A swap currencies of debt service obligation, it

A swap is an contract
between two parties to trade two surges of cash flow. The purpose of swap is to
change the character of an advantage or obligation without liquidation Issuer
of swap can contract to pay a floating rate and get a fixed rate, or the other
way around. Swap contracting as we probably am aware it today is a genuinely
late wonder. Swap market is originated from swap agreement negotiated in Great
Britain in the 1970s to dodge outside trade controls received by the British
government. The principal swaps were minor departure from cash swaps. The
British government had a strategy of burdening outside trade exchanges that
included the British pound. This made it more troublesome for cash-flow to
leave the nation, subsequently expanding household venture.

 

After that in 1981 a
noteworthy swap assention by Salomon Brothers in the interest of the World Bank
and IBM and included a trade of cash flowdesignated out Swiss francs and
deutschemarks added brilliance to swap showcase.

Why
are swaps so popular? What is their economic rationale?

Swaps
are contractual agreements to exchange or swap a series of cash flows.

These
ash follows are most commonly the interest payments associated with debt
service.

·        
If the agreement is so for one
party to swap its fixed interest rate payments for the floating interest rate
payments of another, it is termed as interest rate swap.

·        
If the agreement is to swap
currencies of debt service obligation, it is termed a currency swap.

·        
A single swap may combine elements
of both interest rate and currency swap.

Economic rationale of
swap:

When favorable stocks
are less likely, the exposed firm chooses to issue long term debt and uses a
floating for fixed interest rate swap to take advantage of declining interest
rates. These results provide an economic rationale for the widespread use of
interest rate swaps by nonfinancial firms.

How
would you define currency swap?

A currency swap should
be distinguished from a central bank liquidity swap.A currency swap is a foreign-exchange
agreement between two institute to exchange aspects of a loan in one currency
for equivalent aspects of an equal in net present value loan in another
currency.

Ø  Mechanics of currency
swap

The swap agreement is
a contract in which one party borrows one currency from, and simultaneously
lends another to, the second party. Each party uses the repayment obligation to
its counterparty as collateral and the amount of repayment is fixed at the
forward rate as of the start of the contract.

 

Ø  Cash flow diagram

 

 

Ø  Role of credit ratings
in SWAP

Approaching a credit
rating agency is a good option for small and medium enterprises given the
problem they face in seeking finance. Rating agencies assess a firm’s financial
viability and capability to honor business obligations, provide an insight into
sales, operational and financial composition, thereby assessing the risk
element and highlights the overall health of enterprise, they also benchmark
their operation within the industry as well and also plays a vital role in two
counterparties of SWAP contracts.

Analyze
a swap between two companies

Interest rate swaps
can hedge companies against interest rate exposure.

If a company makes
floating interest rate payments on its liability, it can enter
into a swap agreement with another company or financial institution
to hedge against the risk of interest rate fluctuations. In this scenario, the
company should create a swap according to which it will make fixed interest
rate payments to its counterparty, while it will receive the floating interest
rate payments in exchange.

 It can help
companies to leverage their comparative advantage in obtaining a liability. By
using swaps, companies can leverage their comparative advantage in short-term
or long-term borrowing and save money on interest payments.

Imagine companies A
and B. Company A is an AAA-rated company and it can obtain a long-term loan
with a 5% interest and a short-term loan with LIBOR+0.5% interest. Company B is
a BBB-rate company and it can loan long-term with an 8% interest and loan
short-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 absolute
advantage in obtaining loans over Company B because in both cases, it can
obtain loan money and pay lower interest rates. However, after the calculation
of the quality spreads, we can say which companies demonstrate a comparative
advantage; thus, the Company A should borrow long-term, while the Company B
should borrow short-term.

