Question

Question 8
What are Swaps? Which are the main types of swaps involved in project finance?

Answer 1

• Swaps are basically a derivative, a derivative is a product whose value is derived from the value of one or more basic variables,called underlying. The underlying asset can be equity,index,foreign exchange,commodity or any other asset.
• Swaps are the private arrangements between two parties to exchange cash flows in the future.They can be regarded as portfolios of forward contracts.
• Swaps is an agreement to exchange one stream of cash flows for another. Swaps are most usually used to:

1. Switch financing in one country for financing in another
2. To replace a floating interest rate swap with a fixed interest rate (or vice versa)

• Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.If firms in separate countries have comparative advantages on interest rates,then a swap could benefit both firms.
• There are various types of swaps which are been mentioned below:

1. Currency swaps- These entail swapping both principal and interest between the parties,with the cash flows in one direction being in a different currency than those in a opposite direction.Cross currency swaps are arrangements between counter parties to exchange interest and principal payments in different currencies. in a currency swap, these streams of cash flows consist of a stream of interest and principal payments in one currency exchanged for a stream,of interest and principal payments of the same maturity in another currency.
2. Credit default swap- It is a financial instrument for swapping the risk of debt default. credit default swaps may be used for emerging market bonds,mortgage backed securities,corporate bonds and local government bond. The buyer of a credit default swap pays a premium for effectively insuring against a debt default. he receives a lumpsum payment if the debt instrument is defaulted. The seller of a credit default swap receives a monthly payments from the buyer.If the debt instruments default they have to pay the agreed amount to the buyer of the credit default swap.
3. Commodity swap- A commodity swap is an arrangement whereby a floating price is exchanged for a fixed price over a specific period. A swap where exchanged cash flows are dependent on the price of an underlying commodity. This swap is usually used to hedge against a price of a commodity. Commodities are physical assets such as precious metals, base metals,energy stores and food.
4. Equity swap- It is a special type of total return swap,where an underlying asset is a stock, a basket of stocks, or a stock index. An exchange of the potential appreciation of equity's value and dividends for a guaranteed return plus any decrease in the value of an equity.An equity swap permits an equity holder a guaranteed return but demands the holder give up all rights to appreciation and dividend income.Equity swaps make the index trading strategy even easier. Besides diversification and tax benefits,equity swaps also allow large institutions to hedge specific assets or positions in their portfolios.
5. Interest rate swap- It is an arrangement between 2 parties to exchange a sequence of interest payments without exchanging a underlying debt. in a typical fixed/floating rate swap, the first party promises to pay to the second at designated intervals a stipulated amount of interest on the notional principle calculated according to a floating rate index.These are essentially a strip of forward contracts exchanging interest payments. Thus,interest swap rate offer a mechanism for restructuring cash flow and,if properly used,provide a financial instrument for hedging against interest rate risk.