Home            

Resume         

White Papers

Presentations

A Swap is an agreement between two parties, called Counterparties, who exchange cash flows over a period of time in the future. When exchange rate and Interest rates fluctuate, risks of forward and money market positions are so great that the forward market & money market may not function properly. Currency futures and options are inflexible and available only for selected currencies. In such cases, MNC’s & governments may use swap arrangements to protect the value of export sales, import orders and outstanding loans dominated in foreign currencies.

There are three basic motivations for swaps:

Firms use swaps to provide protection against future changes in exchange rates and interest rates.

Firms use swaps to eliminate interest-rate risks arising from normal commercial operations

Firms use swaps to reduce financing costs

Financial swaps are now used by Multinational companies, commercial banks, world organizations and sovereign governments to minimize currency and interest-rate risks. Thus swaps have become another risk management tool along with currency forwards, futures and options.

The origins of swap market can be traced back to 1970’s when traders developed currency swaps to evade British controls on movement of foreign currency. The market has grown rapidly ever since and in year 2002 about $44 trillion was traded via swaps

A Parallel Loan refers to a loan which involves an exchange of currencies between 4 parties, with a promise to re-exchange the currencies at a predetermined exchange rate on a specified future date. Typically, the parties consists of two pairs of affiliated companies. Parallel loans are commonly arranged by two multinational parent companies in two different countries.

The structure of a typical parallel loan is illustrated in the following example.

IBM in USA with a subsidiary in Italy wants to obtain a one year Lira loan for its subsidiary.

Olivetti in Italy wishes to invest in US via a loan to its US subsidiary. With a Parallel loan, these loans can be arranged without currency crossing the national border. IBM lends $10M to Olivetti’s US subsidiary at US interest rates. Olivetti in return lends $10M in Lira to IBM’s Italian subsidiary.

Back-to-Back Loans

Bank to Back loan involves an exchange of currencies between two parties, with a promise to re-exchange the currencies at a specified rate on a specified future date. Back to back loans involve two companies domiciled in two different countries. For example, IBM borrows money in US dollars and lends the borrowed funds to Olivetti in Italy, which in return borrows funds in Italy and lends those funds to IBM in the United states. By this simple arrangement, each firm has access to capital markets in foreign country and make use of their comparative advantage of borrowing in different capital markets.

The difficulty in finding counterparties with matching needs. Firms must find firms with mirror-image financing needs. Financing requirements include principals, types of interest payments, frequency of interest payments, and length of the loan period. The search cost for finding such a counterparty is quite considerable.

One is still obligated to comply with the loan terms even when the other defaults. In the above example, IBM is still liable for the loan even if Olivetti defaults. To avoid default risks, a separate agreement defining the right of offset must be drafted.

The loans are carried on the accounting books of both the firms. This limits additional borrowing and hence limits the leverage of these firms.

 

Swaps on the other hand overcome the above drawbacks by:

Making it easier to find counterparties via swap brokers.

Defining an offset agreement as a part of the swap.

Principal amounts in a swap do not appear on the accounting books. These off book transactions help banks avoid increases in their capital requirements under applicable regulations

As a result, Swaps are very popular financial instruments. In 2000, the size of world swap market was greater than $25 billion

Financial institutions which assist in the completion of a swap is called "Swap Bank". The swap bank makes profits from the bid-ask spread it imposes on the swap coupon. A Swap broker is a swap bank who acts strictly as an agent without taking any financial position in the swap transaction, i.e., mearly matches counterparties and does not assume any risk of a swap. A Swap Dealer is a swap bank who actually transacts for its own account to help complete the swap. In this capacity, the swap dealer assumes a position in the swap and thus assumes certain risks.

Plain Vanilla Swaps

Its the simplest kind of swaps. Here two counterparties agree to make payments to each other on the basis of some underlying assets. These payments include interest payments, commissions and other service payments. The swap agreement contains specifications of the assets to be exchanged, the rate of interest applicable to each, the timetable by which the payments are to be made and other provisions.

The two parties may or may not exchange the underlying assets, which are called Notional Principals, in order to distinguish them from physical exchanges in the cash markets.

Interest Rate Swaps

An interest rate swap is a swap in which counterparties exchange cash flows of a floating rate for cash flows of a fixed rate or vice-versa. No notional principal changes hands, but it is a reference amount against which interest is calculated. Interest swaps can be international or purely domestic.

The most common motive for Interest rate swaps are:

Changes in financial markets may cause interest rates to change

Borrowers may have different credit ratings in different countries

Borrowers have different preferences for debt service payment schedule

Interest rate swaps are normally arranged by an international bank which serves as a swap broker or a swap dealer. Through interest rate swaps, borrowers obtain a lower cost of debt service payments and lenders obtain profit guarantees.

Currency Swaps

A Currency swap is a swap in which one party provides a certain principal in one currency to its counterparty in exchange for an equivalent amount in a different currency. For example, An US firm wants to exchange its Dollars for Italian Lira while an Italian firm want to exchange Lira to US dollars. Given these two needs, the two may engage in a swap deal.

Currency swap is similar to parallel loans, but swaps are better due to:

Ease of finding counterparties

The right to offset the loan payments

Off books transactions.

Swaptions, caps, floor and collars

A swaption is an option to enter into a plain vanilla swap. A Call swaption gives the holder the right to receive fixed-interst payments. A put swaption gives the holder the right to make fixed interest payments. Call swaptions are attractive when interest rates are expected to fall. Put swaptions are attractive when interest rates are expected to rise. Banks & investment firms usually act as dealers rather than as brokers.

An interest rate cap sets the maximum rate of interest on a floating rate interest payments; An interest rate floor set the minimum rate of interest on a floating rate interest payments; and an interest rate collar combines a cap with a floor.

A buyer of these instruments pays a one time premium, which is a small percentage of the notional capital.

There are three basic motivations for swaps. First, companies use swaps to provide protection against future changes in exchange rates. Second, Companies use swaps to eliminate interest rate risks arising from normal commercial operations. Third, companies use swaps to reduce financing costs.

Swap market has emerged largely because financial swaps escape many of the limitations inherent in currency futures and options markets. Swaps are custom tailored to the needs of two parties, swap agreements are more likely to meet the specific needs of the counterparties than currency futures and options. Swap market is done via financial institutions and offers privacy when compared to foreign exchange markets. Lastly swaps are not as highly regulated as options and futures markets.

Home  Resume White Papers  Presentations