Swaps

Question 1

swap

Answer 1

a derivative security that enables a company to change its form of financing, two basic types

Question 2

interest rate swap

Answer 2

an interest rate swap enables a company to charge fixed and floating rate loans

Question 3

cross-currency or currency-swap

Answer 3

a currency swap enables a company to change a fixed rate loan between one currency and another

Question 4

interest swap process

Answer 4

• an OTC (over the counter) agreement which two parties agree to exchange periodic payments based on predetermined notional principal amount and two sets of interest rates
• principal amount is notional, never exchanged but used to calculate the payments
• interest swaps normally cover initial periods of 1 to 30 years
• “buyers” pay fixed rates and receive floating rates, “sellers” pay floating rates and receive fixed rates under interest rate swaps

Question 5

the market maker:

Answer 5

• dealers or swap banks act as market makers quote two way prices in interest rate swaps
• convention is for the market maker to set the floating rate at LIBOR and then set out the fixed rates that the bank will pay or accept against LIBOR
• thus swap quotes are fixed rates against LIBOR
• the swap bank will ask for a fee in a return for their market-making service

Question 6

use of interest rate swaps

Answer 6

interest rate swaps are the instrument for changing interest profiles between fixing and floating , they allow banks or companies to raise fixed rate debt and swap it into floating rate, and they also allow them to borrower on a floating rate basis then fix the interest payments if needs be

Question 7

FRA vs IRS

Answer 7

both contracts buyers benefit when LIBOR increases
FRA
- one single cash settlement
- maturity usually short
- more practical and solves short-term needs
IRS
- multiple cash settlements
- maturity is long often up to 30 years
- more strategic and helps firms structure cash flows

Question 8

Swaps Vs Interest rate Futures

Answer 8

Swaps
- tailor made
- only one single swap contract needed
- counterparty risk minimal if swap dealer part of major bank
- prices of OTC swap less transparent
Futures
- standardised
- many different contracts
- no counter part risk once clearing house confirms contract
- as traded on exchanges prices are transparent

Question 9

currency swaps

Answer 9

• cross currency or a currency swap enables a company to change a fixed rate loan between one currency and another
• currency can be floating for fixed, fixed for floating, floating for floating

Question 10

exchange of principal

Answer 10

• in an interest rate swap the principal is not exchanged
• in a currency swap the principal is usually exchanged at the beginning and the end of the swaps life

Question 11

typical use of a currency swap

Answer 11

• convert a liability in one currency to a liability in another currency
• convert an investment in one currency to an investment in another currency

Question 12

rationale for currency swap:

Answer 12

• currency helps reducing transaction costs
• the joint saving of the IBM-WB swap was the costs of issuing new bonds to retire old debts
• MNCs typically borrow in the low-cost denomination and then exchange that loan into their desired currency
• without currency swap MNCs need to hedge the future liabilities with forwards often illiquid
• currency swaps allow companies to exploit comparative advantages in borrowing in different currencies