Question

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

INTEREST RATE SWAP

An interest rate swap is a contract between two parties to exchange all future interest rate payments forthcoming from a bond or loan. It's between corporations, banks, or investors. Swaps are derivative contracts. The value of the swap is derived from the underlying value of the two streams of interest payments.

Swaps are like exchanging the value of the bonds without going through the legalities of buying and selling actual bonds. Most swaps are based on bonds that have adjustable-rate interest payments that change over time. Swaps allow investors to offset the risk of changes in future interest rates.

Advantages

The adjustable-rate payment is tied to the Libor, which is the interest rate banks charge each other for short-term loans. Libor is based on the fed funds rate. The receiver may have a bond with low interest rates that are barely above Libor. But it may prefer the predictability of fixed payments even if they are slightly higher. Fixed rates allow the receiver to forecast its earnings more accurately. This elimination of risk will often boost its stock price. The stable payment stream allows the business to have a smaller emergency cash reserve, which it can plow back.

Banks need to match their income streams with their liabilities. Banks make a lot of fixed-rate mortgages. Since these long-term loans aren’t paid back for years, the banks must take out short-term loans to pay for day-to-day expenses. These loans have floating rates. For this reason, the bank may swap its fixed-rate payments with a company's floating-rate payments. Since banks get the best interest rates, they may even find that the company's payments are higher than what the bank owes on its short-term debt. That's a win-win for the bank.

The payer may have a bond with higher interest payments and seek to lower payments that are closer to Libor. It expects rates to stay low so it is willing to take the additional risk that could arise in the future.

Similarly, the payer would pay more if it just took out a fixed-rate loan. In other words, the interest rate on the floating-rate loan plus the cost of the swap is still cheaper than the terms it could get on a fixed-rate loan.

Disadvantages

Hedge funds and other investors use interest rate swaps to speculate. They may increase risk in the markets because they use leverage accounts that only require a small down-payment.

They offset the risk of their contract by another derivative. That allows them to take on more risk because they don't worry about having enough money to pay off the derivative if the market goes against them.

If they win, they cash in. But if they lose, they can upset the overall market functioning by requiring a lot of trades at once.

EXAMPLE

ABC Company and XYZ Company enter into one-year interest rate swap with a nominal value of $1 million. ABC offers XYZ a fixed annual rate of 5% in exchange for a rate of LIBOR plus 1%, since both parties believe that LIBOR will be roughly 4%. At the end of the year, ABC will pay XYZ $50,000 (5% of $1 million). If the LIBOR rate is trading at 4.75%, XYZ then will have to pay ABC Company $57,500 (5.75% of $1 million, because of the agreement to pay LIBOR plus 1%).

Therefore, the value of the swap to ABC and XYZ is the difference between what they receive and spend. Since LIBOR ended up higher than both companies thought, ABC won out with a gain of $7,500, while XYZ realizes a loss of $7,500. Generally, only the net payment will be made. When XYZ pays $7,500 to ABC, both companies avoid the cost and complexities of each company paying the full $50,000 and $57,500.

CURRENCY SWAP

Currency swap is the exchange of interest or principal in one currency for the same in another currency. Currency swapping is where interest is paid on an equal principle in their respective currencies and their difference. It is otherwise known as cross currency swap.

Types of Currency Swap

The different types of currency swaps are as follows:

1. Fixed to fixed currency swap- It is the exchange of fixed interest rate on a credit in one currency for fixed interest rate on an equivalent credit in another currency.

2. Fixed to floating currency swap- It is the exchange of fixed interest rate on a credit in one currency for floating interest rate on an equivalent credit in another currency.

Advantages of Currency Swap

Some advantages of currency swaps are:

1. Companies can use currency swap to raise funds in one currency to save in other currencies.

2. Companies can change their loans from one currency to another currency.

3. Currency swap offers adaptability to corporate who want insurance against risk associated with one currency.

4. Reduce expenses and risk associated with exchange rate.

5. A company can enter into a money swap at any time during the life of a transaction.

6. Early termination of swap contracts is possible by agreement of both parties.

Disadvantages of Currency Swap

Certain disadvantages of currency swaps are:

1. Parties are prone to credit risk as one or either party could default on interest and principal payments.

2. There may be central government intervention in the exchange markets.

3. The process of setting up currency swap agreement might be expensive in terms of fees charged by intermediary.

Example of Currency Swap

An American company can borrow in dollar in United States at the rate of 5.25%. It wants to make an investment in India in rupee where the relevant borrowing rate is 14%. Similarly, an Indian company can borrow in India at the rate of 9.45%. It wants to finance a project in United States in dollars where direct borrowing rate is 11%. In this case, the American company can borrow U.S dollars for 5.25%, then it can lend the money to Indian company at same rate. Similarly, the Indian company can borrow rupee for 9.45% and lend it to American company at the same rate. Both the parties will benefit by the currency swap.

CREDIT SWAPS

A credit default swap (CDS) is a financial derivative or contract that allows an investor to "swap" or offset his or her credit risk with that of another investor. For example, if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults. Most CDS will require an ongoing premium payment to maintain the contract, which is like an insurance policy.

A credit default swap is the most common form of credit derivative and may involve municipal bonds, emerging market bonds, mortgage-backed securities or corporate bonds.

Example of a Credit Default Swap:

Credit default 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.

Advantages

The main benefit of credit default swaps is the risk protection they offer to buyers. In entering into a CDS, the buyer – who may be an investor or lender – is transferring risk to the seller. The advantage with this is that the buyer can invest in fixed-income securities that have a higher risk profile.

The seller of a CDS, on the other hand, can leverage swaps to collect the premium fee that applies during the maturity contract. Contracts can be short-term, lasting a period of months, or long-term, lasting a period of years.

In this scenario, the seller assumes that no negative credit event will require them to make a payment to the swap’s buyer. If a credit event occurs and the seller is required to issue a payout, they may be able to offset it through the fees they’ve collected in connection with other swaps. Sellers can diversify and insulate themselves against risk by offering multiple swap contracts to different buyers.

Disadvantages

There are some downsides to credit default swaps. For starters, the buyer could lose money assuming that no negative credit event occurs. Again, that’s like buying life insurance. If you have a term life policy, you could pay premiums for 20 or 30 years. And if you stay healthy, your beneficiaries will never see a death benefit.

The seller of the CDS is also taking on risk because they may have to make good on the payments to the buyer if a default or another credit event occurs. Again, sellers can sell multiple swaps to spread out this risk.

One of the main risks historically associated with credit default swaps is the lack of federal regulation. However, that was eliminated in 2010. The Dodd-Frank Act, which addresses many of the key issues that lead to the 2008 financial crisis, increased federal regulation for CDS trading. Specifically, the act introduced a regulatory agency to oversee swaps and prohibit swaps that are deemed too risky.