Therefore, if Company
A needs a short-term loan and Company B needs a long-term loan, they can obtain
loans in which they enjoy a comparative advantage and create a swap between
each other. The design of the swap may look like:

 

 

 

 

 

 

 

 

 

 

In this case, both
companies 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 paying
LIBOR+1% for the short-term loan, Company A will pay LIBOR-1%, while Company B
will pay an interest rate of 7% on its long-term loan, instead of 8%.

                           

Where
do the gains from SWAPs arise from? Find three reasons?

A
currency SWAP allows the two counter parties to SWAP interest rate on borrowing
in different currencies. However gains from SWAP arise from following reasons

ü  Flexibility

Unlike interest rate
SWAP which allows companies to focus on their comparative advantage in
borrowing in single currency in the short end of maturity spectrum, currency
SWAP gives companies extra flexibility to exploit their comparative advantage
in their respective in their respective borrowing markets.

 

They also provide a
chance to exploit advantage across a network of currencies and maturity.

The success of the
currency swap market and the success of Eurobond market are explicitly linked.

ü  Exposure

Currency swaps generate
a larger credit exposure than interest rate swaps because of the exchange and
re-exchange of notional principal amounts.Companies have to come up with the
funds to deliver the notional at the end of the contract, and are obliged to
exchange one currency’s notional against the other at a fixed rate.

 

The more actual market
rates have deviated from this contracted rate, the greater the potential loss
or gain.

 

This potential exposure
is magnified as volatility increases with time. The longer the contract, the
more room for the currency to move to one side or the other of the agreed upon
contracted rate of principal exchange.This explains why currency swaps tie up
greater credit lines than regular interest rate swaps.

ü  Pricing

Currency swaps are
priced or valued in the same way as interest rate swaps using a discounted cash
flows analysis having obtained the zero coupon version of the SWAP curves.

Generally, a currency
swap 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.”

 

Why
investors use fixed and floating rates in setting up currency SWAP?

Investors
use fixed and floating rate swaps to convert financial exposure, to obtained comparative
advantage, to speculate on interest rates on currencies.

Let’s
suppose a risk seeker investor expect interest rate to rise and wants to lock
in the fixed rate available for him/her. So he chooses a swap contract that
provide him fixed interest rate.

A
risk averse investor expects interest rates to decline and wants floating rate
borrowing. So he chooses a swap that provides him floating interest rate.

 

What
are the differences and similarities between FX and interest rate SWAP?

The most widely recognized sort
swap is interest rate swap in which Party A consents to make payments to Party
B in view of a fixed loan cost, and Party B consents to influence payments to
Party To an in light of a floating financing cost. What’s more, Currency swaps
is like a loan cost swap, aside from that in a cash swap, there is a trade of
important, while in a financing cost swap, the vital does not change hands.
Rather, on the exchange date, the counterparties trade notional sums in the two
monetary standards it is an agreement or understanding between two gatherings
wherein one gathering trades the chief and enthusiasm for one cash with vital and
enthusiasm for another money held by another gathering. They are additionally
done to fence danger of changing financing costs and danger of vacillation in
outside trade rates.

 

The essential loan fee swap is a
fixed-for-floating rate swap in which one counterparty trades the intrigue
payments of a fixed-rate obligation commitment for the floating-intrigue
payments of the other counterparty. Both obligation commitments are named in a
similar cash. In a cash swap, one counterparty trades the obligation benefit
commitments of a bond named in one money for the obligation benefit commitments
of the other counterparty which are named in another money.

 

A swap bank is a nonexclusive
term to portray a money related establishment that encourages the swap between
counterparties. The swap bank fills in as either an agent or a merchant. When
filling in as a facilitate, the swap bank matches counterparties, however does
not accept any danger of the swap. When filling in as a merchant, the swap bank
stands willing to acknowledge either side of a cash swap.

