Question

Define swap. Differentiate the different types of swaps. Know how to choose swaps to hedge interest rate risk.

Answer 1

SWAP - A swap is basically an agreement between two parties to exchange a financial instruments, cashflows or payments for a certain time. The instruments can be anything but most swaps involve cash based on a notional principal amount.

TYPES OF SWAPS-

Interest Rate Swaps

Interest rate swaps are the most popular types of swaps. They allow two parties to exchange fixed and floating cash flows on an interest-bearing investment or loan.

Currency Swaps

Currency swaps offer efficient ways to hedge forex risk. The value of capital that changes hands in currency markets exceeds all other markets.

Commodity Swaps

Commodity swaps are commonly used by individuals or companies that use raw materials to produce goods. Profit from a finished product may suffer if commodity prices vary, as output prices may not change in sync with commodity prices.

Credit Default Swaps

A credit default swap offers insurance in case of default by a third-party borrower.

HOW TO USE SWAPS TO HEDGE INTEREST RATE RISKS-

Interest rate swaps allows a companies to exchange interest payments on an agreed amount for an agreed period of time. Interest rate swaps allow both counterparties to gain from the interest payment exchange by getting better borrowing rates than they are offered by a bank.

These are arranged by a financial intermediary, so the counterparties never meet. The obligation to meet the interest payments remains with the original borrower if a counterparty defaults, but this counterparty risk is reduced or eliminated if a financial intermediary arranges the swap.

Most common type of swap is fixed interest payments being exchanged for variable interest payments on the same notional amount. This is known as a plain vanilla swap.

Interest rate swaps allow companies to hedge over a long period of time than other interest rate derivatives. However, they do not allow companies to benefit from favourable movements in interest rates.

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