Question

what is differentiate currency & Interest Rate Swaps?

Answer 1

An interest rate swap is a financial derivative contract in which two parties agree to exchange their interest payments. It generally involves exchange of pre specified amounts with fixed and floating rates as agreed on original contracts.

For example, assume bank XYZ owns a $5 million investment, which pays the LIBOR, plus 3% every month. It is considered a floating payment because as the LIBOR fluctuates, so does the cash flow. On the other hand, assume bank ABC owns a $5 million investment, which pays a fixed rate of 5% every month. However, bank XYZ suddenly decides that it would rather receive a fixed monthly payment. On the other hand, bank ABC also decides to take a chance on floating payments. Therefore, the two banks agree to enter into an interest rate swap contract. Bank XYZ agrees to pay bank ABC the LIBOR plus 3% per month on the amount of $5 million. Bank ABC agrees to pay bank XYZ a fixed 5% monthly rate on the amount of $5 million.

A currency swap is an agreement to exchange cash flows in one currency to another. Thus it is a foreign exchange agreement involving two currencies contrary to interest rate swap which just involves one currency.

For example, assume bank XYZ operates in the United States and deals only with U.S. dollars, while bank QRS operates in India and deals only with Indian rupees. Suppose bank QRS has investments in the United States worth $10 million. Assume the two banks agree to enter into a currency swap. Bank XYZ agrees to pay bank QRS, LIBOR plus 1% per month on an amount of $10 million. Bank QRS agrees to pay bank XYZ a fixed 3% monthly rate on the amount of 607,400,000 rupees, assuming $1 is equal to 60.74 rupees.