IndexEconomic rationale for swapHow would you define currency swap?Mechanics of currency swapRole of credit ratings in SWAPAnalyze a swap between two companiesGain from SWAP between partiesFlexibilityExposurePriceWhy investors use fixed and floating rates in defining up on currency SWAP? What are the differences and similarities between FX and interest rate SWAP? How many types of swaps? A swap is an agreement between two counterparties to exchange two cash flows the parties the cash flows The purpose of the swap is to change the character of an asset or liability without liquidation The issuer of the swap can contract to pay a floating rate and receive a fixed rate, or vice versa. Swap trading as we know it today is a fairly recent phenomenon. The swap market originates from a swap agreement negotiated in Britain in the 1970s to circumvent exchange controls implemented by the British government. The first swaps were variations of currency swaps. The British government had a policy of taxing foreign currency transactions involving the British pound. This made it more difficult for capital to leave the country, thus increasing domestic investment. Say no to plagiarism. Get a tailor-made essay on "Why Violent Video Games Shouldn't Be Banned"? Get an original essay Then in 1981 a major swap agreement between Salomon Brothers on behalf of the World Bank and IBM involving an exchange of cash flows denominated in Swiss francs and German marks brought prestige to the swap market. Why are swaps so popular? What is their economic logic? Swaps are contractual arrangements to exchange or exchange a series of cash flows. The ashes that follow are most commonly the interest payments associated with debt service. If the agreement involves one party exchanging its fixed interest rate payments for the variable interest rate payments of another, it is called an interest rate swap. If the agreement is to exchange bond currencies for debt service, it is called a currency swap. A single swap can combine elements of both interest rate and currency swaps. Economic Rationale for the Swap When favorable actions are less likely, the exposed firm chooses to issue long-term debt and uses a variable/fixed interest rate swap to take advantage of falling interest rates. These findings 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 an exchange agreement between two institutions to exchange aspects of a loan in one currency for equivalent aspects of a loan of equal net present value in another currency. Mechanics of Currency SwapSwap agreement is a contract in which one party borrows one currency from the second party and simultaneously lends another to the second party. Each party uses the repayment obligation to its counterparty as collateral, and the repayment amount is set at the forward rate at the inception of the contract. Role of Credit Ratings in SWAP Turning to a credit rating agency is a good option for small and medium-sized businesses given the problem they face in seeking financing. Rating agencies evaluate a company's financial sustainability and ability to honor commercial obligations, provide insight into sales, operational and financial composition, thereby assessing the element of risk and highlighting the overall health of the company , they also evaluate their operations within the industry and also plays avital role in two counterparties of SWAP contracts. Analyzing a Swap Between Two Companies Interest rate swaps can protect companies from interest rate exposure. If a company makes variable interest rate payments on its liability, it may enter into a swap agreement with another company or financial institution to protect itself from the risk of interest rate fluctuations. In this scenario, the company should create a second exchange that will make fixed interest rate payments to its counterparty, while receiving variable interest rate payments in return. It can help companies leverage their comparative advantage in obtaining a liability. By using swaps, companies can leverage their comparative advantage in short- or long-term lending and save money on interest payments. Imagine companies A and B. Company A is a AAA-rated company and can get a long-term loan with 5% interest and a short-term loan with LIBOR+0.5% interest. Company B is a BBB rate company and can lend long term with 8% interest and short term loans with LIBOR+1% Obviously Company A has an absolute advantage in obtaining loans over company B because in both cases they can get a loan and pay lower interest rates. However, after calculating quality spreads, we can tell which companies demonstrate comparative advantage; therefore, Company A should borrow long-term, while Company B should borrow short-term. Therefore, if Company A needs a short-term loan and Company B needs a long-term loan, it can obtain loans where it has a comparative advantage. advantage and create an exchange between them. The structure of the swap could be as follows: Profit from the SWAP between the 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 long term loan. term loan, instead of 8%. Where do the profits from SWAPs come from? Find three reasons? A currency SWAP allows the two counterparties to SWAP the interest rate on loans in different currencies. However, the gains from SWAP arise from the following reasons. Flexibility Unlike the interest rate SWAP, which allows companies to focus on their comparative advantage in borrowing in the single currency in the short-term maturity range, the currency SWAP gives companies the extra flexibility to exploit their comparative advantage in their respective lending markets. They also offer the ability to leverage advantage across a network of currencies and maturity. The success of the currency swap market and the success of the Eurobond market are explicitly linked. Exposure Currency swaps generate greater credit exposure than interest rate swaps due to the exchange and re-exchange of notional principal amounts. Companies must find the funds to deliver the nominal value at the end of the contract and are obliged to exchange the nominal value of one currency for another 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 amplified by increasing volatility over time. The longer the contract, the more room there is for the currency to move to one side or the other of the contractually agreed main exchange rate. This explains why currency swaps tie up larger lines of credit than regular interest rate swaps. Pricing Currency swaps are priced or valued in the same wayof interest rate swaps using a discounted cash flow analysis having obtained the zero coupon version of the SWAP curves. Generally, a currency swap is carried out at the outset with no net value. Over the life of the instrument, the currency swap can become “in-the-money”, “out-of-the-money” or remain “at-the-money”. Why do investors use fixed and variable rates when setting up currency SWAPs? Investors use fixed and floating rate swaps to convert financial exposure, to gain comparative advantage, to speculate on currency interest rates. Suppose a risk-seeking investor expects the interest rate to rise and wants to lock in the fixed rate available to him. He then chooses a swap contract that provides him with a fixed interest rate. A risk-averse investor expects interest rates to fall and wants variable rate loans. He then chooses a swap that provides him with a variable interest rate. What are the differences and similarities between FX and Interest Rate SWAP? Interest Rate Swaps The most common type of interest rate swap is one in which Party A agrees to make payments to Party B based on a fixed interest rate, and Party B agrees to make payments to Party A based on of a variable interest rate. And currency swaps are similar to an interest rate swap, except that in a currency swap there is an exchange of principal, whereas in an interest rate swap, the principal does not change hands. Instead, on the trade date, the counterparties exchange notional amounts in the two currencies: this is a contract or agreement between two parties where one party exchanges principal and interest in one currency for principal and interest in another currency held elsewhere. They are also carried out to hedge the risk of changes in interest rates and the risk of fluctuations in exchange rates. A basic interest rate swap is a fixed-rate swap in which one counterparty exchanges the interest payments of a fixed-rate debt obligation for the variable interest payments of the other counterparty. Both debt obligations are denominated in the same currency. In a currency swap, one counterparty exchanges the debt service obligations of a bond denominated in one currency for the debt service obligations of the other counterparty denominated in another currency. A swap bank is a generic term to describe a financial institution that facilitates swapping between counterparties. The swap bank acts as a broker or dealer. When acting as a broker, the swap bank matches counterparties but does not assume any swap risk. When acting as an intermediary, the swap bank is willing to accept both sides of a currency swap. In an example of a basic interest rate swap, it was noted that a necessary condition for a swap to be viable was the existence of a quality spread differential between the default risk premiums on fixed rate and floating rate interest rates of the two counterparties. Furthermore, it was noted that there was no exchange of principal amounts between the counterparties to an interest rate swap because both debt issues were denominated in the same currency. Interest rate trades were based on a notional principal. After inception, the value of an interest rate swap to a counterparty should be the difference between the present values ​​of the payment streams that the counterparty will receive and pay on the notional principal. In a detailed example of a base currency swap, it has been demonstrated that the debt service obligations of the counterparties in a currency swap are effectively equivalent to each other in terms.