 

In a case of an essential loan
cost swap, it was noticed that a fundamental condition for a swap to be
attainable was the presence of a quality spread differential between the
default-chance premiums on the fixed-rate and floating-rate financing costs of
the two counterparties. Furthermore, it was noticed that there was not a trade
of important aggregates between the counterparties to a loan cost swap in light
of the fact that both obligation issues were named in a similar money. Loan fee
trades depended on a notional main. After beginning the estimation of a loan
fee swap to a counterparty ought to be the distinction in the present estimations
of the installment streams the counterparty will get and pay on the notional
primary.

 

In a point by point case of an
essential cash swap it was demonstrated that the obligation benefit commitments
of the counterparties in a money swap are viably proportional to each other in
cost. Ostensible contrasts can be clarified by the arrangement of worldwide
equality connections.

 

After beginning, the estimation
of a cash swap to a counterparty ought to be the distinction in the present
estimations of the installment stream the counterparty will get in one money
and pay in the other cash, changed over to either cash group.

 

Notwithstanding the fundamental
fixed-for-floating loan fee swap and fixed-for-fixed cash swap, numerous
different variations exist. One variation is the amortizing swap, which
consolidates an amortization of the notional standards. Another variation is a
zero-coupon-for-floating rate swap in which the floating-rate payer influences
the standard intermittent floating-to rate payments over the life of the swap,
however the fixed-rate payer makes a solitary installment toward the finish of
the 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 recurrence
of a similar file.

 

Explanations behind the
advancement and development of the swap market ought to be fundamentally
analyzed. We contend that one must depend on a contention of market culmination
for the presence and development of financing cost swaps. That is, the loan fee
swap advertise helps with fitting financing to the sort wanted by a specific
borrower when a wide range of obligation instruments are not consistently
accessible to all borrowers

How
many types of swaps?

 

The following types of
swap are:

1.     
Basis Rate

A basis
swap is an interest rate swap which involves the exchange of two
floating rate financial instruments. A basis swap functions as a
floating-floating interest rate swap under which the
floating rate payments are referenced to different bases

2.     
Bond Swap

In simple terms, a
bond swap is when an investor chooses to sell one bond and subsequently
purchase another bond with the proceeds from the sale in order to take
advantage of the current market environment. Investors may choose to swap a
bond for a wide variety of reasons

3.     
Commodity Swap

A commodity
swap is a type of swap agreement whereby a floating (or market
or spot) price based on an underlying commodity is traded for a fixed
price over a specified period. A Commodity swap is similar to a Fixed-Floating
Interest rate swap.

4.     
Credit Default Swap

A financial contract
whereby a buyer of corporate or sovereign debt in the form of bonds attempts to
eliminate possible loss arising from default by the issuer of the bonds. This
is achieved by the issuer of the bonds insuring the buyer’s potential losses as
part of the agreement.

5.     
Volatility Swap

A volatility swap is a forward
contract on future realized price volatility. Similarly, a
variance swap is a forward contract on future realized price
variance, variance being the square of volatility. In both cases, at
inception of the trade, the strike is usually chosen such that the fair value
of the swap is zero.

6.     
Forex Swap 

A forex
swap is the interest rate differential between the two currencies of the
pair you are trading, and it is calculated according to whether your position
is long or short. The FxPro Swap Calculator can be used to determine
what your swap fee will be for holding a trade open overnight.

7.     
Interest rate swap

Interest rate swap is
a contact or agreement between two parties wherein one set of fixed future cash
flows of interest payments is exchanged for another set of floating future cash
flows of interest payments based on usually a same principal amount. The
payment is not of principal amount but of the interest amount that is exchanged
in order to hedge the risk of fluctuating interest rates or can be described as
swapping of fluctuating interest rates and floating interest rates.

8.     
Currency swap

Currency swaps is a contract or
agreement between two parties wherein one party exchanges the principal and
interest in one currency with principal and interest in another currency held
by another party. They are also done to hedge risk of changing interest rates
and risk of fluctuation in foreign exchange rates.

 

9.     
Cross currency swap

A cross currency swap is an over
the counter derivative in a form of an agreement between two parties to
exchange interest payments and principals on loans denominated in two different
currencies.