This article is authored by Fousteena George, Assistant Professor

1. Introduction

Swaps originated from the barter system which was followed in the ancient times to exchange goods. Since there was no common unit of money the parties used to exchange goods to one another to fulfill the contract. Basically swap refers to exchange.

Financial Swaps are asset-liability management techniques. It involves exchange of cash flows between two parties. Swap is a derivative contract which is used to hedge various risks including interest rate risk and currency risk. Swaps are defined as “private agreement between two companies to exchange cash flows in future according to a predetermined formula”. These agreements are done either between parties or by counterparties or intermediaries like bank. The swaps are not traded through organized exchanges.

There are different types of swaps among them the most common types of financial swaps are currency swaps and interest swaps also known as coupon swaps. Interest rate swaps are used to hedge interest rate risk while currency swaps are used to hedge exchange rate risk. It allows the parties to exchange fixed and floating cash flows.

2. Types of swaps

These are the most commonly used swaps by corporates to hedge and minimize risk,

  1. Interest rate swaps
  2. Currency swaps

2.1 Interest Rate swaps:

Under Interest rate swap a party who has fixed interest loan exchanges this with a party who has floating interest rate or vice versa.

For example:
Borrower A has taken a fixed interest loan from lender X. Now borrower A has to make interest payment in fixed rates. if A want to converts fixed interest loan to floating then he can enter into an interest rate swap agreement with an intermediary to receive the floating rate interest from the intermediary and get fixed interest in return of the floating rate interest.

The interest received by borrower A at fixed rate from intermediary would be passed on to the lender X. this is known as fixed to floating interest rate swap, also known as plain vanilla coupon swap.

Most of the times companies with the need for swapping a fixed rate liability for a floating rate may not easily find another company with same coincident need.

Under such circumstances financial institution such as banks are prepared to enter into contract with such companies. The intermediary in turn would enter into contract with other parties to reverse the risk arising from first swap deal. This can be explained with an example: Here,

Co. A borrower
Co. X lender
Bank
Co. B borrower
Co. Y lender
Co. A borrowed from lender

Co. A has borrowed from lender X on fixed interest rate. The co. x wants to convert it into floating exchange rate liability and approaches the bank for swap deal. The bank agrees to receive floating interest rate from co. A, in exchange of fixed interest rate to co. A. At the same time co. B has borrowed from lender y at floating interest rate PLR and wants to have fixed interest rate approaches bank for a swap deal. Bank agree for the exchange. Now bank has entered into two swap deals with both the deals in opposite direction, which helps them offsetting its commitment to co. A with payment to be received from co. B.

Once this contract is done the relation between co. A and lender co. y is unaffected. Principle amount is calculation of cash flow exchanged between the parties. The floating rate in swap agreement are PLR (Prime Lending Rate), Treasury bill rate, LIBOR (London Inter-Bank Offer Rate), MIBOR (Mumbai Interbank Offer Rate).

2.1.1 Motivation for coupon swap

It is important to understand the motivation or reason behind the parties entering into interest rate swaps or coupon swaps. Some of the possible reasons are as follows:

Reduce interest rates
The companies which borrows from banks have different creditworthiness which gives them differential access to loan from the bank. Some companies might have comparative advantage in fixed interest rate markets which helps them borrow at a lower interest rate in fixed interest market. Whereas other companies might have comparative advantage in floating interest market where they can get the loan at lower interest rates.

However, a company which have comparative advantage in floating interest market may want fixed interest and vice versa. Under such situations it can enter in swap deals which help in exchanging the comparative advantages with each other. Swapping may be done at a rate lower than prevailing market rates.

2.2 Currency swap

A currency swap facilitates conversion of loan in one currency into another currency. Currency swaps are specifically used in situations where the company has a liability denominated in one currency and an income denominated in another currency.

2.2.1 Motivations of currency swap

It is important to understand the motivation or reason behind the parties entering into interest rate swaps or coupon swaps. Some of the possible reasons are as follows:

Avoid foreign exchange risk
A company is expose to foreign exchange risk when it receives income denominated in one currency and has liability denominated in another currency. Whenever the company pays interest on its liability it will have to convert currency in accordance with the currency in which the liability is denoted.

For Example, an Indian co. has a loan from Japanese co. therefore the liability of Indian company is in Japanese yen. Meanwhile the Indian co. exports its goods and services to US and receives its income in USD. Here whenever interest payments has to be made it has to convert USD to yen and the Indian co. is exposed to foreign exchange risk. There is a possibility that USD may weaken against the Japanese yen in future. Likewise firm will incur loss while converting USD into Japanese yen.

This situation can be avoided my converting the liability of Japanese into USD. Through currency swaps.

In the example when the Indian co receives loan to meet its requirement in yen it can exchange the yen with a bank for equal amount of USD in accordance with the swap agreement. The intermediary bank would pay interest on the deposit to the Indian co in Japanese yen and Indian co would be now in a position to meet its obligation in Japanese yen

with the interest received from bank in Japanese yen. Indian co will use the income received from export in USD to pay the interest payment to the bank.

On maturity of the loan, hey would re-exchange the principle amount in two currencies. This will enable the Indian co to repay the Japanese co in Japanese yen. The Indian firm also exchanges the USD equivalent to Japanese yen received from bank.

The bank also enters into a currency swap agreement with another party to offset its commitment with the Indian co.

Reduce borrowing cost

Currency swaps can also be used to reduce borrowing cost of foreign currency loans. When a company has comparative advantage to borrow in one currency market and another company has a comparative advantage in another currency market, each company will borrow from those market which it has comparative advantage and engages in swapping. The important advantage of this currency swapping is that each company is able to obtain the loan at reduced borrowing cost.

The interest payments in two currencies in currency swaps have different interest rates. The counterparties may agree to exchange interest payments at respective rates throughout loan period, thereby getting fixed rate liability swap. This is known as fixed to fixed currency swap.

The swap in which interest rate payment in one currency may be calculated at fixed interest rate and interest payment in other currency maybe calculated at floating interest rate. Such a swap is known as fixed to floating currency swaps. It is a combination of currency swap and interest rate swap it is also known as cross currency coupon swap.

CONCLUSION

Thus, Most financial swaps involve the exchange of cash flows related to a notion amount such as a loan or a bond and can be done on basically any instrument. The principals, however, do not change hands. Each swap consists of two legs, which is the reference instrument of the trade where each party has one leg. One cash flow is usually fixed, while the other is variable depending on the benchmark interest rate. Unlike most financial trades, swap meaning trade is based on an over-the-counter agreement and is tailored according to the stipulations of the clients.