Derivatives: Interest Rate Swaps & Currency Swaps

Swaps

Swaps are private agreement between two companies to exchange cash flow in the future according to prearranged formula. The first swaps contract were negotiated in 1981

We have two contract:

•         Interest rate swaps

•         Currency swaps

1.  Interest rate swaps

There is two companies. One have a comparative advantage in fixed rate market while other have comparative advantage in floating rate markets.

	Fixed rate	Floating rate
Company A	10 %	LIBOR + 0,3
Company B	11,2 %	LIBOR + 1

Differences:                1,2 %                            0,7 %

Company A more credible than B. Company B have comparative advantage in floating rate, while company A have comparative advantage in fixed rate

Two companies agree to make swaps arrangement:

Company B wants to borrow at fixed rate & company A wants to borrow at floating rate!

Interest Rate Swaps (No Intermediary)

Company A

-           Pay to outside                    = 10%

-           Pay to company B             = LIBOR

-           Receives from company B = 9,95

-           Total Payment                    = LIBOR + 0,05

-           If Borrow from outside (floating rate) = LIBOR + 0,3

-           There is saving from swaps = 0,25%

Company B

-           Pay to outside                    = LIBOR + 1

-           Pay to company A             = 9,95

-           Receives from company A = LIBOR

-           Total Payment                    = 10,95

-           If Borrow from outside (fixed rate) = 11,2

-           There is saving from swaps = 0,25%

Conclusion: Gain from IRS = a – b = 1,2 – 0,70 = 0,5

Where:   a = difference between interest rate in fixed rate

                  b = difference between interest rate in floating rate

Interest Rate Swaps (With Intermediary)

Conclusion: Gain from IRS = a – b = 1,2 – 0,70 = 0,5 will divided for three parties: Company A, B and Financial Institution

2. Currency swaps

There is two companies. One have a comparative advantage in USD while other have comparative advantage in another currency.

Differences:                      2 %                                     0,4 %

Company A more credible than B. Company B have comparative advantage in £, while company A have comparative advantage in USD

Two companies agree to make swaps arrangement:

Company B wants to borrow at USD & company A wants to borrow at £!

Gain from CS = a – b = 2 – 0,4 = 1,6

Where:   a = difference between interest rate in USD

                b = difference between interest rate in £

Currency Swaps (Risk in Financial Institution)

Currency Swaps (Risk in Firm A)

Currency Swaps (Risk in Firm B)

In general, it makes sense for the financial institution to bear the foreign exchange rate risk as it is in the best position to hedge it.