Swap are similar to future and forward contracts in providing hedge against financial risk. A swap is an agreement between two parties called counter parties to trade cash flows cash flows over a period of time. Swaps arrangements are quite flexible and are useful in many financial situation.
Two most popular swap and interest rate swap. These two swaps can be combined when interest on loan in two currencies are swapped. The interest rate and currency swap market enable firms to arbitrage the differences between capital markets.
Currency swap involves an exchange of cash payments in one currency for cash payments in another currency. Most international companies require foreign currency for making investment abroad.
These firm find difficulties in entering new market and raising capital at convenient terms.Currency swap is an easy alternative for these companies to overcome this problem.
Use of currency swap to transform loan and assets.
A swap such as the one considered can be used to transform borrowing in one currency to borrowing in another.
For example IBM an issue $15 million of U.S. dollar denominated bonds at 8% interest. It has the effect of transforming this transaction into one where IBM has borrowed £10 million pounds at 11% interest.
It has the effect of transforming this transaction into one where IBM has borrowed £10 million pounds at 11%.The initial exchange of principal converts the proceeds of the bond issue from U.S. dollar to sterling.
It can also be used to transform the nature of assets. Suppose that IBM can invest £10 million pounds in the UK to yield 11% per annum for the next the five years. But feels that the U.S. dollar will strengthen against sterling and prefers a U.S. dollar will strengthen against sterling and prefer a U.S. denominated investment.
Valuation of currency swaps
In the absence of default risk. A currency swap can be decomposed into a position in two bonds. As is the case with an interest rate swap.It is short GBP bonds that pays interest at 11% per annum and long a USD bond that pays interest at 8% per annum.
In general, if we define as the value in U.S.dollar of a swap where dollar are received and a foreign currency is paid them.
= U.S. dollar
= spot exchange
Interest rate swap
The interest rate swap allows a company to borrow capital at fixed (or floating rate) and exchange its interest payments at floating rate or fixed rate. This is the most common type of swap is a plain vanilla interest swap. In this a company agree to pay cash flows equal to interest at a predetermined fixed rate.
On a notional principal for a number of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time.
The floating rate in many interest rate swap agreement is the London interbank offer rate(LIBOR). LIBOR is the rate offered on one-month deposit.
LIBOR rates are determined by trading between bank and change frequently so that the supply of the reference rate of interest for floating rate loans in the domestic financial market. LIBOR rates are determined by trading between banks and change frequently so that the supply of the reference rate of the interest for loans in international financial markets.
To understand how it is used consider a five year loan with a rate of interest specified as six-month LIBOR plus 0.5% per annum.
The life of the loan is divided into ten periods. Each six months in length. For each periods the rate of interest is set 0.5% per annum above the six month LIBOR rate at the beginning of the period interest is paid at the end of the period.
Valuation of interest rate swaps
An interest rate swap is worth zero or close to zero, when it is first initiated. After it has been in existence for sometime its value may become positive or negative.
To calculate the value we can regard the swap either as a long position in one bond combined with a short position in another bond or as a portfolio of forward rate agreements.
Valuation in terms of bond prices.