Question

SWAPS Agreement between two parties. Give an example and your opinion as to an advantage and a disadvantage of each of the following Swaps to a company and why? Provide an example and discuss the importance of the following three SWAPS. Be specific.

1. Interest rate Swaps

2. Currency SWAPS

3. Credit Swaps

Answer 1

Type of Swap	Brief meaning	Real world Example	Advantage	Disadvantage
Interest rate swap	An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap.	Suppose that PepsiCo needs to raise $75 million to acquire a competitor. In the U.S., they may be able to borrow the money with a 3.5% interest rate, but outside of the U.S., they may be able to borrow at just 3.2%. The catch is that they would need to issue the bond in a foreign currency, which is subject to fluctuation based on the home country's interest rates.	1. No upfront payment- In option and future there are upfront payment required but in swap no upfront payment. 2. When a company want to obtain a fixed rate borrowing, but due to credit rating or any other reason company is unable to access the market then, due to interest swap arrangement floating rate can be converted into a fixed amount of interest. 3. Reduction in borrowing cost- As borrowing cost in market depends upon credit rating of the borrower and this borrowing cost also depends upon interest rate basis. So company may choose a basis advantageous to them with reference to borrowing cost and thereafter they may convert the basis through interest rate swap arrangement. 4. It helps to manage the fixed and floating interest rate mix in a debt mix. If interest rate expected to rise company may convert it variable basis to fixed interest rate basis and if rates are expected to fall fixed basis may converted into variable. Therefore this arrangement provide flexibility and it can be used to reduce the exposure arise due to change in interest rate.	1. Interest rate swaps involves default risk . 2. Market risk is also present if interest rate moves against the expectation of counterparties.
Currency swaps	In this arrangement principal and interest in payment in one currency exchanged for principal and interest payment in another currency. A specific principal requires for each of the currency in agreement. The principal amounts are usually exchanged at the beginning and end of the life of the swap.	For example, a US company, General Electric, is looking to acquire Japanese yen and a Japanese company, Hitachi, is looking to acquire U.S. dollars (USD), these two companies could perform a swap. The Japanese company likely has better access to Japanese debt markets and could get more favorable terms on a yen loan than if the U.S. company went in directly to the Japanese debt market itself, and vice versa in the United States for the Japanese company. Assume General Electric needs ¥100 million. The Japanese company needs $1.1 million. If they agree to exchange this amount, that implies a USD/JPY exchange rate of 90.9. General Electric will pay 1% on the ¥100 million loan, and the rate will be floating. This means if interest rates rise or fall, so will their interest payments. Hitachi agrees to pay 3.5% on their $1.1 million loan. This rate will also be floating. The parties could also agree to keep the interest rates fixed if they so desire. They agree to use the 3-month LIBOR rates as their interest rate benchmarks. Interest payments will be made quarterly. The notional amounts will be repaid in 10 years at the same exchange rate they locked the currency-swap in at. The difference in interest rates is due to the economic conditions in each country. In this example, at the time the cross-currency swap is instituted the interest rates in Japan are about 2.5% lower than in the U.S.. On the trade date, the two companies will exchange or swap the notional loan amounts. Over the next 10 years, each party will pay the other interest. For example, General Electric will pay 1% on ¥100 million quarterly, assuming interest rates stay the same. That equates equate to ¥1 million per year or ¥250,000 per quarter. At the end of the agreement, they will swap back the currencies at the same exchange rate. They are not exposed to exchange rate risk, but they do face opportunity costs or gains. For example, if the USD/JPY exchange rate increases to 100 shortly after the two companies lock into the cross-currency swap. The USD has increased in value, while the yen has decreased in value. Had General Electric waited a bit longer, they could have secured the ¥100 million while only exchanging $1.0 million instead of $1.1 million. That said, companies don't typically use these agreements to speculate, they use them to lock in exchange rates for set periods of time.	It helps to leverage comparative advantage of borrowing in different countries. For example a domestic company might be able to borrow on more favourable terms than a foreign company in a particular country.	1. Default risk is present in currency swap 2.The potential exposure is very high due to exchange and re-exchange in different currencies. 3.As period of agreement increase , volatility will also increase.
Credit swaps	A credit default swap is a financial derivative that guarantees against bond risk. Swaps work like insurance policies. They allow purchasers to buy protection against an unlikely but devastating event. Like an insurance policy, the buyer makes periodic payments to the seller. The payment is quarterly rather than monthly. Most of these swaps protect against default of high-risk municipal bonds, sovereign debt, and corporate debt. Investors also use them to protect against the credit risk of mortgage-backed securities, junk bonds, and collateralized debt obligations.	Credit swaps were widely used during the European Sovereign Debt crisis. In September 2011, Greece government bonds had a 94% probability of default. Investors holding Greek bonds could have paid $5.7 million upfront and $100,000 each year for a credit default swap (CDS) to insure $10 million worth of bonds for five years. Many hedge funds even used CDS as a way to speculate on the likelihood that the country would default.	Swaps protect lenders against credit risk. That enables bond buyers to fund riskier ventures than they might otherwise. Investments in risky ventures spur innovation and creativity, which boost economic growth. This is how Silicon Valley became America's innovative advantage. Companies that sell swaps protect themselves with diversification. If a company or even an entire industry defaults, they have the fees from other successful swaps to make up the difference. If done this way, swaps provide a steady stream of payments with little downside risk.	Swaps were unregulated until 2009. That meant there was no government agency to make sure the seller of the swap had the money to pay the holder if the bond defaulted. In fact, most financial institutions that sold swaps were undercapitalized. They only held a small percentage of what they needed to pay the insurance. The system worked until the debtors defaulted. Unfortunately, the swaps gave a false sense of security to bond purchasers. They bought riskier and riskier debt. They thought the CDS protected them from any losses.