borrow USD at a cheaper rate. They can enter into a currency swap to share advantage of the cheaper borrowing capacity of the other company. The rationale for currency swap lies in the fact that one borrower has a comparative advantage in borrowing in one currency, while the other borrower has an advantage in borrowing in another currency.

The purpose of currency swap is to arrange the funds denominated in other currency.

Interest Rate Swaps

In interest rate swaps, two parties make a series of interest payments to one another at pre-determined dates at different interest rates. At least one of the interest rates is variable, i.e., a floating rate, such that the rate at which interest payments will be made at a later date is not known.

The most common type of interest rate swap is ‘Plain Vanilla’ swap in which one rate is fixed and the other one is floating.

In plain vanilla swap, one party has an initial position in fixed rate debt and the other party has an initial position in floating rate debt. The latter is exposed to changing interest rates. By swapping the interest obligations, the counter parties eliminate their initial exposure and create obligations as of what they want.

For instance, let us suppose that there are two parties: Firm A and Firm B. And, both want to borrow $30 million. The fixed rate of interest charged by banks is 7% and 8.5% from Firm A and Firm B, respectively. However, in case of floating rate system, they can obtain the loan at LIBOR + 1.0% and LIBOR + 4.0%.

Here, we can clearly see that Firm A has a clear advantage over Firm B in case of fixed rate as well as floating rate system. But Firm B has a comparative advantage over Firm A in case of fixed rate system, as the former has to pay only 1.5% extra as compared to 3% extra in floating rate system. Both Firm A and Firm B can be benefitted by arranging a swap, through a broker, and share this comparative advantage. Thus, a swap transaction will be arranged between the end-user parties by the swap dealer.

 Swap

It is important to note that:

  • In interest rate swaps, there is no exchange of principal amount either on maturity or initially, and
  • On each interest payment date, only the interest payments or the net amount will be exchanged.

It should also be noted that the reason to enter into a swap arrangement is predominantly the comparative advantage in different interest markets vis-à-vis fixed and floating for different parties. The swap has the effect of transforming a fixed rate loan into a floating rate loan and vice-versa.

 

References:

Rustagi, Dr. R.P., Investment Management: Theory and Practice (2008)

 

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